Firms Need to Gear Up for the Basel III Shakedown in 2013

Basel III has been the source of much transformation over 2012 as the industry prepares for the changes in capital requirements that were due to start from January 2013, although delays are now a foregone conclusion for the US and EU. Rules relating to liquidity ratios, leverage ratios and capital buffers have all been finalised. In addition, other initiatives have emerged, including guidance on systemically important firms (SIFIs), the establishment of central counterparties (CCPs) and trade repositories for over-the-counter (OTC) derivative trades, a new focus on resolution plans and the demand for more extensive stress testing.

Financial firms should also not underestimate the impact of other pending changes such as the introduction of the Legal Entity Identifier (LEI) programme. This will give each counterparty and issuer a unique reference code, which will allow authorities to identify, track and record which transactions belong to which institutions.

Macro-prudential regulation will mean for the first time that the contents of a firm’s regulatory return may not be enough to determine a regulator’s reaction. Then there is the prospect, particularly in the EU and US, of a split between proprietary trading and banking deemed to have a degree of state support through the Volcker rule in the US, the Independent Commission on Banking (ICB) in the UK, or the Liikanen report in Europe.

Regulators Get Tough

To top all these changes the finance sector also has to face increasingly intrusive and better-resourced regulators, who are more likely to hold the board and senior managers to account for the condition of the firm at a given point in time. We have also witnessed a much greater willingness by the authorities to issue very large fines for rule infringements and, in many cases, a concerted effort to use criminal law. Even where a firm is not suspected of breaching any regulatory rules, the requirement that the regulator and the firm understand the business means that for many the volume of ad hoc and explanatory queries will increase to higher levels than previously experienced. The expectation of the regulatory authorities is that institutions will have a strong grip on the issues affecting their firms.  Their attitude is that if a firm’s house is not in order, they will step in and put it in order for them.

These changes have put firms under pressure to improve their infrastructure and organisation to cope with the impact. The required improvements are needed on many levels. Board level and senior managers will need more appropriate, timely and clearer reporting, as well as explanations of their business issues, particularly as they pertain to issues that concern their regulators. This level will also need information that allows them to make the right choices between the balance of capital, liquidity and leverage within their firm, in adherence to their risk appetite.

At the business operational level the firm’s infrastructure must deliver enough information – and in a timely manner – in order to address not only current issues, but also the new controls that are demanded by the new regulations. Firms must also take care that not only is information effectively reported, but also understood and acted upon.

Information infrastructure needs to be responsive. For some firms, liquidity reporting may need to be submitted to the regulatory authorities on a daily basis when under stress. At the same time, firms will need to able to run multiple and coherent stress testing scenarios, addressing and quantifying perceived risks. Clearly the stress and scenario testing process will only be effective if the results arrive in time to answer the key questions.

The information infrastructure needs to be built in such a way that it is comprehensive, addressing all of a firm’s activities. Responsiveness is also aided by having a streamlined process that reduces to a minimum, or preferably eliminates, the need for reconciliation processes. This points to the establishment of a single clean data source, based not on technical criteria, but built to reflect and process according to the firm’s business model. This source will not contain unnecessary duplication and will be able to service the needs of the regulation, risk, finance, credit, treasury and other departments within a financial firm.

Firms are moving towards such a model, with the more nimble also using these developments to create competitive advantage through improved responsiveness to business changes, more accurate analysis of business benefits and cost, as well as a more unified coherent reaction to opportunities and threats. Overall the changes are making firms even more risk aware, but at the same time are proving increasingly demanding. The next few years promise to be even tougher than those experienced to date by firms.

Many of the Basel III measures are in various stages of development in terms of the legislative process. Some will be postponed as authorities wrestle with the legislative issues surrounding implementation, meaning delays in producing the final rules will result in less implementation time for firms. As a consequence, one of the biggest impacts on them next year will be the pressure on their internal resources. This trend will probably continue in the following years as the changes being discussed are only one wave of many before Basel III is finally implemented in full in 2019. Uncertainty regarding how, and when, the final rules will be delivered will continue to be a major issue for financial institutions, with the US and Europe in response both announcing delays to the planned 2013 start date

Other Challenges Await

In addition, new regulations outside of Basel III are being considered, such as those around the London Interbank Offered Rate (Libor) and other indices, shadow banking, foreign exchange (FX) risk settlement rules and new standards regarding effective bank supervision. Financial firms will find once again that when the resources to make changes are most needed they will be least available. There is a need for firms to carefully consider their contingency plans; preparations made now will pay off later.

These regulatory changes, combined with the generally lower returns expected from the banking business, means that those of us working in the financial services sector are about to witness massive changes in the way the business of finance will be conducted. There will be surprises, but now is the time to take stock and act. 2013 and onwards promises to provide even more hustle and shake-up in the financial services industry and those firms not prepared and organised could be in for an uncomfortable ride.

Season’s greetings to you all.

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