TLDR: The 2008 financial crisis prompted global regulatory reforms like the US Volcker Rule and the UK’s Vickers Report to separate risky trading from retail banking, aiming to protect taxpayers and stabilize the core banking system, despite challenges posed by complex and evolving regulations.
Overview and context
The credit crisis of 2008 exposed critical weaknesses in the global financial system. The interconnectedness, opacity and leverage of the largest global financial services firms suddenly posed a significant threat of sinking the entire world economy into a depression.
The failure of Lehman Brothers - smallest of the remaining four major Wall Street Investment Banks - showed all too clearly the impact that any larger bank failure could have had. Much like the poor King in the Lewis Carroll story, the society and governments of many countries experienced the shock of suddenly being moved by forces much larger and stronger than they had ever experienced before.
Governments and central banks, judging the costs of financial system failure to be too high, stepped in and bailed out major banks. The banking system was saved at the expense of taxpayers in the US and Europe who had to shoulder the massive burden of bail-outs that reached trillions of dollars. Overall the results were a mixed success.
A political backlash against “privatized gains and socialized losses” started almost immediately. The G-20 jointly and individual countries separately, embarked on an ambitious path to re-regulate the financial services industry to avoid the repeat in the future.
The ongoing goal is to protect taxpayers, strengthen the stability of the core banking system and to make sure that bank shareholders and bondholders bear the losses in the future.
The complex web of financial regulation
Today, almost four years into the era of re-regulation, the financial services industry is faced with complex, somewhat contradictory and, in some instances an incomplete regulatory framework. The Dodd-Frank Act, EMIR, MiFID, MiFIR, Basel II and other regulations have created a tangled web of new rules that aim to change the way the industry operates for the better.
Cutting ties
A key component of all of these regulations is the separation of risky trading and investing activities from more mundane retail banking. Deregulation of the financial services industry over the 20 years preceding the credit crisis allowed for the creation of giant universal banks that under one umbrella offered vanilla banking services to retail depositors and traded complex derivatives with their own capital. As a result, some of the largest universal banks have grown to have balance sheets almost as large as their home country’s GDP - making them “too big to fail” and “too costly to save”. Today they are known as Systemically Important Financial Institutions (SIFIs).
US and UK Regulatory Initiatives: Different approaches, similar aims
The Volcker Rule in the US and the UK’s Independent Commission on Banking recommendations (dubbed the Vickers Report) are two main regulatory approaches to separating risky trading activities from retail banking that have emerged. Both aim to address problems arising from the integrated business models used by SIFIs before the crisis. Both have similar philosophical underpinning but are taking very different approaches to achieve their goals.
While the Volcker Rule essentially prohibits covered banking entities from engaging in proprietary trading and investing in hedge funds, the Vickers Report recommends ring-fencing retail banking operations within existing universal banks. Conceptually, both approachers could ensure that the risky trading activities do not topple a major bank.
Arguments can be made to support both approaches. The reforms proposed by Vickers implicitly recognize the difficulty of separating capital markets activities from commercial banking. It also acknowledges that there are synergies that large universal banks can realize from engaging in both retail banking and capital markets activities. Therefore, the focus of the Vickers reform is on protecting the retail banking operations within large universal banks at the time of the stress.
On the other hand, proponents of the Volcker Rule aim to achieve hard separation of risky trading and vanilla banking activities by effectively forcing large banks to choose the business they want to be in. They point out that even the best managed firms such as JP Morgan can be exposed to substatioal losses from proprietory trading activities as shown in the recent $5 billion plus trading loss in the firm”s CIO unit. Although JP Morgan has sufficient strength to abserb this loss, the very possibility of similar losses at large yet stable banks reinforces the drive to ensure that it does not happen again.
Table 1 provides a high-level comparison between the two approaches proposed.
| Volcker Rule (1) The “Volcker Rule” is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010 and introduced in Title VI the “Bank and Savings Association Holding Company and Depository Institution Regulatory Improvements Act of 2010.” |
Vickers Report (2) The “Vickers Report” is the name dubbed for the UK’s Independent Commission on Banking Report published in November 2011. |
|
|---|---|---|
| Scope | The rules define a covered banking entity very broadly to include: - any insured depository institution, - any company that controls an insured depository institution, - any company that is treated as a bank holding company for purposes of the IBA, and - any affiliate or subsidiary of any of the above. |
All UK banks and bank holding companies that engage in services that mandatorily belong to the ring-fence plus UK subsidiaries of foreign banks offering ring-fenced services. |
| Approach | Prohibition of proprietary trading which is broadly defined as engaging as a principal for the trading account of a banking entity in any purchase or sale of one or more covered financial positions. This relates to short-term trading. Permitted activities include: - underwriting - market-making - hedging activities - investing in obligations of the US Government and states. Strict limit on investments in hedge funds to 3% of Tier 1 capital. |
Ring-fencing of retail activity which aims to separate UK domestic retail banking services (ring-fenced banks) from global wholesale/investment banking services. The following activities would be prohibited for ring-fenced banks: - any service which would result in a trading book asset or in a requirement to hold regulatory capital against market risk - any service that could hinder the smooth resolution of a ring-fenced bank - services that increase the exposure of the ring-fenced bank to global financial markets and market volatility - services that involve taking risks not integral to the provision of payment services or the direct intermediation of funds between savers and borrowers within the non-financial sector - services provided outside the EEA - services which result in exposure to a non-ring-fenced bank or non-bank financial institution. |
| Territorial Reach | The rules specifically limit the extra-territorial effect by permitting international banks to engage in proprietary trading and to invest in funds solely outside the US. | UK specific |
| Structural Impact | Banks or Bank Holding Companies subject to the rule cannot house affiliates, even as separately capitalized and independent subsidiaries, that engage in prohibited activities. | Ring-fenced banks can co-exist within the same group as affiliates offering prohibited services. However, they must do so as separately capitalized, independently managed subsidiaries. |
| External Links and Activities | No links can be established that seek to circumvent prohibition of proprietary trading and funds investing. | No such links can be established without prior regulatory approval except with such entities within a ring-fenced bank’s own group. Within the group, such transactions must be conducted at arm’s-length and be subject to prudential constraints on intra-group exposures. |
| Deadlines | Implementation Deadline = July 21, 2014 | Regulation Finalized = May 2015 Implementation Deadline = 2019 |
The challenges to find a regulatory regime
A number of key questions are being asked:
— Can either one of these approaches succeed in achieving policymaker’s goals of protecting the core banking system and ultimately taxpayers? Or is today’s financial services industry too big, complex and influential to be regulated in any meaningful way, without leading to unintended consequences.
— Will specific rules clearly separate risky trading activities from core banking or will this result in a lower appetite to extend credit due to a perceived inability to hedge?
— Will higher capital requirements ensure that risk is appropriately priced and managed or will this simply lead to higher cost of available funding to the economy, thus stifling the growth?
These broad questions are at the forefront of global debate and must be addressed in a consistent, comprehensive way.
The path to a global regulatory regime
It must be noted that while the Volcker Rule in the US and the Vickers Report in the UK have been proposed, in continental Europe countries within the Eurozone that are battling a sovereign debt crisis have not yet chosen an approach. Unlike in the US and UK where corporations and governments rely on the capital markets for financing, in Europe banks play an important role directly financing both sovereigns and businesses. Whilst in Asia banks serve as instruments of Government economic policies by directly lending to preferred industries, companies and infrastructure projects.
As a result of the diverse role that large banks play in different regions, a consistent and comprehensive approach to regulation must be flexible enough to accomodate specific regional nuances without createing the opportinuty for regulatory arbitrage.
The development of a global financial regulatory regime will be a long and iterative process that will involve all stakeholders, including legislators, policymakers, industry practitioners and end users in all major economies. It will incorporate limits on specific types of activities (as the Volcker Rule does for proprietary trading) as well as broader regulation of capital requirements (such as Basel III).
Despite the challenges of building a global regulatory regime, it is likely to be centered on the differentiation between and the monitoring of permitted and prohibited activities. The burden of supplying the regulators with appropriate information and data on a timely basis will fall on the industry. It is expected that the cost of compliance will be significant. Looking at past regulations such as Sarbanes-Oxley and Basel II it is clear that the costs of ongoing compliance are likely to be several million dollars per year; as an example the OCC in the US estimated the cost of implementing the Basel II Regulatory Framework to be $21 million for a large bank*. As it is highly unlikely that these regulations will go away, banks need to gear up for the cost implications of implementation.
* Source: Networks Financial Institute: The OCC estimated that a typical bank utilizing the full Basel II regulatory framework faced a total compliance cost of about $21 million.
What to do in the environment of regulatory uncertainty?
It is not our goal to try to guess the final shape that exact regulations will take. In our ongoing discussions with clients, one recurring comment we hear is that they are reluctant to take specific steps or make substantial changes until regulations are finalized. Is this a viable approach?
We believe that the financial services industry, and in particular the largest players, must accept that the regulatory uncertainty will continue for the foreseeable future. Further, regulations will evolve and change over time. Faced with this, every financial services firm should focus on building up their strategic flexibility to comply when the regulations become final.
We have identified three key areas that banks need to pay attention to and invest in today:
1. Organizational simplicity
Today’s financial services firms, particularly large global banks, are a complex web of interconnected legal entities set up in various jurisdictions supporting various business activities. While this structure served banks well when there was little or no cost of compliance, regulatory reporting and capital, it very well may become prohibitively expensive to operate in the new environment. The Winchester Mystery House* comes to mind as an apt metaphor for some of the existing organizational set ups.
The Winchester Mystery House* [Source: Wikipedia] The Winchester Mystery House is a well-known mansion in Northern California. It once was the personal residence of Sarah Winchester, the widow of gun magnate William Wirt Winchester. It was continuously under construction for 38 years. Under Winchester’s day-to-day guidance, its “from-the-ground-up” construction proceeded around the clock, without interruption, from 1884 until her death on September 5, 1922, at which time work immediately ceased. The Queen Anne Style Victorian mansion is renowned for its size and utter lack of any master building plan. According to popular belief, Winchester thought the house was haunted by the ghosts of the people who fell victim to Winchester rifles, and that only continuous construction would appease them.*
Indeed, with regulators looking to understand each firm’s risk profile, organizational complexity stands in the way of regulatory reporting. To meet the requirements of regulators in various jurisdictions, financial services firms must be able to quickly and accurately identify within their business mix what activities should be reported, where these activities are captured, if they captured in a consistent manner and how required reports can be created.
Furthermore, as the cost of capital is increasing and funding is becoming more challenging, maintenance of a large number of legal entities becomes costly and inefficient. Only so much can be achieved by optimizing existing funding approaches before limits are reached and wholesale rethink of the legal entity structure is required.
The Winchester Mystery House* comes to mind as an apt metaphor for some of the existing organizational set ups.
Legal Entity Architecture
Given the level of business complexity of large financial services firms, there are obviously some legitimate business, tax, legal and other reasons to maintain multiple entities to house specific types of activities. Balancing this need with the need to achieve organizational simplicity requires an end-to-end review of the overall “legal entity architecture”. This review must take into account breadth of business activities and conflicting priorities (such as legal, tax, finance.), identify best possible architecture that balances simplicity without sacrificing legitimate benefits, as well as create a framework for any future additions required. Any architecture model will also need to be stress tested to identify any specific failure points that must be addressed in times of market stress.
Once this architecture is defined, organizations must undertake a comprehensive review of their existing activities and assign them to their logical place in the new structure. Migration to the new set-up is likely to be a multi-year excercise. However, the resulting structure will provide the required flexibility to meet evolving regulatory requirements as well as provide business benefits by lowering costs of compliance, funding and management.
2. Data transparency
Access to complete, accurate and timely data has been a key business requirement for financial services firms. Recent regulations made this an absolute must. Just to comply with the requirements of the Volcker Rule, many large banks will need to produce a comprehensive set of metrics to prove that their trading activities do not violate the ban on proprietary trading. Other regulations set specific compliance rules based on the type of counterparty, client and instrument.
Reporting to industry data repositories and regulators requires even larger sets of data to be supplied at higher frequency and retained over longer periods of time. In addition to regulators, clients, rating agencies, investors and other stakeholders clamor for data transparency to understand what kinds of risks are embedded in large financial services firms.
However, the industry today struggles with internal data problems. Many financial services firms were built over the past decades as a result of multiple mergers leaving a legacy of disparate systems, processes and data stores. The lack of industry standards and high costs of retrofitting existing systems to comply with even limited standards led to a mess of tactical solutions implemented while waiting for “strategic” ones. C-level executives in the industry are struggling on a daily basis to get access to timely and consistent management information to make decisions in real-time and respond to sudden market moves or requests from regulators.
Solving “The Data Problem”
Why is “the data problem” so difficult to solve and more importantly, what has changed to ensure that this time it will be different? Despite the difficult business environment and cost pressures, many financial services firms are continuing to invest in their “data assets” and in developing an “enterprise data architecture”. The core of these initiatives are focused on identifying golden sources of data, ensuring enterprise-wide compliance with standards and gradual transition of legacy platforms to new data sources.
Investment in improving data quality will pay dividends over a long time. Even partial wins will give financial services firms better capability to meet regulatory requirements, enforce compliance and communicate to external stakeholders. One could argue that having access to accurate data on a timely basis is a prerequisite to being able to operate in today’s volatile markets. Giving executive management the ability to accurately understand risks and to identify potential business impacts of new regulations is critical to ensuring strategic flexibility.
3. Operational sophistication
The financial services industry, in particular capital markets firms, have been investing in their technology platforms as a way to boost revenues, launch innovative products and improve client services. Many of them spent a significant amount of resources on developing trading systems to manage complex derivatives or to provide the capability to trade in the stock markets using sophisticated algorithms.
Most of these investments were geared to supporting new businesses or products at the expense of streamlining processing and control systems. In many cases Risk Management, Finance, Operations, Compliance and other support functions are still operating on inefficient, complex and disparate systems with heavy manual interventions.
As compliance burdens are likely to increase over time, the industry must address the investment imbalance and substantially enhance capabilities of processing and control systems. This effort should be focused on further automation of real-time transaction flows, increase in data quality and development of data warehousing and retrieval capabilities.
Improvements in systems must be closely followed by improvements in business processes to reduce the operational cost while increasing operational sophistication. Coupled with “legal entity architecture” and “data architecture”, investments in operational and support systems will build a platform to support future businesses.
Conclusion
Whatever shape regulations take over time, financial services firms must approach their design with the goal of achieving flexibility to meet regulatory requests with the lowest possible cost — not an easy task given the complexity of some new regulations.
Whilst consultations are still ongoing around some of the major regulatory initiatives, deadlines are looming. Elements of Dodd-Frank are already impacting the industry, FATCA will begin to hit from January 2013, the Volcker Rule from July 2014 and although Vickers is not expected to be fully implemented until 2019, much work is required to prepare for the impact on UK financial institutions in the next 7 years. Not to mention Basel III, EMIR, MiFID… and then there is the Asian regulatory landscape to consider.
Although the rulemaking bodies have so far been accommodating to industry pleas that they are simply not equipped to meet strict requirements, as deadlines approach time is running out and the patience of regulators is beginning to wear thin.