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Global Banking: A Look Ahead

by internationalbanker

By Phillip Mann – phillip.mann@internationalbanker.com

Big banks across the globe are still facing new waves of amendments to regulation. There has been an overhaul of the regulatory and legal restrictions placed on the global banking sector following the global financial crisis. However, this process of change is an iterative one. Regulators and policy makers have been working together to amend regulation to find the best implementation—one that balances a number of time-critical factors, such as the banking business and economic growth, whilst focussing on their key goal of providing greater stability to the financial system. In some cases, this has meant that big banks have had to negotiate with policy makers—arguing their case for more lenient measures so that their banks may continue to grow and rebuild business after the credit crisis damaged their balance sheets significantly. 

In a few cases regulators have been considerate of the concerns of bank executives—in particular when the issues deal with stimulating lending to small businesses and areas of mortgage lending, as this is a vital driver of economic growth for most nations and also between economic borders. However, in the main regulators are remaining understandably strict and steadfast with their rulings, seeking to not repeat the mistakes of the lax approach that caused the financial collapse more than five years ago. Seven years have passed since the time of the credit crunch, and bankers have been optimistic that after this amount of time, the worst may have passed in terms of any dramatic new regulations being added into the banking-business operational infrastructure. However, regulators are not showing any signs of slowing and are releasing new phases of significant regulation as each year goes by. Global banking regulators are coming together to discuss and propose sets of new regulations.  Regulators, rather than slowing down on their toughening measures, are in fact increasing their pace and fervour and have recently been suggesting an entirely new system designed around restructured banking and financial-services institutions. These changes are in the early proposal stages. However, they are being discussed in very real and serious terms, giving banks renewed cause for concern. 

As a key example, toughening the capital-buffer levels banks are required to hold is under continued consideration. This regulation, originally put in place to protect bank balance sheets and consequently shareholders, financial markets, governments and the wider economy against future and further loss and damage, has already been put into action in banks across the globe. Banks, not accustomed to this type of operational structure, have been restructuring dramatically, and in some cases drastically, to meet the strict regulation. However, further tightening of the rules is now under consideration. Banks across the globe, under the current capital ratios, have been put in the position of funding their lending and spending to a greater extent with their own equity funding rather than with depositor funds or investor capital. This factor, economic conditions aside, has hit banking returns hard as this is a major shift from the previous working model. Although the measures do provide improved stability to the financial system as intended—guarding against liquidity squeezes on major financial institutions—they have been tough for bank bosses to implement. However, regulators want to continue forging forward with changes to these measures as well as with several other key parameters. 

In particular, when it comes to capital buffers, the Financial Stability Board (FSB) has been working to amend international regulation and to limit further how much a bank may double count the capital that it holds. The FSB is a panel of experts, regulators and central bankers from across the globe. They have suggested this tougher measure as part of countering the threat of an institution being “too big to fail”—and are additionally looking at other measures to further protect each nation’s taxpayers from being forced to bail out large financial institutions, as they had to do more than five years ago. The new plans will be presented at the next G20 summit, which is scheduled to be held in Australia later this year. The proposed plan is in the early phases but should be finalised by the end of next year, after which time the timeline for rollout will be established. The FSB is responsible for identifying the largest global banks and those that pose the greatest risk of systemic failure. The FSB creates an updated list of these big banks annually every November. Under the rules, big banks across the globe will be required to hold greater amounts of capital than previously—the balance of assets and liabilities will be reset to a stricter level so as to provide enhanced stability to the global financial system. Under the proposed new ruling, the amount of assets and liabilities that a bank holds and keeps available in the case of a major loss or crisis will have to be greater than that previously held. It has been proposed as part of these discussions that the new minimum level could reach as high as 25 percent of a bank’s risk-weighted asset holdings. 

This capital-buffer level had been previously set at between 16 and 20 percent of the amount of risk-weighted assets that a bank holds. However, the regulators have suggested that this amount does not sufficiently address the full extent of regulatory concerns. There is a wider range of capital-buffer concerns that a bank must address, and therefore the minimum level must be adjusted accordingly so that the bank is properly prepared and protected. The new regulation will be tough for banks to meet, but regulators are arguing that these standards are important for creating a strategy to limit taxpayer exposure to failing financial institutions and banks. The topic of future flexibility, particularly with regards to each domestic regulator, is relevant to the finer details of the implementation of the rules and will most likely be ironed out over the next year of discussion. 

Regulators are working on a range of measures to enhance the strength and stability of the banking system. These new regulations are in addition to the current range of measures—such as the higher capital requirements put in place by the international regulatory standards under Basel III. The Basel Committee put in place the first of these buffers in 2010, and this regulation has now been expanded to state that banks must have core capital amounting to 2.5 percent of risk-weighted assets beyond the previously set minimum Basel requirement for loss absorption. As an indication of how serious and strict regulators are about this measure, they have built into the regulation stipulations that if this standard is not met sufficiently then the bank will have restrictions placed on its ability to pay bonuses to its staff and dividends to its shareholders. In addition, the FSB has set out plans for the global big banks to expand this buffer so that it may increase by a further 2.5 percent of risk-weighted assets, providing an additional protection in case of financial crisis. Regulators have specified that capital-buffer requirements should be met with high-quality capital, such as ordinary shares and retained earnings. This is an indication of how the basic capital-buffer standard has now increased from between 16 to 20 percent to approximately 21 to 25 percent. The level of capital-buffer requirements has the potential to increase further in the future given any new regulatory concerns that are identified as time goes by. As an example, certain nations are considering forcing banks to hold capital against countercyclical economic risks, which may be set by a national regulator to control domestic credit bubbles.

The proposed FSB measures also include requirements that debt and other security holdings must meet a certain level to count towards a bank’s minimum required “total loss absorbency capacity”, or TLAC. As part of the TLAC requirement, lenders are unable to count equity when it comes to meeting the terms of two international capital-buffer parameters. Regulators are suggesting that the majority of instruments used to meet TLAC standards should be made up of subordinated debt and some form of capital. As yet the FSB has not outlined any specific instruments or securities that must be used towards the loss-absorbency parameter.  However, there are certain securities that have been outlined as definitely not satisfactory in fulfilling the TLAC measure. Examples include instruments that “are preferred to normal senior unsecured creditors under the relevant insolvency law”. Derivatives-based securities also do not qualify towards this measure. In addition, liabilities that cannot be written down directly or those that cannot be transferred into equity holdings at a time of financial crisis will not be allowed to be held as part of the TLAC measure. When it comes to putting debt-issuance holdings towards the TLAC, the regulators have stated that these securities would need to have a minimum remaining level of maturity so as to count in value, and this minimum maturity has been outlined for the time being as at least one year. 

The plan is designed so that instruments that may count towards a bank’s TLAC will be such that, under normal conditions, they are able to absorb losses, to avoid having to turn to other liability holdings that are less likely to qualify and satisfy the need. The systemically important banks across the globe will have to issue junior debt and other securities, and these holdings may then be written down if needed to cover losses associated with failure or restructuring. The TLAC should be a mechanism that covers shortfalls in a way that will prevent significant risk building up. The regulation for now suggests that unsecured debt should be put towards the TLAC measure. However, banking and economic experts have argued that certain uninsured, unsecured liability holdings are not effective and reliable loss-absorbing tools to be applied in resolution. In addition, these commentators have noted that it can be difficult to apply senior-class debt holdings when it comes to loss-absorbency needs. The problem is that there can be potential adverse knock-on effects when attempting to apply resolution measures within a security class that is made up of liabilities. This concern reduces the bail-in potential of this regulatory strategy, which has been outlined for implementation in 2019 at the earliest. 

These regulations have been designed on an international scale—taking into account the concerns of both the biggest and largest economies across the globe. In particular the US and UK economies have been faced with the “too big to fail” problem in which taxpayers have had to bail out major banks such as Bear Stearns and Northern Rock respectively. These nations as well as their media, governments, public and policy makers have been calling for international consensus on changes to avoid these circumstances in the future. The measures of the TLAC and enhanced capital buffers, alongside others, are designed to address these concerns. All nations are looking for enhanced loss absorption from a sustainable, consistent and long-term solution. However, certain sceptics of the regulation have suggested that smaller nations across the globe should be afforded the flexibility to allow a wider range of capital holdings to count towards this particular measure. This argument points to a key problem with certain elements of global regulation: nation-by-nation interpretation, application and enforcement. Does this component of implementation mean that the integrity of the regulation should be compromised? On the other hand, regulation that is not a proper fit for a certain nation’s economic condition risks hampering the financial systems of this nation, and this may bring other forms of financial failure. The application of a varied approach across the globe should be handled carefully and with proper control and balance so as to maintain regulatory integrity whilst also suitable application within each country’s borders. 

There is a degree of flexibility incorporated into this EU regulatory parameter, which will allow regulators a certain amount of discretion when it comes to deciding if certain liabilities can be applied towards write-downs or not. In some cases, banks would be allowed to count liabilities towards the TLAC even if they have seniority that is of a similar level to those instruments and securities that have been designated as unsatisfactory by the FSB. Under such consideration, these banks may be allowed to count such securities for up to 2.5 percent of their risk-weighted assets. Some national regulations are in fact stricter than those set by international-standards setters. As an example, the Federal Reserve in the US, which regulates American banks, has suggested that the largest banks may have to exceed an additional capital level, and this may increase the buffer level by up to as much as an additional two percent. Each nation has its own internal economic circumstances to manage and balance, but they must be managed within a context of global economic interconnectivity, an equally important consideration of the FSB, G20 countries, central bankers and policy makers from across the globe. 

In addition to adding to regulation for capital buffers, global regulators have also been looking at amending leverage-ratio restrictions. The leverage ratio has been a hot-button element of discussion since the time it was first proposed. This ratio is centred on constraining the amount of loans and investments a bank may hold to a set multiple of its capital holdings. The measure as it stands does not account for how risky the loans and investments are. National regulators across the globe are for now stating that they are applying maximum leverage-ratio rules but may afford the measure a degree of flexibility when setting its level. Regulators are now considering setting this measure in a stricter format so as to enhance stability with regards to leveraged exposure for banking institutions. 

Aside from leverage, capital restrictions and regulations, there has been a major overhaul proposed in regulation with regards to how banking institutions are structured. This area of regulation continues to evolve, and international regulators have stated outright that this regulation change is not yet complete. Not only is this component of global banking regulation incomplete, it is also most likely the least understood worldwide at this point in time. Senior bankers and executives are grappling with the new structural restrictions that are being imposed on their institutions. Regulators have set out their goals of making banks simpler operational and organisational structures so that business departments or banks as a whole can be clearly identified as adhering to or failing to satisfy the range of regulations. It should be clear and easy for a regulator to identify a bank or department that fails to meet a certain regulation so that it can be shut down, or the problem rectified appropriately and in a suitably timely manner.  When a business department or bank breaches a regulatory buffer, it should be flagged and plain to see—not clouded by cross-departmental bureaucracy and overly complicated and complex bookkeeping. This structural reorganisation essentially will help implement, execute and support the new regulatory regime and enforce the strategy of providing greater protection and stability to the financial marketplace and wider economic landscape. This problem needs to be addressed head-on and thoroughly. On the one hand, banks should be allowed to continue as central parts of the economy—facilitating financial transactions of society and corporations at all levels without unnecessarily disjoining the working departments of the institution. On the other hand, only by properly organising the structure—in clear and intentionally considerate ways—will the regulation be successful and effective in its purpose. 

For the past seven years, the European Union has been considering enforcing rules to make banks “ring-fence” different business departments so as to limit the damage in case of a failure or loss in any given unit. This may in the end require extra capital buffers yet again, as each stand-alone unit may be forced to meet strict and substantial buffer levels. If the regulation cannot be applied properly, all the regulatory-improvement discussion and work of the past five years will be for nothing; let alone the fact that the lessons learnt from the financial crisis will not be applied. Additionally, in the long term, if the regulator does find failure to meet regulatory standards within a bank, they may choose to break up the business forcibly and in a way that is more damaging than necessary. It may be in a bank’s interest to reorganise properly in advance so as to escape this drastic fate. For now the regulation with regards to structural reorganisation remains under discussion. However, it is very likely, as is expected by industry experts, to be proposed in more finalised, mandatory terms over the coming year. Banks may choose to reorganise their legal structures pre-emptively to avoid a costly squeeze on time and resources in the future. 

Whilst banks and their executives have been hit hard by the regulatory regime change combined with the difficult economic climate over the past five years, they have also had to contend with the charges made by legal bodies worldwide regarding past misdeeds and improper transactions carried out at these institutions. Banking businesses are not only seeing falls in profits from structural reorganisation and business adaptation to meet regulatory restrictions but also from payments of sizeable legal fees and penalty fines to both regulators and legal bodies, such as the US Department of Justice. These cases, and their associated fines and charges, have been snowballing in size and number over the past two years and are not showing much sign of slowing for the short term at least; it is estimated by Morgan Stanley that by the end of 2016, regulatory bodies across the globe will have collected more than $295 billion in fines from banks. The banks that have been identified as systemically significant, i.e. those that come under the heading of “too big to fail”, have been particular targets and are having to pay out billions of dollars in fines to meet regulatory and legal penalties. This is understandably displeasing to shareholders, who are seeing capital that could have been invested into the business to add value passed out of their investments and into fees and fines.  In some cases banks have even had to issue new shares to help raise the capital to pay the fines.  

Implementing a new set of regulations has significant teething pains, and ushering in a new age of banking approach and implementation is creating a broad range of transitory hurdles. As a further example of regulatory difficulties in application, a rule to cap banker bonuses in the EU has proven difficult to execute and far from successful. The British plan to claw back bonus payouts of the past has been equally troublesome and ineffective. Additionally, much banking regulation has restricted derivatives-trading activity, and this has removed a significant profit-making business from the banking marketplace. Struggling with these profit-eroding conditions has led many in the banking business to turn instead towards the asset-management sector. Regulators are less concerned with this sector for the time being, and profits are still there to be made. Other banks are choosing to ride out the regulatory storm—optimistic that this phase of regimen change will slow down soon. There may be potential for this slowing; a big factor is the political environment.  For example in the US, if the Republicans increase their hold on the government during the next election, they have outlined policy plans for softening the regulatory atmosphere. 

There has been much difficulty in implementing regulatory change over the past five years. This turbulent phase of change is likely to continue as regulators seek to enhance the measures further in pursuit of a stable financial system. The business of banking is taking an entirely new shape and is now operating under more competitive and cost-oriented terms than ever before. Only the banks with effective business leadership and strategy will survive. This sector-reshaping period may be somewhat messy in transition but will support a more efficient and effective financial marketplace into the future.


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