The worst of regulatory oversight for banks is yet to come

Those of you in the banking industry that thought Barack Obama's recent announcement about limiting the size and scope of banks and their trading activities was enough to make you want to leave a job in the City and become a yoga instructor, well it seems we haven't seen the worst of the regulatory backlash against banks yet.

That is the view of Oliver Wyman's Financial Services practice and is one of the key findings in its State of the Financial Services Industry 2010 report, which was released at Davos last week. The report, which is published annually, is based on feedback from 70 financial services firms globally.

While Obama's announcement signified that the period of  "temporary leniency" by regulators to enable banks to shore up  their capital reserves and balance sheets, may be over, Oliver Wyman says Obama's announcement was not that tough on the banks. "The big question now is how the industry will interface with regulators," says David Moloney, from Oliver Wyman's Sydney-based financial services practice. For more on regulation from David Moloney, listen to this voice grab.

Jamie White of Oliver Wyman in London, said that if Obama's definition of what constitutes proprietary trading is too wide, the regulation itself could be difficult to enforce as it could be argued by some that market making is proprietary trading, although outlawing that would have a detrimental impact on the market.

Yet, Obama is perhaps missing the point by focusing so much on proprietary trading, which Oliver Wyman maintains was not the root cause of the recent financial crisis. It also questions the "excessive faith" regulators are placing on regulatory capital as a source of systemic stability. Some of the high profile casualties of the financial crisis such as Bear Stearns were deemed to have more than their fair share of regulatory capital, yet that did not prevent it from collapsing.

Oliver Wyman believes the worst in terms of regulatory aggressiveness has yet to come in the form of initial proposals under consideration for Basle III.  Obama's "mini-Glass-Steagall", which is largely US focused, will seem like a walk in the park compared to some of the proposals under consideration as part of the revision of Basle's supervisory requirements.

White says the next incarnation of Basle could end up making some lines of a bank's business impossible. For example, he says initial proposals talk about getting rid of netting, which could in effect quadruple banks' exposures.

Although we would like to think that the worst of the crisis is over and that banks are in the "convalescence" stage, Oliver Wyman's report shows that while 57% of market value losses have been recovered by financial firms since the crisis began in 2007, these green shoots may be "astroturf" as there are still high levels of consumer debt and if government support of financial services firms is withdrawn too quickly, they could relapse. Moloney said Japanese and Scandinavian examples suggest that governments maintaining equity ownership of financial institutions can go on for longer than anticipated.

Te possibility of another "relapse" in the not too distant future can not be ruled out, with 32% of CEOs surveyed in is report saying there is a 32% chance of a double dip or "W-shaped recession". Relapse risk is highest in Continental Europe, says Mark Weill of Oliver Wyman, where there are still a large number of losses on banks' books, that have not been accounted fors.