Financial Regulatory Reform: What it means for bank business models

(Third of three parts)

By Christian G. Lauron

First Published in Business World (6/10/2013)

Over the last two weeks, we have been talking about the many challenges facing banks, supervisors and policy-makers given the current convoluted and evolving financial regulatory reform landscape. While these reforms are still in various stages of finalization, we have enough information to make qualified assessments of how these reforms will impact banks and their business models, providing financial organizations with a small breathing space within which to engage in scenario planning and risk management assessments.

We identified three main themes, two of which we have discussed in the first two parts of this article.

Preparing for industry consolidation and structural reforms
It is true that our broader financial sector is not coming from stress, compared to those hit by the late-2000s financial crisis, though we continue to face transmission risks, mainly through the capital market and foreign exchange channels, as well as regulatory fragmentation risk. Further, our real economy faces structural issues that could present missed opportunities or ‘profitable risks’, and we still have to clearly assess and manage our free trade and ASEAN integration commitments. These factors pose significant dependencies for macro-prudential financial regulation and will drive the level and depth of systems-oriented policies.

The increasing balance sheet, disruption, and systems costs create pressures on industry consolidation. Consolidation and efforts to increase scale and reduce costs likely will square off against a range of regulatory constraints intended to restrain size, complexity and interconnectedness, without undermining the growth enabler role of the financial sector.

More structural reforms are under way, and some of these could replace some of our ‘capital-as-mitigant’ approaches to regulation. Some reforms focus on permissible activities (e.g., Volcker). Others focus more on structure and where activities may be carried out in the organization (e.g., Liikanen, Lincoln amendment), while others have morphed into stronger investor suitability and customer protection regulations.

There continue to be calls to limit the overall size of banking institutions as a way to contain systemic risk and taxpayer exposure. The future evolution of these proposals and the way they interact with each other will further complicate the global banking landscape. The intensity of these structural reform proposals will likely depend on the pace of the economic recovery and the associated risks that banks may pose to home-country economies in the future.

The structural reforms are not limited to the financial services sector; they will also cover the real economy, particularly where a more inclusive growth agenda is being pushed. Its implications will have repercussions on the rethinking of the universal banking model and even on the debate on banking as a ‘public utility’, particularly when the role of enabler of growth enters the picture.

Systems Thinking and Resilience Modeling. The rapid emergence of macroprudential financial regulation as the dominant mental model, the rise of transmission risks, the impending structural changes in the real economy, and the complexity in managing financial regulatory reforms. These all point to an urgent need for banks, supervisors and regulators and policy-markets to take a thorough and thoughtful way of looking at our financial and real economy systems.

This requires a systems-based way of assessing and quantifying interdependencies within and between systems, based on a set of premises, such as the following:

a.The financial system has to function and proportionately flow through the real economy systems unimpeded;
b.The real economy systems have developmental and inter-generational absorptive capacity; and,
c.Both systems have resilience mechanisms to absorb shocks and enable inclusive growth.

This would call for a fundamental review and refresh of systems-based economic and financial models to incorporate transmission risk monitoring and ‘incompleteness’ approaches. Irrespective of the technical and methodology aspects, these refreshed models should be governed by a fundamental truth – the system is the same as its parts.

In our next article, we will discuss and propose Resilience Modelling as an integrated governance process that will allow banks to link their RRPs or ‘Living Wills’, stress testing, and strategic planning. Resilience Modelling can also be used as an integrated policy framework for evaluating the probability and severity of stress for the financial system and establishing the resilience of the financial sector in enabling inclusive, intergenerational and structurally sound economic growth.

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.