Nick Andrews, executive chairman and founder of corporate compliance and regulatory advisory firm MPAC, outlines key regulatory changes in the banking sector
There are significant pressures and regulatory changes coming down the line that will affect the banking sector and which, combined, and in certain cases, individually, will have a profound effect upon the business a bank conducts. Some of these issues are considered below, and readers should consider them in the context of the specific activities their firm carries out.
The changes in the trading environment arising from the financial crisis, the advent of technology, the demand from politicians and regulators to make the banking sector more accessible and transparent while also removing the potential risk of future government bailout, ie, less leveraged and therefore a safer sector, has given rise to far greater competition encroaching on the traditional banking business, coming from the shadow banking sector. Shadow banks in this context are any firms that conduct a bank’s natural business but are not authorised as banks. Think of the hedge funds who now lend, electronic money institutions, payment services firms and the profusion of lending platforms who are all causing margin transfer from the banks to themselves, driven by their lower cost base and their marginal cost of attracting business giving them the significantly lower operational costs than the existing incumbents. This is perhaps no surprise following the distinct lack of trust within the banks for the past circa 15 years that coincides with the availability of cheap and efficient technology allowing for ease of distribution of products.
In addition, the reduced hurdles to obtaining a banking licence has allowed for challenger banks to rise, albeit they typically have a niche business model and concentrate on providing that product in their sector, eg, small and medium-sized enterprise lending, property lending and internet based current accounts.
2. Regulatory pressure
There are five main areas to consider.
The proposed ring-fencing, coming in from 1 January 2019, of the business model is the first stage of the break-up of the universal banking model (Banking Reform Act 2013). The cost of capital within a bank to trade a proprietary book has and will become increasingly more penal, and this in an environment where the cost of that capital is significant. The ‘old normal’ saw a period of returns on equity in the 15% to 20%+ area; it is now down to single digit returns and has been for the past eight or nine years and is simply not covering the cost of the equity. This is causing banks to shift from being takers of risk to intermediaries, although it is questionable who will be taking these risks in the future if it is not the banks.
Markets in Financial Instruments Directive II
Alongside the change in strategy required for banks, the revised Markets in Financial Instruments Directive (MiFID II) will also be having significant impact upon any bank (or other entity for that matter) that transacts in MiFID products – not only down to the expansion in products that come in scope, but also the infrastructure changes needed to manage this business (transaction reporting as a prime example). This again coming in a time of commissions reduced by regulation. The changes required in behaviours in banks operating in this area will likely favour those that are volume actors rather than those that are niche players.
Capital Requirements Directive IV (including liquidity coverage ratios, credit risk and CR/bail in/living wills)
This has all been well documented in prior editions, however one consequence that is becoming apparent and will have the potential to cause significant securities sector disruption (with the consequent increase in risk and costs in protection for investors), is in respect of the client money/safeguarding accounts offered by banks. These have become hugely restricted in recent years predominantly due to financial crime risk and the operators not getting their client money processes right (see the fines and sanctions to date), but banks are increasingly reluctant to offer these accounts due to the total lack of liquidity benefit from holding such accounts. Expect banks to cease to offer such accounts, unless they are able to charge significant costs and also expect client money accounts to be held in other EU jurisdictions to also attract additional costs. Expect greater concentration of risk into those banks that do offer such accounts. Users of those banks will have higher credit risk cost requirements as a consequence.
It is also worth considering that from 1 January 2016, all FCA regulated firms that have client money accounts (so not banks) are now expected to have a much more onerous client money audit imposed on them, following a new standard for audit firms issued by the Financial Reporting Council in November 2015, Providing assurance on client assets to the financial conduct authority
. This requires the client money auditor to opine upon the policy, processes and procedures of the firm holding such an account and also to opine on the honesty and integrity of all persons involved in the process – this includes board members down to persons undertaking the reconciliation. Noting that it will potentially double the costs of the client money audit for firms with such accounts, it is likely to impact on certain banks as some provide advice or direction upon how such accounts are supposed to operate. In lesser cases, it may mean additional costs in providing greater information to the clients. Potentially, it also means banks may well restrict yet further the offering of such accounts.
Again from a capital point of view, the Remuneration Code currently implemented will see the shift of what were variable costs to fixed costs.
This area had not been specifically targeted by the regulator as other priorities took precedence, but the warning has been given that it is now in focus within banks (and other firms) and will be specifically reviewed and supervised.
The Senior Managers Regime (SMR) is now embedded (in relevant firms) and driving change from the top, with those that should have been responsible for activities now being demonstrably responsible.* The further implications of this will be the trickle-down effect to those banks and firms that have not yet been required to implement it. Foreign bank subsidiaries and branches especially should be very conscious of the problems they may face if they do not get it right. The culture and ethics of banks will be driven now with transparency from the top to those banks affected by the SMR with the collective responsibility it imposes, despite there being no real clarity as to how this will translate into regulatory action in the event things go awry.
4. Capital adequacy
a. With a low interest environment, banks will continue to struggle to make profits. Nothing will change this economic truism unless banks increase their risk considerably (noting that prop trading is now becoming unprofitable). If shareholder value is not coming through returns, where they have traditionally been seen as secure, reasonably high-yielding investments, then this may very well change investors’ behaviours and desire to hold investments in banks. Therefore the natural past attractiveness of bank share investments as utilities is unlikely to be true in the future. Who will be providing the capital needs of the future just to cover the increased regulatory capital requirements is open to discussion.
b. The International Financial Reporting Standard 9 is out, and one specific area of impact will be on the credit risk costs – the need to provide additional capital to cover the 'pre-provisioning costs' and the increased need for greater provisions is a thorny area. The precise amount needed by the sector is difficult to quantify without analysing each bank’s portfolio, provisioning policy and provisions already made. We do know that in certain EU countries, the amount needed is considered to be circa 133% of the existing provisioned amount. UK banks are unlikely to need that much, but the requirement will have a double impact of course: cost of capital to raise it and reduced liquidity within the balance sheet (note again the rise of the shadow banking sector, which do not all need this cost).
c. Zombie loans are fine to keep on the balance sheet at the current low interest rate environment but will become a problem in the future as and when rates rise and the firms are unable to fulfil their obligations, leading to defaults and restructuring. Unless managed quickly and allowed to fail, the problem will worsen and reduce yet further the ability and willingness of banks to lend. (note the example of the Japanese banking sector crisis of the 1990s). Allied to this potential capital issue, the funding of bank pension fund liabilities is also coming to the forefront as an issue in the current low interest environment.
5. IT and other
For the major banks, many years of not taking suitable and forward looking attitudes to managing, replacing and updating the IT infrastructure will take a severe toll in the not too distant future. So many banks run thousands of intertwined systems, some of which are based on software developed circa 50 years ago (and where the original developers are either now retired or soon to be so). With the shadow banking businesses being much more nimble, reliable, efficient, and with significant cost benefits, the banks are going to have to take brave, long-sighted decisions – a very difficult thing for a CEO to do when the profits are down and capital needs are increasing significantly. Blockchain will not be a ‘silver bullet’, simply because the technology is too early to be so and the simple factor inbuilt implementation process of such systems are designed to be slow, laborious and costly in their own way, ie, the complete opposite of how the new technology works and which has a ‘throwaway’ modular ability.
Coming out from the OECD and an international obligation, there are many areas where banks need to be exceedingly careful as base erosion and profit shifting (BEPS) is introduced over the next few years. Two major areas are those of transfer pricing and country by country reporting. Both of these are hugely time consuming, detailed projects that have a major demand on the existing IT systems and, in the latter case, will need to be publicly disclosed. Country by country financial reporting will also throw up some very peculiar numbers, dependent upon the firm’s global operations, especially when revenues and profits are double counted within the requirements and compared to head count in jurisdictions. Note, banks’ audit costs will increase for this.
Gender pay gap reporting
This is already required in the current financial year for firms with 250 or more staff. The calculations are relatively complex and will throw up some unusual figures that may make comparisons difficult. Note, banks’ audit costs will increase for this as well.
* The CISI and the Chartered Banker Institute have jointly launched a new initiative, the Certificate of Professionalism, as third party verification to support the PRA/FCA Senior Managers and Certification Regime (SMCR). Find out more.
Views expressed in this article are those of the author alone and do not necessarily represent the views of the CISI.