From the Biggest Regulatory Storm in 80 Years to an Established Regulatory Framework

The world has come a long way since the massive bank bailouts, and subsequent calls for stricter regulation. The dust is finally starting to settle. However, as the new regulatory framework becomes established, many institutions are grappling with the impacts.

The previous regulatory framework, in place since 2006, failed to prevent the worst banking crisis since the Great Depression. Even financial institutions with seemingly safe capital ratios experienced severe problems. In November 2009, Federal Reserve chairman Ben Bernanke reported to the Financial Crisis Inquiry Commission that 12 of 13 of the most important US financial firms were at the edge of failure at the height of the credit crisis in 2008.

The mechanics of the new regulations are well documented. Our G20 leaders mandated global regulatory reform in Pittsburgh in 2009 and Seoul in 2010. In December 2010, the Basel Committee on Banking Supervision (BCBS) published the details of global regulatory standards on bank capital adequacy and liquidity. These new standards will be phased in gradually until 2019, with some aspects such as liquidity and leverage ratios still currently subject to calibration.

What is now termed Basel III includes many significant adjustments to Pillars 1, 2 and 3 of the prior Basel II Accord. The higher capital and liquidity standards introduced by Basel III are intended to reduce not just the probability, but also the severity, of banking crises. The effects of the new regulation include:

  • A significant increase in the amount and structure of minimum regulatory capital, as well as three new regulatory constraints: a leverage ratio and two liquidity ratios. If simulation models are used to compute regulatory capital, they will need to be calibrated to periods of significant stress within a bank.
  • Restrictions on business activities including proprietary trading, over-the-counter (OTC) derivatives and securitisations, in terms of capital requirements.
  • Stricter monitoring on the independence of a firm’s risk function, and the prioritisation of risk management at board level.
  • Higher levels of monitoring and restrictions on systemically important financial institutions (SIFIs).

Compliance

Compliance with the new rules and reporting requirements is an essential first step. Any potential sanctions imposed on a firm by regulators would be a showstopper for business. Furthermore, a firm’s reputation among its clients and peers will also be at stake.

Firms will need systems and calculators to compute minimum regulatory capital for standardised models and sophisticated simulators in order to qualify for advanced internal models. As part of their Internal Capital Adequacy Assessment Process (ICAAP), firms will be required to operate systems that provide: comprehensive and timely identification; measurement and monitoring; and control and mitigation of risks. As we move forward, the aggregation of risks (including hedging effects and highlight concentrations) across old traditional silos will be a prerequisite for compliance.

Although it is not mandatory, in practice firms need to take stock of their system infrastructure. In addition to meeting current regulatory requirements, a system needs the flexibility to adapt to any future regulatory fine-tuning or changes in best practice. We are also likely to see a number of banks streamlining their systems landscape, and, implicitly, the amount of mapping rules they need to maintain. This will not only improve overall transparency, but also help to free up budgets.

Streamlining the Business

The new regulatory framework is forcing banks to review their business models. The cost of keeping capital aside that could otherwise be used to generate profit raises questions on the future viability of certain business activities. Proprietary trading, securities lending, OTC derivatives, and securitisations will be restricted or strongly penalised. Commercial and wholesale banking activities will need to reduce illiquid assets, and limit wholesale and other sources of unstable funding – or pass the increased cost of capital on to their clients.

In order to allocate capital to the most profitable areas of business, a bank’s management will need timely and consistent views of their global activity: what their potential risks are, how much regulatory capital they consume, and how the risks can be mitigated.

Real Time

The crisis illustrated that an institution’s stability could change overnight. In adverse trading environments, decision-makers need to review their risk profile as the market evolves, and make quick assessments, to protect or decrease their exposure. This means having the capability to get consolidated views of risk and price positions, and the ability to run ‘what-if’ scenarios on these positions, and run regular risk simulations. In addition to this, there is the increased scrutiny from shareholders who need reassurance that the risks being taken are in line with the agreed risk appetite and return expectations.

The need to track risk with multidimensional complexity, to play through different future strategies and make informed decisions about risk/reward trade-offs is driving the development of real-time risk management systems. By real time, we mean the capability to have an instantaneous view of business at any point in time, whenever this is asked for, and as granular as needed. In addition to detailed, on-demand information, real-time systems will also enable ad hoc scenario analysis. For example, to quantify the change of a risk profile should a given market event happen or to measure the impact of an individual trade on the profit and loss (P&L) distribution.

An important point that relates to the new regulatory framework and should not be overlooked is that a good system can save considerable amounts of time. Real-time reporting can free risk managers from daily operational processes and standard reporting, to focus on complex issues such as evolving business topics and non-standard queries.

Conclusion

Financial institutions are all preparing for changes in regulation and governance – from top-tier banks looking to manage their exposures and regulatory requirements across multiple platforms and geographies, to European mid-tier banks and banks in emerging countries that are getting up to speed with regulation. Tomorrow’s front-runners will be the firms that can evolve beyond pure compliance to embed risk management processes into their business practices in a way we have not seen before.

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