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.

Good bank, bad bank

While financial stocks are reeling in the wake of U.S. president Barack Obama's announcement that he wants to limit the scope and size of banks and their trading activities, their must be mixed feelings amongst banks about this announcement and what it means for certain parts of the bank.

Trading, hedge funds, private equiy and  investment banking look as if they could be the hardest hit particularly as much of the U.S. government's rhetoric is around those banks that have become more than just deposit takers and are indulging in risky trading activity on their own books (and still expecting to be bailed out by the government). According to a WSJ.com article, one White House spokesman said that banks that received a "backstop" from the taxpayer shouldn't be able to make a profit off their own investing."

It goes back to the co-mingling of clients' funds with the banks' money, but as early newspaper reports suggest trying to disentangle one from the other could be tricky unless you clearly separate good old fashioned banking (lending and deposit taking) from proprietary trading. That smacks of Glass-Steagall.

Most banks will be reluctant to separate investment banking or proprietary trading from the rest of the bank and will argue that one feeds into the other in terms of cross-selling opportunities. After all investment banking or proprietary trading, although  high risk, made a substantial contribution to  banks' balance sheets prior to the recent crisis and in its wake.

But what does this mean for the less riskier parts of a bank's business, for example, transaction banking? Does Obama's clampdown on banks mean that transaction banking - which is less volatile and a relatively stable business in good times or bad - will become the most prized of all the banks' businesses?

We are certainly seeing that with the likes of Citi, which has divided itself into "good bank", "bad bank", putting its more core, stable and profitable businesses such as GTB into a separate unit called Citicorp and riskier non-core assets into Citi Holdings. Are other banks going to have to follow this example in order to comply with Obama's requirements? And if they don't is transaction banking in danger of being polluted or fouled by the mistakes or errors of judgement of its riskier investment banking counterparts?

Wake-up call for banks about cost of new liquidity regime

The New World regulatory order that is likely to be ushered in as a result of the recent financial crisis, not only means more regulation for banks, but also more cost.


Experts are already warning banks that the UK Financial Service Authority's (FSA) new requirements around strengthening liquidity standards will overload banks with reporting requirements, and as think tank JWG-IT points out, the level of reporting is on such a scale that even the regulators may not be able to understand it or use all of it. Therein lie the dangers of over-regulation.

What got us into this mess is that the regulators did not understand what they were regulating. Are they in danger of treading the same path when it comes to the new liquidity standards that will be imposed on banks and building societies as of next year?

According to JWG-IT, the FSA's survey of more than 30 firms has put the potential incremental costs of implementing the new "liquidity reporting regime" at more than £2.4 billion (JWG-IT arrived at this figure, which the FSA confirmed, based on its own analysis of the FSA survey), orders of magnitude higher than the FSA's original overall estimate of £150-£250 million.

JWG-IT says that the implementation challenges around the new liquidity standards and reporting requirements are unprecedented and that the FSA's estimates "overwhelm" the estimated costs (between £870 million and £1 billion) from one year ahead of the Markets in Financial Instruments Directive (MiFID) implementation.

It is symbolic of the afterthought regulators often pay to cost; let's implement the regulation so we are seen to be doing something and worry about the cost later. But how are firms going to fund this level of investment? And is it so onerous that banks are likely to implement piecemeal solutions or even delay liquidity risk projects further?

The comparison with MiFID is illuminating given that the cost estimates for that regulation were based on a regulatory framework that was more clearly defined. The new liquidity risk regime is less finalised than MiFID and has a much shorter implementation time frame (March 2010).

The FSA says that the more than 600 firms that will be impacted by its new liquidity reporting regime will need to devote resources to change their systems and hire more staff, which is ironic given that in the current climate banks have been shedding staff, particularly in IT departments, which will have their work cut out trying to implement the new liquidity requirements, which require "granular quantitative liquidity data" on a daily basis.

In its second consultative paper on Strengthening Liquidity Standards, the FSA estimates that the resource and staffing changes required could result in average one-off costs for UK banks of approximately £3.3 million and up to £7.4 million for "full-scope" investment firms. The UK branches of foreign banks will not escape unscathed either and could be looking at a bill of more than £500,000 each. On an ongoing basis, estimates suggest that banks will need to spend anywhere from £517,000 and £775 million, dependent on the level of "crisis reporting" required.

While the FSA's analysis of the impact the new liquidity reporting regime is likely to have on firms, "should be taken with a grain of salt" as it was prepared quickly, PJ DiGiammarino, CEO of JWG-IT, says that the cost estimates should serve as a wake-up call to banks.

He argues that global liquidity standards are needed for firms to more quickly and cost effectively implement the new regime. The Financial Stability Board, which extends the mandate of the Financial Stability Forum, is looking at the development of global standards for liquidity reporting, in addition to the reviews being undertaken by the US and the EU.

Overzealous regulators

Aah! What a difference five years of hindsight and a loss in US market competitiveness as a result of overzealous regulation can make. Most of us have been following the recent backlash against Sarbanes-Oxley (SOX), particularly Section 404 of the act, which requires companies to certify and assess the effectiveness of its financial controls.

Whilst the SEC has not totally repealed the controversial act, in light of a marked decline in companies looking to list in the US, which a number attribute to the onerous task of having to comply with regulations such as SOX, it has announced amendments to the controversial SOX legislation.

Yet, the greatest moment of clarity regarding SOX has to be a recent comment made by House Financial Services Committee chairman Barney Frank at a Council for Institutional Investors' meeting in the US last week. According to an article in the Investment News, Frank, alluding to the over enthusiasm of accountants drafting the SOX act stated:

"The accountants probably, in helping draft 404 regulations, overdid it a little bit, and we violated a very important principle: Never ask your barber if you need a haircut."

Perhaps other overzealous regulators should heed Frank's pertinent remarks.

It's time for 'better regulation'

In recent months there appears to have been somewhat of a backlash against over-regulation. The US is indulging in some long overdue navel gazing with US Treasury Secretary Henry Paulson weighing in on the debate by saying that the US capital markets "face significant challenges" and that Sarbanes-Oxley may have gone too far.


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The Committee on Capital Markets Regulation further inflamed the debate with its publication of 32 recommendations for making US capital markets more internationally competitive. It also published some startling figures which suggested that over a period of five years, the value of global initial public offerings raised in the US had declined from 50% in 2000, to 5% in 2005.

Of course, the US is only probably just waking up to the fact that they are no longer the epicentre of capital raising for companies and that listing on an exchange is not quite the badge of honour it used to be for companies particularly in those markets where compliance is onerous.

I think it may be a slight overreaction given that US investment firms like Goldman Sachs, JPMorgan et al still underwrite a number of the deals that take place, but the competition as to where to list may be hotting up again and the US may not necessarily be able to have it all their own way.

The Committee on Capital Markets Regulation may have some problems getting its recommendations drafted into law, as there is only two years of the Bush administration left to serve and me thinks Bush junior may have his hands full 'cherry picking' from another set of recommendations on how to get the US out of Iraq without any more egg on their face.

At least the SEC has correctly gauged the general mood and is expected to announce on 13 December revisions to the onerous Section 404 of the Sarbanes-Oxley Act (SOX), which requires companies to audit the effectiveness of their financial control procedures. Also it is expected to announce that it will make it easier for foreign companies with more than 300 shareholders that are US residents, to withdraw from US regulatory oversight if they wish to do so.

Interestingly, before SOX came into effect, the SEC was by law required to conduct a cost/benefit analysis of the regulation's impact. But it appears no analysis anticipated the spiralling costs associated with Section 404 compliance.

Could all of this hold some interesting lessons for the UK and European markets where regulations such as MiFID, which comes into effect next November, could cause the same backlash as SOX has in the US?

Like the SEC, the FSA is also required to conduct a cost/benefit analysis of regulations. It has done that for MiFID estimating that there will be a "one-off" cost of between £870 million and £1 billion with ongoing costs of around an extra £100 million a year, although this is likely to vary from firm to firm. Click here for more info on the FSA's analysis of MiFID.

According to the FSA, some of the largest MiFID-related compliance costs are one-off costs arising from the introduction of changes to client categorisation and best execution requirements. However, the benefits in all these cases are difficult to quantify as the rationale behind implementing regulations such as SOX and MiFID is to protect the investor not to make life easier for the companies that service these investors.

While no one will argue that greater transparency is needed around the costs of trade execution, will MiFID like SOX go too far and force companies to spend more time on compliance than actually running their business? Furthermore, whilst the UK and the US conduct cost/benefit analyses before regulation is implemented, other European regulators are not required to do so. Surely that has to change.

The International Securities Market Association appears to be on the right track with its 10 "Principles for better regulation," which has been endorsed by the International Capital Market Association. The principles are based on the belief that in the case of a market failure, regulators should determine whether current regulations or market forces will sort the problem out before putting pen to paper on a new set of regulations. The question now is, will the International Organisation of Securities Commissions (IOSCO) support these principles?