Benefits and unintended consequences of financial markets reform

“I worry that planned financial regulations will inhibit growth in my industry” % respondents, by region Category 1 Category 2 Category 3 Category 4 Category 5 Category 6 Source: Economi

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Executive summary 2

2 Overall expectations of regulatory impact vary 11

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In response to the 2008 financial crisis and the world recession that followed, central bankers, regulators and governments have drafted numerous regulatory reforms and measures designed to minimise risk and maximise consumer protection in the global financial system

In order to investigate the potential impact of these new regulations on businesses, the Economist Intelligence Unit, on behalf of Lloyds Bank Wholesale Banking & Markets, surveyed over

450 senior executives from different companies and also conducted interviews with experts

Key findings include:

Companies are aware of and worried about regulatory changes—but are not prepared

One-half of respondents cite regulation as one of their main concerns, alongside the global economic crisis (58%) and the euro zone crisis (54%)—far ahead of other issues such as availability of finance More than three-quarters (77%) of respondents believe that their boards are aware of the impact of changes in regulation on their company, but only 61% feel prepared

Executive summary

In June and July 2012 the Economist Intelligence Unit, on behalf of Lloyds Bank Wholesale Banking

& Markets, surveyed 454 senior executives in order to explore what companies think about the current regulatory landscape as well as how these firms are planning ahead to handle the impact of future regulation

Respondents were drawn from Europe (60%), Asia-Pacific (20%) and North America (20%), and were divided into financial services (44%) and non-financial services companies (56%)

In addition, in-depth interviews were

conducted with three experts from leading financial companies Our thanks are due to the following for their time and insight (listed alphabetically):

Jessica Ground, UK bank analyst at Schroders Ricky Maloney, head of treasury processing

at Ignis Asset ManagementMark Stancombe, head of client management

at Insight InvestmentThe report was written by Faith Glasgow and edited by Monica Woodley of the Economist Intelligence Unit

About this report

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There is concern that new regulation will hinder growth and innovation

More than one-half (51%) are concerned that planned financial regulation will impact on growth

in their industry, while 44% expect it to affect innovation UK and US companies are somewhat more anxious (54 and 53% respectively) about the negative impact of the new regulations than either European or Asia-Pacific companies (46 and 48%

The cost of compliance is the greatest worry

Almost three-fifths (59%) of respondents see the increased costs of complying with the new regulations as the biggest threat, but the rising costs of obtaining funding (39%) and

implementing information technology systems (25%) are also concerns

Companies are contemplating a range of responses

The most popular plan, selected by 42% of respondents, is to change their company’s corporate finance or risk-management model But significant numbers are also thinking of relocating

or changing their legal structure (26%), looking for alternative funding (27%), reducing their use

of derivatives (25%) or seeking alternative service providers (24%)

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Introduction

As a result of the 2008 financial crisis and consequent world recession, central bankers, regulators and governments have drafted a raft of new regulations to better protect and stabilise the global financial system

The reforms have several broad aims, but include (among others) measures to boost surveillance, raise bank capital adequacy standards, reduce risk in over-the-counter (OTC) derivative activity and remove opportunities for regulatory arbitrage among non-bank lenders (known as “shadow banking”)

Some of the reforms, such as Basel III and the

International Financial Reporting Standards (IFRS), will be implemented globally Others are regional directives; thus, the Markets in Financial Instruments Directive II (MiFID II), the European Market Infrastructure Regulation (EMIR) and Solvency II affect the EU, while the US financial landscape will be reshaped by the Dodd-Frank reforms and the Foreign Account Tax Compliance Act (FATCA) Then there are national reforms; for example, the UK is introducing its own regulatory banking requirements as a result of the Vickers Report (See box below for a brief explanation of each regulation.)

Basel III: global agreement on bank capital adequacy and

market liquidity risk

IFRS: creating a single set of enforceable and globally accepted

international financial reporting standards

MiFID II: far-reaching legislation designed to modernise, make

more transparent and harmonise the EU securities markets; it is

likely to affect everyone involved in the EU industry

EMIR: an EU directive providing for a harmonised regulatory

framework for OTC derivatives

Solvency II: EU directive requiring greater capitalisation for

insurance companies, which is expected to push them towards

more risk-averse investment strategies

Dodd-Frank: wide-ranging US reforms, including bank and

insurance company capital requirements but also regulation of hedge funds

FATCA: US legislation requiring US taxpayers to report to the

Internal Revenue System (IRS) specific foreign financial assets over a certain threshold It also requires foreign financial institutions to report similar information to the IRS on companies operating in the US

Independent Commission on Banking (ICB, known as the Vickers Report): UK banking reform proposals including ring-

fencing of personal and SME deposits from wholesale and institutional operations

Financial regulation definitions:

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Although companies have always had to take into account the changing requirements of the regulators, both the pace and the scale of these overhauls is unprecedented Moreover, they have major implications for non-financial as well as financial corporations For example, the cost of borrowing will rise as banks’ lending spreads to customers are pushed up by the banks’ obligation

to provide greater capital adequacy In addition, the introduction of reporting obligations and central clearing for OTC derivatives will increase

transactional costs for both financial and financial firms that use derivatives to hedge their costs or for other purposes

non-This report examines the views on new regulations of financial and non-financial companies around the world, including how important these firms think regulatory reform is in the current global economic climate, in addition to how prepared they are for those changes that will affect them directly and others that may have an indirect impact on their bottom line

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Responses vary regionally, however European companies are primarily focused on regional problems and are less troubled by the impact of regulation (only 41% cite it)—perhaps also because they are already well used to a steady stream of EU directives By contrast, regulatory change is the single biggest headache for North

American corporates, with 61% identifying it as a concern

As might be expected, there are also clear differences in perspective between financial services (FS) companies and non-financials Only 36% of non-FS respondents see regulation as a major issue For them, sales-driven considerations such as lack of consumer demand (30%) is well over twice as significant as it is for financials (12%)

By contrast, regulatory change tops the list of worries for FS respondents, cited by over two-thirds (68%)

Regulation on the radar

23 26

62 47

24 27 15

25

68 36

12

31

58 58

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Ricky Maloney, head of treasury processing at the UK-based Ignis Asset Management, foresees

“severe difficulties” in regard to the OTC derivatives market changes, in the current economic climate

“Governments and regulators have contradictory strategic goals, in that they are removing liquidity from the markets by way of increased margin and capital requirements, while at the same time trying

to stimulate economic growth,” he notes

At the corporate level, there seems to be reasonable confidence that senior directors at least

understand the implications of the regulations:

more than three-quarters (77%) of respondents say that their board of directors is up to speed with the impact of the new regulations on their

company But that does not necessarily translate into confidence that they are actually taking action, with only 61% believing that most or all of the necessary preparations have been made, and almost one in ten (8%) of respondents perceiving their company as unprepared

Q

North America Mainland Europe UK Asia-Pacific

What do you see as the most important issues facing your company today?

% of respondents, by region

Category 1 Category 2 Category 3 Category 4 Category 5 Category 6

Source: Economist Intelligence Unit survey, July 2012.

Global economic uncertainty Lack of (consumer) demand Regulatory changes Availability of finance Lack of confidence Eurozone crisis

Lack of industrial/economic growth/investment

Other

55 55 56

66 27

24 21 19

61 41

53 48 21

26 19 17 23 27 27 26

44

57 60 48

27 21 25 27 3

3 3 1

Q

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Q

Strongly/somewhat agree Neutral Somewhat/strongly disagree

My company is prepared for the impact of planned financial regulations.

Our board is aware of how planned financial regulations will impact our company.

Do you agree or disagree with the following statements?

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Although companies have little choice but to take some kind of action in response to the changes, most—and especially FS companies—have serious misgivings about the wider impact on economic growth and innovation One in two companies (51%) overall, and 64% of FS respondents, expect growth in their industry to be inhibited as a result of reduced market liquidity and increased trading costs

Again, there is some regional differentiation, with European firms notably less fretful than those based in other areas about the impact of

regulations on growth—again perhaps reflecting the fact that regulatory issues are to some extent eclipsed by the fragility of the euro zone economy and the need for far-reaching political and economic solutions

It is also rather more worrisome for UK and US companies than for those based in Europe or Asia:

54% of UK firms are downbeat about prospects for growth, compared with 46% of European firms

Jessica Ground, UK bank analyst at the headquartered Schroders, makes the point that unilateral regulation is a real worry for the City

London-“For global markets such as financial services, human capital is very transferable The system did need substantial reform but with international consensus; the danger is of jurisdictions acting independently of each other and capital just moving away.” She points to the UK’s unilateral plans for bank ring-fencing and France’s proposed transaction tax as examples of regulation that could leave countries seriously vulnerable to lost business

Q Q

Do you agree or disagree with the following statement?

“I worry that planned financial regulations will inhibit growth in my industry”

(% respondents, by region)

48 36 16

54 33 13

46 26 28

53 33 15

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Only 5% of respondents see no threat to their company as a result of the new regulatory regime;

most are troubled by the various costs of implementation The biggest issue by far is the impact of increased compliance costs, which concerns 59% of respondents overall and more than 70% of large companies with annual revenue of more than US$10bn (see chart 4) However, rising funding costs (39%) and information technology

(IT) costs (25%) are also concerns FS companies are even more focused on compliance costs (see chart 5)

“The FS industry is underestimating the term costs of compliance—there will be problems down the line with the amount of work for compliance departments and the extent of reporting involved,” comments Schroders’s Ms Ground “The trouble is that additional regulation is

long-Regulatory pros and cons

2

Q

Between $500m and $1bn Between $1bn and $10bn More than $10bn

What are the biggest potential threats to your company from planned financial regulations?

(% of respondents, by company size in USD revenue)

Increased cost

of funding Increased cost

of compliance Increased cost

of hedging risk Increased IT costs

Difficulty in securing banking products or services we need Restrictions on where

we can operate

I don’t see any potential threats Don’t know

39 37 39

70 57

52 17

16 16 23 29 23 12

12 13 10

22 26 6

5 4 1 2 1

Q

Chart 5

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absorbing firms’ profits, yet they don’t feel they’re getting better regulation because the regulators’

focus has been on volume rather than quality.”

Almost one-quarter of companies based in North America (24%) and Asia-Pacific (24%) are also anxious that the regulatory changes will restrict their freedom to operate in other jurisdictions

When asked about the likely positive consequences of the changes, most respondents see some sign of a silver lining to the regulatory cloud hanging over them At the top of the list of

potential benefits are improved transparency with regards to risk (42%) and greater stability for financial markets (41%), with a further 30% also looking forward to greater pricing transparency and reduced counterparty risk (for differences between

FS and non-FS respondents, see chart 6)

But there is less consensus among respondents over the potential downsides to the new regime;

indeed, 13% take a somewhat sceptical view, claiming that they do not envisage any benefits for their company at all

Q Q

Chart 6

FS Non FS

What are the biggest potential threats to your company from planned financial regulations?

(% of respondents, by sector)

Increased cost

of funding Increased cost

of compliance Increased cost

of hedging risk Increased IT costs

Difficulty in securing banking products or services we need Restrictions on where

we can operate

I don’t see any potential threats Don’t know

37 40

74 48

12 20

29 22 9

16 20 19 3

7 1 2

of risk Increased market (pricing) transparency More stable financial

markets

I don’t see any benefits Don’t know

33 27

42 41 30

31

38

43 14

11 1

3

Q

Chart 7

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Most respondents (68%) are bracing themselves for significant or even game-changing effects on their financial and risk-management strategies as a consequence of the new regulatory landscape, with

UK companies expecting to be hardest hit (76%)

Unsurprisingly, FS companies are also predicting a higher impact than their non-FS counterparts FS respondents are particularly worried about the regulations (such as Basel III, MiFID II and Solvency II) that are likely to make their investment business more complex or restrict their ability to issue corporate debt, as well as

those affecting the derivatives market For non-FS firms, the survey suggests that the rising cost of borrowing from banks is the biggest problem, although they are less concerned than FS companies about this issue

However, the FS interviewees point out that what affects their clients ultimately affects them as well

“The big thing for us will be MiFID, though there will also be some fallout from Dodd-Frank,”

according to Ms Ground at Schroders She adds, however: “Basel III and banks’ increased capital adequacy requirements will also impact on our

Overall expectations of regulatory impact vary

3

Q

Please assess the compound impact of all regulatory change

High impact (Fundamentally challenges viability

of our financing and risk management model)

Don’t know

Not applicable

18 19 24 11

46 42 41 39 22

34 21

30 7

3 9 15 8

2 5 6

Q

Chart 8

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Overall, three-fifths (58%) expect a significant or fundamental impact on their finance and management models from the Basel III banking reforms Financials (69%) are expecting markedly more fallout than non-financials (50%), despite the fact that widening bank lending spreads are set to push up the latter’s borrowing costs Indeed, Basel III is the single piece of regulation expected by FS respondents to have the greatest impact on their business

risk-Q Q

Chart 9

FS Non FS

Please assess the compound impact of all regulatory change

(% of respondents, by sector)

7

29

38 44 46 12

5 10 4 6

Low impact (impacts profit of our financing and risk management model) Medium impact (Significantly impacts profit of our financing and risk management model) High impact (Fundamentally challenges viability

Don’t know Not applicable

clients, and therefore our business.”

EMIR is the biggest headache for Mark Stancombe, head of client management at Insight Investment of the UK “It has the potential to have

a very large detrimental effect on our underlying pension fund clients’ ability to mange the risks associated with funding their pension obligations,

and indeed on European pension and insurance funds generally,” he explains

It is unsurprising that concerns over specific regulations vary with significant differences in the primary areas of concern for FS and for non-FS corporates The differences for each regulation are detailed in the boxes below

39 40 11

1

10 10 10

Q

Chart 10

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Unsurprisingly, North American respondents expect to be most significantly affected (36% of US companies expect a fundamental impact, while a further 32% predict a significant impact, compared with 14% and 30% overall) By contrast, around one-fifth of European (23%), Asian (20%) and UK (18%) companies do not see Dodd-Frank as relevant to them

Dodd-Frank

Wide-ranging US reforms, including bank and insurance company capital requirements,

as well as regulation of hedge funds, among other issues

Q

Please assess the impact of Dodd-Frank on your company

(% of respondents, by region)

Low impact (impacts profit of our financing and risk management model)

Medium impact (Significantly impacts profit of our financing and risk management model)

High impact (Fundamentally challenges viability

Don’t know

Not applicable

QChart 11

27 26

33 15

30

36 23

36 12

13 5

32 10

7

17 11

20 18

23 7

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26

33 28

25 17

7

15 17 14 18

QChart 12

Again, despite the fact that this is EU legislation, it appears to be of much greater concern to UK businesses across the board Over three-fifths (63%) of UK respondents anticipate significant or fundamental fallout from the reforms, compared with only 44% of European firms This may reflect the fact that the insurance industry in Europe is skewed towards small mutual specialists serving a local community, which may not even be large enough to qualify for Solvency II, rather than the major one-stop-shop insurers that dominate the UK market

34 31 7

10

15 12

15

EMIR (European Market Infrastructure Regulation)

An EU directive providing for a harmonised regulatory framework for OTC derivatives trading

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Just under one-half (47%) of respondents foresee a significant or greater impact; once again, Europe is fairly in line with the rest of the world, while in contrast UK respondents (58%) are expecting to feel much more heat from the reforms Comparing FS and non-FS responses, more than four times the proportion of FS firms see the regulation as likely to have a fundamental impact

on their business (23%, compared with just 5% for non-FS companies)

However, 15% of respondents overall (including a worrying 13% of FS firms) have no idea how the impending MiFID II regulations will affect their business

18

28

37 32

23 5

13

18 10

17

Q

Chart 14

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