Banks face a continued onslaught of regulation in 2015 as politicians fine-tune forthcoming legislation to toughen up the banking system.

Banks must keep abreast of regulatory change and make tough decisions in order to satisfy regulators’ demands and maintain business as usual. The year 2014 was a year characterised by billion-dollar bank fines, endless consultations and tough talk from politicians, but 2015 looks set to be the year that banks gain clarity on new banking rules and can start to implement change.

The UK’s Financial Conduct Authority is set to introduce the new Senior Managers and Certified Persons Regime in 2015, to replace the existing Approved Persons Regime, which will impose greater responsibility and accountability on individuals.

The new legislation is a game-changer for investment banks, say experts, because it removes the presumption of innocence and will force banks to think more carefully about how they take risk.

Guilty until proven innocent

Under the new proposals, a senior person can be found guilty of misconduct if a contravention occurs in an area for which they are responsible, unless they can show that they took reasonable steps to avoid the contravention. The burden of proof is on the senior person to show their innocence, even if they were not ‘knowingly concerned’.

Will Dennis, managing director of compliance at trade body the Association for Financial Markets in Europe (AFME), says that there remains an element of ambiguity as to senior managers’ responsibility and also around who is subject to the rules of conduct – senior managers or certified persons. The issue facing banks is the huge amount of training for persons who will be subject to the new rules of conduct, according to Mr Dennis.

“If it’s a wide set of people then obviously a lot of training has to be done. It is not clear yet for banks, but to put in place all these changes in a matter of months is quite a big regulatory ask and requires changes to employment contracts and systems,” he says, adding “I think it will make banks’ decision making more risk averse because individuals [must] think carefully about the decisions they make.”

The new regime is estimated to come into effect in the latter half of 2015, most likely the fourth quarter. Meanwhile, the UK Treasury opened a consultation in November 2014 to extend the new rules to senior managers at UK subsidiaries of foreign banks as well.

The fine mess

Six banks were fined a total of $4.2bn in November for colluding to manipulate foreign exchange benchmarks, and the banks are now keen to put the scandal behind them. But the trend of bank fines is increasing, says Pierre Pourquery, partner in financial services at EY.

Regulators have made it explicitly clear in their rhetoric that they are keen to punish previous bad behaviour and stamp out nefarious practices. A challenge for banks in 2015 is demonstrating to regulators that potential conflicts of interest on the trading floor are properly managed, without putting themselves in jeopardy.

“One problem is that when banks are coming up with a new framework of controls to deal with conflicts of interest on trading floors, they identify issues that can expose them to a future legal suit,” says Mr Pourquery.

Identifying potential conflicts of interest on the trading floor is a tricky issue for banks. For example, a foreign exchange trader may appear to be conflicted when pre-hedging ahead of a client transaction. How can a trader demonstrate that pre-hedging by the bank is always in the best interests of the client?

“We are discussing this with many banks, which are wondering now what to do and how to implement new controls. One solution is to put a limit on the hedge, but I am not sure this is the answer and there is no best practice guidance,” says Mr Pourquery.

Conflicts of interest

It is also paramount for banks to identify potential conflicts of interest between different desks, and to prove to regulators that they understand and manage this risk.

An options salesperson might sell a digital option to a client, for which the payout is contingent upon the price of an underlying bond. Arguably, a bond trader at the same bank could be persuaded to intervene in the market and move the price of the bond when the option is set to expire, in favour of the bank.

Mr Pourquery says: “One suggestion is to forbid trading at the point of expiry, but banks can’t stop making markets. Therefore, some clients are not necessarily profitable anymore because of the risk, and the cost and complexity attached to new controls.”

Banks have until January 30, 2015, to respond to the UK Financial Conduct Authority’s latest consultation on reinforcing confidence in the fairness and effectiveness of the fixed-income, currency and commodities markets.

The rising cost of capital

Banks are also under pressure to put aside more capital to prevent another global financial crisis. In November 2014, the Financial Stability Board (FSB) proposed that banks hold total loss-absorbing capacity (TLAC) equivalent to 16% to 20% of their risk-weighted assets or twice the Basel simple leverage ratio (6% of unweighted assets).

David Clark, a former banker at firms including HSBC and Bankers Trust, and now chairman of the Wholesale Markets Brokers’ Association, believes that banks putting aside more money for capital is “very significant indeed”, and begs an awful lot of questions.

“The two things that jump out at you are where the money is going to come from, and how much will it cost. Cost of capital will go up, it is already more than 10% for some banks,” says Mr Clark.

The introduction of functional living wills for banks is taking an extremely long time to roll out, so the obvious solution is for regulators to ask banks to put up more capital, says Mr Clark. The FSB will finalise banks’ TLAC in time for the G20 Leaders’ Summit in Turkey in 2015.

The key challenge for banks is to issue enough subordinated debt to meet regulators’ demands, according to Gilbey Strub, managing director in resolution and crisis management at AFME.

“One of the concerns of banks is whether there is enough capacity in the market to absorb new issuance in the timeframe, and whether investor mandates will permit investing in subordinated debt. It’s changing the whole market,” he says.

BCBS 239

The 14 principles of the Basel Committee on Banking Supervision (BCBS) paper 239 introduce a global framework for risk data aggregation and reporting, which banks have to comply with by January 2016. A study published in December 2013 found that one-third of global systemically important banks would not be ready to comply by the deadline.

The problem facing a number of banks is their ability to collect data, according to Bradley Ziff, chief risk advisor for technology firm Misys. “Banks use multiple pieces of software that they buy, and occasionally build, and then replace. It’s a case of 'rip and replace' versus work with what you’ve got. Banks need the ability to collect clean data, which is a challenge for a lot of these institutions,” he says. “The next big step is going to be setting up proper limit structures which many institutions do not have yet, in terms of assets and risk limits.”

But the biggest challenge for banks, from a data aggregation perspective, is the computation of stress-testing, says EY’s Mr Pourquery. The bigger a bank, the more complex its systems and data. Stress testing requires strong processes and IT to gather all the necessary data at a granular level.

For the stress tests expected in 2015, especially the US Comprehensive Capital Analysis and Review, it will be the impact of interest rates on macroeconomic variables that are taken into account when stress testing, predicts Mr Clark.

New responsibilities

Ultimately, banks must fortify their three lines of defence, according to many industry experts. The first line relates to the front office, where managers on trading desks and credit teams monitor risks the bank is taking. The second line comprises more senior risk managers who report to the board. The third line refers to internal and external auditors that oversee a bank’s operations.

The key for banks is utilising data and technology to better manage risk. For example, monitoring traders’ conversations to find key words that point to erroneous activity can be like looking for a needle in a haystack. But technology that can perform a semantic search, instead of just searching for key words, can prove to be more fruitful.

In addition, banks need to increase the second line of the three lines of defence by 10% to 15%, according to Mr Pourquery. Regulators say the risk should be owned by the front office, which in effect has created another line of defence focused on control.

“Now we have more lines and more people, as well as IT, infrastructure and data infrastructure. In addition, banks have large cost-cutting programmes of about $1bn to $2bn per bank. The inter-effect of these two [scenarios] will most likely drive banks towards a new model in terms of how they operate,” says Mr Pourquery.

A new role of chief control officer is emerging, but banks must ensure that there is accountability across all three lines of defence. “It is a problem when there is no clear accountability because everyone has a little responsibility,” says Mr Pourquery.


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