The current state of financial regulatory reform

By Christian G. Lauron

First Published in Business World (4/8/2013)

The die is cast.

Ernst & Young’s publication Financial Regulatory Reform reports that the global regulatory reform process is now moving from the policymaking to the implementation phase. In navigating the regulatory Rubicon, it would be wise for banks and financial institutions to adopt a strategic approach to managing the regulatory reform initiatives. One initial step is to obtain a comprehensive understanding of the various reforms, the likely direction and timing of these reforms, and how they relate to each other. This article discusses the current regulatory landscape and progress in implementation.

Current regulatory landscape

Regulatory reforms can be broadly categorized into two types. Type I regulations focus on reducing the probability of bank failure. Type II regulations are designed to reduce the impact should a bank experience difficulties or fail.

Type I regulations (Probability of Failure) cover capital adequacy, liquidity, and leverage. To date, capital adequacy regulations include mainly:
(a) Basel III reforms on the level and definition of qualifying capital;
(b) Basel 2.5, including the fundamental review of the trading book and changes to the Basel II risk-weighted-asset (RWA) regime; and,
(c) Introduction of capital buffers and surcharges, particularly the capital conservation buffer, countercyclical capital charge, and systematically important financial institutions (SIFI) surcharges.

A new framework for global-systematically important banks (G-SIBs) has been agreed upon, with the regime to be implemented beginning 2016. An initial 28 G-SIBs have been identified.

Liquidity requirements cover the liquidity coverage ratio (LCR), net stable funding ratio (NSFR), and liquidity reporting requirements. The Bank for International Settlements (BIS) endorsed amendments to the LCR, particularly on the definition of high quality liquid assets and net cash outflows. According to the BIS, LCR will be introduced as planned on January 1, 2015, but the minimum requirement will begin at 60%, rising in equal annual steps of 10 percentage points to reach 100% on January 1, 2019. The finalization of LCR guidelines will allow the BIS to focus on the NSFR, which has a slower implementation track and subject to an observation period ahead of its implementation on January 1, 2018.

Irrespective of the implementation stages of the two ratios, banks are expected to face growing and intense supervisory expectations on how they measure, manage and govern their liquidity risk. In the run-up towards the adoption of these ratios, liquidity risk and its capital implications could be covered through an internal liquidity adequacy assessment process (ILAAP). On the leverage ratio, the parallel-run testing period extends until January 2017, with disclosure to commence January 2015. Changes on the calculation of this ratio are still to be expected, particularly on the treatment of netting, off-balance sheet exposures and repo/security lending activities.

Under Type II regulations (Severity of Failure), the two most important initiatives include recovery and resolution planning (RRP) and over-the-counter (OTC) derivatives reforms.

On RRPs, the Financial Stability Board (FSB) issued in November 2011 its paper Key Attributes of Effective Resolution Regimes for Financial Institutions, providing a global framework and principles for supervisors and banks, with national regulators introducing more specific requirements and timelines for developing RRPs. From a global perspective though, the key issue is how to resolve cross-border banking institutions. Another important, related development is a proposal by the Committee on Payments and Settlement System (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish recovery and resolution-planning requirements for financial market infrastructures. The OTC derivative reforms, on the other hand, broadly cover the move to exchanges, reporting to central derivative repositories, reducing counterparty credit risk through incentives to move activities to central counterparties, and margining for non-cleared OTC derivatives. Most of the reforms are progressing at the national and regional levels, with the US furthest along.

Implementation progress

With the shift in focus of the Basel Committee and the FSB from policy development to implementation, the Basel Committee introduced three levels of review for the banking sector. Level 1 reviews focus on the timely implementation of the new regulations by member countries. Level 2 reviews focus on the substance, i.e., whether compliance is consistent with the global agreements. Level 3 reviews focus on the actual outcomes of the regulatory reforms at individual banking institutions. Despite efforts to coordinate global reform initiatives, there continues to be regional and national differences in substance and timing.

There are interesting updates on the reviews – some expected, others quite revealing.

At the start of 2013, both the US and Europe missed their Basel III implementation targets. The European Union is considering changes to detailed capital reforms that have been agreed upon in detail, notably on the definition of common equity and deductions from the capital base (e.g., for investments in insurance entities). The US developed proposals that are generally consistent with the global agreement where permitted by law, with the primary deviations related to the Dodd-Frank restrictions on external ratings and the Collins amendment’s introduction of a capital floor. The main issue for the US continues to be its slow implementation of the Basel II agreement embedded in the Basel III framework. As of November 2012, no US bank has been allowed to exit the parallel-run phase of Basel II.

Other countries, especially in Asia, tend to follow the Basel III agreement quite closely or are implementing it more conservatively. Among the observed implementation approaches include accelerated phasing-out of ineligible hybrid capital, calibration of the leverage ratio, and stringent deductions from qualifying capital (e.g., other equity investments in non-financial allied undertakings and non-allied undertakings, credit-linked notes and other similar products in the banking book with issue ratings below investment grade).

Another source of variation concerns OTC reforms and RRPs, which are regulations that have been agreed to at the global level through high-level principles. It remains to be seen whether the issuance of guidelines (such as the Basel Committee’s October 2012 issuance Framework for Dealing with Domestic Systematically Important Banks) can temper the wide scope of interpretations among national supervisors.

Pragmatically, synchronized implementation timelines will not happen because of local regulatory reforms, evolving market conditions and rapid transmission risks, and the depth and commitment in changing the structural aspects of economies. Most of the local regulatory reforms are politically driven. Examples include the Volcker rule, which prohibits proprietary trading; the UK Independent Banking Commission (ICB) proposal to wall off retail banking activities from the rest of the institution; the ‘Swiss Finish’, which requires banks to hold higher levels of capital and more contingent capital and provides certain protections in the event of a resolutions scenario; and the Liikanen effort of the EU, which proposes to wall off the trading operations of banks – both proprietary and market-making – in separately capitalized subsidiaries if they exceed certain thresholds. Some of these reforms have morphed into customer protection regulations, ranging from requiring more quantitative yet relevant disclosures and rigorous suitability tests (such as those contained in the Markets in Financial Instruments Directive) and the creation of consumer protection authorities (such as the Consumer Financial Protection Bureau in the US and the Financial Conduct Authority in the UK).

The next article will focus on the ensuing challenges and some practical considerations for banks, supervisors, and policy makers.

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.