Financial Regulatory Reform: What it means for bank business models

(First of three parts)

By Christian G. Lauron

First Published in Business World (5/27/2013)

Banks face a sobering truth – the clear response under the intoxicating regulatory environment is to accept and adapt. The regulatory fine print and national versions of the reforms may still be in various stages of finalization, but enough is now known and can be known to assess the aggregate impact, and to consider the effects of regulatory changes on banks’ business models and the interdependent implications with the broader economy.

In our April 8 article ’The Current State of Financial Regulatory Reform, we discussed why banks need to take a strategic approach to understanding and managing the regulatory changes. We looked at Type 1 regulations that cover capital adequacy, liquidity and leverage, and that are designed to reduce the probability of bank failure. We talked about Type 2 regulations, notably on recovery and resolution planning (RRP) and over-the-counter (OTC) derivatives reforms designed to reduce the impact should a bank experience difficulties or fail.

We also broadly explored the implementation issues occurring around the world, and concluded that synchronized implementation 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.

We will now examine the ensuing challenges for banks, supervisors and policy-makers, looking at what we have identified as three strategic themes, namely:
1. Reforming business models in an uncertain environment;
2. ‘Accept and Adapt’ strategies for an industry under siege; and,
3. Preparing for industry consolidation and structural reforms.

Reforming business models in an uncertain environment
Uncertainty is the new certainty. The post-crisis view is that the broader economy and the public’s exposure to systemic and transmissions risks must be always minimized, if not eliminated. This leads to a fundamental rethinking of the universal banking model and two strategic costs – balance sheet costs and disruption costs.

Balance sheet costs
The global economic downturn, financial deleveraging, and excess capacity in areas like investment banking are forcing banks to downsize many activities. The previous originate-to-distribute business model has contracted severely, especially in the securitization and ‘off-balance sheet trading’ markets. This changes the nature of balance sheet usage and liquidity needs going forward. It also shifts the breakeven costs for many businesses, further compounded by the higher regulatory costs for capital-market related activities.

Three things are certain for banks in the medium-term:
1. Costs need to be cut while implementing higher regulatory requirements;
2. Capital and funding pressures remain high; and,
3. An integrated risk-finance view must be taken when managing and optimizing balance sheet costs.

Banks have started to embark on cost rationalization and efficiency programs against the backdrop of a fundamental regulatory change that imposes additional costs and investment requirements, especially in the areas of financial services risk management, compliance and data infrastructure. One of the main costs of global banking — compensation — remains sticky and will only gradually come down. Moreover, pressure to contain bonuses relative to the fixed component of the salary will further increase operating leverage.

Most banks, especially those subject to countercyclical buffers and systematically important financial institutions (SIFI) surcharges, need to continue raising capital in an environment where return-on-equity expectations are not falling commensurate with the decline in leverage of the banking sector; tighten and rigorously implement business plans; and ‘shrink’ the balance sheet if necessary.

The longer-term view is that there will still be customer demand for the full range of banking services, notwithstanding the increased balance sheet costs. But to get there, banks must assess the viability of business lines and products in the face of increased capital and liquidity levels and costs; greater systems and data infrastructure investments; higher compliance costs, and outright activity restrictions or structural constraints.

Banks will have to develop both planning and aggregation tools to manage against a new set of constraints, including risk-based capital, the leverage ratio and liquidity ratios. This means close and synchronized coordination across risk, finance, planning and treasury functions to understand how different business decisions affect cash flow and earnings projections, risk profiles, and regulatory capital requirements subject to the new constraints. Banks also need to move beyond pure regulatory compliance and optimize the use of new tools required by regulations to manage risk and grow the businesses.

Here are three practical considerations:
1. Use consistent, granular and integrated risk-finance data in support of operational agility and capital adequacy evaluation;
2. Enhance asset-liability management and funds transfer pricing to segment and price products effectively in the face of growing competition from non-banks and quantify the cost-benefit proposition on customer relationships; and,
3. Revisit profitability measurement methodologies in relation to clarified or revised operating models, with risk capital either being allocated to certain businesses or included as a financial decision variable, not just a capital adequacy metric.

The convergence of risk-finance measures will become the performance ‘norm’. Risk-finance is fast becoming the new language of business, not just in financial stability standards. This is highly evident in financial reporting, an area that in the past often lags in terms of developments in value-based reporting. There is increasingly a “current value” balance sheet, more business model-based revenues and gains, expected value-based measures for such costs and expenses as provisioning and impairment, and a comprehensive income measure that encompasses the hybrid performance-based operating income (mainly as a ‘management view’) and flow-based comprehensive income (mainly as a ‘shareholder view’).

Disruption costs
Every business model has three overlapping facets – the strategic imperative, the operating model, and the financial model. This article focuses mainly on balance sheet costs in the operating and financial models; disruption costs are in the realm of the strategic imperative.

The Journal of Financial Perspectives (in a technical paper by Saunders and Walter) notes, “…advances in transactions and information technologies, regulatory changes, geographic shifts in growth opportunities, and the rapid evolution of client requirements…in combination have obliged financial firms to rethink their roles as intermediaries… .” This adds to the need for banks to incorporate disruption costs in their strategic and corporate planning, particularly in the scenario planning exercise (which we touched on in our article Governance: The Return to Scenario Planning published on January 9 and 16, 2012).

In overseeing business model reforms or refresh, as well as disruption costs and its linkage with balance sheet costs, banks need to strengthen risk governance frameworks. This would mean demonstrating an appropriate balance between business strategy and risk appetite. Top-down assessments of risk capacity and appetite will need to be pushed down within the firm and influence the way businesses are managed, motivated and compensated. Reporting to the board will need to be more rigorous and comprehensive; reports will need to aggregate firmwide exposures and identify risk concentrations under stressed economic and financial environments. There are cases when boards are not getting the right information to make decisions about the interaction of business strategies, associated risks and the constraints imposed by capital and funding needs.

The quality of information and metrics used to set and measure risk appetite is often insufficient to meet banks’ business needs and regulatory expectations for more forward-looking risk and resilience assessments. While there have been structural changes in the governance process, many banks are still struggling to embed these processes in day-to-day, line-of-business decision-making. Even where banks meet both minimums and buffers for capital and liquidity, weaknesses in associated risk governance processes will bring intense supervisory responses that can impose substantial constraints on the businesses, both tactically and strategically.

In the next part of this article, we will look at the second theme of “Accept and Adapt” strategies for the industry.

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.