Operating in a challenging regulatory environment

By James Barclay
Executive Director, J.P. Morgan, Global Market Infrastructures

Meeting the evolving regulatory obligations imposed on banks in a difficult economic environment is increasingly challenging. Regulators have been particularly active over the past three years in setting new operating conditions aimed to preserve financial stability, particularly in times of stress on financial institutions. The ongoing sovereign debt crisis brings additional challenges and promoting economic recovery in a secure operating environment has an ever more significant impact on how we deliver solutions to customers who transact on a global basis.

In this environment, we as financial institutions – whether banks, securities firms, fund managers or others – continue to provide services within an increasingly complex regulatory framework, made more difficult as some of the key rules and regulations have yet to be finalized. This means we have to work under assumptions that different regional and national approaches will leave the markets open to regulatory arbitrage, where it may well be more beneficial for financial institutions or multi-national corporates to do business in some markets with less penalizing regulations, rather than in others. In addition, this world of uncertainty, may lead to unintended consequences negatively impacting economic recovery and the cost of services we provide to our customers.

Basel III and its implementation
From a global perspective, the regulatory response to the financial crisis is primarily driven by a set of global recommendations from the Basel Committee. This has led to the drafting of Basel III: A global regulatory framework for more resilient banks and banking systems. These recommendations do, of course, have to be integrated into national legislation to come into force.
For this legislation to work effectively there needs to be a form of global consensus on how the objectives for financial stability are attained. This is being driven by the G20, who published a Global Plan for Recovery in 2009, including provisions aimed at strengthening financial supervision and regulation. These decisions are based on expert reports from entities such as the aforementioned Basel Committee on Banking Supervision.

Implementation at a national level is being carried out as follows. Many of the proposed rules are written but are still to be implemented or have been delayed pending economic recovery, and some are still to be finalized:

  • Europe: The European implementation of Basel III is through the Capital Requirements Directive IV, split into a Directive (Capital Requirements Directive – CRD) and a Regulation (Capital Requirements Regulation – CRR). The CRR establishes rules on capital, liquidity, leverage and counterparty credit risk. The CRD contains requirements for capital buffers (capital conservation buffer and countercyclical buffer), supervisory review and corporate governance. The CRR will be directly applicable as a regulation, whilst the CRD will need to be transposed into national law by the Member States. Regulations are currently the favored approach in Europe as they leave less room for Member State gold-plating..

  • US: From a US perspective, regulatory change is being driven through the Dodd Frank Wall Street Reform and Consumer Protection Act – the Dodd Frank Act. Similar to measures being undertaken in Europe, it aims to address systemic risk, increase transparency and promote market integrity. The Act includes new obligations on living wills and resolution, clearing and settlement, and the Durbin Amendment on interchange fees.

  • Asia: Asia does not have a regional regulatory framework that can coordinate the outcome of individual implementations, however none of the Asian jurisdictions disagree with the underlying principles of Basel III. Implementation may vary by country given that each country has its own considerations in regards to its banking industry and the state of its economy. Some countries may choose to implement Basel III standards faster than required, and some may even choose to implement more stringent requirements.

  • Latin America: Latin America regulatory developments are being driven in the local markets; each country conducts their own assessments and develops their own plans. Basel III work has commenced in a few markets. Brazil has published draft regulations and Argentina is in the processing of developing regulations.

Globally, the national supervisory bodies still hold the final decision-making authority and banks may remain challenged by consistency of approach and varied national interpretation of legislative requirements. In order to enforce new legislation, Europe has established new supervisory authorities, which have significantly more regional power than was previously the case and include the European Banking Authority (EBA) and the European Securities Market Authority (ESMA). These bodies are still in the process of constitution and it is still not yet clear how powerful these entities will become.

J.P. Morgan continues to provide services within an increasingly complex regulatory framework, made more difficult as some of the key rules and regulations have yet to be finalized. With a view to getting appropriate legislation into place, J.P. Morgan is actively engaged in the process of finalizing the different legislative texts.

Increased capital requirements, new liquidity ratios, living wills and continuity of service

New regulatory proposals include increased capital requirements and new liquidity ratios. These were recommended by the Basel Committee as many financial institutions, ‘…despite having adequate capital, experienced difficulties because they did not at the same time manage their liquidity in a prudent manner’. Failure to meet the criteria will have an impact on a firm’s ability to manage its affairs independently, however it is less clear at what stage the regulatory bodies will be able to intercede in the management of an individual institution. Regulators may find themselves in the challenging position of needing to take a decision that the institution has reached a point of non-viability. Proposed legislation allows for early intervention and the potential for regulators to put in new management structures, which would prove interesting in a real life scenario.

The resolution framework requires banks to have robust plans in place for the orderly wind down of an institution, which also have to take into consideration existing insolvency legislation. Additionally, there is the increasing perception that retail banks should be in a position to provide continuity of service, even in the case of failure, allowing customers to continue to pay for goods and services the day after an institution is declared to have failed. This would require the injection of capital from the national Deposit Guarantee Schemes and the creation of some form of separate legal entity that can continue to operate in payment systems without increasing systemic risk. From a practical perspective, the combination of Resolution and Ringfencing proposals in the UK has initiated reflection by banks on what would be realistically possible over and above the seven working days payout commitment under the Financial Services Compensation Scheme.

The final outcome?
It still remains to be fully understood how all the new financial stability measures come together. In an ideal scenario the new capital and liquidity requirements should help financial institutions to avoid being pushed into resolution. Various stress tests should help reassure the market that financial institutions are sound. In the worst case scenario, resolution arrangements should provide comfort that the failure of one or a limited number of financial institutions would not negatively impact the financial stability.

Early regulatory intervention based on micro prudential concerns could lead to the scenario where institutions go through an orderly, progressive wind down process — writing down debt, selling business where possible, working through a bridge bank — thereby allowing for the institution to be maintained with a limited operational scope as a going concern. This should help sustain confidence in the market and certainly provide a much better outcome for depositors than liquidating the institution under existing bankruptcy codes.

How quickly all of this can be pulled together will depend on the evaluation of potential economic impacts of the measures. Implementation of the ratios will be progressive and dependent on findings from the observation periods for the Liquidity Coverage and Leverage ratios, and subsequently for the Net Stable Funding Ratio. Full implementation will run, at a minimum, through to 2019, subject to an improving economical situation and evaluation of the implications based on empirical data over a period of several years.

Global Systemically Important Banks (GSIBs)

GSIBs will have to meet additional capital requirements in relation to their global activity and systemic risk. The assessment methodology for determining GSIBs covers five broad categories:

  • size
  • interconnectedness,
  • lack of substitutability,
  • global or cross jurisdictional activity, and,
  • complexity

These in themselves are challenging to establish and impacted banks may look to diminish their systemic importance in the eyes of the regulators. We have already seen countries making it clear that the national banks do not fit into this category.

Trade Finance
It was originally believed that the proposed 100% Credit Conversion Factor for trade instruments under Basel III would be reduced, as a result of arguments to do so based on empirical data which clearly demonstrates that trade activity carries exceeding low levels of risk.1 However, the Basel Committee has not been swayed and the proposed credit conversion factor for trade finance remains largely unchanged. The impact could be less availability of funds for trade finance and almost inevitably an increase in cost, likely to have a negative impact on international trade’s contribution to economic recovery.

Working with the regulations
As financial institutions continue to respond to both current and emerging regulations, J.P. Morgan continues to build on its strengths, leading industry developments and adapting to new legislative obligations in such a way that we can enhance and develop our customer service offerings.

1The ICC Banking Commission paper on 'Global Risk in Trade Finance' of October 2011 documents the low default and loss rates across all trade product types, where, for example, fewer than 3,000 defaults were observed in a dataset comprising 11.4 million transactions.

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