After every financial crisis, the regulators come up with a new rule. Now the rule book is so thick that banks are staggering under its weight. Small banks could find the struggle all too much and go to the wall, writes Parveen Bansal.
Conservative estimates put the cost to the world's 30,000 largest banks of complying with Basel II at $2250bn. That is one-and-a-half times more than Germany's GDP or 14 times the turnover of General Motors. It is also a lot larger than the $1.8bn of Tier One capital held by the banks listed in The Banker's latest Top 1000.
Rather than making this huge outlay to comply with ever more burdensome regulations, would it not be better - and safer - for the banks to hold this money as additional capital?
Add to the Basel II outlay the expense of keeping up with all the other regulations being imposed on banks - anti-money laundering, data protection, national and state regulations, European Union Directives, even rules on training - and a cost issue threatens the banks' existence. Could the rules designed to prevent banks collapsing actually make some of them unviable? These are the dilemmas confronting bankers as they struggle first to understand their obligations and second to deal with them in a cost-effective way. For small banks, the burden is particularly heavy.
"Every time there is a problem, a new rule is written and all banks must bear the cost of complying," says Michael Quicke, group chief executive of small UK private bank Leopold Joseph. He has long complained about the unfairness of the regulatory burden on UK banks. "For a small firm, the growing anti-money laundering requirements will present a significant IT solution cost," he says. William MacDougall, chief investment officer of London-based pension fund manager TRW Investment Management (TRWIM), says: "The City is grossly over-regulated. A competitive industry largely involving informed adults should not need so much regulation.
"Regulation has increased significantly in the past 10 to 15 years and has dramatically raised costs with little significant benefit to the public." The situation is no better in other major financial centres. In the US, each individual state has its own regulations, making things even more complex. Some large banks even have a banking examiner full time inside their offices to check up on them. "The cost of regulation in the US is intrusive and the new anti-money laundering laws will make it even more so," says Ray Soifer, chairman of Soifer Consulting in the US. "President Bush has just signed a new anti-money laundering law that will substantially expand the regulations for fighting money laundering and also raise costs."
Nowhere to hide
Bankers say regulation is coming at them from all directions. No sooner do they comply with one set of regulations than another hits them. Each new guideline is lengthier and more complex than the one it replaces. The number of compliance officers banks needs have doubled or trebled, adding to payroll costs. The amount of legal advice required to ensure banks have understood the rules correctly has also increased. The scope for creating an unlevel playing field is huge, as regulators and banks interpret international and national guidelines differently.
"While the Bank for International Settlements sets the rules [on capital requirements] generally, they tend to be rolled out differently in different countries," says Mr Quicke. "This presents an enormous regulatory cost difference in the various jurisdictions."
There are three types of regulatory costs faced by banks: the money they pay in fees to keep the regulatory authorities going; the capital costs associated with Basel II; and the actual costs, in IT systems and personnel, of complying with everything.
Regulator fees
Fees to regulators vary enormously between countries, and are generally more expensive where there are multiple regulators. Bankers prefer the model developed in the UK of having the Financial Services Authority (FSA) as a single overarching regulator to the US system where there are many more authorities.FSA fees are charged according to the size of a financial institution and the number of business areas in which it is active. So the more wide-ranging a business, the higher the fees. This can put off small firms wanting to diversify. In the US, banks pay the various regulators when they are examined, and costs will grow if the regulators decide to do several examinations. In a report for the London-based Centre for the Study of Financial Innovation (CSFI), David Lascelles wrote: "The FSA's budget is small by world standards. Its £160m budget is smaller than Canada's and less than one tenth that of the US regulatory machine."
Under the law that created it, the FSA is required to conduct a cost-benefit analysis of any regulation it introduces, taking account of both its own costs and those borne by the regulated firms. An FSA spokesperson says: "The FSA has tried to make the cost-benefit analysis as good as it can be in an imperfect world."
The FSA acquired its full powers as the UK's single financial regulator last month - a process known as N2. However, many in the City are sceptical about the outcome.
Ian Mullen, chief executive of the British Bankers' Association (BBA), says: "Cost of compliance is becoming a serious concern because banks are not convinced of the cost benefit analysis."
One compliance officer for a UK bank says: "The cost of regulation is significant and rising. Both the direct and opportunity costs of additional regulation are very high but whether the overall impact of the regulation is good or bad is debatable."
Mr MacDougall of TRWIM says: "The cost of regulation has increased to 10% of our total costs. If this is true across the City then consumers are paying 10% extra for services, as the costs are transferred.
"Regulation has increased protection very little, only the costs. The FSA is a self-generating albatross. The main effect of regulation has been to increase the number of jobs for regulators and compliance officers and, ultimately, to increase costs for consumers."
Mr MacDougall's main complaint is that failures lead to more regulations, rather than a serious appraisal of why the problems were not spotted earlier. "Previous failures occurred in firms already covered by regulation," he says. "The regulator failed to prevent them; more regulation is not the obvious answer.
"Take, for example, the [Robert] Maxwell case, which involved the theft of pension fund assets. Regulations introduced since then do little to make repetition more difficult. The main reason that such a scandal is less likely now is that professionals in the industry have learned appropriate lessons and are much more likely to spot such abuses. Lessons learnt and pre-existing controls - not regulation - are the main protection against a repetition. "While welcoming the fact that FSA has replaced nine regulators and 14 different rulebooks, bankers are still concerned about guidelines becoming more complex and difficult to follow. This results partly from a lengthy and expensive consultation process that the FSA conducted to ensure consistency.
Take, for example, the case of credit risk. Before the advent of the FSA, a definition of credit risk occupied only half a page of a handbook. The details of how it was to be followed were left for the practitioners to work out. By contrast, the new handbook includes eight pages of text and guidelines on credit risk.
The problem with such an assortment of guidelines is that supervisors will use it as a checklist to examine a bank's compliance. As guidance is taken as best practice, companies are compelled to follow all the guidelines, necessary or not, or risk being accused of not following best practice.
The FSA has created Arrow - guidance on resource distribution, which states that the amount of regulation will be proportional to the risk and impact (of failure) of an institution. Larger banks' failures would have a greater impact than smaller banks and so are higher risk.
But the FSA is only one of challenges bankers face. As Mr Quicke of Leopold Joseph says: "FSA requirements are only a piece of the jigsaw and not the only one resulting in increased costs."
Basel II's three pillars
Many bankers believe Basel II has made financial regulation overly complicated, and maybe even unworkable, compared with the old system, which was crude but reasonably effective.
The structure of the new Basel Accord is based on three pillars: the first focuses on minimum capital requirements and how this is calculated, taking into account various risk factors; the second pillar deals with supervisory review of a bank's own capital allocation and creates a framework within which banks can be required to hold capital in excess of the minimum. The third pillar details new disclosure requirements intended to create the market discipline that will support system stability.
In the UK the capital requirements have been based on risk assessments (with 8% as the minimum risk asset ratio). However, other countries such as Germany and France have used 8% as the set requirement. So the UK's requirements are more expensive.
There is also the cost of compliance, which is the chief controversy. Mr Mullen of the BBA has declared that gearing up for Basel II could exceed spending on year 2000 compliance. "Some estimates suggest that industry implementation costs of the New Basel Accord will exceed the spend on Y2K compliance," he wrote in a recent magazine article. "The costs for supervisors will vary relative to their current practice, ranging from retooling, to rebuilding national supervisory practice. In combination, no exact figures can be calculated. However, it is certain that globally, from start to finish, thousands of man years and millions of dollars will be spent in developing and implementing the new Basel Capital Accord."
The cost outlay in many cases is not going to be spent on bringing banks' internal risk systems up to an improved standard. More often, the expenditure is to bring internal risk systems in line with the regulatory model.
Accord accounts for increase
A spokesperson for a large UK bank says: "The cost of regulation is growing all the time. The obvious costs include the cost of supporting the compliance function, legal aid to understand the requirements, third-party advisers, having to advance and change the IT systems especially for the Basel II Accord." Leopold Joseph identifies compliance as one of the contributors to a 16% increase in costs this year. The Accord's requirement to take into account operational risk as well as credit and other risks in determining the capital requirement means that many firms will have to invest in systems capable of calculating wide-ranging operational risks.
But it does not stop there. Regulation is extending into every part of commercial life, and the banks are under pressure to respond to regulations on e-commerce, management responsibilities and training. Some of this is driven by the EU. The sheer weight of regulation means banks cannot cope with the burden. One law firm claims banks are responding by ignoring Directives on electronic commerce or distance selling of consumer financial services. Gillian Bull, an e-commerce lawyer at Barlow, Lyde & Gilbert says: "Simultaneously with the implementation of the Financial Services and Markets Act 2000, as a member state of the EU, the UK is required to implement in its national law numerous EU Directives affecting e-commerce, which continue to emerge from the legislative process in Brussels.
"In particular, the Directives on electronic commerce and on distance marketing of consumer financial services are due for implementation in January and July 2002. Many websites I have examined do not show that their operators are aware of this."
Non-compliance with such Acts as the 1998 Data Protection Act in the UK could lead to criminal convictions and personal liability for company directors. Other changes that firms need to be preparing for include changes in the conduct of business, prudential requirements, training and competence, as well as the new market abuse regime against insider trading.
Cost effectiveness
The BBA's Mr Mullen says: "There has been a tendency by the government to rush toward statutory regulation. There is much concern over the cost and potential ineffectiveness of statutory regulations as applied to conduct of business." Old-style self-regulation in banking products is an important part of the current regulatory framework. The report of the Banking Services Consumer Code Review Group, chaired by De Anne Julius, a former member of the Bank of England's Monetary Policy Committee, endorsed self-regulation as highly efficient and cost-effective. The report was commissioned by the UK government to recommend how the conduct of business for banking should be regulated. The fear is that the report will be ignored in favour of statutory controls. Mr Mullen says: "Regulation of the conduct of business is about to become a major issue in Europe, unless it is managed in a cost-effective manner." Other points of contention raised by the new regulatory regime of the FSA include senior management responsibilities and "approved persons" provisions. This has important implications for all firms when deciding how they organise themselves and manage risk, including regulatory risk, within the business. With this, the FSA hopes to avoid the scenario of responsibility falling between two areas, as happened at Barings. Firms will need to be able to demonstrate that their supervisory and internal control processes are sufficiently robust and transparent to meet the new standards.
Other FSA requirements are training and competence. A London spokesperson for a large German bank says: "One cannot argue against the principle of the need for individuals to have the correct training. But there is a major cost associated with this. This regime is one of the most demanding and requires the greatest effort in the City."
But the CSFI's Mr Lascelles wrote recently that regulation in the UK was not the sole driver behind compliance costs: higher consumer expectations on disclosure and remediation also play a part.
Bankers must accept that the world has changed and they must change with it. The speed and scale of the changes, however, imply huge organisational challenges that no-one outside the banks seems to comprehend. By the time they have understood, some smaller banks may have collapsed under the weight of regulation.