Outlines of a new regulatory framework
On the political front, the lead has been taken by the G20 group of developed nations. The G20 London meeting in April 2009 charged the Financial Stability Forum with the broad remit of promoting and overseeing regulatory reform in the financial sector, and of monitoring threats to global financial stability.
Much still needs to be done to translate general principles for improved regulation into detailed, practical measures which can be implemented and policed. However, the broad outlines of a new landscape of banking regulation are already clear. This is not simply a matter of new and tougher compliance requirements. The new framework emerging will impact on boards, shareholders, stakeholders, regulators and customers.
Increased capital and liquidity requirements
Financial institutions cannot be prevented from failure, and should not be. The threat or risk of failure acts as an ultimate incentive to efficiency, innovation and growth, and hence the creation of prosperity. The trick is to ensure that the incidence of failure remains low and that where failures do occur, their effects are localised. There is no doubt that banks are going to be required to hold higher levels of capital, and of higher quality, in future. Of itself, this will not prevent another crisis. But if carefully implemented, increasing the size of capital buffers to absorb losses will reduce the general risk of failure; and it should ensure that the danger of systemic damage – the contagious loss of confidence across entire sectors – is minimised.
In this respect, Core Tier 1 capital – essentially shareholder funds and retained earnings – is likely to receive greater emphasis. Banks will be less able to rely on Tier 2 capital such as reserves and general provisions in demonstrating their financial soundness. The quality of other financial assets will be more closely scrutinised in relation to their risk. There could well be moves to impose counter-cyclical provisioning, so that banks build up higher capital reserves during upswings to provide greater protection against downturns.
One of the major characteristics of the crisis was that in the face of collapsing confidence, liquidity dried up. Partly because nobody could foretell where problems would emerge next, and partly because the risk and pricing basis of many assets had suddenly become opaque, financial trading effectively seized up. Regulators are going to ensure that high-quality, liquid assets feature strongly in banks’ reserves. The fact that holding gilts (government bonds) will help finance government debt will provide an added incentive.
Operational and strategic constraints
Much has been made in some quarters of the desirability of insulating retail and commercial banking from investment banking and proprietary trading. A complete return to strict separation between the two aspects of banking, as the US enforced between 1933 and 1999 (the Glass-Steagall Act) will almost certainly prove to be impractical. As a consequence, though, banks will face much tighter constraints on their activities, designed to ensure greater consumer protection, enhanced risk management and control regimes and tougher controls on many aspects of their operations.
Remuneration and compensation arrangements in banking have received strident criticism. While much of this has been ill-advised, and irrelevant to the causes and prevention of financial crisis, the clamour for change has become too loud to ignore. Whether by voluntary action or in response to external regulation, banks are going to have to take a more prudent and long-term approach to remuneration and bonuses. Deferred and performance-related compensation will have to replace guaranteed annual cash bonuses.
The argument that institutions have become ‘too-big-to-fail’ will lead in some cases to banks being deliberately split up. The eventual return to the private sector of banks which had to be nationalised during the crisis will give policymakers further opportunities to define and control the shape of the sector in future. Banks are going to face growing pressure to define a core business and core strategy and retreat to it.
All these developments will place much greater pressure on corporate governance structures. There is a good case to be made that inadequate oversight and supervision played a role in allowing the underlying causes of the crisis to develop. Boards failed to enquire into, monitor or understand the risks that bank executives were running. They are going to have to take greater responsibility in future.
None of these changes will come without a price. Banking is going to become much more like a utility sector again. While this is to be welcomed if it improves stability, reduces volatility and makes a recurrence of the crisis less likely, there will be costs. Increased capital requirements, constraints on operations, higher compliance burdens will result in higher costs, lower returns to shareholders, higher prices to customers. However, regulators appear to be aware of the dangers, and ready to work constructively with the banking sector to try and strike the right balance.
Banks play an essential social and economic role. Besides facilitating financial transactions, they recycle savers’ funds to support investment, growth and wealth creation for the benefit of all. Because of this unique role, the banking sector has received unprecedented government support and investment over the last couple of years. Managing the transition from this emergency action to a sustainable framework of regulation will pose major challenges. But getting the balance right is vital for us all.
This article draws on a presentation, facilitated by David Broom and Pierre Fourie and led by Alison Halsey for Absa, held at KPMG South Africa’s new Wanooka campus in Parktown, Johannesburg.