Participants in The Banker's round table of regulation specialists at leading cross-border banking groups identify the key challenges they are facing and the impact these will have on business models.
Q: Which piece of new or recent regulation do you expect to have the most profound impact on the banking sector in the coming year, and why?
Santiago Fernandez de Lis, chief economist of financial systems and regulation at BBVA: The introduction of the new ratio for Total Loss Absorption Capacity [TLAC] – as well as its European equivalent, Minimum Required Eligible Liabilities – is probably the most important forthcoming change in international financial regulation. With the objective of eliminating implicit taxpayer support, TLAC will affect in a fundamental way the funding structure of banks and how they interact with investors. It will introduce loss-absorbing features in subordinated and senior debt, the amount of which will be regulated and monitored by the authorities. Market discipline will play a key role, rewarding banks with a more resilient business model.
It is important in this regard that the TLAC proposal is neutral for the different business models of international banks. In particular, it should not penalise the decentralised retail subsidiaries model with a multiple point of entry resolution strategy in emerging market economies, where there is limited capacity to place senior or subordinated debt in local markets.
Alan Houman, head of government affairs for Europe, Middle East and Africa at Citi: Since the [post-]crisis repair work started more than five years ago the global banks have been partnering with global, regional and national regulators to improve the safety, soundness and transparency of the system. It has been a tough but necessary journey. Recovery and resolution planning, more and better capital and liquidity, and deep reforms to the derivatives markets will all have specific and interrelated impacts on the sector. But it is likely that the greatly increased amount of capital that banks must have for the business they do will have the deepest impact.
This goes to the heart of how banks deliver their key product: credit. As we return to normal monetary and growth conditions, without quantitative easing and with more normal interest rates, the capital reforms will change how banks are perceived by their customers, the general public, media and politicians. The new rules will shape how much credit there is (less), to whom it is extended (fewer), and at what price (higher).
Oliver Knight, head of regulatory response at Lloyds Bank commercial banking: Given the volume of regulation that the industry continues to deal with, it is difficult to identify a single piece that will have a greater impact than the rest. However, we are entering a phase where we are starting to see a clearer picture of the new regulatory landscape.
One of the most profound changes is how banks dynamically manage balance sheets across the new capital, leverage and liquidity frameworks. Understanding how to optimise allocation of these reduced resources is a significant intellectual and operational challenge that is re-setting the terms of operation. Maintaining consistent approaches to monitoring and pricing for these resources will be a significant challenge in the coming year and for many more to come.
Alongside this is ring-fencing. It is something that will happen and the industry will need to prepare for accordingly. The principle behind it is right; sustainable retail and commercial banking is key to the economic success of this country and we should do all we can to make sure they are protected.
Eric Litvack, head of global regulatory strategy for Société Générale corporate and investment bank: It is difficult to pick just one, not just because there are a great many which will have far-reaching implications on the provision of financial services, but also because many of these regulations intersect poorly either across regulatory themes or across borders.
At a global level, for sheer breadth and depth of impact, the Basel-driven capital and liquidity reforms will have had the most profound impact on the way the banking sector finances the economy. Liquidity and capital are the basic fuel of banking activities; by driving up the quantity and quality of reserves held, these measures directly affect the return on equity and drive capital allocations. When banks announce changes to their business model and mix, you can generally trace it back to this.
At the European level, the move to banking union will be transformative for the eurozone sector.
Aurelio Maccario, head of group regulatory affairs at UniCredit: The sheer number of significant regulatory changes and the sum of the impacts of the same are deeply changing the banking sector. The major changes that come to mind are: TLAC; new floors on risk-weighted assets based on new standardised approaches; Basel rules on interest rate risk on the banking book; the European Bank Recovery and Resolution Directive; and bank structural reform [BSR].
The most profound impact on the banking sector in my view could come from TLAC and BSR. The former will sizably increase the total capital requirement of systemic banks and will dramatically change banks’ funding strategy with an impact on capital markets' absorption capacity. BSR would mean a change of business model for a significant number of major banking groups. Many banks would require fundamental modifications to their organisational structure, including operations and IT, their funding structure could be impacted, and significant one-off and increased recurrent costs would be incurred. A number of banking groups could decide as a consequence to wind-down their investment banking business, creating a more concentrated industry.
Daniel Trinder, global head of regulatory policy at Deutsche Bank: The key regulatory development impacting the banking sector is the increasing shift to standardised approaches and the leverage ratio, especially for banks headquartered outside of the US. Although these are still under development, the expected impact on the banking sector is significant, so banks have already started changing their balance sheet. The potential impact is multiple: as these tools become the primary focus of regulators, low-risk assets become less appealing as they attract capital requirements that do not necessarily reflect their riskiness.
Conversely, higher risk assets become relatively cheaper and more appealing to hold. This encourages banks to hold a riskier asset mix on the balance sheet. Low-yielding, high-balance-sheet intensity assets become less appealing and we have already seen drops in banks’ repo and cash management businesses, for example.
Q: What business lines or products do you see as most affected by new regulation?
SFL: In general, wholesale banking will be more affected than retail banking, due to the impact of a series of regulations such as BSR and TLAC, as well as ring-fencing trends. Global banks with a centralised wholesale structure based on significant intragroup positions are less adapted to a ring-fenced world than retail banks operating with a decentralised model. The latter are more resilient to global shocks, as has been recognised by several official sector reports, the most recent by the International Monetary Fund Global Financial Stability Report in April 2015.
Some lines of business have been negatively affected by reform, such as trade finance, small business lending, securitisations or correspondent banking networks. In some cases this is related to an excessive perception of risks or high compliance costs that have resulted in a de-risking by banks or restricting the exposure of their balance sheet to specific businesses, products, regions or countries. Despite recent discussions to improve the treatment of some of these business lines, such as simple and transparent securitisations, they remain penalised by the new regulation, and the new proposal for the standardised approach floors under discussion in the Basel Committee does not help in this regard.
AH: Basel’s regulatory capital reforms will inevitably lead to less credit flowing via the banking system to finance the wider economy, with smaller enterprises and individuals (with lower credit scores) hardest hit. The European Commission’s capital markets union initiative shows that policy-makers have recognised this. We are exploring how to deepen Europe’s capital markets and increase the flow of non-bank finance to larger and medium-sized companies. This should help free up banks’ balance sheets and enable more direct lending to smaller enterprises. Intermediaries such as Citi, investors and entrepreneurs across Europe need to play their part in meeting that challenge. It would be a huge shift in approach for Europe’s companies, but one that, if successful, should lessen reliance on traditional bank lending and help link savers to investors to generate economic growth.
OK: The structural change in the derivatives markets is one of note. With banks reducing exposure due to increased costs of holding inventory, coupled with increased trading transparency and central clearing, market liquidity is no longer reliable. Not only has this reduced significant business lines of the past, but we are now adjusting to a new marketplace of less plentiful and less dependable liquidity than was available before.
EL: Market-based activities have been the most impacted, notably by the introduction of the leverage ratio which acts as a sharp constraint on low-risk activities with significant balance-sheet consumption. This has driven significant reductions in bond dealer inventories and bilateral repo activity, and raises very serious questions for the economic model of derivatives clearing. Securitisation has also been hit very hard post-reform, notably in Europe which is ironic because European securitisation generally fared rather better through the crisis.
But many of the impacts are still to come. We are still only partway through the implementation of over-the-counter derivatives reform, and the impacts of the Markets in Financial Instruments Directive, TLAC, and the Basel fundamental review of the trading book are still ahead of us and require very careful calibration. Likewise, while the drive for greater simplicity and comparability of regulatory frameworks of such reforms is welcome, they should not translate into dropping internal models altogether, as current frameworks adequately capture the diversity of risk management models across the European banking industry.
AM: Apart from the investment banking business that is impacted by the above mentioned TLAC and BSR, many regulatory changes are related to and increase risk-weighted assets [RWAs]. Consequently, capital consumption in general, and business lines that are high RWA-users, are natural candidates to be affected.
DT: High-balance-sheet, low-yielding business (generally the safest business) – such as mortgages, repo, cash management, etc – will be the most impacted as banks are forced to make economic decisions increasingly on a return-on-asset basis rather than on an RWA basis. Rules such as the Net Stable Funding Ratio and Leverage Ratio have been calibrated such that risk mitigation around derivatives netting and linked equities transactions are not fully recognised, therefore these types of products are also becoming more challenging for banks.
Q: What do you see as the most significant risk facing the banking sector in the coming year, and why?
SFL: One obvious risk is the development of shadow banking alternatives to traditional banking, as a result of the regulatory pressure on the latter. At the same time, new technologies are offering huge opportunities for better experiences to banks’ clients, but sometimes these are offered by new digital players that have the advantage of enjoying a much lighter regulation. The regulator should aim at allowing efficiency gains and better customer satisfaction while at the same time ensuring a level playing field and avoiding the concentration of systemic risk in the more opaque segments.
The risk of excess conservatism on the part of banks is also worrying. Banking is about taking risks, but with a reasonable control. Recent regulation may create incentives for inaction due to high regulatory uncertainty.
And finally there is a risk of excess nationalism of financial regulation, as a result of the contagion seen in the crisis and the mistrust between home and host authorities. The more developed countries with the biggest financial centres are giving a bad example in this regard, whereas emerging markets are following policies more consistent with the benefits of financial globalisation. We need to correct the excesses of financial globalisation, but without putting at risk the benefits of free capital flows.
AH: Hasty and unnecessary bank structural reform is perhaps one of the most significant risks facing the banking industry and the real economy clients it serves. Given all the efforts to make banks safer, potentially breaking up banks so that they can no longer serve clients effectively is not going to enhance financial stability. We must not let the volume of regulation that is being implemented – or still being suggested – stifle basic banking around the world.
Added to this, regulatory incoherence (different rules addressing the same problems in different jurisdictions) and poor international co-operation are big challenges that could get worse. Regulators need to co-operate, not compete, to avoid making rules that overlap badly with each other. That said, there are other big risks out there, especially cyber security; timely cross-sector information sharing through public-private partnership is key to cyber security protection.
OK: There is a lot of uncertainty that could impact the banking sector. Globally, banking remains very exposed to any significant geopolitical shock such as Greece. In addition, the level of debt on central government balance sheets, coupled with unreliable market liquidity, means that any significant economic or political crisis will reverberate throughout the banking sector.
EL: The banking sector faces a huge transformative challenge: banks need to deliver acceptable profitability that is above the cost of capital. Additional capital buffers, but also the extraordinary environment created by massive liquidity injections from central banks, with interest rates at historically low levels, are acting as drags on the profitability of banks, and likely even more so if rates remain low for a protracted period of time. At the same time, the pace of technological revolution in financial services, while offering a lot of opportunities for banks, will also unbundle services and drive down margins. That is why having the right business model – focused on an individual bank’s core strengths and businesses where they have scale – able to grow organically and generate synergies is more important than ever in the new environment.
AM: The multitude of regulatory changes calls for sound coordination and calibration. We see that different regulations sometimes produce opposite incentives. The floors and standardised approaches to capital charges are not risk based/sensitive. The possible introduction of concentration caps on banks’ exposure to a particular sovereign could contradict high-quality liquid assets requirements in the liquidity coverage ratio. The stable funding imperatives of the liquidity coverage and net stable funding ratios, which emphasise the stable value of retail deposits as a funding source, contradict the Financial Stability Board’s TLAC proposals that require banks to issue subordinated debt instruments, even in the case of banks that are fully funded with stable deposits.
DT: There is a real risk that we move to a system where regulators favour risk-insensitive tools and end up undoing all the good work of progressing from Basel I to Basel II and III. Not only will this result in the shift to riskier assets, but using these blunt tools it is not possible for regulators, supervisors and investors to really understand the actual risks on the balance sheet.
Q: How far can the risk, regulatory reporting and finance functions of a bank be aligned in your view?
SFL: Risk, regulatory reporting and finance are different functions that need to be carried out with a high degree of consistency. Adequate risks control is essential for any banking organisation, and it needs to be developed with sufficient independence, which should be acknowledged in the corporate governance of the institution. Regulatory reporting is increasingly burdensome, and requires a very tight link with supervisors and a good communication in both directions. Finally, the finance function must be clearly interconnected with the risk management function and regulatory reporting to ensure a proper management of capital and liquidity.
AH: These functions should be thoroughly aligned to meet a bank’s overall business objectives. But they are different functions and involve different professional skills. And they each provide a perspective that needs to be clear and not conflated into a single view. It is for the senior management and the board to take these inputs and see the risks in the round, not to have it all synthesised before they receive it.
OK: Alignment between the risk, finance and regulatory reporting functions has become essential. These functions are inextricably linked and certain activities such as the conduct of stress tests cannot take place without efficient co-operation. The level of integration, particularly of data, is going to become an increasing competitive differentiator for the efficient allocation of scarce resources and management of risks.
These functions share a number of similar processes and rely on similar data sources that will help navigate risks. The challenge for a bank is to overcome the inevitable cultural differences and operational challenges that exist in any large organisation to ensure these functions understand and work with each other.
EL: These functions serve different, though necessarily related purposes. It is not desirable to align functions that serve different purposes and aim at various audiences. Indeed alignment cannot be a goal – only a means to improve consistency. I suspect it would entail complexity and would be potentially counterproductive to seek a full alignment. It is more important in my mind to have efficient functions and to ensure overall consistency.
AM: I believe banks should align these as much as possible. There has to be an overall strategic direction, and in service of that you have functions, with their own deliverables, but whose activity is aligned. Banks have found different ways to spur this alignment: through points of coordination in the form of committees at various levels in the organisation; through coherent and comprehensive risk appetite frameworks; or even through dedicated organisational structures, autonomous from both the risk management and finance functions, with the sole aim to align these functions on strategic options, including those related to regulatory changes.
DT: They can and must be fully aligned through clear roles and responsibilities with clear senior management oversight. This is essential to ensure that internal decision making is based on full and accurate information. Only through having these functions aligned can we make sure that supervisors and regulators have a full view of the bank – this is key to the proper functioning of and trust in internal models.
Q: What has been the most significant effect so far of the single supervisory mechanism for the way eurozone banks are supervised?
SFL: The unification of supervision in the eurozone is a learning process for both supervisors and banks of which we have only seen the beginning. For supervisors, the identification of best practices is a must as well as an enriching process from which both the European Central Bank [ECB] and national authorities are benefiting. For banks, understanding new supervisory practices and explaining their business model to a new supervisor requires a rationalisation effort that may unveil some gaps and lead to improvements in business models. On top of this mutual learning process, the 2014 comprehensive assessment was an initial exercise that helped identifying strengths, weaknesses and areas where harmonisation is necessary, and that dispelled doubts on the situation of European banks. The majority of the supervisory effort in 2015 levered on that experience. To sum up, the process has just begun, but the results are already very encouraging.
EL: Danièle Nouy, the head of the single banking supervisor, warned banks that the new supervision would be both tough and intrusive: that has certainly turned out to be true! It is very demanding supervision, with a tremendous amount of data reporting to be done by banks. Despite some teething problems, it is a very open and constructive dialogue with the supervisor, which brings European banks in line with the highest international standards in terms of supervision. The comprehensive assessment and stress test were a critical step in bolstering the credibility of eurozone bank supervision. It will take time for the structural consequences to become fully visible, but with 85% of the euro area’s total banking assets now under robust and unambiguous central authority, the basis for trust in the system has been soundly laid.
AM: So far we have seen an understandable increase in data requests and reporting, and a different approach to on-site visits and interaction with top management, implying an intensification of engagement and pressure on the banks. Moreover, the ECB will conduct a business model analysis of the banks under its supervision, and engage the top management of banks in this process, by discussing their strategies and the sustainability of their businesses. In my view, after the comprehensive assessment, it was clear that the ECB had the natural need to achieve a sound knowledge of its newly supervised groups in the shortest possible time.
At the same time, we are starting to see the first fruits of efforts to come to a more harmonised supervisory approach in the spirit of the banking union. In a cross-border banking group, the single supervisory mechanism can better promote consistent supervision, especially in the eurozone, where previously differing home-host incentives and priorities can now be aligned and managed by a single consistent approach under a truly European view.
