Mary Filippelli, Partner, National Banking Leader
Diana Lowe, Associate Partner, Advisory
Certainly global regulatory implementation presents enormous challenges of scale and complexity, but Canadian banks that can balance the spirit of regulatory change with an acute focus on new sources of revenue and customer profitability—will be a step ahead when it comes to managing growth in the new regulatory environment.
Regulatory reform is here to stay and the focus of attention is now shifting to implementation – progressing action on the business implications and planning for compliance. Banks must also remain flexible to adapt to subsequent changes and developments, with a number of other parallel policy initiatives being put in place, notably recovery and resolution planning, attention to corporate governance, enhanced college of supervisor arrangements and continuing uncertainty over tax. Changes in any of these will impact a regulatory response plan.
Certainly, there will be adaptation and implementation challenges as banks work to understand new standards, predict impacts, implement complex new compliance procedures, and design appropriate regulatory controls. While the outlay of resources can strain operations and slow growth, current changes in the banking regulatory landscape are the necessary products of a long series of hard lessons. On the plus side, the new regulatory environment should ultimately lead to renewed customer confidence, profit stability, and growth opportunities for banks, such as those in Canada, whose sound practices allowed them to preserve capital and liquidity and weather the recent downturn with relative success. With the spirit of good governance, risk management and compliance already built into our financial structures, Canadian banks are particularly well-positioned to move seamlessly into the new regulatory environment.
The Emerging Framework to Strengthen Banking Regulation
Although still debated, most financial analysts agree that better regulation could have at least stemmed the tide of the recent global financial crisis. With those lessons still fresh, individual countries all over the world are striving to create regulatory frameworks that address certain deficiencies. According to the Chairman of the Basel Committee of Banking Supervision, this would include: poor liquidity risk management and insufficient liquidity buffers; excessive leverage combined with weak underwriting; inadequate amounts and insufficient quality of bank capital; and shortcomings in corporate governance, risk management and market transparency.
The development, implementation, and ultimate oversight of such a framework (or frameworks) is a monumental task that will take years, and it will not be uniformly smooth. Already, major players are taking different paths and implementing diverging policies, and timelines will be radically different for countries facing different economic realities. But the basic intent of the new regulations is to add layers of comfort and safety to the banking system, for customers using it and within the system itself. These regulations attempt to address systemic risks that had not been widely anticipated. They also attempt to ensure that banks operate in ways that limit those risks, and that they are better prepared to respond to serious future financial events.
The following is a brief summary of some of the regulatory changes banks are currently facing. The key will be balancing compliance yet understanding the converged impact to our Canadian bank’s business models. Basel III The features of Basel III that address identified deficiencies include: an increase in the quantity and quality of capital; a leverage ratio; capital buffers (conservation and countercyclical); and global liquidity standards. Within Basel III, there are other efforts to strengthen risk management and supervisory practices beyond capital and liquidity. These areas of change—such as governance, supervision, deposit insurance, methods to identify systemically important financial institutions (SIFIs) at the global and domestic level and reliance on external ratings—has a separate consultation, debate, and implementation phase, adding considerably to implementation challenges.
The Dodd-Frank Act is major, comprehensive regulatory legislation intended to assure stability in US financial markets, the impact of which will likely exceed that of Sarbanes Oxley. The Dodd-Frank Act has broad implications on the financial services industry in eight key areas:
- Systemic Risk (limiting concentration)
- Financial Stability and Capital Requirements
- Volcker Rule (limiting proprietary trading)
- OTC Derivatives (managing counterparty credit risk)
- Consumer Protection and Mortgage Reform
- Federal Bank Supervision
- Registration of Investment Advisers
- Other Areas (Compensation, Asset-Back Securities, Whistleblower Programs, and more).
Though it is US legislation, it will have global effects on both the financial services industry and corporate accountability in general, affecting banking, securities, derivatives, executive compensation, consumer protection, and corporate governance.
FATCA (Foreign Account Tax Compliance Act)
Under this legislation, the U.S. government intends to combat tax evasion intensely by imposing a 30% withholding tax on U.S. source income unless a receiving financial institution enters into an agreement with the IRS and reports its U.S customers. Financial institutions that are impacted include any bank invested in the US market for its customers’ accounts or for its own account, as well as any bank which is part of a group which invests in the U.S. market for its customer’s accounts or for its own account. The FATCA provisions are additional and not substitutive to the current QI regime already in place. Under FATCA, a 30% withholding tax is applied on any payment (interest, dividend or sales proceeds) on US securities made to a Foreign Financial Institution, unless it agrees to identify U.S accounts; comply with verification and due diligence procedures; perform annual reporting; deduct and withhold 30% from any pass-through payment made to a recalcitrant account holder or another institution without an FFI agreement; and comply with requests for additional information.
Recovery and Resolution Planning or Living Wills
Arising from all the regulations above and supported by the G20, a living will is a regulator-approved plan, or "will," for SIFIs that lays out an orderly wind-down in case of a “life”-threatening event. It would provide a much wider range of options than straight government bail-out.
Impacts and Challenges—Key Questions Surrounding Growth
The successful implementation of changes to business operations in order to comply with these regulations will radically alter the Canadian and global banking environments, and despite the expected return of customer and investor confidence in global markets, banks will face some specific challenges. Canadian banks have been growing, and this is obviously a trend that the financial industry, and the Canadian economy at large, would like to see continue, but in the initial stages of regulatory adjustment, it may be reasonable to expect a slow-down of this trend. The mechanics and cost of compliance will initially increase costs for virtually all financial entities. The question is, once business returns to “normal” under the new regulatory umbrella, how much will growth be affected by the new regulatory environment? Assuming customer confidence grows and profitability grows, will the organization be able to leverage that success into global growth?
One major question is how consistently regulatory reform will be implemented globally. If it is inconsistent, regulatory arbitrage may continue to fragment overall financial system stability, as it has despite earlier reforms such as Basel I and Basel II. It is, of course, impossible to predict exactly how this regulatory landscape will develop, but Canadian banks should consider possible scenarios and apply some critical questions to their long-term strategies.
Canada is in a good position relative to many other countries. The banking industry in general, has strong liquidity and capital, and, comparatively speaking, should emerge as a global leader in accessing available opportunities. But how much and what kind of risks—always necessary to success and growth—will be removed or lessened as a strategic option? Will significant growth be achievable via the same strategies as before? Canadian financial institutions need to and want to be part of the global imperative to eliminate events like the financial crisis, but they are well aware of the fine line between controlling risk and reducing risk to the point where commercial viability is affected. If profit is too constrained, customer banking costs may be affected, running the risk of undoing any gains revitalized customer confidence might provide.
Balance—Build Toward a New Risk-Profit Equation
As in all businesses, there is a trade-off between risk and profitability. The greatest challenge for Canadian banks is to understand how this equation gets reconstituted in the new regulatory environment. The goal of regulatory reform is not to destroy the ability of banks to grow and earn, but the formulae will certainly be different. How do banks leverage their core strengths moving forward? Where can they take on risk to provide extra return? How can this all happen while safeguarding the customer relationship the industry is working so hard to recapture? Are there opportunities to become more efficient and off-set the adverse effect on profitably greater regulation can entail?
The answers will differ for individual banks. The positive aspect is that Canada will be as well-off as any country in the new milieu—set to transition effectively to new regulatory mandates, ready to enhance customer confidence, and better positioned than most to develop effective growth strategies. The key is to formulate governance and risk management infrastructures that balance the goals and requirements of compliance and strengthening of the financial system, with commercial realities.