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Evolving Banking Regulation

By Lukas Annen, Manager Audit Financial Services, KPMG.

The Evolving banking regulation report has been developed and published by KPMG’s network of regulatory experts in December 2011 and insights were based on discussions with our firm’s clients, our professionals’ assessment of key regulatory developments and through our links with policy bodies. The purpose of this article is to provide a summary of the key messages highlighted in the evolving banking regulation report and hereby focusing on the global regulatory developments. The full report entails much more information on specific regional perspectives which will not be covered by this article in detail.

The report focused on two main areas – the implementation of various reforms across regions and countries, and the “second wave” of regulatory reform, which at the global level has concentrated primarily on systemic risk and on systemically important banks (SIBs). These banks will be subject to a range of measures to make them both safer and easier to wind-down in a crisis – capital surcharges, holding bail-in debt and recovery and resolution planning.

Major implications of Regulatory Reform
There are many issues stemming from the contagious debt crisis and the avalanche of regulatory reform but two implications, in particular, are most critical:

1. Structural Reform and New Business Models
Banks face a pressing need to reassess the viability of their current strategies and business models in response to an immense number of regulatory pressures. Some of the regulatory and related reform initiatives – capital, liquidity, recovery plans, bail-in debt, consumer protection, reporting, taxes and levies – will have an unprecedented impact on the costs of banking activities. Overall, these costs will be huge and will force many banks to scale back some of their activities while seeking opportunities to maintain or expand other activities through aggressive cost-reduction, deleveraging and restructuring.

As a result, banks are already implementing or considering various changes to their strategies and business models, including:
- Becoming smaller and safer, with lower but less volatile profits
- Defining a narrower set of core activities, becoming more specialized, and exiting from non-core activities
- Moving away from universal and full service banking
- Adopting a “utilities” model of focusing narrowly on the traditional core banking activities of deposit taking, retail and corporate lending, and payment system services
- Increasing market share in chosen core activities, through consolidation, mergers and acquisitions, to boost margins from economies of scale and market power
- Retrenchment from international and cross-border activities
- Geographic focus on a small number of high growth markets

As part of the requirement to enhance capital, some banks will consider the use of “bail in” debt. Bail-in debt automatically converts to common equity when a bank’s capital levels dip below a prescribed amount or when a bank becomes “non-viable”.

2. The Cost of Reform and its Impact on Growth
Historic bank returns RoE have dropped dramatically not inspiring investors. Coupled with downgrades for some of the largest banks and the pressure to cover the cost of capital it is appropriate to consider whether we are at the point at which the costs of reform exceed the benefits and are contributing to unnecessarily slow economic growth.

In October 2011 the Financial Stability Board (“FSB”) and the Basel Committee on Banking Supervision (“BCBS”) published their latest estimates of the impact, extending this to cover the BCBS proposals on a capital surcharge for Global Systemically Important Banks (“G-SIBs”). The key element of their approach is that for a one percentage point increase in banks’ capital ratios, lending spreads increase by 16 basis points and real GDP falls over eight years to 0.17% below its baseline level before rising back to baseline. At the end of 2009 banks’ average core tier one ratios were 5.7%, compared with the Basel 3 minimum of 7%. Therefore, the cost of moving up to 7% over the Basel 3 transition period would be a 0.23% fall in real GDP (1.3x0.17%). Any estimates have to take a view on what will happen to the cost of banks’ capital and long-term funding (extent to which higher costs of capital and funding are passed on to borrowers through higher lending spreads).

Key Policies Driving Reform
There are a number of key drivers, common across the three regions that will influence the strategy, business models, size, shape, structure and cost to banks over the next few years:

1. Systemic Risk, Recovery and Resolution Planning

Systemic Risk
Although dominated by the Eurozone problems, the G20 summit in October 2011 demonstrated the determination of the authorities to press ahead with a second wave of major regulatory reforms, building on the tougher capital and liquidity standards already agreed in the Basel 3 package (first wave). The G20 agreed on a package of measures for Global Systemically Important Financial Institutions (G-SIFIs), including capital surcharges on global systemically important banks (G-SIBs); a requirement for G-SIFIs to have credible recovery plans and for the authorities to be able to develop effective resolution plans for these institutions; and more effective supervision of SIFIs. G-SIBS will be required to hold a capital surcharge of between 1 and 2.5 percentage points on their core tier one capital ratios, with an additional one percentage point surcharge held in reserve in case a global bank becomes even more systemically important.

Recovery and Resolution Planning
The FSB’s principles for recovery and resolution planning aim to introduce a common set of powers and tools that all national authorities should put in place to enable the smooth resolution of a SIFI without costs to the taxpayer including the power to “bail in” debt as part of a resolution. In addition SIFIs should be required to construct credible recovery plans that would enable them to recover from a range of severe stresses, and to provide information to the authorities from whom the authorities could construct an effective resolution plan. Although very uneven at present, these principles are beginning to be implemented. At the EU level they are expected to underpin a new Crisis Management Directive that will apply to all credit institutions, not just SIBs. In the US, the authorities have finalized rules on the information that large banks will have to provide on resolution planning. RRPs and Crisis Management proposals help drive the need for structural change, and although the UK is leading the way, there appears to be convergence of the global regulatory agendas in this area.
Banks will face high costs in making changes to their business activities and to their legal entities and operational structures in order to satisfy the authorities that a credible resolution plan can be constructed.

These include:
- Developing and implementing contingency plans
- Reporting recovery plans and resolution packs to the authorities
- Creating a comprehensive, regularly updated and ring-fenced management information system to support resolution planning
- Limiting intra-group exposures
- Establishing service level agreements that are legally enforceable in crises and in resolution

The implications for SIBs are significant. For many banks, this second wave of regulatory reforms will represent a tipping point. They will need to seriously consider the impact of these proposals on their strategies and business models. Significant changes may be required to preserve business value.

2. Capital and Funding Strategy
The tougher Basel 3 capital and liquidity standards are being rolled out globally, albeit not in an entirely consistent manner. In the EU, the Basel 3 text has largely been copied into the latest Capital Requirements Directive (CRD4). The intention is to implement CRD4 across the EU in the form of a maximum harmonizing regulation. More immediately, a number of European countries and the European Banking Authority (“EBA”) have imposed tough stress tests based on higher capital rations than in Basel 3 – the latest EBA stress tests requires major EU banks to meet a 9% core tier one capital ratio by June 2012.

In the US, the regulators have announced an intention to follow the Basel 3 principles. US regulators have been applying a series of stress tests since 2009 focusing on the quality and quantity of capital and have pushed many banks to raise significant amounts of capital. In many cases, banks’ current capital levels exceed the Basel 3 requirements.

In Asia, countries have taken different approaches to the implementation of Basel 3, with many countries imposing higher minimum capital ratios than those in Basel 3 and accelerating the implementations timeline.

The European sovereign debt crisis has highlighted that the value placed by Basel 3 on sovereign debt for both capital and liquidity purposes must be re-assessed. Banks may choose to hold additional capital against sovereign debt even if it is zero weighted under Basel 3, but they may have less scope to diversify their liquid assets unless the regulatory requirements are adjusted.

3. Supervision and Reporting
Banks in many countries are facing pressures from changes in supervisory structures and from heavily increased reporting burdens.
In the EU, three new European Supervisory Authorities (ESAs) have been established in a move to further integrate financial services supervision on a pan-European level. In the US, new agencies such as the Financial Stability Oversight Council (FSOC) and the Bureau of Consumer Financial Protection (CFPB) have been established. Many other countries are also changing their supervisory structures and introducing new bodies to undertake financial stability and macro-prudential oversight. In addition, an increased emphasis on cross-border regulation and supervision re-emphasizes the need for effective supervisory colleges. Banks need to support and be linked in to these structures to ensure that they operate effectively.

Furthermore, the reporting burden on banks is increasing. This is a result of the implementation of Basel 3, the information requirements to assess the systemic importance of banks and underpin recovery and resolution planning, the increased emphasis on detailed stress testing, the imposition of regional and national regulatory reform initiatives such as the reporting required in the US under the Dodd-Frank Act and the trade reporting and regulatory reporting required under the MiFID2 and European Markets Infrastructure Regulation (EMIR) legislation in the EU.
Banks will need to enhance the quality of their data, systems and processes in order to meet these regulatory reporting requirements.

4. Governance and Remuneration
Governance is high on the agenda across the three regions. Supervisors are focused on increasing the accountability of Boards and the robustness of reporting and control frameworks. However, other than at the EU level and the high-level principles established by international standard-setters such as the Basel Committee on Banking Supervision (BCBS), it seems unlikely that detailed international standards will be introduced. This may be an advantage to the extent that governance structures differ widely across countries and regions and a single approach may not work well in all countries. Equally, banks with subsidiaries in many countries may find themselves subject to increasingly onerous and inconsistent requirements.

On remuneration, the application of the FSB principles on the structure of remuneration has not required banks to reduce bonus payments as a proportion of total pay. Nevertheless, many banks have significantly reduced the variable component of pay and increased the fixed aspect of compensation in some areas of their business, although a recent report by the FSB reveals that bonuses still account for the majority of total pay awarded to US and UK banks’ highest-paid employees. This is in contrast to Asia where bonus pay accounts for between 30 and 60 percent of the total pay awarded to senior executives with a lower percentage again in Japan. There have been discussions in the EU on setting a maximum ratio for the variable component of total pay, on the basis that this could reduce incentives to take excessive risk.

5. The Customer Agenda
Although much of the recent regulatory focus has been on prudential issue, there is also increasing emphasis being placed on consumer protection. Consumer finance is a key focus of consumer protection in the US, while in the EU a host of regulatory initiatives relate to how banks treat their customers. In Asia, new requirements have been introduced with regard to the selling of retail investment products in Hong Kong and Singapore. A focus for banks will be designing strategies to develop, market, distribute and administer retail financial services products in a sustainable way, whilst controlling conduct risk.

For banks, the data, systems and process implications of these regulations are substantial and onerous, but this is also an opportunity for banks to gain valuable commercial insight that could lead to the improvement of the customer experience and increased revenue. Banks globally are fighting to retain and attract customers at branch level, and looking at how to improve the customer experience – how to optimize, rather than reduce, associated costs and how to improve the overall sales and service experience. Some of the regulatory requirements may be beneficial in encouraging banks to refocus on their customers.

The banking sector continues to be re-shaped by the ever-expanding set of regulatory and related reform initiatives at global, regional and national levels. Each of these initiatives plays its part in enhancing financial stability, protecting investors and consumers, and making it easier to deal with failing banks. But they could also have significant negative impacts on banks and their business models and in turn on banks’ customers and the real economy. A long and difficult road lies ahead.

There are a number of key drivers, common across the three regions EMA, US and ASPAC, that will influence the strategy, business models, size, shape, structure and cost to banks over the next few years:
1. Systemic Risk, Recovery and Resolution Planning - added dimensions for systemically important banks and regulatory pressures for new business models
2. Capital and funding strategy - increased capital funding costs and slimmer balance sheets
3. Supervision and Reporting - more intense supervision and a plethora of reporting requirements
4. Governance and Remuneration - governance and remuneration are once again being forced to the top of the agenda
5. The Customer Agenda - more checks and balances to protect customers and combat mis-selling

In addition, Regulatory Reform has two major implications:
1. Structural Reform and New Business Models – The process of undertaking complex business and structural reviews and adjusting to new ways of doing business consumes significant time and money. Banks are under severe pressure to determine the strategies and businesses that will maximize their value in response to the woeful economic climate and long list of regulatory demands.
2. Costs of Reform and Impact on Growth – Historic bank returns look unlikely to return, not inspiring investors. Coupled with downgrades for some of the largest banks and the pressure to cover the cost of capital it is appropriate to consider whether we are at the point at which the costs of reform exceed the benefits and are contributing to unnecessarily slow economic growth.

Need for action for Swiss banks?
Since various reform initiatives are at a global level there is need for action also for Swiss banks. More specifically the two G-SIBs in Switzerland, namely CS and UBS, are confronted with more severe capital requirements than required by Basel 3. Based on the Too-Big-To-Fail (“TBTF”) bill of the Swiss Federal Council from September 2011 large banks cover their risk-weighted assets with up to 19% equity capital, which exceeds the minimum requirement recommendation of Basel 3. A further central point is the requirement of large banks to take organizational measures so that system relevant functions such as domestic deposit and credit banking or payment settlement can be continued in the case of insolvency. In addition, global operating Swiss Banks are affected by a number of reform initiatives at a global, regional and national level. For example the Lugano Convention allows clients to file a complaint in his / her place of residency (jurisdiction at the domicile of the consumer); with EMIR the EU strives to minimize counterparty risks in the area of derivative financial instruments also impacting Swiss Banks; with FATCA the USA wants advantages to achieve more transparency on assets that are not held in the USA.

In short, Swiss financial institutions will most likely need to intensively address the following topics over the next five to ten years in order to remain competitive and minimize the legal and reputation risks:
- Transparency guidelines with respect to taxed monies
- Disclosure of compensation to third parties for the distribution of products
- Investor protection
- Cross-border services
- Product suitability
- “Client suitability”
- Capital and liquidation planning

Thus, the service offerings as well as the distribution and management of clients will have to undergo significant changes in order to maintain pace with the increasing requirements.

Lukas Annen, Manager Audit Financial Services, KPMG
10 April 2012

Mercredi 9 Mai 2012

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