Sam Ahmed, an industry expert on OTC derivatives in Asian markets, offers his views on how the DNA of banks and bankers is changing as a result of the regulatory overhaul and greater focus on compliance and risk management
Introduction
Banking has entered a new era. The greed and excesses of the past two decades met an abrupt halt as the tsunami of the 2008 financial crises swept across continents and markets. The balance of power thus began to shift from traders and investment bankers who once sat unchallenged on the thrones of the financial institutions to a newly empowered army of regulators, compliance officers, auditors, controllers and risk managers, determined not only to fix the lapses and gaps of a broken system, but to use this momentum to forever change the DNA of banks and bankers. Question remains: how much is enough?
A new landscape
The past five 5 years following the financial crises has seen the rollout of various regulations (Dodd Frank, EMIR and Basel III3) and banks themselves have taken severe measures to boost internal risk management, compliance and auditing. The result: a new landscape for banking. Banks have been deleveraging and minimizing the use of balance sheet related activities whilst at the same time increasing capital buffers to comply with Basel and local regulatory capital requirements. These measures have forced banks to revisit revenue streams from traditional client related businesses. Proprietary desks in most banks have either been marginalized or shut down. In Singapore, we are increasingly seeing a shift back into conservative and core banking activities with the attention on retail, corporate and private banking. On the markets side, with the exception of Commodities, FX and Rates trading desks have been struggling with low volatility and yields for the better part of 2014 and buy side clients have been reluctant to put on large trades as they are weary of imminent offshore OTC regulations that will increase costs of margining along with dealing with the headache of a shift from bilateral trading to central clearing. Banks with a capital markets arm (such as JPM and Citi) have realized that revenues from execution desks and trading platforms are growing smaller, and instead are relying on providing services such as clearing, collateral and custody that cater to a post regulatory environment and can potentially supplement client revenue. Overall, banking as we knew as depicted in the it during the Wall Street days of Gordon Gekko’s Wall Street are dead: gone are the hostile take overs, the insatiable appetite of trading desks to innovate triple A notes from mezzanine debt, the squandering entertainment expenses and the search for yield in riskier emerging markets. The new landscape is one of conservative banking with a focus on servicing client business with a disproportionately large emphasis on risk management, capital adequacy and control.
Regulations and Compliance: more to come?
While the army of regulations, risk management and compliance have won the battle there seems to be no ceasefire ahead. Why stop now when you’re on a roll? The past two years also saw numerous banking scandals and their respective hefty fines, which could not have come at a more opportune time for those calling for added regulations. $8.9 billion on BNP Paribas ascribed for business with sanctioned countries, $2.6 billion attributed to Credit Suisse for tax evasion, $1.9 billion to HSBC for anti-money laundering and $1.5billion to UBS for its part in the LIBOR scandal. The result: an immediate focus for most banks on mitigating future compliance related breaches and fines.
Both JP Morgan and HSBC announced in Aug 2014 that it would boost compliance personnel and internal controls. Following HSBC’s $1.9 billion fine, the bank released details of hiring a further 3,000 compliance staff while JP Morgan announced it plans to spend $4 billion and hire 5,000 staff globally to oversee compliance related activities. Standard Chartered after yet another hiccup last month where they were fined $300 million for a systematic error that failed to capture test transactions done with sanctioned counterparties stated that it had already increased their legal and compliance headcount by 30 percent over the past twelve months. Other banks are also in the process of boosting their compliance personnel and implementing processes for surveillance and supervision. In Asia, a few banks such as Deutsche bank, RBS and Bank of America are even creating front office supervision departments with the objective of overseeing, capturing and dealing with breaches immediately upfront through ‘level 1 controls’ before it heads downstream.
With fines in their billions seemingly a norm in today’s financial landscape, banks are shifting their traditional goal of pursuing revenues in new markets and products towards protecting downside compliance risk. Regulators, risk managers and compliance officers, empowered by the financial crises and further strengthened by the recent spat of scandals are now on a mission not only to change banking into a more regulated, transparent, controlled and low risk industry but are going all the way into transforming the culture, DNA and the very soul of banking: its employees.
How does one change the DNA of bankers?
Simply asking employees to take online code of conduct courses by a certain dates with systematic escalation deadline procedures is not enough. Infusing the message of compliance throughout the firm has to come from the Chairman and Board of Directors to the CEO who, with his directs, need to ensure this message is converted into a tangible code of conduct policies from top down to the lowest level. This also means that compensation and corporate promotion titles need to be aligned with the new conduct principles in order to incentivize employees who are able to display ethical behavior, self identify any market, credit, operational risks, inconsistent client behavior or product unsuitability. Middle management will also have to bear a strong responsibility in playing role model for supervisors and employees under them. Business models will have to be revised where the well being of the client is also rewarded alongside goals of revenue generation for the firm. Recruitment models and objectives have to incorporate ethnical and risk management parameters during screenings and interviews.
Are we going too far with Risk Management and Compliance? Do we really need to change the DNA of employees?
Last month at a meeting with one of the regional heads of the newly set up front office compliance team for an international bank in Singapore I was asked as a former trader, how I ensured that the price that I was giving a buy side client was not too far off the interbank market. In the conversation that ensued, I realized the nature of compliance today had taken a complete new meaning since my days on the trading desk. The role was not just to monitor traders for inconsistent P&L swings, market manipulations or insider trading. Front office compliance wants to pervade a sense of corporate responsibility and culture that will force the trader to give the client a fair market price even if the client was willing to pay more in the first place either through ignorance or through lack of price sensitivity. In other words, a trader generating revenue in excess of what is normally made from a particular client would be questioned and penalized.
Compliance in banking has been given a challenging mandate: to repair the damage done in the crises of 08’, bring back credibility in the finance industry and to ensure mistakes or scandals do not reoccur. There is no arguing that regulations and compliance have bought in much needed controls and transparency, the lack of some of which, contributed to the financial crises. Know your Customer (KYC) & Anti-Money Laundering (ALM) measures, client product-suitability checks, electronic surveillance, conflict of interest and Chinese walls, OTC trading counterparty risk mitigated by collateral and central clearing, added capital buffers, cross border regulatory checks are all initiatives which can be applauded as they have made financial markets safer. However one needs to be careful where we draw the line between compliance and allowing markets to function by themselves.
To answer the original question on how to ensure a client gets the best price, my answer would have been the following: “A buy side institutional client trading a G7 FX Forward or even a long dated swap, should first have full knowledge of the product both from a pricing, liquidity and operational perspective. He has, at his disposal, various electronic price feeds and a host of competing broker dealers that will gladly make him an alternative price. Hence, if a buyside client trades on a price that is wider than the market, no one is to blame but himself”.
Trading desks were created to provide liquidity, earn revenue from customer flow and take proprietary risk and have always been a prime source of revenue for most banks. Trying to change this objective and asking trading desks to baby sit the client is now crossing the line from compliance to promoting mediocrity in the markets. Like any market, a consumer who pays too much for a certain good or service from a certain vendor without checking the prices of other vendors, has only himself to blame. As Gordon Gekko put it in the movie -Wall Street, “in my books, you do it right or you get eliminated.”
Promoting a culture of risk management and ethnical behavior should not be confused with rewarding complacency, punishing calculated risk taking and instilling a climate of fear. Douglas Flint, HSBC chairman sums it accurately by stating publicly, “an observable and growing danger of disproportionate risk aversion is creeping into decision-making in our businesses”.
We live in a day and age of low volatility, tight spreads and excessive regulations, which in turn is making it exceedingly difficult for banks to run profitable businesses. The result will eventually spill over to capital markets which will be starved off flows and this in turn has severe negative implications for the real economy: it chokes credit, impedes an efficient flow of capital to sectors which need it, stifles growth and reduces the overall circulation of money and its related multiplier effect benefits.
So what is the future of banking then?
If the army of compliance and risk officers who have been hired to monitor front office activity and install a new DNA and culture of risk succeed in their objectives, we may just end up in three years with an over regulated, tightly controlled and highly ethical banking sector. However with dealings rooms too tightly regulated, traders too cautious to take on risk and business heads with their hands tied, revenues from capital markets will dry up. The question then will turn to: who pays for this army of compliance and risk officers?
“How much is enough Gordon?” yells Bud Fox to the unrelenting greedy corporate raider Gordon Gekko in the movie Wall Street. Gordon replies “It’s not a question of enough, pal. It’s a zero sum game, somebody wins, somebody loses.” We may be on the other extreme of the “Wall Street” era where steep banking fines, over compliance, overlapping regulations and risk aversion dominate the present market. The only difference in this scenario is…. everyone loses!
