Introduction
Welcome to the March 2009 edition of Banking and Capital Markets Insight, which focuses on technical issues currently coming out of the banking, capital markets, securities and fund management arenas. Our particular focus for this edition is on the changing supervisory oversight, at a domestic and a Europe wide level, the quality of capital held by banks and investment firms, and the revised client money and asset requirements.
Our four pieces cover the following areas:
- Mike Williams on the FSA's Financial Risk Outlook 2009 and its likely impact on firms' capital adequacy, liquidity, strategic and risk management procedures.
- Clifford Smout on the regulators' likely different approaches to the maintenance of additional capital to provide better levels of credit reserving throughout the cycle, and whether their tools should be focused on taking a macro economic or firm level view.
- Eric Wooding on the likely development of the Basel Committee's thinking on international regulatory principles, including the need for cross-border co-operation, the effective implementation of standards, and appropriate focus on systemic risk issues.
- John Hammersley on the changes brought about by the FSA's Policy Statement 08/10 on the client money and assets requirements which are implemented on 1 January and 1 May 2009, which apply a more principles based approach, and which provide greater harmonisation between the provisions applied to MiFID and non-MiFID firms.
We look forward to your comments on the current edition.
Mike Williams
Editor
FSA points the way with financial risk outlook
Anyone looking for a clear statement of the FSA's intentions in terms of the future application of their prudential rules to all categories of investment firms, banks and insurers need look no further than the recently published Financial Risk Outlook ("FRO") 2009, which is available from the FSA website.
The publication provides an excellent overview of the macro economic issues which have led to the current downturn and the related drivers for their regulation of financial firms. My own thoughts on the likely impact of the current trend of regulation, based on some of the issues raised in the document, are as follows:
- Capital adequacy: the trend of capital requirements for smaller as well as more significant firms is already starting to be edged upwards by the FSA, using firms' updated ICAAPs and the Individual Capital Guidance derived from their own Supervisory Review and Evaluation Process, performed as part of the current round of ARROW or ARROW light visits. Firms will need to define in a more quantitative manner their expectations of required capital, based on their risk appetite, as a core part of the ICAAP process, and the FSA will start to penalise firms, which cannot articulate their risk management of new business clearly, with potentially higher regulatory capital requirements. Higher charges to cover the perceived deficiencies in the existing market risk charges and the requirement for counter-cyclical reserving policies are likely to be a given in the near term, and firms can also expect more challenge when applying for Value at Risk or stand alone model permissions.
- Liquidity: the proposed liquidity requirements, which come into
force in October 2009, require all full scope firms to build
quantitative and qualitative systems and controls, to measure,
monitor and stress test their cash flow requirements over an
appropriate set of time horizons in respect of both their on and
off-balance sheet business.
In a similar way to the ICAAP, under the Individual Liquidity Adequacy Assessment ("ILAA") process, firms will need to stress test their liquidity against their liquidity risk tolerance and to analyse the separate impact of possible future liquidity stresses against cash flows, their liquidity position, their profitability and their solvency, over the short and long term, based on their own specific and market wide liquidity stress scenarios. Monitoring, which should be demonstrably overseen by senior management, will need to include intra-day management of liquidity and liquidity across the firm's other group members, where appropriate, and firms will need to demonstrate a diversified liquidity strategy, with no undue reliance on one type of liquidity funding or particular counterparties. Higher buffers of highly liquid, high quality assets are likely to be required. These changes taken together represent a major undertaking for the majority of firms. For some firms, which have previously passed liquidity back and forward to overseas group entities on a daily basis, will, in the absence of an appropriate waiver, have to fundamentally review their approach to maintaining local European and UK based liquidity. The difficulty for the regulators will be applying the regime in an even handed way when overseas branches and other foreign institutions may well achieve waivers from the proposed regime and so potentially have a competitive advantage as a result.
- Institutional coverage: European leaders at the recent summit
in Berlin have emphasised their intention to fully regulate all
types of institutions, including hedge funds and rating agencies.
The FRO flags the FSA's intention to regulate firms on a
substance over form basis, that is, based on the complexity of on
and off balance sheet structures which they create, in an effort to
rein in the so-called shadow banking system. The FSA is likely to
be more intrusive into all types of business which firms undertake
in aggregate, including those which currently do not require
prudential regulation, and they have signposted that this is likely
to have a significant effect on current bank and investment banking
practices. As the FRO notes, the FSA will need to more involved in
the identification of macroeconomic trends and risks, and will
require increased dialogue with other regulators. This initiative
will also have a far reaching effect on both the FSA's resource
requirements, if they are to pursue these wider objectives, and the
quality of detailed oversight required.
There will, however, also be a potentially significant effect on the prevailing climate for firms wanting to undertake innovative business in London or the other onshore European locations, and there is clearly a risk that financial creativity could be stifled or driven to offshore locations, which would not meet the regulators' intentions. - The Icelandic banking crisis and its lessons are analysed in the FRO. The FSA proposes that either passporting rights for retail business should be restricted so that fully capitalised subsidiaries have to be created in local jurisdictions, or better European wide processes will need to be put in place to assess the effectiveness of home state regulation for passported business, with supporting cross-European deposit insurance arrangements in place. Host states could also be given more power to insist on the strengthening of home state regulation, for example, over contingency planning. Better international regulatory co-operation and reporting is a key theme in a number of regulators' thinking at the moment, but its effectiveness will rely on whether individual countries can maintain focus on the wider economic and regulatory good, rather than a return to the style of incremental local regulation which we saw under the Investment Services Directive, which could easily lead in turn to more trade protectionism.
- The importance of strong risk management at a fundamental level, rather than pure reliance on quantitative models, for example, for market risk management of OTC products or for setting probabilities of default for credit risk management purposes, is emphasised in the FRO. There is a real concern that, as firms are likely to shed staff in the face of the tougher market conditions, risk management functions for financial, conduct of business, operational and fraud and financial crime purposes are likely to be depleted. Firms are more likely to experience some of these areas of risk, such as fraud and financial crime, as the downturn continues, so maintenance of their resources across all areas of risk management is essential. This also extends to firms controlling their risks of mis-selling or mis-communicating products to clients or not treating them fairly in the course of the sales process, as the need to maintain revenues increases, and also of not treating customers appropriately in the arrears and repossessions process. This is bound to come to the fore, and to engender a higher focus in terms of client complaints, in the coming year.
- Firms' business models need to be sustainable, with reliable and well diversified income streams to support their medium term survival, strong Tier 1 capital ratios to support that business, and remuneration policies which support the effective longer term development of the firm's business, rather than incentivising staff to pursue higher-risk strategies in the short term which could run contrary to the firm's longer term overall risk appetite. In many ways, this is one of the FSA's most intrusive messages, in that they are taking a remit over firms' strategic and remuneration policy decision making. On the other hand, the extreme market events of the last nine months show that there is a real risk that, from niche financial sector businesses to the largest banking conglomerates, any firm could potentially founder if they do not have the right strategic vision and effective oversight of how that vision is implemented, or their funding and risk strategies are too reliant on a single model. Firms should therefore expect more challenge from FSA on the detail of their strategic plans (and how they feed into the firm's budgets and projections) and their approach to remunerating staff to support the development of those plans.
The Financial Risk Outlook 2009 sets an ambitious agenda for the FSA and for regulated firms. The challenge will be, for both sides, to maintain a close spirit of co-operation in achieving these objectives and for the FSA to demonstrate that they have the appropriate resources and, most importantly, the wider vision at grass roots level to achieve their objectives of maintaining stronger capital and liquidity levels, and better strategic and risk management focus, in firms in an individual firm centric and risk based way.
Mike Williams
Counter-cyclical capital requirements: preparing for a rainy day?
Over the past thirty years, prudential regulation for banks has got ever more sophisticated. We have moved from a simple leverage ratio to one in which assets are weighted by risk (Basel 1), then to a system that uses models to deal with market risk, and finally to Basel 2, in all its complexity.
But to some the recent market turmoil suggests that these requirements failed to work effectively. To others, it suggests that while they are important, they offer only a partial solution. Instead other "lines of defence" are needed.
For instance, there is growing interest in a leverage ratio, perhaps expanded to include off balance-sheet items, as a supplement to Basel 2. And there is a great deal of interest in "macro-prudential tools" which are designed to make the financial system less cyclical and to dampen down booms and busts. In particular, policymakers want banks to build up buffers of capital in good times, to be used when times get hard. At present, by contrast, they feel the system tends to exacerbate the cycle rather than smooth it.
Procyclicality
Why is this? In an upswing writedowns typically decrease, with capital consequently increasing. Unless robust "through-the-cycle" methodologies are used, instead of "point-in-time" estimates, the reduction in defaults also feeds through into a lower "risk" measure for the assets held by the bank. With higher capital, and less risk, measured capital ratios rise, allowing a firm either to increase leverage, or move into riskier assets. Both steps should allow it to increase its reported return on equity. With gross revenues higher, there is scope to boost salary and bonuses. And shareholders, through higher dividends and capital buy-backs, also benefit tangibly, at least in the short-run.
In a downturn, these steps unravel. Reported risk soars just as the capital base comes under strain. It takes time to cut back on salaries and bonuses and – at present at any rate – there is little chance of repayments by staff. Assets acquired in the boom still need to be funded, which can be difficult if balance-sheets have grown significantly or if higher-risk assets are opaque and difficult to value, and while dividend payments can be cut, it may well be more difficult to attract new capital than it was to buy back old.
Possible solutions
One answer to this problem is to get firms to "put away" capital in the good times, by provisioning accordingly. The Spanish example of "dynamic provisioning" is the best-known example of this: it uses an extensive sectoral database of loss experience to compare the current level of specific provisions against a historic average, so that if in an upswing such provisions fall, reserves are set aside to guard against future losses. Importantly the system is transparent – i.e. the level of these "dynamic" provisions is published – and there is a cap on their amount, so that if there really has been a structural shift down in the riskiness of a portfolio, a firm does not need to make additional provisions against it for ever. This transparency, and the rule-based nature of the provisioning, both contrast sharply with the "hidden reserves" regime that operated in the UK thirty years ago. Others thinking of following this example then need to consider whether such reserves should be charged against P&L or taken below the line, whether they should count as Tier 2 capital, and whether they should be tax deductible.
But other approaches have also been mooted. One would be to use calculate a multiplier for capital ratios, using a formula based on asset prices or credit expansion (at the macro-level) for instance, or on, for example, leverage or liquidity mismatches (at the level of the individual firm). Each of these measures is open to objection (for instance, rapid credit growth may reflect a structural change in the economy; it is always difficult to identify asset price bubbles at the time; leverage ratios penalise growth in low-risk assets but not a switch from low to high risk assets). There is also the issue as to whether the same multiplier should be applied to all banks in a country, which might seem best for a "macro" tool, or whether this approach unreasonably penalises the prudent institution that has not overextended itself, with a "micro" approach being preferred instead.
Another variant, based on the example of the Bank of England Monetary Policy Committee but applied to a different context, would be to establish a committee to set a multiplier on a judgmental basis. Such an approach would most likely be applied to all banks as an across the board charge, and such a committee would be subject to heavy lobbying from bankers and others reluctant to accept that the present benign circumstances were in fact temporary.
One criticism sometimes heard is that such solutions involve double-counting. In theory this should not be the case: the risk-weighted approach is designed to force banks to hold capital against future (unexpected) losses whilst these tools encourage capital to be retained against outcomes that are likely (perhaps even "expected") in the future. In practice the distinction is less clear, particularly if firms move to "through-thecycle" approaches to credit risk. But the proponents of this approach argue that a certain amount of duplication is a price worth paying if, as a result, the financial system is materially more stable than otherwise.
The international dimension
Finally, there are likely to be complications whether or not such tools are introduced by one country, or globally.
If introduced by one country when times are good, its banks will argue that this hampers both their domestic and international business, as they will hold more capital than their foreign competitors. When times are bad it may not be possible for capital requirements to be reduced below internationally agreed minima. Even if it is, this might meet with resistance from counterparties and others.
If introduced multilaterally, there could still be complications if economic cycles are not aligned. If, for instance, one country is booming and used such an approach it might set capital ratios 50% above international norms (say at 12%). But banks from other countries could branch into that country at the "standard" 8% ratio. This would be likely to result in accusations of unfair competition, and pressure to narrow this gap (and hence remove some of the rationale for the charge). Alternatively there could be calls to disallow branching, as opposed to separately incorporated subsidiaries which would be subject to local capital requirements. It will be important to obtain clarity on points such as these before any new requirements are introduced.
Clifford Smout
Changes to the client money and assets "CASS" sourcebook
1 January 2009 saw the introduction of a number of relatively significant changes to the FSA's CASS sourcebook, although these have not been widely publicised given the other significant market and regulatory events which have predominated.
Following on from its original Consultation Paper, CP 08/6, the FSA published the new rules back in September 2008 in Policy Statement 08/10. The new rules aim to harmonise the standards between MiFID and non-MiFID firms, as far as possible, and streamline this complex and sometime burdensome area of regulation. The most significant change is the deletion of Chapters 2 and 4 (non-directive rules) of CASS from the handbook and the move to a single set of rules for both MiFID and non-MiFID business. The full-scope CASS rules will now apply to all firms including those firms "administering or safeguarding" assets as part of their non-MiFID business, which previously only needed to comply with CASS 2 and 4.
While the majority of the changes outlined in PS08/10 will be relevant to firms currently applying the Chapter 2 and 4 non-MIFID client money and assets rules, there will also be some potentially important changes impacting MiFID business. The distributions section of the rules has been delayed, following industry correspondence with the FSA, and will now be introduced in the second quarter of 2009.
Changes to the client assets rules due for implementation on 1 May 2009 are specifically the terms under which firms lend assets to each other and will give firms scope to limit the way in which assets held in custody on their behalf can be used by the third party, to provide the firm and its clients with a higher level of protection.
The FSA expects that the move to a common CASS standard will not be too burdensome for non-MiFID firms and that, in practice, the MIFID rules will offer more flexibility for firms due to their less prescriptive, more principles based drafting.
We have set out below some of the main changes implemented on 1 January and, where highlighted, to be implemented on 1 May.
Exemptions:
- The FSA have retained a number of important exemptions including the current carve-out for "affiliate companies" in the current non-MiFID regime, so that firms can continue to hold or administer monies on behalf of affiliated companies without the need to treat those monies as client monies, unless either the firm has been notified that the monies belong to an underlying client of the affiliate, or if the affiliate is otherwise dealt with as a client on an arm's length basis. The FSA have also retained the exemption from the client money rules for non-MIFID operators of collective investment schemes.
- Firms will be able to continue to opt Professional Clients or Eligible Counterparties out of the CASS client money rules for non-MiFID business on a twoway agreement basis.
Principles-based approach
The FSA has adopted a more principles based approach for the protection of clients assets held in custody for all firms. CASS 6.2.1 requires that "A firm must, when holding safe custody assets belonging to clients, make adequate arrangements so as to safeguard clients' ownership rights, especially in the event of the firm's insolvency, and to prevent the use of safe custody assets belonging to a client on the firm's own account except with the client's express consent." These principles are arguably late in their implementation for the investors with their client money and assets currently held up in the administration of Lehman Brothers (although clear terms of business under the previous rules were no doubt in place), but they will hopefully help to clarify rights and responsibilities for future similar scenarios.
Clearer setting of terms
CASS 6.4.1R will further prevent any firm from entering into any "securities financing transactions" (including stock lending or margin transactions) unless there is express client consent for them to do so. Clients are thereby given scope to restrict the types of transactions that third party firms can undertake with their assets by either granting or limiting permission within their terms of business. This rule extends the scope of the current requirement to obtain express prior consent from retail clients for securities financing transactions to include eligible counterparties and professional clients and will cover all assets held in custody on behalf of all clients. Firms may therefore need to update their client acceptance documentation to, where necessary, obtain this consent, but they will also need to obtain express prior consent from all existing Eligible Counterparties and Professional Clients. Firms have until 1 May 2009 to apply these provisions.
Enhanced due diligence requirements
CASS 6.3 has been extended so that it now requires all firms depositing assets with third parties to undertake more wide ranging, documented initial and periodic assessments of those banks or custodians, to demonstrate its exercise of "due skill, care and diligence" in appointing third parties in to hold those assets. A firm may only deposit safe custody assets in a jurisdiction which specifically regulates the safekeeping of safe custody assets, unless the nature of the investment business requires assets to be deposited in a jurisdiction without safe custody protections or a professional client requests the use of a third party in that jurisdiction in writing.
Reconciliations
Firms now have increased flexibility to determine the appropriate method and frequency of their internal and external client money and assets reconciliations to take account of their particular client base and business. In applying the CASS 6 and 7 rules to all firms, the FSA have moved the previously prescriptive rules in CASS 2 and 4 to a more principles based approach which simply requires "regular" internal and external reconciliations. The firm and its auditors will need to determine between them what reasonable periods are in respect of the firm's particular business. The FSA have concluded the imposing a minimum reconciliation period on firms would be super-equivalent to MiFID.
Record keeping requirements
Client money and assets record keeping requirements (including reconciliations, client money calculations etc.) for non-MiFID firms have also been harmonised from the previous three year minimum retention requirement to the MiFID standard five years in most cases through application of the CASS 6 and CASS 7 rules to all firms.
There are a number of changes of detail to the client money and assets requirements under the Policy Statement 08/10. Given the FSA's increased focus on client money and asset provisions following the Lehman Brothers administration, firms would be well advised to consider its provisions and their impact on their client money and assets systems and controls in detail.
John Hammersley
The direction in which the Basel Committee is moving
While the current crisis continues to be their priority, governments, central banks and regulators have of course not lost sight of the longer term issue of how to fix banking regulation. An "official" indication of "the direction in which supervision is moving" recently came from Mr Nout Wellink, Chairman of the Basel Committee on Banking Supervision, in a short speech.
In summary, Mr. Wellink identified three "current areas of supervisory focus", namely:
- the need for a macro-prudential approach;
- regulatory gaps; and
- cross-border co-operation.
In addition he announced that the Committee has begun a review of the procyclicality of the Basel II framework and taken steps to improve implementation of the Committee's standards and guidance.
A summary of Mr. Wellink's main points under each of these five headings is set out below and is followed by brief comments:
A macro-prudential approach
While strong supervision of individual institutions remains essential, supervisors need to devote more resources to understanding interactions among banks as well as between the banking sector and other financial sectors. The Committee will be exploring ways of doing this, that is, of implementing a macro-prudential approach.
Regulatory gaps
Noting that a key lesson of the crisis is that non-deposit taking institutions can be a major source of systemic risks, the Committee is aiming to ensure that unregulated and under-regulated firms, such as hedge funds and, in some countries, non-bank mortgage intermediaries, are subject to adequate oversight commensurate with their potential to pose systemic risk. A variety of different types of oversight are possible, ranging from capital requirements to disclosure.
Cross-border co-operation
One lesson of the current episode is that existing national crisis management and resolution arrangements are not tailored for cross-border banking crises. Further analysis will be conducted and the Committee will continue to promote information sharing and the use of supervisory colleges during both normal times and periods of stress.
Procyclicality
The Committee has begun a comprehensive top-down review of the potential procyclicality of the Basel II framework, that is the possibility that it amplifies the economic cycle. This is a difficult issue owing to the fact banking, and human behaviour in general, is inherently procyclical and that other factors such as valuation and loss provisioning are relevant. A range of measures that might have a countercyclical influence is being evaluated. These include ways of promoting a capital buffer that a bank would build up in good times and draw on in bad and, secondly, a simple leverage measure, supplementary to the risk asset ratio, that would be intended to restrict the growth of leverage in good times and hence reduce the scale of deleveraging in the downturn.
Implementation of standards
An important lesson of the crisis is that sound standards of credit and liquidity risk management were not practised. Therefore the Committee is replacing the Accord Implementation Group which was focused solely on the implementation of Basel II with a group (the Standards Implementation Group) that has a broader mandate that includes implementation of all the Committee's risk management standards and guidance, not just Basel II.
Comments
If the two practical issues – cross-border co-operation and implementation – are set aside, the dominant theme is greater focus on systemic risk. The Committee has clearly accepted the point, made by Professor Charles Goodhart and others (before Basel II was finalised), that it is not sufficient to focus, as Basel II does, on the safety and soundness of individual banks since actions (such as fire sales that drive down market prices) which are prudent and rational from the standpoint of the individual bank may weaken other banks and hence the financial system as a whole.
However, Mr. Wellink emphasises that the greater focus on systemic risk does not mean that Basel II will be entirely scrapped. For example, he notes in particular the "need to retain the benefits of risk-sensitivity and differentiation across institutions" that Basel II contains. Some eyebrows will be raised at this particular suggestion since, arguably, the goal of risk sensitivity led to the development and implementation of Basel II consuming a vast amount of regulatory resources over the best part of a decade and may well have contributed to the regulators' difficulty in keeping abreast of market developments and seeing the bigger picture.
Lastly, the greater emphasis on systemic risk and macroprudential regulation and supervision surely suggests a greater role for central banks in supervision both in the oversight of the system as a whole and in the supervision of individually systemic firms, whether or not banks, and in the oversight of markets.
Eric Wooding
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