The financial crisis of 2007-08 had an immediate impact on the world's economies, with deep recession experienced across the globe. The longer-term impact on the banks will also be significant, as regulatory authorities learn lessons from the crash and implement new supervisory rules. Regulation arising as a result of the crash will indeed heavily influence bank business models, compared to what was practised in the past decade. In this article we discuss how banks will have to adjust their strategy and approach in response to new regulatory requirements.
Implementing higher standards
Regulators around the world, including the UK Financial Services Authority (FSA) as well as the Basel Committee on Banking Supervision (BCBS), have published myriad recommendations for the future of both macroprudential and microprudential bank regulation. Whatever the final form of the new regime is, it is clear that there will be significant impact on the bank business model.
In the first instance, the definition of bank capital will become narrower. Tier 1 capital will comprise only pure equity and retained reserves. Taken together with a requirement for higher capital ratios per se, banks will be holding a materially higher core capital balance in future. Ceteris paribus, this will impact bank return on equity, hence a lower target return would be logical.
Higher microprudential standards will naturally demand a different funding structure. There is no doubt that banks on both sides of the Atlantic forgot the key principles of liability management during the bull market of the previous decade. A key contributor to the crisis was high levels of leverage and excessive reliance on short-term wholesale market funding. This trust in volatile funding sources, at the expense of more stable retail deposits, left institutions at risk of an interbank freeze, as was observed in 2008 after the Lehman Brothers collapse.
The FSA's Policy Statement 09/16 will require most banks to make significant changes to their operating model as they move to a healthier funding structure. These include the following:
- a more diversified funding base, with lower concentration of capital;
- a longer average tenor of wholesale funds; and
- a 'liquid asset buffer' of high-quality sovereign securities.
Implementing these measures will add to the cost of doing business. Hence senior management and shareholders must be aware that return-on-capital targets will have to be adjusted downwards.
Both the FSA and the BCBS have emphasised the need for more effective macroprudential regulation.
The latter has recommended limits on the leverage ratio as well as the need to boost capital levels during boom times, so-called 'counter-cyclical' capital. The contingent convertible bond, which converts to equity on pre-specified triggers, will become a mandatory capital instrument for many banks.
Liquidity measurement
As noted, a big impact of the new regime will be felt in the field of basic asset-liability management. Ultimately, banks will be expected to adhere to a minimum standard for their funding liquidity model. This will require more stringent stress testing, together with a rigorous liquidity coverage ratio as well as, for the first time, a longer-term structural liquidity ratio. This 'net stable funding' (NSF) ratio measures longer-term, stable sources of capital employed by a bank relative to the assets funded. The standard requires a minimum amount of funding that is expected to be stable over a one-year time horizon. The NSF ratio is intended to promote more stable longer-term structural funding of banks' balance sheets.
There will also be a minimum set of common liquidity measurement metrics - banks that do not already report this common set will have to incorporate this standard into their liquidity reporting model.
The future
The widespread review of banking regulation, which followed the various government bailouts of the worlds' banks, will result in substantial changes to the Western banking asset liability management (ALM) model. As the foregoing makes clear, banks will be following a more conservative approach to ALM to fit in with the new regulatory regime. Although this will add to the cost base, it will also make the industry more robust and less exposed at the time of the next recession.
Moorad Choudhry is head of treasury at Europe Arab Bank in London and author of Bank Asset and Liability Management (John Wiley & Sons 2007)
