Banking And Capital Markets Insight, March 2009

Introduction

Welcome to the March 2009 edition of Banking and Capital Markets

Insight, which focuses on technical issues currently coming out of

the banking, capital markets, securities and fund management

arenas. Our particular focus for this edition is on the changing

supervisory oversight, at a domestic and a Europe wide level, the

quality of capital held by banks and investment firms, and the

revised client money and asset requirements.

Our four pieces cover the following areas:

Mike Williams on the FSA's Financial Risk

Outlook 2009 and its likely impact on firms' capital adequacy,

liquidity, strategic and risk management procedures.

Clifford Smout on the regulators' likely

different approaches to the maintenance of additional capital to

provide better levels of credit reserving throughout the cycle, and

whether their tools should be focused on taking a macro economic or

firm level view.

Eric Wooding on the likely development of the

Basel Committee's thinking on international regulatory

principles, including the need for cross-border co-operation, the

effective implementation of standards, and appropriate focus on

systemic risk issues.

John Hammersley on the changes brought about

by the FSA's Policy Statement 08/10 on the client money and

assets requirements which are implemented on 1 January and 1 May

2009, which apply a more principles based approach, and which

provide greater harmonisation between the provisions applied to

MiFID and non-MiFID firms.

We look forward to your comments on the current edition.

Mike Williams

Editor

FSA points the way with financial risk

outlook

Anyone looking for a clear statement of the FSA's intentions

in terms of the future application of their prudential rules to all

categories of investment firms, banks and insurers need look no

further than the recently published Financial Risk Outlook

("FRO") 2009, which is available from the FSA

website.

The publication provides an excellent overview of the macro

economic issues which have led to the current downturn and the

related drivers for their regulation of financial firms. My own

thoughts on the likely impact of the current trend of regulation,

based on some of the issues raised in the document, are as

follows:

Capital adequacy: the trend of capital requirements for smaller

as well as more significant firms is already starting to be edged

upwards by the FSA, using firms' updated ICAAPs and the

Individual Capital Guidance derived from their own Supervisory

Review and Evaluation Process, performed as part of the current

round of ARROW or ARROW light visits. Firms will need to define in

a more quantitative manner their expectations of required capital,

based on their risk appetite, as a core part of the ICAAP process,

and the FSA will start to penalise firms, which cannot articulate

their risk management of new business clearly, with potentially

higher regulatory capital requirements. Higher charges to cover the

perceived deficiencies in the existing market risk charges and the

requirement for counter-cyclical reserving policies are likely to

be a given in the near term, and firms can also expect more

challenge when applying for Value at Risk or stand alone model

permissions.

Liquidity: the proposed liquidity requirements, which come into

force in October 2009, require all full scope firms to build

quantitative and qualitative systems and controls, to measure,

monitor and stress test their cash flow requirements over an

appropriate set of time horizons in respect of both their on and

off-balance sheet business.

In a similar way to the ICAAP, under the Individual Liquidity

Adequacy Assessment ("ILAA") process, firms will need to

stress test their liquidity against their liquidity risk tolerance

and to analyse the separate impact of possible future liquidity

stresses against cash flows, their liquidity position, their

profitability and their solvency, over the short and long term,

based on their own specific and market wide liquidity stress

scenarios. Monitoring, which should be demonstrably overseen by

senior management, will need to include intra-day management of

liquidity and liquidity across the firm's other group members,

where appropriate, and firms will need to demonstrate a diversified

liquidity strategy, with no undue reliance on one type of liquidity

funding or particular counterparties. Higher buffers of highly

liquid, high quality assets are likely to be required. These

changes taken together represent a major undertaking for the

majority of firms. For some firms, which have previously passed

liquidity back and forward to overseas group entities on a daily

basis, will, in the absence of an appropriate waiver, have to

fundamentally review their approach to maintaining local European

and UK based liquidity. The difficulty for the regulators will be

applying the regime in an even handed way when overseas branches

and other foreign institutions may well achieve waivers from the

proposed regime and so potentially have a competitive advantage as

a result.

Institutional coverage: European leaders at the recent summit

in Berlin have emphasised their intention to fully regulate all

types of institutions, including hedge funds and rating agencies.

The FRO flags the FSA's intention to regulate firms on a

substance over form basis, that is, based on the complexity of on

and off balance sheet structures which they create, in an effort to

rein in the so-called shadow banking system. The FSA is likely to

be more intrusive into all types of business which firms undertake

in aggregate, including those which currently do not require

prudential regulation, and they have signposted that this is likely

to have a significant effect on current bank and investment banking

practices. As the FRO notes, the FSA will need to more involved in

the identification of macroeconomic trends and risks, and will

require increased dialogue with other regulators. This initiative

will also have a far reaching effect on both the FSA's resource

requirements, if they are to pursue these wider objectives, and the

quality of detailed oversight required.

There will, however, also be a potentially significant effect on

the prevailing climate for firms wanting to undertake innovative

business in London or the other onshore European locations, and

there is clearly a risk that financial creativity could be stifled

or driven to offshore locations, which would not meet the

regulators' intentions.

The Icelandic banking crisis and its lessons are analysed in

the FRO. The FSA proposes that either passporting rights for retail

business should be restricted so that fully capitalised

subsidiaries have to be created in local jurisdictions, or better

European wide processes will need to be put in place to assess the

effectiveness of home state regulation for passported business,

with supporting cross-European deposit insurance arrangements in

place. Host states could also be given more power to insist on the

strengthening of home state regulation, for example, over

contingency planning. Better international regulatory co-operation

and reporting is a key theme in a number of regulators'

thinking at the moment, but its effectiveness will rely on whether

individual countries can maintain focus on the wider economic and

regulatory good, rather than a return to the style of incremental

local regulation which we saw under the Investment Services

Directive, which could easily lead in turn to more trade

protectionism.

The importance of strong risk management at a fundamental

level, rather than pure reliance on quantitative models, for

example, for market risk management of OTC products or for setting

probabilities of default for credit risk management purposes, is

emphasised in the FRO. There is a real concern that, as firms are

likely to shed staff in the face of the tougher market conditions,

risk management functions for financial, conduct of business,

operational and fraud and financial crime purposes are likely to be

depleted. Firms are more likely to experience some of these areas

of risk, such as fraud and financial crime, as the downturn

continues, so maintenance of their resources across all areas of

risk management is essential. This also extends to firms

controlling their risks of mis-selling or...