Jan 2, 2015 - removes the presumption of innocence and will force banks to think more carefully about how they take risk
Regulation and stRategy | reporT contents
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The regulaTory challenges of 2015
Banks face a continued onslaught of regulation in 2015 as politicians fine-tune forthcoming legislation to toughen up the banking system. Farah Khalique investigates.
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facing upTo regulaTory fragmenTaTion
Differences in the content and timing of rules on resolution planning, structural reforms and derivatives are threatening to unravel cross-border banking models. Philip Alexander reports.
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Breaking Bad Banking
Conduct risk – the risk of staff acting unprofessionally, unethically or illegally – has become a major concern for supervisors and banks, as Michael Imeson reports.
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Banking: The nexT generaTion
The UK banking industry is opening itself up to new entrants in the hope that this will stimulate greater competition in the market. Jane Cooper discovers early signs that innovative new players could be doing exactly that.
RegulatoRs weRe alReady woRRied about Risk cultuRe because of the excessive Risk taking pRe-cRisis, then we have had all these behaviouRal issues post-cRisis Patricia Jackson, page 8
The Banker
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January 2015
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reporT | Regulation and stRategy introduction
The regulaTory challenges of 2015 Introduction Banks face a continued onslaught of regulation in 2015 as politicians fine-tune forthcoming legislation to toughen up the banking system. Farah Khalique investigates.
Banks must keep aBreast of regulatory change and make tough decisions in order to satisfy regulators’ demands and maintain business as usual. the year 2014 was a year characterised by billion-dollar bank fines, endless consultations and tough talk from politicians, but 2015 looks set to be the year that banks gain clarity on new banking rules and can start to implement change. the uK’s Financial Conduct authority is set to introduce the new senior Managers and Certified Persons Regime in 2015, to replace the existing approved Persons Regime, which will impose greater responsibility and accountability on individuals. the new legislation is a game-changer for investment banks, say experts, because it removes the presumption of innocence and will force banks to think more carefully about how they take risk.
GuilTy unTil proven innocenT
Will Dennis, managing director of compliance, Association for Financial Markets in Europe
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under the new proposals, a senior person can be found guilty of misconduct if a contravention occurs in an area for which they are responsible, unless they can show that they took reasonable steps to avoid the contravention. the burden of proof is on the senior person to show their innocence, even if they were not ‘knowingly concerned’. Will dennis, managing director of compliance at trade body the association for Financial Markets in europe (aFMe), says that there remains an element of ambiguity as to senior managers’ responsibility and also around who is subject to the rules of conduct – senior managers or certified persons. the issue facing banks is the huge amount of training for persons who will be subject to the new rules of conduct, according to Mr dennis. “if it’s a wide set of people then obviously a lot of training has to be done. it is not clear yet for banks, but to put in place all these
changes in a matter of months is quite a big regulatory ask and requires changes to employment contracts and systems,” he says, adding “i think it will make banks’ decision making more risk averse because individuals [must] think carefully about the decisions they make.” the new regime is estimated to come into effect in the latter half of 2015, most likely the fourth quarter. Meanwhile, the uK treasury opened a consultation in november 2014 to extend the new rules to senior managers at uK subsidiaries of foreign banks as well.
The fine mess
six banks were fined a total of $4.2bn in november for colluding to manipulate foreign exchange benchmarks, and the banks are now keen to put the scandal behind them. But the trend of bank fines is increasing, says Pierre Pourquery, partner in financial services at ey. Regulators have made it explicitly clear in their rhetoric that they are keen to punish previous bad behaviour and stamp out nefarious practices. a challenge for banks in 2015 is demonstrating to regulators that potential conflicts of interest on the trading floor are properly managed, without putting themselves in jeopardy. “one problem is that when banks are coming up with a new framework of controls to deal with conflicts of interest on trading floors, they identify issues that can expose them to a future legal suit,” says Mr Pourquery. identifying potential conflicts of interest on the trading floor is a tricky issue for banks. For example, a foreign exchange trader may appear to be conflicted when pre-hedging ahead of a client transaction. How can a trader demonstrate that pre-hedging by the bank is always in the best interests of the client?
Regulation and stRategy | reporT introduction
“We are discussing this with many banks, which are wondering now what to do and how to implement new controls. one solution is to put a limit on the hedge, but i am not sure this is the answer and there is no best practice guidance,” says Mr Pourquery.
conflicTs of inTeresT
it is also paramount for banks to identify potential conflicts of interest between different desks, and to prove to regulators that they understand and manage this risk. an options salesperson might sell a digital option to a client, for which the payout is contingent upon the price of an underlying bond. arguably, a bond trader at the same bank could be persuaded to intervene in the market and move the price of the bond when the option is set to expire, in favour of the bank. Mr Pourquery says: “one suggestion is to forbid trading at the point of expiry, but banks can’t stop making markets. therefore, some clients are not necessarily profitable anymore because of the risk, and the cost and complexity attached to new controls.” Banks have until January 30, 2015, to respond to the uK Financial Conduct authority’s latest consultation on reinforcing confidence in the fairness and effectiveness of the fixed-income, currency and commodities markets.
When banks are coming up With a neW frameWork of controls to deal With conflicts of interest on trading floors, they identify issues that can expose them to a future legal suit Pierre Pourquery
The risinG cosT of capiTal
Banks are also under pressure to put aside more capital to prevent another global financial crisis. in november 2014, the Financial stability Board (FsB) proposed that banks hold total loss-absorbing capacity (tlaC) equivalent to 16% to 20% of their riskweighted assets or twice the Basel simple leverage ratio (6% of unweighted assets). david Clark, a former banker at firms including HsBC and Bankers trust, and now chairman of the Wholesale Markets Brokers’ association, believes that banks putting aside more money for capital is “very significant indeed”, and begs an awful lot of questions. “the two things that jump out at you are where the money is going to come from, and how much will it cost. Cost of capital will go up, it is already more than 10% for some banks,” says Mr Clark. the introduction of functional living wills for banks is taking an extremely long time to roll out, so the obvious solution is for regulators to ask banks to put up more capital, says Mr Clark. the FsB will finalise banks’ tlaC in time for the g20 leaders’ summit in turkey in 2015.
the key challenge for banks is to issue enough subordinated debt to meet regulators’ demands, according to gilbey strub, managing director in resolution and crisis management at aFMe. “one of the concerns of banks is whether there is enough capacity in the market to absorb new issuance in the timeframe, and whether investor mandates will permit investing in subordinated debt. it’s changing the whole market,” he says.
BcBs 239
the 14 principles of the Basel Committee on Banking supervision (BCBs) paper 239 introduce a global framework for risk data aggregation and reporting, which banks have to comply with by January 2016. a study published in december 2013 found that one-third of global systemically important banks would not be ready to comply by the deadline. the problem facing a number of banks is their ability to collect data, according to Bradley Ziff, chief risk advisor for technology firm Misys. “Banks use multiple pieces of
software that they buy, and occasionally build, and then replace. it’s a case of ‘rip and replace’ versus work with what you’ve got. Banks need the ability to collect clean data, which is a challenge for a lot of these institutions,” he says. “the next big step is going to be setting up proper limit structures which many institutions do not have yet, in terms of assets and risk limits.” But the biggest challenge for banks, from a data aggregation perspective, is the computation of stress-testing, says ey’s Mr Pourquery. the bigger a bank, the more complex its systems and data. stress testing requires strong processes and it to gather all the necessary data at a granular level. For the stress tests expected in 2015, especially the us Comprehensive Capital analysis and Review, it will be the impact of interest rates on macroeconomic variables that are taken into account when stress testing, predicts Mr Clark.
new responsiBiliTies
ultimately, banks must fortify their three lines of defence, according to many industry experts. the first line relates to the front office, where managers on trading desks and credit teams monitor risks the bank is taking. the second line comprises more senior risk managers who report to the board. the third line refers to internal and external auditors that oversee a bank’s operations. the key for banks is utilising data and technology to better manage risk. For example, monitoring traders’ conversations to find key words that point to erroneous activity can be like looking for a needle in a haystack. But technology that can perform a semantic search, instead of just searching for key words, can prove to be more fruitful. in addition, banks need to increase the second line of the three lines of defence by 10% to 15%, according to Mr Pourquery. Regulators say the risk should be owned by the front office, which in effect has created another line of defence focused on control. “now we have more lines and more people, as well as it, infrastructure and data infrastructure. in addition, banks have large cost-cutting programmes of about $1bn to $2bn per bank. the inter-effect of these two [scenarios] will most likely drive banks towards a new model in terms of how they operate,” says Mr Pourquery. a new role of chief control officer is emerging, but banks must ensure that there is accountability across all three lines of defence. “it is a problem when there is no clear accountability because everyone has a little responsibility,” says Mr Pourquery.
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reporT | REGuLATioN ANd STRATEGy banking models
Facing up to regulatory Fragmentation Banking models Differences in the content and timing of rules on resolution planning, structural reforms and derivatives threaten to unravel cross-border banking models, writes Philip Alexander. In Its fIrst consultatIon on total lossabsorbIng capacIty (tlac) to ease the resolution of the world’s largest cross-border banks, the Financial Stability Board (FSB) included the concept of pre-positioning. This means 75% to 90% of the resources needed to recapitalise the local subsidiaries of a global parent – known as material subsidiaries of the resolution entity – would be held in the local jurisdictions. Speaking at the Financial Times/Banker banking summit in November 2014, Credit Suisse investment banking co-head Gael de Boissard
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depicted this as a significant departure from the previous efforts, especially in the Basel Committee on Banking Supervision, to develop genuinely global standards. “TLAC is the first time under the [capital] framework that we have a fundamentally national concept. That’s new, and in a way we have accepted the reality that we have seen through the development of the resolution and recovery planning process of a fundamentally domestic-based thinking,” said Mr de Boissard. Alongside TLAC and resolution plan-
ning, a number of key jurisdictions such as the uS, uK and Eu have implemented or are considering bank structural reforms that prohibit deposit-taking institutions from engaging in proprietary trading or impose ring-fences within universal banks to enable easy separation of retail banking and trading desks in the event of resolution. “Banks are trying to retain the advantages of being global, but they also have to make statements about how they would implement structural reforms, such as the Bank of England’s requirement to see ring-fence plans by
REGuLATioN ANd STRATEGy | reporT banking models
January 2015. it is questionable whether structural reforms are necessary if we have resolvability through TLAC and other initiatives, but regulators have a deep-seated belief – rightly or wrongly – that trading is inherently riskier than lending activities,” says Thomas Huertas, partner and coordinator of Ey’s global regulatory network.
naTional suBsidiaries
The FSB’s intention is that the TLAC proposals should improve the co-operation between jurisdictions, because it will give everyone more visibility about how a cross-border bank would be resolved. But Koos Timmermans, vice-chairman of the board at iNG Bank, is concerned that the top end of the FSB’s proposed range for pre-positioning of internal TLAC (90%) may be going too far. He fears it could create incentives for host supervisors to bail in subsidiaries early, knowing they have almost enough resources locally to recapitalise the subsidiary completely. That incentive would be even stronger if banks were able to move pre-positioned TLAC to other, more damaged subsidiaries. Moreover, the FSB proposal would leave supervisors with the discretion to add further TLAC requirements under the Basel pillar two (supervisory oversight) process. “The pre-positioning of TLAC could lay the groundwork for home-host coordination as long as the FSB’s proposed balance is maintained. But if host countries start to demand that the subsidiaries they regulate hold larger amounts of capital downstream, the overall pattern does not work, because the sum of what banks would have to keep in the subsidiaries would exhaust the ability of the parent to hold a sensible amount of capital,” says Mr Huertas.
Breaking The Branch
Mr Timmermans’ other concern is that prepositioning of TLAC in material subsidiaries is likely to encourage host supervisors to require the creation of a subsidiary where a branch previously existed. The process of resolution planning has started this trend already. “Most banks are evaluating how to migrate to a global subsidiarised model and how fast and far that needs to go. Very few have an expectation that they will be able to continue operating on an integrated cross-border basis – governance, capital, liquidity and the resolution planning requirements all drive toward an appreciation that firms in resolution are addressed on a jurisdiction-by-jurisdiction basis. The comfort level in most jurisdictions for relying on co-operation with other countries is fairly low,” says Marc Saidenberg, a
asian approaches
Asian regulators have moved more gradually than the US or Europe to implement derivative rules and resolution planning, in part reflecting the lower degree of financial complexity in the region. But this does not mean they will necessarily follow a similar path to the US or Europe, or develop any form of regional consistency. Although they have not declared it openly, it seems likely that the largest Asian financial centres – Hong Kong and Singapore – would like to see themselves as potential trading hubs. At present, derivatives trading poses a much smaller systemic risk in Asian markets than in the US and EU before the financial crisis.That means there is limited need for a heavy blanket of regulation, says Rebecca Terner Lentchner, head of policy and regulatory affairs at the Asia Securities Industry & Financial Markets Association. “What is most useful is to build risk-worthy infrastructure, especially central clearing counter parties [CCPs].There is a consensus among both buyside and sell-side that Asian CCPs are rather opaque at present.That is not so important yet because they are currently small collectors of systemic risk, but as they evolve they will need to adopt best-in-class standards of resilience,” she says. Keith Pogson, senior partner for Asia-Pacific financial services at EY, says Singapore and Hong Kong have retained a pragmatic line on whether wholesale banking operations in their jurisdictions need to be subsidiarised.This means global banks have more flexibility on the distribution of capital in these two markets, whereas others such as India, South Korea and Indonesia are more likely to push for ring-fenced capital in the local market. Even
in Hong Kong and Singapore, however, foreign bank branches are still likely to face requirements to implement asset maintenance ratios that would trap liquidity in those branches. “We have seen perhaps six or seven major derivative houses exploring whether it is possible or makes sense to create a single Asian booking location in a stand-alone ex-US subsidiary for uncleared overthe-counter derivatives trading such as foreign exchange swaps. Dealers have to examine how much capital they would need in a given jurisdiction and balance that with the need for a reputable regime that makes people comfortable with a transaction. Those banks that already have a network of subsidiaries on the ground are more likely to look instead at a multiple location customer-centric model,” says Mr Pogson. For Asian banks that are becoming cross-border regional players, the scale involved is smaller.The Association of South-east Asian Nations (Asean) has a blueprint to form an Asean Economic Community in 2015.This includes the concept of Qualifying Asean Banks, and potential members have pledged to adopt Baselcompliant regulatory regimes by 2018 with a view to regional bank passporting by 2020. For now, however, regulatory co-operation has focused on bilateral memoranda of understanding rather than full mutual recognition regimes. “We are seeing discussions that enabled Malaysian banks to operate in Indonesia, deals for funds passporting, and now the Hong Kong/Shanghai Stock Connect initiative. It is an exciting time,Asian regulators are trying to build closer links and to learn from the roll-out of crossborder rules elsewhere,” says Ms Terner Lentchner.
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reporT | REGuLATioN ANd STRATEGy banking models
taxing times
Bank regulation is not the only area stimulating concerns about a lack of cross-border coordination. Governments are also worried about the implications of poorly coordinated tax systems.The Organisation for Economic Co-operation and Development (OECD) launched an action plan to combat tax base erosion and profit shifting (BEPS) in July 2013, and has since been drafting consultation papers on the implementation of its 15 proposed actions. The meeting of ministers from the G20 countries at Brisbane in November 2014 welcomed progress on the BEPS initiative and committed to “finalising this work in 2015, including transparency of taxpayer-specific rulings found to constitute harmful tax practices”.The G20 members also want a common reporting standard for the reciprocal automatic exchange of tax information by 2018. “We are moving fast to limit the period of uncertainty.The rules are changing, and if they do not change at the OECD level, countries will change them in their own jurisdictions.The new rules will be known by the end of 2015, and a good investor will anticipate the environment, because the direction is clear,” says Pascal Saint-Amans, director of the OECD’s centre for tax policy and administration.
What matters to the financial sector is some degree of alignment between the direction of travel on tax and the many initiatives in the regulatory sphere. But that has not happened so far, according to EY international tax partner Anna Anthony. “The OECD process is running separately, and is not necessarily focused on some of the specific characteristics of the financial services sector,” says Ms Anthony. Areas likely to be affected include the effects of new VAT and transfer pricing rules on cross-border banks that hold their core functions in one entity that provides services internationally across the group. Banks will also need to understand the interaction between specific financial contracts and tax rules on whether an entity has a permanent establishment in a given jurisdiction. “Some of these issues may not necessarily have large direct consequences in terms of an increased tax take, but they will impose huge additional costs of compliance in working out all the activities carried out by the bank’s staff, and where those activities are taking place. Approaches to reporting vary, and some banks currently report by business line rather than by country, which is what will be required by the OECD proposals,” says Ms Anthony.
principal at Ey and former director of supervisory policy at the New york Federal Reserve. The uS has required foreign banking operations (FBos) to collect their American subsidiaries into an intermediate holding company (iHC) that will carry its own capital and liquidity requirements, and could be bailed in separately. That challenge could be further intensified by the uS stress-testing process. Mr Saidenberg believes for some foreign banks the effective capital that Fed stress tests will require in the uS will exceed what would be required by their home supervisors, although the use of stress tests is rapidly spreading around the world. “The new environment is leaning toward a change in funding model for some firms. Pre-crisis, many were comfortable sourcing dollar liquidity in the uS to finance dollar assets globally, with little or no capital or liquidity attracted to those activities in the uS. For groups that face solo capital requirements or scrutiny of trapped capital in their home jurisdiction, this is going to challenge their model,” says Mr Saidenberg.
Where To Trade?
Most banks are already operating international retail banking services as a collection of subsidiaries, so the pressure to subsidiarise is mainly a concern for the economics of wholesale banking, says Mr Huertas. if wholesale banks cannot operate an overseas branch structure to reach their clients, they will naturally want to see if the clients can reach them via an international financial centre, such as London in the case of Europe. “if the clients can come to the financial centre, that makes things manageable. But whether this works for every wholesale product is something that is in the process of being determined. We are working with some institutions to try to solve this problem, and the solution generally depends on how their home country regulation is going to change,” says Mr Huertas. The focus on how to resolve global systemically important banks is also running parallel to difficulties between uS and Eu regulators in their efforts to provide equivalence regimes for post-crisis derivatives rules. derivatives are global products, and the industry is certainly keen to avoid duplicate but differing regulation in the two largest financial market jurisdictions.
no-acTion relief
G20 members praised progress on the tax base erosion and profit shifting action plan at a recent meeting in Brisbane (pictured) in November 2014
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in November 2014, the uS Commodity Futures Trading Commission (CFTC) extended its no-action relief for non-uS swap dealers to comply with certain dodd-
REGuLATioN ANd STRATEGy | reporT banking models
Frank rules on trading via uS-regulated swap execution facilities (SEFs) if they used any uS personnel to handle a trade – even if the client is also a non-uS entity. This still leaves the final rules unknown, but one uS derivatives lawyer says the extension will be very welcome, as the deadline was already too close for banks to be able to comply. “The extra-territorial guidance in 2013 was already contentious, and the CFTC’s interpretation of it came as a major shock. Many non-uS banks use New york as a centralised location for handling Canadian and Latin American trading operations – all that business would have had to move out of the uS in 2015,” says the lawyer. New CFTC chairman Timothy Massad is becoming more closely involved in the agency’s guidance on extra-territorial issues. As well as the treatment of foreign banks, the impact of SEF rules on uS bank operations overseas are also in play. “Non-guaranteed affiliates of uS banks are treated as non-uS entities, but the CFTC’s definition of guarantees could potentially be broad enough to swallow up many types of relationship,” says the lawyer. Moreover, the SEF rules are just one part of the uS extra-territorial equation. The Volcker Rule’s prohibition of proprietary trading has generated significant confusion among foreign banks. The rule is due to come into force in July 2015. uS banks are allowed to make markets in uS treasuries without falling foul of the proprietary trading ban, but the treatment of foreign banks and sovereign bonds is prompting serious concerns. “depending on which part of the rule you examine, it is unclear if a foreign banking organisation with a uS subsidiary can trade its home sovereign debt anywhere or only in the uS, which would be a very strange situation. There also seems to be an implication that local sovereign debt can only be traded in the home jurisdiction, which would raise questions about, for instance, trading German bunds in London,” says derek Bush, a financial institutions regulatory partner at Cleary Gottlieb in Washington, dC.
ring-fencing
The uK structural reform set out in the 2013 Banking Reform Act, including a ring-fence around core retail banking and essential operations, is due to come into force in 2018, so there is more time to iron out any ambiguities. Concentration limits will apply to the ring-fenced bank, so that its ability to finance its non-ring-fenced units will be constrained. Possible Eu structural reforms, along the lines set out in a report by Finnish cen-
tral bank governor Erkki Liikanen’s expert group in 2012, are at an earlier stage of development. The European Council and European Parliament are still debating whether to adopt the Liikanen Report’s proposed separation of trading desk operations. “Ring-fencing any part of a bank and requiring it to be separately funded and capitalised is a complicated requirement to meet, which unbundles long-established treasury mechanisms internally, so that each new function has to manage itself,” says Glenn Leighton, a managing director of balance sheet solutions in the financial institutions group at Barclays investment bank. The uK approach, however, seems easier to implement because of the location of the proposed ring-fence. inside the fence, the bank’s retail and small business franchise will provide deposit funding. outside the fence, larger corporate and international clients will have deposits that can fund the entity, potentially together with individual savings over the deposit guarantee cap. in Liikanen, by contrast, the trading book is potentially supposed to be ring-fenced as a specific entity. “The trading book is not an entity, it does not have its own separate systems or people, it is just items within a portfolio that are not separately distinguished. The trading book has no natural customer base in the sense of customers coming into branches or retail funding. individual derivative positions could be the aggregate of several customer trades or the positions of internal market risk managers,” says Mr Leighton. From an international perspective, the operations of uK-headquartered banks that are outside the European Economic Area will need to be placed outside the ring-fence. Mr Huertas says this has sent a signal in itself to other jurisdictions, influencing the introduction of the uS FBo rules and the domestic ‘lifeboat’ rule for Swiss banks that would separate their international operations in a resolution. “That is also consistent with the legislation of many countries that sets the supervisor’s objective as promoting financial stability in the domestic jurisdiction, rather than internationally,” says Mr Huertas. Mr Leighton at Barclays says uK groups that are run as a federated set of subsidiaries will have existing financing arrangements for much of their international business, easing the transition to ring-fencing. “But for banks running a bolt-on branch network or complex offshore structures, the intra-group lending limits will make that more difficult to manage,” he says.
Banks are trying to retain the advantages of Being gloBal, But they also have to make statements aBout how they would implement structural reforms Thomas Huertas
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reporT | REGUlATIOn And STRATEGY ConduCt risk
On the dark side: banks’ inability to manage conduct risk has resulted in a number of high-profile scandals
Breaking Bad Banking Conduct risk Conduct risk – the risk of staff acting unprofessionally, unethically or illegally – has become a major concern for supervisors and banks, as Michael Imeson reports. The
huge penalTies levied on banks in
for poor standards of behaviour, failures in operational controls, regulatory breaches and illegal activity has created a new term in the lexicography of risk management: conduct risk. The inability of banks to manage this risk has resulted in severe cases of benchmark rigging, product mis-selling, sanctions busting, failures in anti-money laundering procedures, rogue trading, insider dealing and other transgressions. As a result, some banks have been ordered by criminal prosecutors, regulators and others in authority to pay hundreds of millions – often billions – of pounds, dollars or euros in fines and compensation. “Regulators were already worried about
recenT years
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risk culture because of the excessive risk taking pre-crisis, then we have had all these behavioural issues post-crisis,” says Patricia Jackson, head of financial regulatory advice, Europe, the Middle East, India and Africa, at EY. “It has really made the regulators concerned about the conduct of firms vis-à-vis their customers and the markets. Boards are concerned too because the fines and the reputational damage have been substantial.”
GloBal acTion
The Financial Stability Board’s Guidance on Supervisory Interaction with Financial Institutions on Risk Culture: A Framework of Assessing Risk Culture, published in 2014, has done a lot to help banks understand and
improve their risk culture, and guide supervisors on how they should be supervised. One of the foundations of a sound risk culture, says the guidance, is that employees in all parts of an institution should “conduct business in a legal and ethical manner”. Effective risk governance is another foundation: the board of directors, the risk management department and the compliance function should have an important role to play in “conduct risk control”. In addition, the Basel Committee is consulting on a revision to its corporate governance principles for banks. The consultation, which ends on January 9, 2015, has a strong focus on risk management. It includes proposals to strengthen the guidance on risk governance, including the risk management roles played by business units, risk management departments, and internal audit and control functions (the three lines of defence), as well as the importance of a sound risk culture. One of the responsibilities of a bank’s board, says the Basel Committee, is to have a role in writing the bank’s risk appetite statement, which should include “qualitative statements to address reputation and conduct risks as well as money laundering and unethical practices”. Regulators have moved into the policy area and are telling banks that the three-linesof-defence principle of risk management has not worked, says EY’s Ms Jackson, who is also editor of the just-published book Risk Culture and Effective Risk Governance. “In effect, it has been reduced to only one line of defence,” she says. “Only the risk function is controlling the risk, while the frontline – which should be the first line of defence – is just interested in revenue generation. Regulators are saying that the frontline has to own the risk.” Ted Price, advisor, risk governance, for the Americas at EY, adds: “Supervisors are struggling with how to assess risk culture and conduct in financial institutions because it is out of their comfort zone. They are used to auditing things they can touch and feel, whereas culture is largely intangible. Supervisors are therefore putting together different kinds of assessment frameworks, and some have considered hiring psychologists.”
The european dimension
The European Banking Authority (EBA), in its June 2014 Risk Assessment of the European Banking System, noted that “detrimental business practices of EU banks continue to affect consumer confidence in banks and have an increasingly adverse impact on institutions involved”. It added: “Inappropriate conduct such as
REGUlATIOn And STRATEGY | reporT ConduCt risk
mis-selling of banking and other products to consumers, failures with regard to rate benchmark setting processes, and alleged manipulation of markets for credit default swaps has already been mentioned in previous reports. However, the scope of alleged inappropriate practices is widening, and the magnitude of previously identified detrimental practices, for example related to foreign exchange trading business, is increasing.” The EBA said that individual banks had paid out in the form of compensation, redress, litigation and similar payments aggregate amounts of more than €1bn in the previous year. “Such rising conduct costs in some cases substantially affect profitability of institutions concerned”, it says. As a result, there is “a need to keep conduct risks high on the supervisory agenda”. In conclusion, the EBA recommended that risk cultures should be adjusted and that banks should “better integrate conduct of business concerns in their governance and risk management arrangements”. Current arrangements, it said, frequently fail to identify conduct of business concerns as “there often is no internal institutional definition of conduct risks, and most risk models applied in institutions fail to capture conduct risks”. The EBA also includes conduct risk in its draft guidelines for common procedures and methodologies for the supervisory review and evaluation process (SREP) under the Capital Requirements directive IV. The final guidelines will be issued shortly, for national supervisors to follow from January 1, 2016.
The uk experience
The UK’s Banking Reform Act 2013 not only introduced structural changes to the country’s banking sector but took action to improve bankers’ behaviour. The measures taken included a criminal sanction for reckless misconduct if it leads to bank failure, a more stringent approval regime for senior bankers run by the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA), and the creation of the Banking Standards Review Council (BSRC). The PRA and FCA are currently reviewing the responses to a joint consultation paper – CP14/13 Strengthening accountability in banking: a new regulatory framework for individuals – which will replace the Approved Persons Regime (APR) with something much stricter. “The behaviour and culture within banks played a major role in the 2008-09 financial crisis and in conduct scandals such as payment protection insurance mis-selling and the attempted manipulation of libor,” says
RegulatoRs weRe alReady woRRied about Risk cultuRe because of the excessive Risk taking pRe-cRisis, then we have had all these behaviouRal issues post-cRisis Patricia Jackson the paper. The new framework will “mark a fundamental change in the regulators’ ability to hold individuals to account”. The APR will be replaced with: ■ A Senior Managers Regime, which will “clarify the lines of responsibility at the top of banks”, force banks regularly to vet their senior managers for “fitness and propriety” and impose tougher penalties. ■ A Certification Regime, which will apply to a wider range of staff than under the APR, will require banks to assess the fitness and propriety of staff who are “in positions where the decisions they make could pose significant harm to the bank or any of its customers”. ■ A new set of conduct rules – applying to all bank employees except those in exempt positions such as security guards or canteen staff – which lay down expected standards of behaviour.
The BankinG sTandards review council
The regulatory push is being complemented by industry initiatives, chief of which is the creation of the BSRC to promote high stand-
ards of behaviour and competence across the UK banking sector – standards that cannot be enforced by regulation alone. Strictly speaking, the BSRC is not a true industry initiative because it is was recommended by the Parliamentary Commission on Banking Standards, after which the UK government told the UK’s six biggest banks and the biggest building society, nationwide, to set it up. The banks appointed Sir Richard lambert, former director-general of the Confederation of British Industry, to get the ball rolling. In May 2014 he published a report stating exactly how the board should be organised and what it should do. The report said that the council should contribute “to a continuous improvement in the conduct and culture of banks and building societies doing business in the UK”. dame Colette Bowe was appointed the BSRC’s chairman in november 2014 by a selection panel chaired by the Bank of England governor Mark Carney and which included the Archbishop of Westminster. Executive managers are now being recruited. In the first half of 2015 it should be able to report on the state of banking standards and good practice.
TeachinG Good Behaviour
The Centre for Commercial law Studies at Queen Mary University of london has recently set up an Institute for Regulation and Ethics and is carrying out research into conduct risk. “More should be done at corporate governance level to make sure that the directions from the top actually reach the ‘foot soldiers’ below,” says dr Costanza Russo, the Institute’s deputy director. “Banks have realised that complying with rules is no longer enough. Some are sending very clear messages that aggressive selling is not an accepted practice, and most of them have sent their employees back to school to attend ethics and compliance training programmes. However, conduct will not improve unless the culture changes too.” EY’s Ms Jackson agrees that ethics courses are important. But banks must still have hard frameworks in place to ensure accountability, to set the risk appetite and to improve risk transparency. “If you go down the ethics training route, it has to be explicit case-study based training, so that when issues come up people know exactly what to do,” says Ms Jackson. “You have to make sure that everyone in the organisation lives by those values – they can’t always put profit first.”
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Taking steps forward: UK regulators are now far more welcoming to those hoping to set up a new bank in the country
Banking: the next generation New approaches to banking The UK banking industry is opening itself up to new entrants in the hope that this will stimulate greater competition in the market. The early signs are that innovative new players could be doing exactly that. Jane Cooper reports.
Life has got easier for anyone wanting to set up a new bank in the uk. Simpler regulation, cheaper technology and political pressure on the industry to encourage more competition in the banking sector are just some of the reasons why the UK is now more likely to see new entrants to the market. According to one news report from April 2014, 29 companies are in the process of applying for a banking licence in the country. This includes names such as Atom Bank, Starling and Lintel Bank, all of which are currently being considered by the UK’s regulators. Of the new licencing process, Anthony Thomson, founder and chairman of Atom
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Bank, says: “It is a lot easier, but it is not easy.” He should know, this is the second time he has been through the process of setting up a bank in the UK.
easing up
When Mr Thomson set up Metro Bank in 2008, it was the first time in more than 100 years that someone had created a new standalone bank in the UK. Although the regulator at the time – the Financial Services Authority (FSA) – had received applications for new banking brands, these were all set up as subsidiaries of existing companies, which already had a banking licence. For example,
Egg, an online bank launched in 1998, was created by the banking arm of UK financial services provider Prudential; First direct was a branchless brand from UK bank HSBC; and Ing direct was a subsidiary of dutch banking group Ing. In setting up Metro Bank, there were a number of challenges owing to the length and the opaque nature of the authorisation process, says Mr Thomson. Another challenge, he says, related to the amount of regulatory capital the FSA required a new bank to hold. A minimum figure was not fixed and “it kept asking for more and more, which is not efficient from
REgULATIOn And STRATEgy | reporT new approaches to banking
the shareholders’ perspective”, he says. Access to the payments systems also proved difficult for a small, new player. now, Mr Thomson notes, there is a payment systems regulator in the UK, which ensures fair access to payments systems for players of all sizes. Since his experience with Metro, Mr Thomson says there has been a “real sea change” in the attitude of the UK’s regulators. Since March 2013, he says the process has been simpler and clearer.
More opTions
There are now two regulators in the UK – the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA), which replaced the FSA in April 2013. But new bank hopefuls need only apply once to the PRA, which is the lead regulator for banks. There are also now two options for banks to apply for authorisation: ‘option a’ and ‘option b’. Option a is suitable for companies that already have investors, capital and technology in place to set a new bank up quickly. With ‘option b’, banks are able to able to overcome the old problem of having to make plans without a licence. Previously, it was difficult to attract investors and raise capital without a banking licence and it was equally difficult to get a banking licence without investors and plans in place. Option b is a staged ‘mobilisation’ route, and is the option that Atom Bank, Starling and Lintel Bank have all opted for. Firms can be authorised based on their business plan but are restricted from operating as a bank until they have raised the necessary regulatory capital. By gaining regulatory approval first, it makes it much easier for banks to then mobilise the funds from investors. Atom, for example, has already been authorised with restriction and is now in the process of raising more capital. In december 2014, it announced another investor – Jim O’neill, the former chairman of goldman Sachs Asset Management – who invested £25m ($49.1m) in the bank, which plans to launch in 2015.
eMerging coMpeTiTion
Another new entrant to the UK market is Starling, which also plans to launch in 2015. Anne Boden, the bank’s CEO, says “option b makes things a lot easier – before that you could not hire people or make contracts”, without a banking licence. Ms Boden explains that there are now numerous opportunities to discuss an application with regulators. A number of meet-
ings are offered, such as a coffee meeting to discuss the proposition, then the applicant can send in a business plan and discuss it with the regulators, then there is a challenge session. After an applicant has gone through all these stages, it can then hand in its formal application, explains Ms Boden. UK regulators are now far more welcoming to those hoping to set up a new bank, an attitude borne out of a wider political drive to encourage more competition in the country’s banking sector. Politicians from all parties have been calling for the dominance of the big four high street banks – Barclays, HSBC, Lloyds and RBS – to be reduced, especially since two of these players, Lloyds and RBS, needed taxpayer bailouts at the peak of the financial crisis.
Delivering something the customer wants is the most important thing.
Banks have Been far too
focuseD on solving their own proBlems
[rather]
than solving customer proBlems Anne Boden
Making The swiTch
One initiative, the current account switching service, was launched in the UK in September 2013, and is aimed at motivating more consumers to consider switching their current account to another bank. It was thought that one of the factors stifling competition in the UK was the reluctance of many consumers to switch to a new bank, because of the perceived difficulties in changing payments to a new bank account. The scheme simplifies the process of changing current accounts and also guarantees the payments, with a promise to reimburse customers for any charges that occur for erroneous transactions. The current account switching service was a technology project implemented across the banking industry in the UK. However, it is not the only new technology making life easier for new entrants; other advances are also helping to make it easier for new challengers to enter the market. now, explains Mr Thomson, it is possible for start-up banks to rent the technology infrastructure necessary to run a bank rather than having to buy it or build it themselves. Atom Bank has opted to use Fiserv’s software for its operations. Fiserv is one of the first providers of a simple off-the-shelf technology package for start-up banks, but Mr Thomson anticipates that more technology providers will start offering similar solutions in the future. Ms Boden says that Starling has decided to build its own technology and is aiming to bring techniques found in Silicon Valley – and used by the likes of Facebook, google and netflix – to the UK banking sector.
splinTer groups
While the UK has seen a number of challenger brands entering the UK banking
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space – such as Virgin, TSB and Williams & glyn – Ms Boden argues that these all use traditional banking models. And, although they are new brands, they have been borne out of older entities. Virgin, for example, expanded into a retail bank by acquiring northern Rock. And TSB and Williams & glyn are brands that have been spun off from Lloyds Banking group and RBS group, respectively, in line with an agreement with European competition regulators. In return for state aid during the global financial crisis, Lloyds and RBS agreed that they would sell off some of their businesses. They both opted to separate out these businesses by reviving old brands, which will be sold off at a later date. Ms Boden also points to another trend in the banking sector: “There is a huge amount of disaggregation in financial services – lots of people are providing parts of the value chain. What we are going to do is one thing: we will do current accounts.” Banks typically offered a range of banking products to their customers, but now consumers can get their financial products from other sources. This could mean a credit card from personal credit card provider MBnA, a peer-to-peer loan from peer-topeer lending service Zopa, or a current account from another niche provider.
an e-soluTion
Alex Letts, CEO and founder of UK-based Ffrees Family Finance, talks of a “componentisation” of the industry, where different financial products can be provided by different players and not a single bank. Ffrees offers a current account, which is targeted at the unbanked segment in the UK. Although it functions in the same way as a bank account, the Ffrees solution does not need a banking licence behind it. European regulations – through the E-Money directive – allow the creation of electronic money institutions that can issue ‘e-money’. Prepaid card programmes have proliferated under this regulation and the Ffrees account is an evolution of such a product. In 2009, the second E-Money directive, which was implemented in the UK in 2011, made it easier to become an e-money issuer. There are now no initial capital requirements for small institutions that have less than €500,000 of e-money outstanding, on average. Institutions with more than this must hold initial capital equal to 2% of their average outstanding e-money total. The Ffrees account is provided and licenced by Contis Financial Services, which
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[the regulator] kept asking for more anD more
[capital], which
is not efficient from the shareholDers’ perspective Anthony Thomson
is an e-money institution that has an e-money licence from the UK’s FCA. Peter Cox, executive chairman of Contis group, explains how the company fits into the payments ecosystem. The company is a shareholder and principal member of Visa Europe and is also a Visa-certified processor, he says, which means that Contis processes all the transactions for the cards it issues under its e-money licence for its client brands. Contis is also connected to the regular banking payment rails, which allows funds to be paid into and out of the Ffrees account via the regular banking network. “We brand ourselves as the home of alternative banking,” says Mr Cox, who explains that the company’s solutions are also used by more than 100 credit unions, as well as by other brands in the UK and the EU. Ffrees makes its money from transaction and monthly account fees. Although such an idea would be unusual to most UK consumers – whose ‘free’ bank accounts have been cross-subsidised by exceptions charges – the Ffrees proposition is attractive to lowincome people who have been stung by bank charges for being overdrawn. not being able to go overdrawn is marketed as a key benefit of the Ffrees account.
The account is not a deposit account – such as those offered by banks with banking licences – and so it does not pay interest on the balances. Another difference is that prepaid programmes are not covered by the UK’s Financial Services Compensation Scheme. However, customers’ funds are held in a segregated account, so if the issuer of the prepaid programme were to run into trouble, it would be protected from the company’s creditors. When asked if Ffrees would ever consider applying for a banking licence, Mr Letts says: “This is not in our thinking. The whole point of running on the e-money rails is to be able to create a business model that out-competes the banks and the new challenger banks with their streamlined services in the core current account business. It means we don’t carry the regulatory and capital burdens that the deposit takers face. We do not intend to make a land-grab for the other services offered in the banking ecosystem. We intend to own the heart, not the limbs!”
hoMing in
Ms Boden says that Starling has a streamlined strategy, with the current account at the heart of the bank’s operations. The mobile banking proposition will help people with their personal finances. For example, when a cheque comes into the account, the bank will notify the customer and will also alert them if it is more or less than they were expecting. “We will predict for them how much they will have left until the end of the month,” says Ms Boden. The target group is 18- to 35-yearolds, who Ms Boden says usually manage their money well for the first two weeks of the month but, after that, things may get problematic. “We are helping people so they do not go overdrawn,” she says. When asked what the key to building a new sustainable bank is, Ms Boden says: “delivering something the customer wants is the most important thing. Banks have been far too focused on solving their own problems [rather] than solving customer problems.” For Mr Thomson at Atom, success and sustainability rest on two things. The first, he says, is the strength of the proposition and having a good business plan. The other is the strength and experience of the management team, as well as the oversight and governance through a high-calibre board of nonexecutive directors. Putting together a team and building a strong proposition in this way is not easy, but at least now with simpler regulation in the UK it does become a lot easier.
