Torrential reign

Making bankers pay for their exuberance is popular and the political pressure for reform is unlikely to abate despite hopes in some quarters that the slowly improving global economy will dampen the reform fervour.

In Europe, France and Germany have led calls for action against bank 'excesses'. French president Nicolas Sarkozy wants to cap bankers' pay and bonuses, and German chancellor Angela Merkel says big banks have too much power and cannot be allowed to blackmail governments. UK prime minister Gordon Brown backed moves to clamp down on bankers' remuneration ahead of September's Group of 20 summit of leading and developing countries in Pittsburgh.

There is broad agreement in Europe on linking pay and bonuses more closely to long-term performance, deferring rewards and clawing back part of bankers' remuneration when things go wrong. Governments mostly agree on moves to tighten rules on capital and provisions, and that something must be done to improve financial supervision, seen by many as having failed in the build-up to the global financial crisis.

The European Commission has been given the unenviable task of drafting proposals for financial reforms that will be acceptable to the European Parliament and governments eager to show they are doing something to prevent new crises from emerging.

In July, the EC presented proposals revising European Union rules on capital requirements and remuneration, following earlier wide-ranging proposals to strengthen financial supervision published in May.

Other EU measures are aimed at strengthening the supervision of credit rating agencies and counterparty clearing houses. Discussions on controversial proposals to regulate alternative investment funds are likely to drag on well into next year.

The Basel Committee on Banking Supervision has published its own report outlining enhancements to the Basel II framework on capital requirements that, among other things, will require banks and financial firms to do much more rigorous testing for risk.

None of this will happen overnight. The EC's timetable for regulatory changes is tight, but it is likely to slip as governments haggle over the detail. EU officials hope proposals on capital requirements and bankers' pay will be formally approved in the first quarter of next year and be adopted into member states' national law by January 1, 2011.

Governments want the new supervision structure "to be adopted swiftly in order for the new framework to be fully in place in the course of 2010". EU officials admit this is optimistic. The new regulatory architecture will probably not be operational until the second half of 2011, possibly later.

Capital requirements and liquidity risk
EC proposals on capital requirements will tighten rules for assessing risk and impose higher provisions to cover complex financial products and future risk. Banks will be required to improve the information they make available about their exposure to complex securities investments.

“These new rules target some of the investments and practices that lie at the root of the financial crisis. New rules on resecuritisations – the highly complex financial products that caused huge losses for banks – will require banks to hold significantly more capital to cover their risks when investing in these products, while the additional disclosure rules will help to create a climate of market confidence,” internal market commissioner Charlie McCreevy said when presenting the proposals in July.

Banks will be restricted in their investments in complex resecuritisation operations if they cannot demonstrate they have understood the risks involved.

Officials say this does not mean banks will not be allowed to make such investments, but national supervisors will be able to impose a punitive risk rate of 1,250% in provisions for these positions if they believe the risks are too great or not properly understood, effectively discouraging the bank from going ahead.

Governments and regulators, under public pressure over the financial turmoil, want to ensure banks have more capital and liquidity to face future problems.

“There is a huge political momentum to get the banks to have more capital. There is a rush and a desire to get infrastructure in place that will protect regulators and governments,” says John Tattersall, consultant at PricewaterhouseCoopers and former chairman of PwC’s UK regulatory consultancy.

The difficulty is deciding how to achieve this, how much capital and provisions should be set aside and avoiding inconsistencies and the possibility of arbitrage between different jurisdictions. The spectacular collapse of major banks has also taught that having the required level of capital under Basel II rules is one thing, but it does not in itself offer sufficient protection in a liquidity crisis.

“Liquidity regulation was inconsistent around the world and supervisors did not focus on it enough. Liquidity or the lack of it is what causes banks to face solvency problems. That’s what brought down Northern Rock and Lehman,” Tattersall says.

The problem is not everyone understands the rules the same way, which makes life difficult for large banks operating across borders.

“We have seen a high level of international convergence around regulatory capital requirements for Basel II. However, we do not see this same level of convergence happening for liquidity risk because regulators are interpreting the requirements for holding funding liquidity differently,” says Algorithmics in a statement, a global provider of enterprise risk management systems. “Between regulatory jurisdictions there is a lack of consensus on how these risk measures should be interpreted in terms of regulatory requirements, specifically around the amount of liquidity funding institutions are required to hold.”

This makes it all the more necessary for large banks to have “robust liquidity risk systems with enterprise liquidity risk frameworks and solid data infrastructures”, says Mario Onorato, senior director of balance-sheet risk management solutions at Algorithmics.

Suhas Nayak, product director at consultancy and software firm Fernbach, says: “Liquidity management issues have been swept under the carpet for a long time. One of the mistakes made in the past was to confuse liquidity and capital. Our understanding of risk liquidity is still in its infancy.”

The European Council, which represents Europe’s governments, believes that establishing  forward-looking provisions for expected losses on loan portfolios will help, but more might be needed. “While such provisioning will be an important step forward, it might not be enough as provisioning for losses in the loan portfolio might not be sufficiently large, and buffers are also needed against fluctuations in the value of financial assets,” it says.

Governments want more work to be done on how to create strong counter-cyclical capital buffers, separate from basic capital requirements. “It is important that counter-cyclical capital buffers are not perceived as new minimum capital levels when conditions deteriorate and that they do not count towards eligible regulatory capital so as to allow banks in downturns to draw on buffers previously built up in good times,” the European Council warned.

The Committee on European Banking Supervision, the Committee of European Insurance and Occupational Pensions Supervisors and the Basel Committee are studying proposals to deal with risk-based capital.

The G-20 summit was expected to make sure banks have enough cash in hand to deal with the unpredictable. The difficulty is determining how this is calculated and how it is reflected in accounts, says one banker.

“For regulatory purposes it’s important to know where you are in the cycle,” says Tattersall. “But when it comes to building it in the accounting and reporting to shareholders, I have doubts. Shareholders need to know what is happening, not what might happen.”
For now, accounting standards, including International Financial Reporting Standards, do not allow recognition of expected future losses.

European governments believe that allowing recognition of expected losses will ensure provisions built up in good times can be used in a downturn. It would also contribute to a better assessment of real profits, help to adjust managerial incentives over pay and bonuses, make investors more aware of underlying risks and enhance consistency between accounting and prudential rules.

The European Council wants standard setters to give priority to amending current accounting rules to allow for more flexibility in provisioning for expected losses.

Adair Turner, UK Financial Services Authority (FSA) chairman, said at a meeting of the British Bankers’ Association in June: “We also need to make capital to a degree counter-cyclical – with capital buffers built up in good times to be drawn down in bad times – and we need that approach to be reflected in some way in published accounts, with provision or reserve movements that reflect future possible losses.”

Changes in accounting practices are likely and the International Accounting Standards Board is due to publish a proposal on these issues in October.

Fixing remuneration and bonuses
The EC has been under intense pressure to come up with radical plans to deal with bankers’ pay and bonuses. Under its proposals, banks will have to introduce “sound remuneration practices” to discourage excessive risk-taking. National supervisors will review banks’ pay policies and will have the power to impose sanctions if they do not meet the new requirements.
“The requirements on pay and bonuses are designed to put an end to the culture of excessive risk-taking for short-term success at the expense of long-term profitability and sound risk management,” McCreevy said.

Everyone agrees with that in theory, but not on how to make it work. Officials say “sound remuneration practices” does not mean regulators will tell banks how much they should pay their employees and managers, but that remuneration should be based on principles. These are being discussed with member states and are likely to be similar to those adopted by the FSA in the UK.

The discussion over pay and bonuses has brought to the fore important cultural differences and the debate is likely to “run and run”, one banker says.

“In the Anglo-Saxon view, the real problem is that remuneration is not linked to risk. For the French, it’s that they’re paid too much. The problem is, if you have legislation limiting the amount people can be paid, it will drive them away,” says Tattersall.

The new European supervision model
The EC proposals on supervision envisage the creation of a new European Systemic Risk Council (ESRC) and a new European System of Financial Supervisors (ESFS). “The new system will help the EU and its member states to tackle problems with cross-border firms and the build-up of overall systemic risk,” EC president José Manuel Barroso said.

While the proposals’ objectives were welcomed, reaching agreement will be difficult as they touch on sensitive issues of national sovereignty.

McCreevy says change is necessary. “Financial supervision in Europe has not kept track with market integration. The crisis has shown that the current system is not sufficiently responsive and not appropriate for a single financial services market. This new system will combine the expertise of all those responsible for safeguarding financial stability with strong European bodies to co-ordinate their work.” The proposals aim “to build a stronger, more globally consistent, regulatory and supervisory system for financial services”.

The ESRC will be responsible for macro-supervision, monitoring and assessing risks to the stability of the global financial system. It will provide an early warning of systemic risks that may be building up and, where necessary, recommend action. Initially the European Central Bank was given the leading role in the council, but countries not in the eurozone objected and responsibilities in the new council will be shared out more broadly.

The ESFS will be responsible for supervision of individual financial firms and deal with cross-border risk and problems more effectively. It will consist of a “robust network” of national financial supervisors working in tandem with new European supervisory authorities created by the upgrading of the three existing advisory committees for the banking, securities and insurance and occupational pensions sectors.

A steering committee will co-ordinate the work of the new authorities – the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities Authority – and help resolve disputes.

The authorities will have a broad remit to “foster harmonised rules and coherent supervisory practice and enforcement,” the EC said. Day-to-day supervision of individual firms will remain with national supervisors, who will carry out on-site inspections.

Cross-border firms will be supervised by colleges of supervisors. The new authorities will have the power to intervene and settle disputes between national supervisors if necessary.
The new authorities will not set rules, but “will play an important role in bringing about a common rule book”, the EC says. “They will be able to develop technical standards, which will be binding unless the EC opposes them and they will draw up interpretative guidelines to assist the national authorities in taking individual decisions.”

Arbitration decisions in cases when there is a disagreement in the supervisors’ colleges will set a precedent. Appeals against the authorities’ decisions will be heard at the European Court of Justice, which will have the final say.

The push to harmonise is controversial, but the EC says it is important there is a level playing field in the single market. “One of the problems observed in the build-up to the crisis was the inconsistent application of supervisory rules. A common set of rules leads to heterogeneous supervisory actions. The new authorities will play an important role to avoid similar problems in the future,” it says in a explanatory note.

“Differences in the national transposition of community law stemming from exceptions, derogations, additions or ambiguities in current directives must be identified and removed, so that one harmonised core set of standards (a single rule book) can be defined and applied throughout the EU by all supervisors,” it says.

The fear among financial firms is that the rush to harmonise and give greater responsibilities to the new supervisory authorities will allow them to tell individual institutions how to behave, and that, says Tattersall, “is a hugely tricky territory”.

“I think we are at risk of being over-regulated,” says Selwyn Blair-Ford, senior business domain expert at FRSGlobal. “The financial industry has a lot to do. Firms are at different stages of readiness regarding regulation and the pace of implementation will not be the same everywhere,” he says.

Financial firms are worried about the potential effect of so many changes and many would like an overall impact assessment bringing together all the proposals.
For risk managers, the effect of all these changes will really only come next year when more details of the new rules will be available. And there could still be some surprises as a new EC will have been installed by then.