Basel III, like most regulation, has been fraught with delays in the last year. In a Q&A, Matt Clay of Baringa Partners explains the impact delays have had on Basel III implementation, the best practices for strategic change programmes and what banks should be thinking of the new FRTB proposals.
Q. From a legislative perspective 2012 was a somewhat a difficult year in terms of the Basel III implementation path (delays to CRD IV in Europe; US agencies confirming indefinite delays, etc.) – how has this impacted Basel III planning and the progress of Basel III change programmes within global banks?
A. In terms of the delays to CRD IV in Europe, we haven’t actually seen that much impact across the big programmes of change and delivery that most of the tier-1 banks have had in place for a minimum of 18 months now. Uncertainty around the legislative process in the European Parliament has changed the way in which certain technical standards will be phased in, which has hindered some firms in their delivery of the data architecture required to support new reporting requirements but these have largely been inconveniences rather than game-changers. By and large, national regulators in Europe have ensured that firms have continued to push ahead with implementing the core changes needed.
As a result, programmes around core capital, liquidity, leverage and risk management requirements have continued to progress, albeit there remains a significant amount of work to complete for many banks. That said, our sense, which is perhaps different to that which is sometimes portrayed in the mainstream media, is that the larger firms now have the requisite level of stakeholder engagement and executive level sponsorship across their Basel III change portfolio to ramp up the speed of delivery.
Delays to legislation in the US have perhaps been more unsettling because of the sense that US regulators are less convinced about the overall robustness of the Basel III framework. In turn this has created some doubt about the relevance of some of the work being undertaken. Nevertheless, the biggest US banks have also long since started to execute plans for Basel III compliance and much like their European counterparts have accepted that in many instances the standards laid down by the Basel Committee actually represent the starting point for best practice in this new era of banking.
Q. So as we head into 2013, what are the major challenges that banks still face in terms of complying with the Basel III rules?
A. As mentioned above, the flight path to Basel III is still far from smooth. We still see firms working to determine the line-by-line economic impact of the capital requirements, meaning that many still haven’t implemented the fundamental changes to their business models that will be required to drive profitability moving forwards. Part of the reason for this is undoubtedly due to the fact that other items on the regulatory reform agenda that interact with Basel III have yet to be finalised. For instance, the ultimate capital impact on OTC derivatives portfolios and the scope of Counterparty Credit Risk (CCR) requirements are difficult to define accurately without a complete understanding of exactly which products are to be mandated for central clearing. In that respect, we certainly expect to see some significant progress in 2013.
Another interesting issue to play out in 2013 will be the changes that have been announced recently in respect of the Liquidity Coverage Ratio (LCR). In theory these should be positive for banks and they have certainly been reported as such but let’s not forget that they are still to be transposed into CRD IV in Europe. In that sense there could still be some turbulence around the transition arrangements, which could result in banks trying to align their change programmes with moving targets.
Lastly, we mustn’t forget that a number of the proposals considered central to the resilience of the Basel III framework were designed for a normalised market. We very evidently aren’t yet experiencing normalised market conditions; hence it is very difficult for banks to assess whether their initial strategic and operational responses have been appropriately defined. We may yet find that banks are forced to revisit some of their critical decisions as market conditions settle down.
Q. From your experience of working with clients on their Basel III programmes, what observations can you share in terms of best practice for the successful delivery of strategic and operational change programmes?
A. We certainly believe that there are a number of fundamental things that banks must get right in order to successfully deliver regulatory change programmes on the scale of Basel III.
Form a central clearinghouse for regulatory interpretation, engagement and traceability – Establish a central body to agree and disseminate a single house regulatory interpretation, appoint single ownership to manage external regulators and ensure traceability from regulatory text through business and IT requirements to delivery.
Establish clear cross-functional sponsorship and accountability to drive the agenda – Gain and then actively communicate front-to-back sponsorship, accountability and engagement in order to very clearly signpost the level of commitment within the organisation to achieve the stated objectives. This then makes it possible to force together IT and business streams through the programme structure.
Mobilise a front-to-back regulatory delivery approach and plan but look ahead into the regulatory pipeline to understand the possible risks to that plan – Set-out a clear delivery lifecycle with controlled sign-off points, effective governance and consistent project management but maintain awareness of regulatory activity to understand how the plan might need to ‘flex’ with evolving or new requirements.
Set clear business accountability to manage the internal and external model approval process – Assign single end-to-end ownership to manage the model approval process to help ensure swift information exchange, a common understanding of requirements and transparent communication channels. This level of definition ensures that methodology questions remain focused.
Q. We still haven’t had Basel III finalised and already we’ve got proposals on the table for a new capital regime for the trading book – should banks be thinking of the Fundamental Review of the Trading Book (FRTB) as Basel IV?
A. Whether you call it Basel 3.5, Basel IV or simply the FRTB, the initial proposals laid out in the Basel Committee on Banking Supervision’s (BCBS’s) Fundamental Review of the Trading Book Consultation Paper last May raise some pretty significant challenges for the largest banks with extensive trading operations, the risk exposure for which is calculated by their own internal models. Our view is that the FRTB could ultimately prescribe change on a scale that isn’t too dissimilar to Basel III – albeit confined to a smaller group of institutions given that to the largest extent it primarily hits trading organisations.
Q. What do you believe to be the biggest strategic and operational implications thrown up by the FRTB proposals?
A. Over and above the desire to tackle some of the failings in trading book capitalisation that were evident in the financial crisis, the FRTB represents an attempt by the BCBS to restrict the perceived reliance on a so-called ‘private view’ of risk, which regulators believe has taken hold within firms using the internal model approach to calculate capital outcomes. This relates to the bank-specific modelling assumptions that internal model firms have made in securing their waiver but that have, in certain cases, subsequently broken down in times of market stress.
To this end the BCBS is proposing to increase the sensitivity and prominence of the Standardised Method (SM) relative to internal models – in effect using the SM to create a ‘floor’ for the Internal Model Approach (IMA). In turn, this potentially calls into question the very essence of the competitive advantage that larger trading firms have sought through their expertise in risk modelling.
Strategically, this will require firms to re-examine the economic viability of current trading activities in light of the proposed reforms. The logical extension of this is that some firms may be forced to redefine the composition of their core portfolio of assets. Viewed within the broader context of regulatory change materially affecting the ways in which investment banks seek to drive profitability, the FRTB could be viewed as yet another ‘nail in the coffin’ for previously high-margin trading businesses.
Operationally, these proposals will potentially vastly increase the technological burden that firms face in constructing and back-testing their risk models, as well as re-shaping many of the processes that currently support the calculation of regulatory capital for the trading book. An increased demand for more extensive data analysis, more powerful computation and the expansion of processes to incorporate an enhanced focus on the SM could all be significant operational impacts.
Q. How should banks be positioning themselves to deal with the FRTB proposals? How quickly are we likely to see this move forwards?
A. 2013 should be the year in which we start to see the core components of the FRTB crystallise. In practice this means that we are expecting a second Consultation Paper (CP) from the BCBS, issuing a revised set of proposals (having assessed the feedback provided to the initial CP) sometime in the Spring. Assuming that the FRTB then follows the logical evolution path of other high profile regulatory reforms, we anticipate a Quantitative Impact Study (QIS) to be initiated this Autumn, with the most optimistic (or pessimistic depending on your stance!) forecasts suggesting that may in turn lead to the publication of an initial policy document before the end of the year. That may be a little bit too ambitious but we certainly believe that within the next 18 months, we will have had a formal statement on the implementation requirements for the FRTB.
Whilst all of that sounds quite daunting, it needn’t be for banks that are proactive in their planning. Firms should certainly be thinking about conducting a full, bank-specific Strategic and Operational Impact Assessment on the back of the second CP and then ensuring that sufficient resources are available to quickly ramp up preparations for the QIS. More than anything, banks need to ensure that the FRTB is appropriately positioned on their strategic regulatory change agenda for 2013 – experience suggests that mobilising a response early in the piece is the most effective way to establish a holistic understanding of the requirements and associated change priorities.
