Regulation: Keeping up with the law

The 2008 financial crisis exposed devastating flaws in the regulation of financial institutions (FIs) and shook the global economy in the process.

Corporates and states were badly affected and the financial sector bore most of the blame for the downturn. In response, regulators have endeavoured to reshape the financial system, reinvigorate economic growth and avoid a repeat of the crisis.

Notable reforms to the regulatory landscape include Basel III, which was introduced by the Basel Committee on Banking Supervision to increase the resilience of global banks in periods of stress by improving governance, risk management and transparency. Another prominent reform is the Solvency II Directive, which aims to guarantee insurers’ ability to pay claims.

Six years after the crisis and regulatory reform of the financial sector is showing no sign of easing. In October 2014, the European Commission adopted a delegated act and a draft proposal for a Council-implementing act to calculate the contributions of banks to national resolution funds and to the newly created Single Resolution Fund (SRF) respectively.

The SRF is part of the Single Supervisory Mechanism (SSM), under which the European Central Bank becomes responsible for supervising the largest banks in the euro area from November 2014, among other things. Its purpose is to ensure an orderly resolution of failing banks with minimal costs for taxpayers and to the economy. As such, the SRF ensures the availability of medium-term funding to banks in financial difficulty covered by the SSM to enable them to continue operating while being restructured.

The SRF is due to start on 1 January 2016 and banks subject to it will have to contribute in proportion to their sizes and risk profiles.

Non-compliance

The penalty for breaching regulations can be costly. For example, the Financial Conduct Authority, the UK financial regulator, handed more than €385m worth of fines between January and October 2014.

The largest of those was a €132m fine paid jointly by Lloyds Bank and Bank of Scotland (Bos) for serious misconduct relating to the Special Liquidity Scheme (SLS), the Repo Rate benchmark and the London Interbank Offered Rate.

The SLS was introduced in 2008 to improve the liquidity of banks by allowing them to swap some of their assets that are currently illiquid for UK Treasury Bills for up to three years. Lloyds and BoS were found to have manipulated the repo rate, which determined the short-term fees payable to the government for their participation in the SLS.

With regulation high on the list of priorities for risk managers, delegates at the Financial Institutions Risk Forum discussed the evolution, purpose and necessity of regulation in the industry in a dedicated risk clinic.

A world without regulation

The evolving regulatory requirements for FIs risk clinic was led by Richard Tall, partner and head of financial regulation at law firm DWF.

Tall opened the discussion by asking delegates to consider the necessity of regulatory bodies and what business would be like in a world without regulations.

“It’s a debate between free markets and some kind of intervention. Generally, a balance is required and I don’t think we have found that yet,” said Arooran Sivasubramaniam, Zurich Global Lines Pricing financial lines lead.

The position of financial regulators is central to modern society, according to Tim Atkin, Zurich Global Corporate head of customer, distribution and marketing EMEA.

He said: “If there is no penalty for failure, then you remove one of the fundamental checks and balances of the capitalist environment.

“That means underperformers are likely to continue to underperform and deliver a substandard service because there is no penalty for failure.”

A key issue for multinational FIs is the jurisdictional differences between the countries in which they operate. Of particular concern is the over-aggressive US approach to financial regulation, which is “as much about protecting home markets and creating barriers to trade as it is about protecting the end user,” according to one delegate.

“Does the US want to become the world leader in regulation and expect other regulators to follow?” asked one delegate who wanted to remain anonymous, adding: “I feel we are not pushing the US enough to prevent it from becoming an over-regulator.”

Moreover, the Federal Reserve has introduced a rule that stipulates US operations of non-US banks with more than $50bn (€40bn) in global consolidated assets must hold riskbased capital, liquidity and leverage similar to their US peers, with effect from 1 July 2016. It means some banks may need to set up separately capitalised intermediate holding companies for their US subsidiaries. In July, the US rejected EU proposals to include co-operation of financial regulators in the Transatlantic Trade and Investment Partnership discussions.

Another delegate said: “I don’t think the end consumer necessarily sees many benefits for many of the regulations that are supposedly done in their name [by US authorities].”

A world without regulation

Political expediency of regulations by policy makers was also discussed.

Delegates agreed that governments benefit by backing stringent regulations on FIs as this forces them to take some responsibility for economic stability.

Tall reminded delegates of historic crises that are comparable to the 2008 financial crisis, including the Dutch tulip scandal of 1637 and the South Sea bubble in 1720. The latter paved the way for the establishment of a financial services regulation system, according to Tall, after British parliamentarians lost considerable sums of money.

As society has grown in complexity, so too have the laws and regulations designed to maintain and protect it. Considering the number of recent scandals, such as the manipulation of the foreign exchange rate, perhaps tougher legislation is necessary to protect the world’s economy. As Atkin alluded to, regulators are central in a risk landscape that is so complex.