Rule the world

The spectacular failures of the past few years have added new momentum to calls for global banking reform. But is a universal regulatory framework feasible and, if so, what would it mean for the industry?

When the G20 summit convened in Toronto on June 26, it was clear that one topic of discussion was going to trump all others. In the wake of the global crisis, leaders have been falling over themselves to promise a greater level of regulation on the financial industry, strengthening systems to ensure that something as cataclysmic never happens again. In truth, some of these hard words have been little more than posturing. Battering the banks has become an easy way for politicians to play populist. The general population is unusually eager to see the fat cats it blames for the meltdown get a figurative - and in some cases literal - tarring and feathering. As a way of bolstering poll numbers, elected officials have been happy to indulge their constituents' vengeful urges, at least rhetorically.

But the bellicose words have so far outstripped limited genuine action on the part of government, hardly surprising given the complexity of the problems currently being faced. Therefore, all eyes were on the meeting of world leaders in Canada to deliver some concrete progress. In the days following the summit, plenty of headlines trumpeted the agreements reached in Toronto to apply new rules to the global banking system. On 28 June, Canada's Globe and Mail stated that 'G20 sounds warning on bank rules', while the Financial Times went with the even stronger 'G20 backs drive for crackdown on banks'. But look a little closer and plenty of issues remain, not least that getting to this agreement has meant relaxing the timetable for certain countries to comply with the Basel III regulations - initially slated for implementation in all major centres by 2011. The precise terms state that 'new standards...will be phased in over a timeframe that is consistent with sustained recovery and limited market disruption, with the aim of implementation by end-2012'.

In practice, this means that, as long as the argument can be made that doing so would harm financial recovery, certain states will be able to delay the pain new regulations might inflict on their bottom line. As loopholes go, it's a pretty big one and something that could have a destabilising effect on the global financial system. There are very real concerns that such a staggered implementation would lead to competitive disadvantage for territories that adopted changes early. We have become accustomed to threats that any tightening of the rules will result in the entire industry upping sticks from said territory and moving to a friendlier business climate. While it's worth taking such statements with a pinch of salt, there is little doubt that finance can more easily become nomadic than certain other fields. According to the Chief Risk Officer of a major European insurer, speaking under condition of anonymity, "If you impose a new regulation on the car manufacturers they're not moving their factory easily. But shifting the trade from London to New York or from Frankfurt to London will be a matter of seconds or milliseconds. If you don't have regulations that are equal and create a level playing field that will only create losers because if people want to continue to trade they will trade and they will not stick in Germany and pay the taxes on that transaction if they can get the same transaction for free in Switzerland or London."

Tech matters

It is not simply the case of lost revenue. A key consideration for financial institutions is the increased compliance costs that new regulations will entail. Even before the crisis, compliance represented a large proportion of financial institutions budget spend. As the rules get tighter, so these costs will get higher. "Regulation is going to become more costly," says Rod Nelsestuen, Senior Research Director, Financial Strategies and IT Investments at analysts TowerGroup. "I think that's a natural consequence, not just because we have more of it but because the regulation needs to become more sophisticated. When you increase the sophistication you also have to increase you investment in both technology and people. In the US for example, there are a lot very knowledgeable regulators but a lot of the people doing the work might not have a depth of experience."

The technology required to beef up regulatory systems also doesn't come cheap. "We need to do a lot more reorganisation and restructuring of data," says TowerGroup's European Research Director Bob McDowall. "Data management and analytics need major overhaul, where the costs are substantial. They run into tens of millions, for the largest institutions."

McDowall believes financial institutions could react to this increasingly stringent regulatory burden in a number of ways. Outsourcing in certain areas would reduce the need to spend on in-house technology, while also passing on some of the compliance burdens. Another alternative will likely be banks divesting themselves of businesses that draw the largest regulatory heat. While this will undoubtedly diminish spending in certain areas, there will still be costs associated with getting rid of businesses as well as the loss of income those businesses brought in. Basically, nobody is getting out of this without being hit in the pocket in some way.

Back to reality?

But the biggest problem at the heart of plans for a more global approach to regulation just might be the entire thing. Getting four people to decide where they want to go to dinner can sometimes be a challenge. Getting dozens of different countries and organisations to settle on a set of rules for something as complex as the international financial system has almost limitless potential for intractability. 

McDowall gives the example of the Basel III requirements, which aren't even expected to be finalised until 2011. "It's not that banks don't wish to implement Basel III," he says. "They would like to take it in two or three pieces. There are those elements that perhaps would like to implement by the end of 2012. There are others who would prefer to leave it to at least the middle of the decade and there are probably others that wouldn't wish to implement at all. They'd like to kick out to the long grass. It's a process of negotiation and there are some big issues at the moment. If we want to either get out of the current economic downturn or help commerce and industry to refinance, then clearly putting strong capital and liquidity constraints on the state might not be too helpful."

On a purely self-interested level, it is completely understandable that certain nations would resist the elements of Basel that might cause them harm. Spanish banks would be affected by the proposal to exclude deferred tax assets from capital, their French counterparts by a rule enforcing full capital allocation for partially owned subsidiaries, while UK banks would feel the pain of a deduction of pensions deficits. However, by allowing reforms to be phased in as and when it suits particular territories, even watering rules down to in search of agreements, there is a very real risk that we'll end up with a weak system that doesn't do the job it was designed for.

It is clearly thought that reducing the scope of the Basel accord and lengthening its transition period is one of the best ways of ensuring that all 27 signatory nations will eventually adopt it. However, with a transition that some believe could stretch to as long as 15 years, there will be ample opportunities for organisations to sidestep rules in certain markets simply by channelling business through those which have yet to impose them.

Taking a very different tack, it is possible to make the case that a single framework for the entire global financial system is too broad a solution. It is undeniable that the industry operates at very different levels and at varying stages of maturity depending on where you are. "If you take the APAC countries, they've not been particularly affected by the crisis and they think that Basel II should have been implemented better," says Bob McDowall. "To the extent the African countries are involved, they'd be very happy with just Basel I. I don't mean that in a pejorative sense. That's just quite an adequate measure for risk regulatory capital for the traditional business conducted in the region. Each geography has slightly different problems to address."

The slow pace of global agreement and the differing regional requirements create the possibility that, by the time they are implemented, proposed global regulations will already have been superseded by more regionally-focused ones. In July, the US Senate passed its long-debated banking reforms, which now only awaits the signature of President Obama before becoming law. Designed to stave off a repeat of the irresponsible practices which led to the collapse of Lehman Brothers and Bear Stearns and which forced the government into a series of mind-bogglingly costly bailouts, the new rules contain provisions to stop institutions becoming too big to fail and prohibit proprietary trading. Could a country as financially heavyweight as the US choosing to implement its own rules have a detrimental effect on progress elsewhere in the world? "I don't think so," says McDowall. "The US has a slightly different situation where perhaps only the top 20 banks there are international while the others are very domestic. In this context I don't think what Europe and Asia are doing is not going to reflect necessarily what the US does."

Regardless of the way that individual regulatory regimes may affect a more global model, their very existence undermines much of the collaborative work which is currently being done. A patchwork of local rules springing up during the long gestation of a more worldwide approach adds layers of complexity to international trade and carves perilous bumps and troughs into an ideally level playing field.

Alternative outcomes

But if global agreement is so hard to reach perhaps there is a more manageable way to stabilise and regulate the market? "You don't need to have the whole world agreeing on it," says our anonymous Chief Risk Officer. "If you have the G20 agreeing on it, than that's enough because I don't think you will see a hedge fund trader going to Angola. He may consider going to Switzerland, Singapore or Hong Kong, but he would certainly not set up in Uzbekistan only to avoid the taxes. That's why the G20 doing it alone would be sufficient. In the financial business, if you look at equities are trading globally, the G20 makes up about 99 percent of global trading."

And what of the oh so familiar complaint that an excessive focus on regulation and compliance will stifle economic recovery? Notoriously resistant to any perceived meddling, the financial industry isn't exactly falling over itself to implement changes. The idea that rushing such plans could slow recovery has been seized on with vigour. "I don't think it's actually oversight of risk management which will stifle recovery," counters Bob McDowall. "It's basically about how regulation is implemented and operated.

"Obviously managing systemic risk is extremely important. That comes right at the top because if the system goes under, the systemic risk goes right to the top. I think secondly you've got to enable banks to service what I call genuine economic requirements; genuine funding of commerce and industry to meet its requirements as it comes out of this recession. The third point is it's important that the national financial system is safeguarded against what I call 'risk pollution' from outside. Each country has to look after its own national financial and banking system.  That may lead to conflict overseas particularly in Europe. For example, for banks from other jurisdictions or countries who conduct business in the UK. We already have the Bank of England telling the banks here to manage their risk within Europe. It's not so much their direct exposure to sovereign bonds in the Eurozone, but to the institutions within those jurisdictions which are economically weak at the moment."

Ultimately, even the idea of a pan European regulator, let alone a worldwide one, might just be a bridge too far. The crisis has been a chastening experience for the industry and being seen as a global institution isn't the badge of honour it once was. Banks are increasingly focusing on local markets and targeting international involvements much more carefully. In such a scenario is it really feasible or desirable to apply a one-size-fits-all regulatory framework? "The idea of the Pan European regulator is a political issue," says McDowall. "I don't think it necessarily satisfies the regulatory needs of each national economy. You can have agreed principles, but principles will be enshrined in national legislation or financial regulation in different ways to suit the needs of the national economy. It could also end up reflecting the political view of the industry because I'm afraid politics is embedded with financial regulation."

It seems the world may have to continue its wait to see the financial industry brought under some form of centralised control. The long and winding road still being traversed towards adoption of the Basel accords is a clear indicator that these kinds of changes can't happen overnight. What is required is cooperation both between national governments and their industries, and between different governments themselves. The turmoil the world has experienced over the last few years had complex roots and will have equally complex resolutions. The intertwined nature of today's global markets mean that we are all in this together. It's up to everybody involved to work towards realistic and genuinely beneficial solutions. Hopefully we won't still be debating the implementation of Basel XI in 2085.

Third time's the charm?

The long road to Basel implementation

1975 - Basel Committee on Banking Supervision (BCBS) established by G10 countries

1988 - Basel Committee produces Basel Capital Accord, applying international standards for credit risk

1999 - New Basel Capital Accord, or Basel II, is proposed. Outlines new focus on operational risk designed to plug gaps left by earlier agreement

2005-2009 - Basel II goes through a number of updates in response to perceived problems with initial draft

2009 - Basel III documents published for review

2010 - G20 meet in Toronto and reassert support for Basel rules

2012 - Basel III implemented?