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In the weeks and months after governments around the world were forced to inject billions to prop up the banking sector, regulators and politicians promised that financial regulation would be reformed to prevent a repeat of the crisis.
But, with the notable exception of new rules on bonuses and pay, relatively little changed on the ground in the City of London and in other leading financial centres. The Financial Services Authority played tough in the UK, but most of the debate over the future of regulation stayed in the theoretical realm.
Now, however, three years on from the start of the financial crisis, everything is about to change.
Global banking regulators have finalised the Basel III package of capital and liquidity regulations, which is likely to kick in over the next few years, while the British parliament and the European Commission have agreed to set up separate pan-EU regulators for banking, insurance and the securities markets, as well as a different body to monitor systemic risk. Meanwhile, Brussels is close to agreeing the first-ever EU-wide rules for hedge funds and private equity.
The UK coalition government is also moving forward with its plans to split up the FSA, and an independent commission on banking, set up by the Treasury and chaired by Sir John Vickers, former head of the Office of Fair Trading, is considering whether institutions’ investment banking activities should be severed from their commercial and retail lending operations.
The City will feel the effects of upheaval across the Atlantic, too – notably the Dodd-Frank financial reform act, which is already forcing US-based banks to reconsider proprietary trading (making bets with their own money) and other activities.
As these rules and regulators come into effect, financial professionals will be forced to adjust how they do business. Some believe this could be the biggest change to affect the City since the “Big Bang” deregulation of the 1980s.
“Major countries and blocs are enacting new legislation at a pace that would have been unimaginable before the crisis,” says John Liver, financial services partner at Ernst & Young. “Business models are likely to change in key areas. In the absence of global consistency in the detail, regulatory and tax arbitrage choices could be among the most significant decisions the banks will make.”
Indeed, many financial services companies say they are so hard-pressed keeping up with all the moving parts of the system that they cannot be entirely sure what the impact will be.
“The big risk of all of these regulation changes is to put enormous strain on the plumbing of the financial system,” says Bill Michael, head of UK financial services at KPMG. “It is a game of cat and mouse now, because there is only so much regulation the system can absorb.”
Among the forces hitting the City, the one that will be felt the keenest will be the new global rules on capital and liquidity from the Basel Committee on Banking Supervision. Basel III will, in effect, require financial institutions to triple the size of the capital reserves they must hold against losses, as well as demanding enough liquid assets to survive a market crisis.
“Regulatory capital will remain at the core of banking supervision, with requirements likely to increase substantially, and in a variety of ways. The impact of this on profitability, margins, business models and willingness to write new business remains to be seen,” says Vishal Vedi, financial services partner at Deloitte.
Alongside these tougher rules on capital, there is also likely to be a greater emphasis on supervision as regulators worldwide seek to prevent a repeat of the financial crisis. Financial institutions in the UK face a particularly challenging situation because, in addition to coping with new rules, they will have to work with new regulators.
The FSA is being reorganised into two separate organisations. One, headed by Hector Sants, the current chief executive, will become an arm of the Bank of England and focus on prudential regulation of banks and insurance companies, while the other, to be known as the Consumer Protection and Markets Authority, will supervise the financial markets and oversee the entire sector for conduct issues, such as treatment of customers. The coalition government has promised to have the process finished, including the necessary legislation, by the middle of 2012.
Critics argue that such structural changes will not solve the problems at the heart of the crisis – namely that regulators failed to react as financial institutions took on ever greater and more complex quantities of risk.
Lawyers and bankers also worry that FSA staff will have to spend so much time on the difficult process of reorganisation that other work could slip.
“While the financial crisis undoubtedly requires a fresh look at the way we organise regulation, the case has not yet been made that the proposed reforms of the UK regulators would prevent a repeat of the crisis and the build-up to it,” says Pat Newberry, chairman of the UK financial services regulatory practice at PwC.
There is also significant concern that the new consumer regulator will fail to make clear what it wants and end up punishing firms unfairly; a body of opinion has already formed that the tough new approach is simply a form of second-guessing firms in the wake of market failures. Indeed, some in the City fear the new consumer body will be even worse.
“The CPMA is doomed to fail to meet its proposed objective of ensuring confidence in financial services and markets if the ground rules aren’t clear at the outset,” says Jenny Stainsby, regulatory partner at Herbert Smith, the law firm.
Nor can the financial services industry afford to overlook what is happening in Brussels. While the new financial regulators in charge of banking, markets and insurance are not expected to act directly against individual firms, they will play a critical role in setting EU-wide rules on everything from capital and pay to the responsibilities owed to customers. Hedge funds will also have to get used to greater regulation from Brussels or consider shifting their operations from the EU.
“There remains a lot to play for,” says Mr Liver at Ernst & Young. “In addition to planning an efficient programme of change to deliver compliance, banks need to intensify their efforts to influence the detailed policy agenda, and both the industry and the authorities need to be alive to the wider global business issues.”