Financial Regulatory Reform: What it means for bank business models

(Second of three parts)

By Christian G. Lauron

First Published in Business World (6/03/2013)

In last week’s column, we explained that banks seem to have no choice but to accept and adapt to the anticipated slew of financial regulatory reforms, and to begin making strategic assessments on how these reforms will impact their business models. We identified three strategic themes, the first of which — reforming business models in an uncertain environment — we explored in detail. We will now talk about the second strategic theme.

‘Accept and Adapt’ for an industry under siege
With the slew of regulatory reforms now moving to the implementation phase within the next three years, the only seemingly strategic response available to banks is to accept and adapt to the regulations. At the same time, banks need to robustly and constructively engage the supervisors on areas that are considered to be expectations or emerging views, mainly through the Pillar 2 process involving Internal Capital Adequacy Assessment Process (ICAAP) /Internal Liquidity Adequacy Assessment Process (ILAAP) reviews and governance assessments.

Bankers should bear in mind that supervisors will not provide the industry with a road map or a framework that relates the different regulations to one another. Taken together, the sum of the reforms can present banks with issues of redundancy, duplication and, in the extreme, rules working at cross-purposes or organizational dysfunction. It is up to the leadership of each bank to make sense of the rules and to implement them in a coherent manner.

Ernst & Young’s Financial Regulatory Reform publication offers some practical considerations:
Move to more binding Pillar 1 regulations. Regulatory requirements are becoming more binding towards Pillar 1, capital and liquidity regulations, and there is less room for Pillar 2 assessments of banks’ internal measurement of risk. Under Basel II, particularly during the 2009-2011 period when Internal Capital Adequacy Assessment Process (ICAAP) as a regime was taking root among Philippine banks, the internal measure of risk capital and liquidity served as the constraint. Going forward, the regulatory requirement will trump these internal measures and lead to significant overlaps between the minimum and internally assessed capital adequacy and planning ranges.

Retrenchment from internal models. Within Pillar 1 regulations, simpler, more standardized approaches are being considered, either by replacing the internal models approaches, introducing a floor, or requiring additional benchmarks. Examples where internal modeling has been scaled back include the treatment of securitizations held in the trading book, the introduction of a floor under the correlation trading book, and limited reliance on internal models for credit valuation adjustment calculations. Recent discussions have focused on simplifying the risk-based frameworks of Basel II and the role that a simpler leverage ratio should play in relation to the risk-based framework. This may, however, place an additional wedge between how banks measure risk internally and what they must report externally.

Will this retrenchment from internal models affect the moves of Philippine banks to transition to advanced approaches for their credit and operational risks? No. On the contrary, we see the internal models increasingly used in planning tools, particularly for strategic and risk-based capital planning. For instance, the approaches used for the ‘micro’ risk models in credit and concentration risks will be the same when applying these in the ‘macro’ but flow-based models in the strategic balance sheet.

A nuanced difference is that under the regulatory and internal capital adequacy systems, the approach involves a bottom-up aggregation of risks, while under the top-down full balance sheet simulation approach, the strategic balance sheet acts as the starting point. We believe that both approaches will become clearly distinct, yet still interdependent, under the Basel III regime, and will be used both for capital planning and in support of strategy and the business. The motivation for using internal models will shift from capital optimization or ‘savings’ to more precise and robust measurement of risks as part of the decision-support or decision modeling processes. All these will be part of strategic balance sheet management (SBSM). SBSM is the answer to the banking industry’s question on what is next after ICAAP.

More intrusive supervision. Supervisory stress tests are displacing bank-specific ones as the dominant standard for establishing capital adequacy above the minimum regulatory requirements. A similar trend is likely to emerge with liquidity. This poses new challenges for how banks set incentives for business lines and whether to use measures such as economic capital or to default to the regulatory constraints, which may not be optimal from a relative risk-reward perspective.

A related issue is on rising host supervisor requirements. Pre-crisis, the focus of supervisors was on consolidated risk measurement, management and home-country consolidated supervision. Post-crisis, however, supervisors are demanding that banks assess and report risks on a legal-entity basis, and ensuring that capital and liquidity are available within the host jurisdiction. This trend will be influenced by how successful supervisors and banks are in their efforts to achieve global coordination of recovery and resolution plans (RRPs) for cross-border banks.

Banks clearly need to develop and maintain capability to manage regulatory change across the enterprise. While much of the implementation effort will continue to be driven by the lines of business most directly affected, banks are establishing core teams to coordinate planning and ensure enterprise-wide consistency across multiple aspects of the regulatory changes. These teams are also responsible for maintaining a strategic view on what the new paradigm and operating model will look like, monitoring the transition of projects into ongoing capabilities. However, these efforts need to be overseen by boards, which will be mainly responsible for making regulatory management both a governance and a strategic agenda, not just a compliance function. Boards are responsible for proactively engaging regulators and policy-makers on both current and emerging supervisory expectations, distilling any observed or emerging regulatory thinking, and in ensuring that these views are captured, processed and synthesized in the enterprise-wide regulatory management process.

Intensive supervision has to be understood in the context of macro-prudential regulation. Under this approach to financial regulation, the overriding philosophy is to ensure that the financial system is stable and serves its role of promoting growth in the real economy.

It would be helpful to remember the three key policy objectives that shaped Basel III, namely:
1. To strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector;
2. To improve the banking sector’s ability to absorb shocks arising from financial and economic stress; and,
3. To reduce the spill-over from the financial sector to the real economy.
These objectives guided the development of operating principles to describe the desired outcomes of the macro-prudential financial regulations:
1. System-wide: take into consideration the interactions between the financial system and the macro-economy;
2. Counter-cyclical: build up buffers during a ‘costly boom’ for the rainy days;
3. Symmetric: responds to business cycles;
4. Long-term horizon: takes into account lags between build-up and identification of risks; and,
5. Holistic: prudential, monetary and fiscal policies must complement each other.

Macro-prudential financial regulation is rapidly emerging as the dominant mental model for supervisors and regulators. It focuses on the mitigation of risks relating to the entire financial system (or systemic risks), armed with a holistic view of prudential, monetary and fiscal policies and the interaction between the financial sector (as a system) and the broader economy through transmission channels. This thinking is ‘operationalized’ through the use of broad and targeted regulatory and policy tool kit and the imposition of capital buffers for the system.

Banks have to understand and clearly see the interdependencies between banks and the financial sector and between the financial system and the broader economy. Banks will also have to realize that they will be ‘seen’ regularly by the ‘system’, and if the financial sector as a whole starts to exhibit systemic risks and inadequacies in providing enabling support to the broader economy, the system-wide capital buffers will be imposed on the sector as a whole, notwithstanding the idiosyncrasies in banks’ risk profiles and resilience.

Thus, articulating business models and strategy clearly become paramount for both strategic and systems purposes. It will help in the supervisory engagement process, particularly when regulators evaluate banks’ risk appetite setting process and risk profiles. It will minimize the unintended consequences of intensive supervision, especially in the imposition of such systems-oriented policies like the countercyclical buffers, system-wide stress testing and SIFI surcharges.

Banks must review their business models and growth opportunities based on a realistic assessment of the total impact of global and national regulatory reforms. They also must develop much stronger decision-making frameworks and tools to assess the trade-offs between business opportunities and a new set of regulatory constraints.

Next week, in the concluding part of this article, we will talk about the third strategic theme, which is preparing for industry consolidation and structural reforms.

Christian G. Lauron is a Partner of SGV & Co.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.