FICCI – IBA Conference
Setting a new paradigm in regulation
Duncan Martin, Partner, BCG London
September 2010
New regulations mean more E, less R, therefore lower ROE
Activity
1
Trading
Most important new rules
• Much more capital for trading exposures, securitisations and financial
counterparties
• Drive to exchange-traded and centrally cleared derivatives
• Restrictions on prop trading, hedge funds, private equity
Impact
Increase in RWA
for trading
activities
Lower revenues
2
Capital
• Higher minimum levels, with active build up in good years
("procyclicality")
• Better quality, essentially restricted to paid in capital and retained
earnings
– Hybrid instruments, deferred taxes, and intangible assets will no
longer be eligible for Tier-1 capital
– Restrictions on minority interests equity stakes in financial
institutions
• Absolute cap on assets based on equity ("leverage ratio")
3
Liquidity
• Holdings of high quality liquid assets to equal stressed liability run-off
• Long term assets to be funded to a greater extent with long term
liabilities
Much higher core
capital
Smaller balance
sheets
Much greater holdings
of liquid assets
More long term
funding
Regulations much more strictly enforced
Source: Basel Committee on Banking Supervision; BCG analysis
1
Far-reaching effects eg Dodd-Franks in US
1. Credit and debit.
Derivatives
reform
Ditto
New Reg.
Bodies
Limit on
interchange
rate for debit
cards
Select swaps
activities must
be in non-bank
affiliate
Move OTC
derivatives
activities to
SEFs and
central clearing
authorities
Financial Stability Council
Ban on
proprietary
trading & limit
on hedge fund
/ PE activities
B/Ds&
HF/PE
Insurers
Volcker
rule
Consumer Financial Protection Agency
Capital
mkts
Other
Card
Reg Q
repeal
Interest on
business
checking
permissible
Commercial
Banks
Nonbanks
Overdraft optin for debit
/ATMs trx and
other
consumer
protection
items
Durbin
Dissolution Authority
Retail/
Cards1
Consumer
protection
covering:
•Billing
•Payment
•Grace period
•Fee limitations
•Rate changes
Reg E
Insurance
Authority
CARD Act
2
Material consequences, some unintended
First order effects
• Higher prices for all financial services
• Forced deleveraging leading to credit rationing
• Another wave of arbitrage products
Second order effects
• Hard to finance long term risky assets eg ports, roads, airports, power stations?
• Increasingly national regulation leading to stranded pools of liquidity and capital?
Third order effect: conflicts of interest. Will governments ...
• Depend on banks to:
– Hold large amounts of "highly liquid" national debt?
– Make large profits to provide tax revenue?
• Apply pressure to:
– Banks (especially state-owned ones) to lend in run up to elections?
– Regulators to overlook anti-competitive behaviours, show forbearance on stressed
institutions, and restrict new entrants?
3
BCG supported the WEF in "Rethinking Risk Management"
Domains
Dimensions
Telecommunications
Pharmaceuticals
System-Wide Perspective
Aviation
Infectious Disease Control/
Immunology
Transparency
Wildfire Fighting
Fisheries management
Governance and Culture
4
Golden rules for rethinking risk management
System wide
perspective
1
2
3
Let small
fires burn
Drive
diversity
Simulate
system
disaster
Information Flow
& Transparency
4
5
6
Scrutinise
complexity
Capture
deep and
detailed data
Make
innovation
transparent
Governance
& Culture
7
8
9
Value
experience
Empower
the front line
Look
for trouble
5
Current regulatory changes at risk of making system less safe
Bail outs have merely suppressed "fire"
• Too many weak institutions still alive
• Next crisis will be worse
Regulatory harmonisation reduces diversity
• Convergence on single set of standards worldwide
• Insurance converging with banking
Increasing centralisation disempowers the front line
• Supranational regulators => National regulators
• National regulators => Banks
• Within banks, Boards, Audit, Compliance, Risk etc all looking over shoulders
Focus on compliance crowds out looking for trouble
• Compliance with rules presupposes system stability, and create illusion of control
• Finance is inherently unstable; control is merely illusory
Haemorrhage of experienced people condemns us to repeat the cycle
6
In finance, unstable is normal
Complex systems – such as global finance -- are inherently unstable
Non-equilibrium Multiple, unstable equilibria
Non-linear
Complex
systems
Interactions between component
inputs and outputs not linear
(feedback loops)
• Predator/prey
population dynamics
• Social phenomena eg
fashion
Dynamic
System inputs changing through
time
Adaptive
Components changes in response
to environment and history
• Financial markets
7