Change amidst uncertainty how banks are adapting to the emerging regulatory landscape

Change amidst uncertainty: how banks are adapting to the emerging regulatory landscape Sean Culbert Partner and Co-lead of Finance, Risk and Compliance sean.culbert@capco.com * For fur

Change amidst uncertainty: how banks are adapting

to the emerging regulatory landscape

Thoughts

Written by the Economist Intelligence Unit

The second, related observation is that some bank leaders may not fully understand the exposure created

by inadequate governance of trading operations within the new environment Laws in the United States and the UK now impose stronger fiduciary and oversight requirements on a firm’s board members and executives, requirements that extend to maintaining robust

compliance around all trading operations and banking Whether or not their front-office moves are part

of broader corporate strategy, firms can become exposed to significant fiduciary and reputation risks by executing new business strategies without adequate controls, communications strategies and change management in place On the up-side, reorganizing quickly and purposefully, and creating compliance programs that meet the test of global regulators, can position banks to increase market share and margin, both in existing and emerging markets

We hope the findings of this report help you chart

a course to new opportunities, leveraging solid governance Please let me know if you would like to discuss the results or have any questions

Capco is pleased to present this report, which explores how capital markets firms are dealing with the dramatic changes that are underway in the financial services industry Based on research conducted by the Economist Intelligence Unit in March 2011, the report provides insight into seven critical questions

regarding banks’ readiness for regulatory reform, which

were the subject of a recent Capco white paper.*

Among the many insights the survey provides, two

are especially noteworthy, and potentially reasons

for caution

First, it is clear that the traders are driving change

Trading operations are taking the lead in implementing

business models and processes to operate in the

newly regulated environment In some cases, they

are quickly executing on geographic strategies, in

jurisdictions where regulations may be more favorable

In doing so, trading operations appear to be outpacing

their back-office and compliance functions by a

wide margin In fact, more than half of the trading

operations surveyed could be conducting business

in an environment without the necessary obligations

support – capabilities that simply may not exist in the

local back office yet, or that regulators may not have

even fully defined

Change amidst uncertainty: how banks are adapting to the emerging

regulatory landscape

Sean Culbert

Partner and Co-lead of Finance, Risk and Compliance sean.culbert@capco.com

* For further discussion of these questions please see the Capco

Thoughts white paper, Regulatory Reform: 7 Critical Questions

for Financial Services Firms, available on capco.com.

About this report

Change amidst uncertainty: how banks are adapting

to the emerging regulatory landscape is a Capco report, written by the Economist Intelligence Unit

It examines how, in light of continuing regulatory uncertainty, financial institutions are reshaping their capital markets businesses to operate effectively in the new environment, and focuses particularly on the likely effect of regulation on overall structure as well

as front, middle and back office operations

The research is based on three components:

• A survey of 60 senior executives at financial institutions, half operating in the UK and half in the US All firms had annual global revenues of more than US$5bn and all respondents work in operations, risk, trading or regulation

• Interviews with a range of industry participants and experts, as well as a follow-up qualitative questioning of survey respondents Because of the sensitivity of the topic, interviewees spoke off-the-record

• Desk research, including a review of financial institutions’ regulatory filings

The author of the report is Geraldine Lambe and the editor is Monica Woodley

Executive summary

As the scale and intensity of the financial crisis

became clear, industry participants knew that a tough

regulatory response would follow Those expectations

have now been met While the final rules remain

uncertain in many areas, a raft of regulatory change is

in process

The regulations create new capital requirements,

address liquidity and counterparty risk, and push trading

of more products onto exchange and into central

clearing They put in place new consumer protections

and seek to reduce systemic risk in order to avoid the

need for future government intervention The cumulative

effect is forcing the financial industry to fundamentally

reassess business models and operating practices

This assessment is driving significant change in

financial institutions Banks are already exiting some

businesses and are likely to shrink or exit others as

new capital rules make them less profitable The

location of new or expanding businesses will be

rethought as firms assess the relative impact of each

jurisdiction’s regulatory constraints New systems and

processes are being put in place to meet demanding

data capture, data management and stress testing

requirements Communications with clients and

counterparties are being revamped, and new

reporting lines put in place Connectivity will have

to be developed and new processes established to

connect to a swathe of new entities that will spring up

in the clearing and settlement space

In this changing environment, the Economist

Intelligence Unit conducted research, on behalf

of Capco, to find out where banks are in terms of

preparation for new regulations and what impact

these are having on operations This research

is based on a survey of senior executives at 60

banks, half based in the US and half in the UK,

working in operations, risk, trading or regulation

The survey results have been supplemented with

in-depth interviews with industry participants and

experts Because of the sensitivity around this topic,

interviewees preferred to speak off-the-record

Key findings from the research include:

Banks see more opportunities than threats in the new regulatory environment Almost a third of respondents believe that new regulations will provide opportunities to take market share as other banks retrench or rethink their business models Almost two-thirds see regulatory change as an opportunity

to transform their business at a systems and process level Some see this as a way to gain competitive edge However, they are unsure whether the greater transparency required by regulation will have a positive or negative impact on competitiveness

While preparations are well underway, the impact

of regulations on bank structures is unclear

More than half of respondents say they are at implementation stage The US is further behind than the UK, however, as the industry waits for many elements of the Dodd-Frank Act to be translated into regulations Almost three-quarters have identified where changes to systems need to be made in order

to handle the new, higher levels of data required A similar number say they have a strategy in place to communicate the impact of regulatory changes to clients and counterparties

However, the industry remains uncertain about how to adapt business entities and operations to new regulations More than half of respondents are keen to retain existing organizational structures and operating models However, in 13 out of the 17 areas

of operation covered by the survey, the majority of respondents do not know if their firms will relocate or outsource business functions, or create a shared utility

Boards and senior management believe they have a good understanding of regulatory impact.

The crisis has been a wake-up call for board members and senior management With regulators and policy-makers taking an increasingly tough line, boards and executive management will be more accountable for a firm’s decisions According to the majority of respondents, they have risen to this challenge and have a good understanding of the implications increased data transparency will have at their own businesses as well as across the industry Once changes to data infrastructure are adopted, respondents are confident that management will be able to prove they have better control over information,

as required by regulators

2010, we liquidated substantially all of the positions that had been held within Principal Strategies in our former Equities operating segment, as this was a proprietary trading business In addition, during the first quarter of 2011, we commenced the liquidation of the positions that had been held by the global macro proprietary trading desk in our former Fixed Income, Currency and Commodities operating segment.”

US regulations are shaping European institutions’ strategy too Deutsche Bank announced in March that

it would deregister its US subsidiary so that it would no longer be a bank holding company Deutsche hopes that by changing the status of Taunus Corp – a part of which is highly leveraged and under new rules would need recapitalizing – it will take Taunus out of the scope of the Dodd-Frank Act and avoid having to raise billions of dollars in new capital

Compliance is diverting management, IT and legal resources from day-to-day operations as IT races to keep pace with front office transformations Some firms have recruited additional expertise in specific areas The impact assessment itself is a major task The Dodd-Frank Act, for example, is long and complex at 2,307 pages, 16 titles and 540 sections It

is expected that regulators will create 243 new rules, conduct 67 studies and issue 22 periodic reports Hundreds of new rules will require consultation with the industry before they can be implemented One bank’s response to the Markets in Financial Instruments Directive (MiFID) consultation alone takes

up 66 pages The bank says its legal and compliance department has doubled in size in the last two years

So, while much of Dodd-Frank, the Financial Services Act 2010 and other regulations still need to be defined, it is clear that banks’ strategy and front office operations are already moving forward, while governance and compliance are lagging

Assessment, understanding and

implementation

The sales and trading functions of financial services

firms seem to have moved quickly to determine which

regulations are relevant to their businesses, consider

what the regulatory impact will be and even to move

forward with implementing changes based on their

impact assessments More than half of respondents

to the survey say they are at the implementation

stage Looking at responses by geography, the UK

is slightly ahead of the US, with 58% compared with

53%, respectively, already implementing changes

Industry participants say that this is explained by

the fact that there is more still to be defined in US

regulation than there is in Europe, meaning that firms

in Europe have a head start UK firms are also more

likely than those in the US to align the implementation

of their country’s main regulatory reforms with those

of Basel III and IFRS (See Figures 1 and 2.)

The UK operations of a European bank are

already advanced in several areas, including those

surrounding internal transfer pricing models These

are central to complying with the UK’s liquidity

buffers, which were implemented in June 2010, as

well as Basel III’s liquidity coverage ratios The bank’s

CEO says the bank’s decentralized business model

has given it a head start in such areas

“We introduced transfer pricing for liquidity risk to all

our branches in June 2009,” he says “Each branch

has to match-fund itself The reason we have been

able to move so quickly is because we operate a

devolved model, where each branch is responsible for

setting the appropriate prices for its own market For

this kind of decentralized pricing model to work, it’s

critical for branches to be charged the correct internal

cost for liquidity, so we already had the processes in

place to enable us to implement this regulation.”

10%

17%

Figure 1 Q1, geographic split At what stage is your company

in preparing for changes required by regulatory reform?

We have identified the regulatory changes relevant

to our business

We have assessed how regulatory changes will impact our business

We have begun implementing changes to our business based

on our impact assessments

97%

80%

Figure 2 Q2, geographic split Have you or do you plan to align the implementation of your country’s main regulatory reform with that

of any of the following regulations? Select all that apply.

U.K.

U.S.

Figure 2 Have you or do you plan to align the implementation of your country’s main regulatory reform with that of any of the following regulations? Select all that apply.

Trading is running out in front

According to the survey, by function, trading is way out in front in terms of preparation, with almost three-quarters (73%) saying they are already at implementation stage Interestingly, the regulatory function, which may be expected to be most advanced, is the least prepared Only 20% say they are at implementation, although a significant 60% have completed the impact assessment (See Figure 3.)

On reflection, it is unsurprising that the trading space

is the most advanced in terms of preparation; they are already positioning for the higher capital charges for various products contained in Basel III and for the proprietary trading ban in the Volker Rule

“If you look at the changes to the trading book treatments, they are so substantial that people have had to think through urgently what is the shape of the business going forward, because the current business won’t be profitable,” says the head of prudential advisory at a consulting firm “And those trading book requirements hit much earlier [than some other changes], so in the trading area it has become critical to move quickly The treatment of counterparty risks in trading books and of bank-to-bank exposures has gone up three to four times in total, and the treatment of securitization books has gone up enormously, so people have already taken action, moving things out of trading books and into banking books.”

There are concerns, however, that implementation may be piecemeal While many firms have created working groups or task forces, these are typically organized at a national level, and therefore do not address change at a global, enterprise-wide level

In addition, some have suggested that the amount

of new regulations flooding into the market may lead banks to focus on the trees but lose sight of the forest – a criticism which has been leveled at banks, regulators, ratings agencies and politicians, and held at least partly to blame for the financial crisis If regulators are aware of this danger, the feeling that the sense of urgency for change is already dissipating means that they want to press on while there is still a chance of getting new regulations passed

Figure 3 Q1, job function split

At what stage is your company in preparing for

changes required by regulatory reform?

We have begun implementing changes to our business based

on our impact assessments

Figure 3 At what stage is your company in

preparing for changes required by regulatory

reform?

A financial services partner at a consulting firm agrees

that the amount of new regulation is clearly an issue

“The message from our research is that the sheer

volume of change is proving very challenging for

firms And it gets more difficult as you move down

from global statements of principal into regional

rule-making, and then further down into national

interpretation We don’t see many institutions that

have an overarching view of the impact on their firm

They may well be doing things on a local or regional

level – but they do not have a consolidated view of the

overarching impact.” Given the new uniform fiduciary

standard obligations for advisers and broker dealers,

that could prove problematic for US executives

Threat or opportunity?

If banks see the challenges posed by regulation, they

also see the opportunity This is particularly true in

the UK, where almost a third (32%) of respondents

strongly agree that the new regulatory environment

is an opportunity to gain market share Bankers in

the US, however, are less optimistic, with only 20%

clearly positive about the potential for opportunity

(See Figure 4.)

At first sight, this looks to be accounted for by the

banning of proprietary trading and constraints on

principal investment – two of the most profitable

areas of investment banking in recent years – that

have been imposed on US banks by way of the

Volker rule But looking into the survey results by

function reveals that 82% of traders agreed with the

potential to gain market share, and none of them

disagreed It is the operations and risk functions

which see more danger than promise in the new

regulatory environment (See Figure 5.)

However, it will not be easy for banks to pick a

winning model – or to make it successful in a

crowded market “The question is, what is the shape

of the business that will be profitable? And I think

the answer to that is unknown,” says the head of

prudential advisory at a consulting firm “Moreover,

if multiple banks change their business in the same

way, how many banks can be profitable with the

same type of business? How many banks can be

major flow players, for example?”

26%

23%

Figure 4 Q3a, Do you agree or disagree with the following statements? We are looking at the new regulatory environment as an opportunity to gain market share

Strongly agree Strongly disagree

U.K U.S.

Figure 4 Do you agree or disagree with the following statements? We are looking at the new regulatory environment as an opportunity to gain market share.

Figure 5 Q3a, functional split

Do you agree or disagree with the following statements?

We are looking at the new regulatory environment

as an opportunity to gain market share

Strongly agree Strongly disagree

Figure 5 Do you agree or disagree with the following statements? We are looking at the new regulatory environment as an opportunity to gain market share.

There is also a worry that the changes in Basel III are so big, if any provision unwittingly creates an unlevel playing field it could proffer huge advantages

to certain players Unequal treatment in just a single area of Basel III could have far-reaching effects

“For example, there has been a worry that the treatment of deferred tax assets (DTAs) might be more beneficial for US banks than for European banks and, depending on how it’s implemented, that would have a number of consequences Firstly, it would immediately make their capital levels higher and their costs lower Secondly, it would make it easier for an American bank to buy a bank in difficulty than for a European bank; banks in difficulty have hitherto been bought on the basis of the benefits of the DTAs, because some

of that tax can be clawed back Seemingly small inequalities could have large ripple effects.”

New regulations as an opportunity for transformation

Part of the optimism surrounding the chance to win market share or gain some form of competitive advantage is tied to the potential of new regulations

to have a transformative effect on the business This has clearly been picked up by survey respondents, with more than half (57%) agreeing with this proposal and the UK, again, markedly more optimistic than the

US (See Figure 6.)However, more than half (54%) of respondents were keen to maintain their current operation models and structures But this is not as counterintuitive as it may seem, as it relates to where bankers see the greatest opportunity for transformation – and this is in systems and processes rather than at the organizational level

“Banks have grown as groups of discrete business silos, with each silo capturing data, interrogating data and leveraging that data,” says the head of

IT at a large European bank operating in London

“The industry may have gone a long way towards achieving overall efficiency, but we have never achieved information efficiency New regulations – while onerous and costly – offer us an opportunity

to take a fresh look at how we manage these and other processes, and to retool operations in a way

Figure 6 Q3b, geographic split

Do you agree or disagree with the following statements?

Scale of 1 to 5 We are looking at the new regulatory environment

as an opportunity to transform our business model/structure

Strongly agree Strongly disagree

U.K.

U.S.

Figure 6 Do you agree or disagree with the

following statements? Scale of 1 to 5

We are looking at the new regulatory environment as an

opportunity to transform our business model/structure.

that benefits the group, rather than how it suits the individual business If we can break down silos, there are clearly opportunities to generate competitive advantage from that.

“There is an element of ‘pre-crisis’, and ‘post-crisis’ thinking here, with new regulations as the catalyst for change,” he adds “Historically, the cost-benefit

of streamlining systems and processes relative to the cost of doing nothing meant it was not worth the hassle or the tax cost Going forward, that cost-

benefit may change Living Wills or other resolution mechanisms, for example, will force banks to think through a more streamlined structure, and this is helpful in the new Basel III world.”

Will transparency help or hurt bank

competitiveness?

A common motif of the emerging regulatory

environment is the aim of shedding new light on every area of banks and financial markets For example, Dodd-Frank aims for greater transparency into risk exposure across the financial system, and several key components of the law require financial services institutions to collect and report on risk exposure

in their business The Financial Stability Oversight Council, in its role as systemic risk monitor, will

collect risk data from various sources including

federal and state financial regulatory agencies and the newly created Office of Financial Research (OFR); among other things, the OFR will be responsible for collecting data from financial services companies.Similarly, the UK’s Financial Services Act and Basel III both impose a high degree of transparency on key metrics, including bank capital, liquidity, collateral and counterparty risk, requiring such data to be reported

to bank boards and regulators The European Market Infrastructure Regulation, meanwhile, will try to bring transparency to the over-the-counter markets and impose data reporting requirements for transactions

to new trade repositories A central plank of the

review into the Markets in Financial Instruments

Directive, currently underway, is to increase

transparency in post-trade reporting

Banks are uncertain about the effect of these transparency requirements on their competitiveness, although some have expressed concern that sensitive data about capital, liquidity and exposures could easily leak out into the marketplace Although some of the regulations specifically aim to increase transparency in the trading arena, the trading function

is the least concerned about the impact (See Figure 7.)

From data deficit to information advantage?

All new regulations mandate significant additional data and reporting requirements These present collection, integration and management challenges for banks’ information architecture

Basel III, for example, aims to eliminate the kind of regulatory arbitrage where a bank moves assets from the banking book into the trading book in order to get better capital treatment It therefore requires banks to consolidate positions from all of their trading desks and to make their trading book compatible with their banking book This requires data to be both accurate and clean, and will be a challenge for any US banks which have not been applying Basel rules up to now

To meet the UK’s liquidity rules, banks will be required

to identify, measure, monitor and stress test liquidity risk in a much more detailed way, and to process and deliver the data to the Financial Services Authority (FSA) on a regular basis

Basel III also requires a unified view of counterparties and counterparty credit risk, and the capacity to measure and process the data In addition, the move

to centralized collateral management, as well as the introduction of the net stable funding ratio and the liquidity coverage ratio, will require new data models

To fulfill many of the requirements, banks need to collect more detailed information from the trading partners and their clients Respondents to the survey highlighted several areas where they needed additional data from counterparties, led by collateral and transaction data By function, there were some noticeable spikes in data requirements (See Figures 8 and 9 on page 13.)

Figure 7 Q10d, functional split

Do you agree or disagree with the following statements?

Rate 1 to 5 We are concerned that the increased transparency

required by new regulations will be a threat to our competitiveness

Strongly agree Strongly disagree

Figure 7 Do you agree or disagree with the

following statements? Rate 1 to 5

We are concerned that the increased transparency

required by new regulations will be a threat to our

competitiveness.

For some banks, data projects are about creating

value as well as compliance “We identified information

architecture as the lynchpin in meeting new regulations

early on, so we are quite a long way down the road in

terms of where we need to be in order to change our

information systems,” says the head of IT at a large

US bank “Because we also identified that this is an

area where we could create value for the business, we

prioritized this over some other IT projects.”

There is a high cost associated with meeting new

requirements, however “There is a huge impact on

data systems across multiple product and business

lines,” says the head of compliance at a large

European bank operating in London “Estimates

suggest that it will cost large banks around $100m

each to put the systems and processes in place to

comply with Basel III We will have to find ways of

calculating the newly introduced net stable funding

ratio and the liquidity coverage ratio, and have the

capability to stress test our calculations and report

to our board and to regulators Because the Basel

Senior Supervisors Group favors a standardized

centralized risk data set – the so-called single source

of truth – on the IT side, this means banks will have

to integrate data sources and adopt new data

Client

communicat ions

Figure 9 In what areas do you need additional or more detailed information from counterparties, due to recent regulatory reform?

Figure 8 In what areas do you need additional or more detailed information from counterparties, due to recent regulatory reform?

e struct

ureCapital allocation Client

communicat

ions Licensin g

Competition issues

Figure 10 Q10a, overall

Do you agree or disagree with the following statements?

Scale 1-5 We have a company-wide strategy for

identifying the systems that will require modification/upgrade to handle the

new, higher levels required by new regulation.

Strongly agree Strongly disagree

Figure 10 Do you agree or disagree with the

following statements? Scale 1-5

We have a company-wide strategy for identifying the

systems that will require modification/upgrade to handle

the new, higher levels required by new regulation.

Figure 7 Q10d, functional split

Do you agree or disagree with the following statements? Rate 1 to 5 We are concerned that the increased transparency required by new regulations will be a threat to our competitiveness

Strongly agree Strongly disagree

Figure 11 Do you agree or disagree with the following statements? Scale 1-5

We have a company-wide strategy for identifying the systems that will require modification/upgrade to handle the new, higher levels required by new regulation.

Strongly agree Strongly disagree

Figure 12 Do you agree or disagree with the

following statements? Scale 1-5

We have already identified the systems that will require

modification/upgrade to handle the new, higher levels

of data required by new regulation.

Strongly agree Strongly disagree

Figure 13 Do you agree or disagree with the following statements? Scale 1 to 5

We have already identified the systems that will require modification/upgrade to handle the new, higher levels

of data required by new regulation.