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Riding the waves of regulation
Riding the waves of regulation

Riding the waves of regulation


Regulatory change is taking a toll on banks - but they can take advantage of the opportunities it creates

Much regulation has been announced in recent years, but is yet to come into effect. This leaves the finance industry stuck between regimes. The new regime has been designed to tighten up risk management and allow firms to take risks on board more safely. It should move Europe from a bank-driven economy to a more market-driven economy, even if the role of banks in financing the economy will remain essential. To support this, new rules are putting a framework in place to mitigate bilateral counterparty risk, systemic risk and cross-border barriers within capital markets.

Standardising and harmonising protocols

The use of central clearing is the element that balances out counterparty risk through the posting of cash and assets as collateral with central counterparties (CCPs). “Creating this baseline enables dealing with strangers,” says one senior advisor at a European regulator. “A successful market economy has to be open to the widest possible range of people.”

Rather than relying on the balance sheets of counterparties, firms can rely on the capital invested in the infrastructure. Consequently it does not matter how big a firm is: it matters only if it can play the game. Regulation is building the infrastructure that is driving standardisation and harmonising protocols. Standardisation means that third-party providers are able to offer outsourced processes effectively.

Data redemption

Digitising these newly introduced processes means they are generating data, which is standardised and often in real time. This data is available and can support third-party service providers. All this information will be stored in bankruptcy-remote databases and access to it will allow data management to redefine risk management. There is an argument to consider data not as a cost but as an asset, but these rules impose a burden on market participants.

Data requests are born of a desire to understand where risk exists in the system. The immediate effect, however, is to push banks to produce a lot of information in multiple formats without collaboration between jurisdictions (or between regulators within a single jurisdiction) that can challenge the data suppliers.

Nevertheless, maintains Lee Burman, EMEA Head of Global Network Management and Market Infrastructure at Morgan Stanley, these costs serve a purpose: “In 2008, our industry lost the trust of the general public. The regulatory frameworks that are being put in place are intended to help regain that trust,” he says. “We always see it as a burden, because frankly we didn’t come into this industry to do regulatory compliance. But if you can see that regulatory compliance is going to take us to somewhere better, is going to make us more agile, then that could lead to some positive outcomes.”

Regulatory policy is fostering innovation in the data space and Burman argues that a new model of banking is inevitable as firms become as innovative in the middle and back office space as they are in the front office. Banks are keen to ‘level out’ some of the returns they are creating to create more of an annuity-style profit model.

“I think the regulatory pattern will continue in the same way,” Burman says. “The institutions that will do well out of the new model are the ones that can be agile and seek these new opportunities, and that is something that we have been good at as an industry over the years.”

A call for evidence

The European Commission’s Capital Markets Union (CMU) project demonstrated that the Commission was keen to promote economic growth in the European Union following the avalanche of new regulation and moderate application and gold-plating by national regulators. But beyond the ‘quick wins’ via high priority projects and longer-term projects outlined by the Commission, it is too early to assess the impact of CMU, says Laurence Caron-Habib, Head of Public Affairs at BNP Paribas Securities Services. “We know for sure that capital requirements will be recalibrated in the regulation on Solvency II for insurance companies and CRDIV-CCR for banks,” she observes. “But if we look at the other potential actions, it’s not very clear. The good news is that this is definitely an opportunity to look at all the new measures which have been adopted since the financial crisis. The call for evidence was very good for the industry and for the regulators as well.”

The industry has been positive in supporting this new approach and a limit on the amount of new legislative initiatives, but the key question will be how the EC will respond to industry feedback from the call for evidence.

Abel Sequeira Ferreira, Executive Director of the Portuguese Issuers’ Association AEM, says, “The European Commission has taken an approach to delivering simple, clear, transparent regulation. However, the central banks and the European Central Bank seem to be going in a different direction.”

An example of this is the work conducted by the Basel Committee. There have been numerous debates and discussions between regulators and industry on the so-called “Basel IV”, but whereas the Committee insists that Basel III must be fully dealt with before looking forward, Caron-Habib points out: “The industry considers that the latest work conducted by the Committee is to be seen as “Basel IV” in view of the new requirements and the new approach on a number of topics, especially the fact that the use of internal models will be much more restricted and prohibited in some cases, typically for operational risk.”

It will be a challenge for the European Commission to manage these different objectives if CMU is going to be a success.

Regulation is disruption

Another industry executive comments: “Regulation is disruptive and I think it’s good. However, a better design of regulation and more collaboration among the regulators would be invaluable for us.” Changing regulation has been so constant that it has had an economic impact on firms. For example, some banks have set themselves on the path of turning into infrastructures, then rolled back as the interpretation of what the regulators wanted changed. Firms are also subject to the risk that policy makers act as generals, preparing for the war they have just lost – rather than for the next conflict.

New initiatives

“Many current discussions with regulators focus on the move from the banking system to other players – for activity traditionally operated by banks – and on paper it looks very nice. There will be a lot of new initiatives to make this a reality. For instance, new platforms for the trading of fixed income will emerge. Asset managers will start new activities which look more like banking activities, perhaps by adding loan funds.”

However, if a new crisis occurs and there is a lack of liquidity on the market, it is unclear whether these new structures will be able to cover the activity traditionally undertaken by market makers and investment banks.

Huge opportunity

The measures that have been taken are sensible from the perspective of regulators trying to make the whole infrastructure more secure and the industry is better prepared because it is able to mine better data, Burman argues, and more collaboration will help bring the industry together to understand it: “If only 25 per cent of financing in Europe is currently conducted through capital markets, that presents a huge opportunity,” he notes.

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