Regulatory topics for 2012
At the start of 2012, with the global and eurozone financial crises still far from over, we have set out our view of twelve key regulatory and supervisory topics for the year ahead. We have approached this from a UK perspective, noting relevant global and EU angles where appropriate. The list is in no particular order of priority.
The regulatory topics for 2012 are:
- Consumer protection
- Bank capital and liquidity
- Insurance capital
- Resolvability and ring fencing
- Extending the SIFI net
- New supervisory structures
- Backlash against complexity
- Client money
- Shadow banking
We expect the FSA to continue to adopt an increasingly challenging and ultimately interventionist stance on consumer protection. It will look to get on the front foot, take action early and “ban” products which it believes are likely to give rise to consumer detriment (as it has already sought to do with traded life endowment policies). In short, the FSA will anticipate as many of the approaches and powers of the Financial Conduct Authority (FCA) as it can. The European Securities and Markets Authority (ESMA )will also flex its consumer protection muscles, as it began to do with exchange traded funds; and the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA) will, on the basis of recent pronouncements, follow suit.
Some higher capital requirements will take effect in 2012 (from CRD3, and the need for large EU banks to maintain core tier 1 ratios of 9%) and some future capital and liquidity requirements may be anticipated by counterparties and ratings agencies. Set against this, market conditions will remain inimical to raising capital and liquidity by all but the very strongest banks. In combination these developments will crystallise some hard choices about which business lines to pursue and which to exit (particularly in relation to investment banking), incentivise the search for capital- and liquidity efficient strategies and put the premium on effective systems, controls and processes for capital and liquidity management. Within this there will be political pressure to favour lending to individuals and small businesses above that to others in the financial sector. Supervisors will continue to press firms to establish robust risk appetite frameworks and strengthen stress testing.
At one stage, 2012 was to have been the year in which the final preparations for Solvency 2 implementation were made. Continual slippages in the EU legislative timetable and process mean that this will no longer be the case. But, as the backlash against complexity gathers pace (see later), there is a risk that Solvency 2 implementation – in particular model approval – will become more difficult and controversial.
A number of regulatory initiatives are serving to increase the need for collateral meaning that banks’ balance sheets will become increasingly encumbered. This is a direct consequence of policies such as the desire to remove banks’ “too big to fail status”, to make senior unsecured creditors participate in the recapitalisation of a bank in resolution (through “bail in” or other mechanisms) and the introduction of depositor preference as advocated by the Government in response to the Independent Commission on Banking (ICB). Faced with this, it seems entirely rational for unsecured creditors to take action – or in this case collateral – to protect their own interests. Moreover, the need to post margin for transactions cleared through central counterparties (CCPs) and to collateralise OTC derivative transactions will add to the demands on banks’ remaining unencumbered assets. The consequences of these developments for banks and how they are supervised in future will be far-reaching. The need for banks particularly and other financial services firms more generally to be able to manage collateral, mark it to market and deal with the resulting risks will be great.
The direction and theory are clear – the G20 Leaders endorsed the FSB’s recommendations on recovery and resolution frameworks at their November summit. No systemic firm (G-SIFI) should be too big to fail. As a consequence all G-SIFIs, starting with the 29 global systemically important banks (G-SIBs), must have a recovery and resolution plan (RRP) in place by the end of 2012. This will see a race to turn theory into practice, with some countries having a head start over others, because they have already begun their national RRP programmes, while others will be running hard to catch up. The practicalities of RRPs will shine a light on the need for better international coordination when firms run into difficulties – one of the toughest nuts to crack. The legislative process of introducing formal bail-in powers is likely to start in the EU. This will receive particularly strong support from the UK, borne out of harsh experience during the crisis which in turn influenced the recommendations of the ICB and the Government’s general endorsement of them. Much of the detail of how the Government and the FSA/PRA will give effect to the ICB’s recommendations will become clearer during 2012. We expect that the largest UK banks will advance their planning for ring fencing significantly in the course of the year.
So far the spotlight on which firms are systemic has been shining most brightly on the banks. However, global insurance supervisors in the IAIS are expected to produce a methodology for assessing and identifying global systemically important insurers by June 2012. In addition the Financial Stability Board (FSB) in consultation with global securities supervisors in IOSCO will prepare methodologies to identify systemically important non-bank financial entities. IOSCO and the Committee on Payment and Settlement Systems will be particularly interested in the systemic role of CCPs. This agenda will develop rapidly and it will be essential for firms and trade associations to ensure that the methodologies for assessing systemic risk in the insurance and non-bank sectors are appropriately tailored, and that the ensuing policy responses are not automatically those already agreed for banks.
There is no doubt that supervisors around the world have been struck by the inability of many large banks and other financial services firms to produce and aggregate risk data quickly and accurately, on demand. And if regulated firms cannot supply the data to their supervisors, the supervisors are asking themselves what confidence they can place in these firms’ ability to manage their risks properly. This is not a new concern, but the sheer number of references to these weaknesses at global, EU and national level (together with the FSB’s deadline of early 2016 for G-SIFIs to put their data houses in order) suggest that this time regulators are serious. Given the long lead time, firms’ planning and preparations to strengthen their capabilities in this area will need to start soon.
2011 saw the introduction of some new supervisory structures (e.g. the European Supervisory Authorities (ESAs) in the EU, the European Systemic Risk Board and the interim Financial Policy Committee (FPC) in the UK) and planning for others (e.g. the creation of the PRA and the FCA in the UK). In 2012 regulated firms will get a clearer sense of what it means in practice to be subject to these new structures, as the ESAs get into their stride (resources permitting) and as the FSA moves as far towards a full “internal twin peaks” management structure as it feels is compatible with its obligations under existing legislation. We also expect to see the role and influence of the interim FPC develop. It will continue to make its presence felt by inviting the FSA to follow up on its priority issues and pursuing the debate about what should be the right set of macro-prudential tools and instruments for it to use.
The run-up to the financial crisis in 2007 is characterised by some as the heyday of the cult of complexity. Risks were sliced, diced, packaged into what were often highly opaque and complex products, modelled, hedged and managed with apparently great precision and sophistication. The efficient market hypothesis dominated economic, business and regulatory thinking – no-one second guessed the market. Now we have turned 180 degrees. Complexity, be it in the form of instruments, corporate structures which impede resolution, or sophisticated modelling techniques, is viewed with suspicion. Simplicity is prized, as in the ICB’s recommendation for ring-fencing of UK retail banks and the Basel Committee’s leverage ratio as a “backstop” for the results provided by risk-based capital models. Moreover, in the US, Dodd Frank will enshrine the Basel 1 capital requirement as a floor beneath which US banks’ capital will not be allowed to fall. This backlash against complexity is unlikely to have run its course. Banks and other financial services firms will find their sophisticated approaches to risk modelling and management being put under the microscope by supervisors who will be expecting a genuine bias towards conservatism, and prepared to apply rough and ready capital add-ons where they have concerns. Efforts to “optimise” risk weighted assets will be very carefully scrutinised. The risk is that the search for simplicity, while very appealing at one level, may blunt incentives to differentiate between more and less risky activities.
The FSA’s drive to ensure that firms holding client money and assets have effective systems and controls in place began in the aftermath of the collapse of Lehman. The reach of the FSA’s programme to improve standards in this area is broad, covering all sectors. Events at MF Global suggest that there will be no let-up in this area in 2012. The challenge for regulators, both here and elsewhere, is how to guard against a situation in which day-to-day client asset controls appear to operate effectively, but do not then survive intact as a firm runs into difficulty.
The FSB has identified the potential for regulatory gaps to emerge in the so called “shadow banking system” - broadly defined as “credit intermediation involving entities and activities outside the regular banking system”. The incentives to move activities into this sector increase as the regulation and supervision of authorised banks continues to become tougher. The FSB has identified the need for further work on the regulation of: banks’ interactions with shadow banks; money market funds; other shadow banking entities; securitisation; and securities lending and repo. Although this work is still at the policy formulation stage, once concluded it is likely to have material consequences for both banks and the entities and activities that are eventually deemed to constitute shadow banking.
The storm of re-regulation that started in the immediate aftermath of the crisis shows no signs of abating. Although the number of new initiatives is slowing, the production machinery has not stopped. For example the European Commission has recently announced the creation of an expert group to consider the case for the separation of retail and investment banking activities at the EU level. As importantly, while the direction of many new regulatory initiatives is clear, much of the all important detail has still to be completed. In the EU the work programmes of the ESAs, especially the EBA, are dominated by the need to prepare a huge number of technical standards. Whether all this can be done to a high quality within the required timescales and whether the UK’s influence will diminish remains to be seen. This has two significant implications for firms. First, a continuing need to devote resources to engage with the consultative processes. Second, a need to monitor and manage regulatory change on a portfolio basis, looking for the linkages and interactions between different initiatives on a country-by-country basis. In this regard, the fact that there are so many moving parts makes the challenge greater, and the need for a portfolio approach even stronger.