In the shadow of the financial crisis, global regulatory reform of the financial services industry is here to stay/ Now, the focus of attention is shifting to implementation – progressing action on the business implications and planning for compliance. Banks must also remain flexible to adapt to subsequent changes and developments, with a number of other parallel policy initiatives being put in place, notably recovery and resolution planning, attention to corporate governance, enhanced college of supervisor arrangements, and continuing uncertainty over tax. Changes in any of these will impact companies' regulatory-response plans.
Certainly, there will be adaptation and implementation challenges as banks work to understand new standards, predict impacts, implement complex new compliance procedures, and design appropriate regulatory controls. While this outlay of resources may strain operations and slow growth, current changes in the banking regulatory landscape are the necessary products of a long series of hard lessons. On the plus side, the new regulatory environment should ultimately lead to renewed customer confidence, profit stability, and growth opportunities for banks, especially for those, such as in Canada, whose sound practices allowed them to preserve capital and liquidity and weather the recent downturn. With the spirit of good governance, risk management and compliance already built into our financial structures, Canadian banks are particularly well-positioned to move seamlessly into the new regulatory environment.
Global regulatory implementation presents enormous challenges of scale and complexity, but Canadian banks that can balance the spirit of regulatory change with new sources of revenue and customer profitability will be a step ahead when it comes to managing growth in the new regulatory environment.
Boards are playing an increasingly important role in establishing and overseeing this critical equilibrium, but they face an evolving range of challenges in the new regulatory environment, as their responsibilities expand and scrutiny of their decisions and actions grows. To manage their changing roles and act effectively under the new regulatory regime, it's important that boards understand the key elements of the new regulations, their potential impacts, and what they can do to protect the organization's best interests as those regulations are implemented.
The Emerging Framework to Strengthen Banking Regulation
Although still debated, most financial analysts agree that better regulation could have at least stemmed the tide of the recent global financial crisis. With those lessons still fresh, countries all over the world are striving to create regulatory frameworks that address deficiencies that, according to the chairman of the Basel Committee of Banking Supervision, include: poor liquidity risk management and insufficient liquidity buffers; excessive leverage combined with weak credit granting policies and practices inadequate amounts and insufficient quality of bank capital; and shortcomings in corporate governance, risk management and market transparency.
The development, implementation, and ultimate oversight of such frameworks is a monumental task. It will take years, and will not be uniformly smooth. Already, major players are taking different paths and implementing diverging policies, and timelines will be radically different for countries facing different economic realities. But the basic intent of the new regulations is to add layers of comfort and safety to the banking system, for customers and the system itself. These regulations attempt to address systemic risks that previously had not been widely anticipated. They also attempt to ensure that banks operate in ways that limit those risks, and that they are better prepared to respond to serious future financial events.
Here are some of the key initiatives to watch:
Basel III – the comprehensive set of reforms developed by the Basel Committee over the last two years –addresses identified deficiencies in financial institutions through such features as: an increase in the quantity and quality of capital; a leverage ratio ; capital buffers (conservation and countercyclical); and global liquidity standards. Within Basel III, there are other efforts to strengthen risk management and supervisory practices beyond capital and liquidity. These areas of change – such as governance, supervision, deposit insurance, methods to identify systemically important financial institutions (SIFIs) at the global and domestic level, and reliance on external credit ratings (what kind of ratings?) – have a separate consultation, debate, and implementation phase, adding considerably to implementation challenges.
The Dodd-Frank Act is major, comprehensive regulatory legislation intended to assure stability in U.S. financial markets. Its impact will probably exceed that of Sarbanes Oxley. The Dodd-Frank Act has broad implications on the financial services industry in eight key areas:
- Systemic Risk (limiting concentration)
- Financial Stability and Capital Requirements
- Volcker Rule (limiting proprietary trading)
- OTC Derivatives (managing counterparty credit risk)
- Consumer Protection and Mortgage Reform
- Federal Bank Supervision
- Registration of Investment Advisors
- Other Areas (compensation, asset-backed securities, whistleblower programs, and more).
Although it is U.S. legislation, Dodd-Frank will have global effects on both the financial services industry and corporate accountability in general, affecting banking, securities, derivatives, executive compensation, consumer protection, and corporate governance.
FATCA (Foreign Account Tax Compliance Act)
Under this legislation, the U.S. government intends to combat tax evasion intensely by imposing a 30% withholding tax on U.S. source income unless a receiving financial institution enters into an agreement with the IRS and reports its U.S customers. Financial institutions that are impacted include any bank invested in the US market for its customers' accounts or for its own account, as well as any bank which is part of a group which invests in the U.S. market for its customer's accounts or for its own account. The FATCA provisions are additional and not substitutive to the current QI regime already in place. Under FATCA, a 30% withholding tax is applied on any payment (interest, dividend or sales proceeds) on US securities made to a Foreign Financial Institution, unless it agrees to identify U.S accounts; comply with verification and due diligence procedures; perform annual reporting; deduct and withhold 30% from any passthru payment made to a recalcitrant account holder or another institution without an FFI agreement; and comply with requests for additional information.
Recovery and Resolution Planning, or Living Wills
Arising from all the regulations above and supported by financial regulators from the G20 group of nations, a living will is a regulator-approved plan, or "will," for SIFIs that lays out an orderly wind-down in case of a "life"-threatening event. It would provide a much wider range of options beyond straight government bail-out.
Impacts and Challenges: Key Questions Around Growth
The successful implementation of these regulations will radically alter the Canadian and global banking environments. Despite the expected return of customer and investor confidence, banks will face significant specific challenges. Canadian banks have been growing, and this is obviously a trend that the financial industry, and the economy at large, would like to see continue. But in the initial stages of regulatory adjustment, it may be reasonable to expect a slowdown of this trend. The mechanics and cost of compliance will initially increase the costs for virtually all financial entities. The question is, once business returns to "normal" under the new regulatory umbrella, how much will growth be affected by the new regulatory environment? Assuming customer confidence and profitability grow, will the organization be able to leverage that success into global growth?
Another major question is how consistently regulatory reform will be implemented globally. If implementation is inconsistent, regulatory arbitrage may continue to fragment overall financial system stability, as it did despite earlier reforms such as Basel I and Basel II. It is, of course, impossible to predict exactly how this regulatory landscape will develop, but Canadian banks should consider possible scenarios and apply some critical questions to their long-term strategies.
Canada is in a good position relative to many other countries. The banking industry has liquidity and capital, and, comparatively speaking, should emerge as a global leader in accessing available opportunities. But how much will risk – necessary to success and growth – be removed or lessened as a strategic option? Will significant growth be achievable via the same strategies as before? Canadian financial institutions need to and want to be part of the global imperative to eliminate events like the financial crisis, but they are well aware of the fine line between controlling risk and reducing risk to the point where commercial viability is affected.
In what should be a change for many organizations, boards will need to know more about the business, get more engaged around capital and liquidity planning, and engage in discussions around acceptable levels of risk. Boards need to get more involved in capital planning, and, most specifically, in reviewing and approving risk-appetite statements and risk tolerance. They will need to make sure regulators can understand the organization's risks and vulnerabilities and the amount and quality of capital they are holding. Boards can drive the creation of living wills, as well as determining the trigger points for when they should be activated.
Balance: Build Toward a New Risk-Profit Equation
In all businesses, there is a trade-off between risk and profitability. The greatest challenge for Canadian banks is to understand how this equation will be reconstituted in the new regulatory environment. The goal of regulatory reform is not to destroy the ability of banks to grow and earn, but the formulae will certainly be different. How do banks leverage their core strengths moving forward? Where can they take on risk to provide extra return? How can this all happen while safeguarding the customer relationship the industry is working so hard to recapture?
The answers will differ for individual banks. The positive aspect is that Canada will be as well off as any country under the new regime, set to transition effectively to new regulatory mandates, ready to enhance customer confidence, and better positioned than most to develop effective growth strategies. The key is to formulate governance and risk-management infrastructures that balance the requirements of compliance and the goal of strengthening the financial system with commercial realities.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.