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The unintended consequences of regulation

Mary O’Connor | 24th June 2015

Regulatory changes are having a far-reaching impact on financial institutions. Are regulators up to these unintended consequences?

Since the financial crisis, governments have made wide-ranging changes to the way financial institutions are regulated. In particular, regulators have focused on the amount and type of capital that banks and other financial institutions must hold, and set new standards as to how they must interact with consumers and markets. This has given rise to a number of unintended consequences, which have far-reaching impacts on financial institutions and the wider economy. Worryingly, regulators seem to lack the tools to address these challenges.

1. Less lending

First, banks have been required to increase levels of capital and reduce the amount of leverage on their balance sheets. Changes, intended to improve the resilience of banks and the economy as a whole, have instead encouraged banks to cut back on lending to key sectors and industries. Non-bank financial institutions have stepped in to plug the gap. This shift will continue unless incentives change. In the meantime, regulators need to establish new ground rules to ensure that all lenders (not just banks) have appropriate levels of capital and operate to the same high standards of conduct towards customers.

In the aftermath of the crisis, regulators cracked down on high-risk activities by increasing the capital required to offset them, and enhancing the penalties for unacceptable conduct. As a result, many banks have reduced or divested themselves of proprietary trading and other “high risk” activities. JP Morgan sold its commodities business on the day after it was declared the world’s top commodities bank, having concluded that the business was not worth the capital or regulatory risks. The business was subsequently sold to Swiss commodities trader Mercuria. Deutsche Bank, Bank of America and Barclays have either exited or are planning to exit the commodities business. It is likely that these businesses will be snapped up by firms not subject to stringent banking requirements

2. More shadow banking

This brings me to the second unintended consequence. As regulation causes banks to deleverage balance sheets, increase capital and withdraw from certain activities, shadow banks and new financial technology or FinTech firms are expanding to take advantage of new opportunities. Recent estimates place the growing shadow banking sector at $71.2 trillion. At present, regulators appear content to allow this growth to continue, provided it does not negatively impact retail bank consumers.

By far the most important megatrend identified by C-suite executives in the Willis Financial Institutions Risk Index, was regulatory changes and complexity. The chart above illustrates six areas of regulatory concern identified by those executives, with significant variation by region

FinTech firms, aided by the ubiquity of smart phones and technological advances, are using digital platforms to reduce overhead to offer low-cost alternatives to traditional banking customers across a range of services from money transfer, FX exchange and e-payments, even matching lenders with borrowers through peer-to-peer and crowdfunding sites.

Although these new FinTech firms compete against banks and offer bank-type services, they are not banks and therefore not subject to the same regulatory standards. Their customers may not always be aware of the differences or fully appreciate the risks of engaging in certain financial activities.

As the role of these non-banks increases, and as their activities become more intertwined with the wider economy through increasing customer engagement, regulators will want to have more oversight over non-banks and the riskiest transactions, not less. As the financial world undergoes this paradigm shift, regulators and regulation will need to keep pace.

3. Regulation-driven trades

Regulations around risk-weighting of assets and capital are responsible for the third unintended consequence. Some banks have been prompted to undertake trades solely to ameliorate the effects of regulation. A major European bank reported that it lost €94m in the first half of 2013 on credit default swap positions that were being used to reduce Basel III capital requirements for the purposes of calculating the bank’s credit valuation adjustment, but which would not normally be required for economic hedging purposes. The loss resulted from a disparity in the way regulators and accountants treated the hedges.

Other banks are engaging in transactions to transfer the risk of assets to third parties to improve their regulatory capital position. Such deals have proved lucrative for some parts of the shadow banking sector. It is certain that, in the near term, the regulatory environment will encourage banks to engage in further transactions to reduce capital drag on their balance sheets – regardless of the economic value created. Regulators will need to carefully draft legislation to ensure consistency and reduce incentives for non-economic arbitrage.

4. Banking brain drain

Stress, strain and brain drain is the fourth unintended consequence. Regulatory pressure, increased scrutiny (including an enhanced possibility of personal liability) and bonus caps have driven experienced individuals out of traditional banking. The risk-reward trade-off is changing. Politicians have strengthened pay codes to limit bonuses and imposed substantial rights of claw-back over payments to executives. The FCA has also been granted new powers to prosecute top executives.

Employees outside the C-suite are also feeling the heat. Bank workers – who already work long hours – have more intensive training, complete additional compliance reviews, and fill out more paperwork, even though their workload has risen due to redundancies. Stress is a genuine problem. The Bank Workers Charity found that 60 percent of bankers suffer from poor sleep quality and job-related stress. Increased levels of stress can lead to absenteeism. Fifty percent of long-term absence in non-manual work is reportedly due to stress – with absenteeism in the UK costing £29bn.

It cannot have been the regulators' intention to drive experienced individuals away from banking, or to reduce the resilience of financial institutions. Regulators need talented people within financial institutions to embed regulatory changes and create the cultural shift necessary to restore faith in finance. Regulators should consider the “people resilience” of organisations, to develop new ways of encouraging institutions to conduct themselves in ways that are beneficial to the economy.

About the author
Mary O’Connor Financial Institutions

Mary O’Connor is global head of the financial institutions group at Willis.

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