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Investment banking

No let-up in supervisory scrutiny

In 2024 the regulatory horizon for Investment Banks (IBs) will become clearer as some key capital markets initiatives in the UK and EU are finalised. On balance, the EU looks set to impose fewer restrictions on third-country firms providing cross‑border investment services into the EU and on third-country clearing than once seemed likely. That said, IBs still face a significant programme of regulatory change management and implementation, with the Fundamental Review of the Trading Book (FRTB) standing out in this regard. We see no let-up in supervisory scrutiny of IBs by the Prudential Regulation Authority (PRA) and the European Central Bank (ECB), particularly in relation to counterparty credit risk (CCR) management and booking model governance and controls. IBs’ exposures to non-bank financial institutions (NBFI) will remain a supervisory priority.

Change, change and more change

 

As policymaking has progressed, particularly in the EU, the answers to some of the major post‑Brexit EU market access questions have become clearer. It now looks certain that third‑country IBs will be able to continue to provide cross‑border investment services into the EU under the Capital Requirements Directive (CRD6). EU legislators are still debating the details of the 'active' account that EU-based firms subject to the clearing obligation will need to maintain at an EU Central Counterparty (CCP). The emerging consensus suggests that the active account will have some operational and activity requirements in a first phase with further additional requirements under discussion. We judge the likelihood of an eventual extension of EU equivalence for UK CCPs beyond June 2025 to be high.

 

Many reforms developed over the past few years, including the latest iterations of the Markets in MIFIR, EMIR and CSDR, are close to implementation.

All that said, IBs still face a significant volume of regulatory change in 2024. Many reforms developed over the past few years, including the latest iterations of the Markets in Financial Instruments Regulation (MIFIR), the European Market Infrastructure Regulation (EMIR) and the Central Securities Depositories Regulation (CSDR), are close to implementation. Although the EU and UK have each gone their separate ways, the extent of divergence is not as great as initially expected. However, there are important differences in detail and implementation timelines. These will require IBs to sharpen their regulatory mapping capabilities to derive potential synergies from implementation of regulatory change programmes and to anticipate peak demands on key resources, especially IT staff.

FRTB: implementation of SA and decision time for IMA

The final deadline for FRTB implementation is very close and IBs face the prospect of higher market risk RWAs under both the revised standardised approach (SA) and Internal Model Approach (IMA). All IBs will have to report SA capital calculations by January 2025 in the EU and July 2025 in the UK and the US.

Success in implementing FRTB SA will be based on having a scalable and robust calculation engine which supports increasingly granular regulatory reporting and the requirement for daily capital monitoring. Many banks continue to struggle with the availability and quality of sufficiently granular data and being able to calculate the SA daily. EU banks have a head start, needing to report FRTB SA as part of the Capital Requirements Regulation (CRR2), but their existing solution is unlikely to be sufficiently scalable to satisfy global FRTB reporting requirements.

IMA will take FRTB implementation a step further. IBs will need to apply for approval for individual desks resulting, on some estimates, in 20–50 times more data generated daily. The accuracy and timeliness of data and alignment between first line of defence and second line of defence will also be a challenge. To generate material benefits from IMA, IBs will need to optimise the number of risk factors they can model and identify non-modellable risk factors in a way which is quite different to how IBs currently manage their trading book risks.

Many IBs are still assessing the capital benefits of IMA, and some may conclude that they are outweighed by the cost of seeking and maintaining approval. However, before making the final decision, IBs must consider the possibility that even if they do not apply for IMA, supervisors may still require IMA-equivalent granularity of information, to satisfy their financial soundness and stability needs, with no resulting capital benefit for IBs. A supervisory ‘Catch 22’.

Focus on counterparty credit risk management

 

Recent instances of extreme, but so far relatively short‑lived, market dislocation have increased supervisory scrutiny of IBs’ preparedness for and resilience to severe market shocks, including through their exposures to NBFIs. This focus on NBFIs reflects both their increasing role in providing market‑based finance (£740 billion1 (around 55%) of all lending to UK businesses as of early 2023), and lack of an agreement on a global regulatory framework to mitigate the risks NBFIs pose. In the absence of such a framework, we expect supervisors to ratchet up their demands of IBs as a means of indirectly regulating the broader financial system, even though senior supervisors2 question the ongoing effectiveness of such an approach.

We expect supervisors to ratchet up their demands of IBs as a means of indirectly regulating the broader financial system.

As a result, we expect supervisors to continue to use all the tools available to them in respect of IBs, with a particular focus on their CCR management practices. In October 2023, the ECB published the outcome of its review of sound practices in CCR governance and management3, specifically focusing on exposure to NBFIs. The PRA also identified shortcomings in CCR management process4, while the FCA found poor management of client relationships and inadequate knowledge of clients’ business profiles5.

Even though there are differences in the detail between the ECB, PRA and FCA they share common priorities that IBs need to be ready for in 2024. These include the need for:

  • improved customer due diligence procedures;
  • enhancements of stress testing frameworks to consider the impact of tail risks on counterparties and own balance sheet and to adapt quickly to rapidly changing risks; and
  • consideration of material and complex CCR exposures in risk appetite statements.

Although supervisors’ focus will be on IBs’ financial resilience, they will also scrutinise their operational resilience, particularly that their operational processes are sufficiently robust and scalable to withstand extended periods of increased volatility.

Stepping up engagement on wholesale conduct

In a period of ongoing macroeconomic uncertainty and market volatility, supervisors are increasingly concerned that new conflicts of interest may emerge, or firms may prioritise commercial interests over regulatory obligations, undermining controls' effectiveness. Supervisors might challenge IBs to demonstrate that their culture and controls remain sufficiently robust despite revenue headwinds. In particular, the FCA will focus on new conflicts arising from market environment changes. For example, when an IB develops new products that align with the UK Government’s agenda of increasing retail participation in capital markets but allows its pursuit of higher volumes and/or margins to override its obligations under the Consumer Duty (‘the Duty’).

In addition, we expect a focus on conduct and culture to continue to drive supervisory activity in some EU jurisdictions, particularly those where wholesale trading has increased as a result of IBs relocating activity following Brexit. IBs need to do more to ensure that they embed a conduct-focused culture effectively into their day-to-day operations. Supervisors will be scrutinising IBs’ ‘speak-up’ culture policies, in particular in areas of improper behaviour and non-financial misconduct.

Consumer Duty – eliminating the tail risk

IBs in the UK will, where relevant to their product set, be working towards compiling the evidence and engaging with the Board to deliver their first Duty compliance report before 31 July 2024. Although IBs may feel that they are not at the top of the FCA’s priority list for Duty compliance, the FCA requires all firms to put their customers’ needs first in particular if they have a direct relationship with retail clients or manufacture products that can ultimately reach retail clients. We expect the FCA to scrutinise and challenge IBs’ reports.

IBs should review their current data and MI on distribution and ultimate destination of their products to determine if they are sufficient to evidence compliance with the Duty and establish the right ‘tone from the top’ to foster an environment where staff are focused on delivering good consumer outcomes.

Conclusion

As visibility for some key capital markets regulations improves in 2024 and many regulatory initiatives enter the implementation stage, IBs will need to step up, once again, their regulatory change management programmes. IBs will have to implement the changes whilst keeping up with ongoing supervisory engagement in traditional areas such as risk management and newly emerging ones such as Consumer Duty.

In detail

Read more about advancing capital markets, FRTB, counterparty risk management, wholesale conduct, operational resilience, digital assets, transition planning, diversity and inclusion and accelerated settlement.

  1. PRA, Review of Solvency II: Reform of the Matching Adjustment, September 2023, available at https://edu.bankofengland.co.uk/-/media/boe/files/prudential-regulation/consultation-paper/2023/september/cp1923.pdf
  2. FCA, Advice Guidance Boundary Review – proposals for closing the advice gap, December 2023, available at https://www.fca.org.uk/publication/discussion/dp23-5.pdf

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