US banks rolling with the punches

Many delegates at Sibos 2013 noted an optimistic ‘business buzz’ around the Dubai World Trade Centre, with exhibition halls bustling with meetings, negotiations and rising expectations. This contrasted with the subdued mood of the finance sector since the 2008 crisis. But it signalled not a return of old certainties, rather a recognition of new realities: these are the new rules of the game; those who adapt fastest have the best chance of success!

As noted by Dubai’s closing speaker, Ian Bremmer, governments and regulators now hold the whip hand, dictating both the direction and pace of travel in the post-crisis finance sector.

From Basel III’s stricter capital and liquidity rules to G-20-inspired mandatory central clearing and trading of OTC derivatives, reforms are changing the fundamentals of how banks, financial institutions, market infrastructures and corporates do business. And it is in the United States, home to many of the institutions brought low by the crisis and host country of this year’s Sibos, where the reform process has reached furthest and deepest. Signed into law in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act sought to change many aspects of existing practice in US financial markets from proprietary trading to mortgage approvals, while attempting to assure that a taxpayer bail-out could never happen again.

Basel bites Regulatory change takes place at different speeds across jurisdictions, but the most important post-crisis reform comes in the form of supra-national guidelines.

According to the Basel Committee, the group comprised of nearly 30 regulators, the world’s biggest banks have nearly met the capital requirements that form the cornerstone of Basel III. Market forces have driven banks’ to adopt guidelines which are not required to be met in their entirety until 2019, as institutions jostle to reassure the market they are financially stable.

The Committee in March said the world’s top 102 banks had a combined shortfall of €57.5 billion by June 2013, half the €115 billion shortfall shared at the end of 2012.

Simply put, the cost of capital for banks is rising, while greater constraints continue to be applied to traditional revenue streams, such as the OTC derivatives business. The net effect, according to Sean Owens, director of fixed income for capital market consultancy Woodbine Associates, is a greater focus on balance sheets.

“The regulatory-driven increase in the cost of capital means banks are rationalising costs around different business lines,” he says. “There is a sense that banks have realised that this regulatory regime is going to persist so they need to change the way they do business.”

Basel III’s recently finalised leverage ratio doesn’t take full effect until 2018, but reporting requirements start in January next year, giving banks another deadline to worry about.

“Banks are having to focus on whether capital-intensive business lines are worth supporting. Many banks will take a long-term view, but some have shown already they are willing to pare back formerly core businesses,” says Owens.

A number of global banks which previously ran all their major platforms for corporate and institutional business using in-house technology and resources are now actively outsourcing, partnering and discussing new forms of collaboration to deliver services to clients at a lower cost.

A clear success Ray Kahn, New York-based global head of OTC derivatives clearing for Barclays, has overseen key adjustments to his firm’s swaps clearing business in line with Title VII of the Dodd Frank Act, which mandated central clearing and trading for the bulk of OTC derivatives.

Overall, Kahn believes banks have responded effectively to the cost and workload pressures facing them with the implementation of post-crisis rules.

“As an industry, we’ve been successful in bringing regulatory requirements for central clearing into the capital markets and now a large amount of interest rate swaps and credit indices are being executed on desks throughout the globe and cleared through clearing houses,” Kahn said.

Trading on new types of trading venues introduced by Dodd Frank – known as swap execution facilities – began in October and became compulsory for certain instruments in February, while central clearing for swaps came into force in three phases last year for US market participants.

These changes have combined to increase the overall costs of swaps trading compared to the traditionally bilateral OTC trading between bank and client. The move to rationalise business lines, said Kahn, has emerged as a natural outcome of post-crisis reform, and has forced banks to increase efficiency.

Banks such as Barclays must maintain a highly automated operating infrastructure to handle global demand for clearing services while meeting rules across different jurisdictions. “We try to work with regulators and clients to come up with the most efficient offering with minimal cost increases and the least amount of liquidity reduction in the market,” he says.

“With such major changes to rules, some businesses have become more attractive than others, which is part of the challenge when regulations change – you have to adapt.”

Fragmented outcomes For OTC derivatives, the US has moved ahead of the other jurisdictions comprising the G-20, which agreed on post-crisis reforms in 2009 to reduce systemic risk. In Europe, new reporting requirements were only introduced in February, with central clearing to follow next year, while trading reforms laid out in MiFID II may not take effect until 2016 or 2017.

According to Alex McDonald, CEO of the Wholesale Markets Brokers’ Association, a body that represents the largest inter-dealer brokers operating in wholesale financial markets, banks and other market participants have had to deal with a growing fragmentation caused by the requirements of different sets of regulation.

“Banks are not just dealing with regulatory fragmentation across products, participants, infrastructures and jurisdictions, they are also dealing with increased capital and liquidity requirements within Basel III,” he said.

The pace and scope of regulatory change is not just tough on bankers, but on regulators too. US derivatives regulators have found it difficult to impose new rules effectively in their home markets, while also being mindful of the impact on other jurisdictions where the progress of financial markets reforms has been slower. The net outcome has been further confusion for banks as key implementation dates have been regularly deferred.

This has been seen most notably through the US Commodity Futures Trading Commission’s (CFTC) use of ‘no action’ letters, altering timelines by which institutions expect rules to be implemented. This has meant Dodd Frank rules for securities-based swaps, which are yet to be finalised by fellow US regulator the Securities and Exchange Commission (SEC), will likely come into force at the same time as CFTC rules developed years prior.

“Despite the SEC taking nearly two years longer than the CFTC to formulate its Title VII rules, the consequence of serial ‘no action’ deferrals will be that both sets will move into the implementation stage at roughly the same time,” says McDonald.

Signs of hope Anshuman Jaswal, senior analyst, for consultancy Celent, who has monitored the changing derivatives regulatory landscape, agreed the SEC’s more measured approach to rule formation will lead to more beneficial outcomes. “The SEC’s approach has given participants more time to deal with rules from the CFTC, but the longer timeline has also caused some uncertainty within the market,” he said.

But throughout such a hectic period of reforms, banks have shown a propensity to meet even drastic changes at short notice, Jaswal added, an attribute they will need for years to come.

“Overall, the market has shown it can adapt to this wide-ranging type of regulation within Dodd-Frank and particularly with the clearing and trading requirements. This is a positive sign.”