New and sweeping financial regulations, some of which challenge the basic foundation of market operations, are being announced at pace never seen before. Viewing their development and regulators’ motives through the recent history of market risk and the shortcomings of risk management provide unique insight for anyone involved with risk, compliance and regulations.
Bradley Ziff, Senior Risk Advisor for Misys, has been involved in the risk industry since the 1980s as Chief Executive of the International Swaps and Derivatives Association and a globally recognised risk management consultant. He reflects on the origins of the crisis: “For a number of years before the 2008 global financial crisis, banks and certain investors saw opportunities that could be maximised by using enhanced leverage to meet an expanded risk appetite.”
Then he pointed out, “At the same time, other market participants, including some second tier banks, took risks alongside the larger participants without the same risk management competency and culture. Combined with flexible credit limits and you had fuel for growing risk.”
Soon, the herd mentality took over. “On some trades or investments you had some of the largest financial institutions with similar positions going in the same direction. At the same time, some smaller firms were replicating the same positions as larger market players.”
Ziff describes how a wave of improperly managed and regulated risk spread across institutions. “Considerable demand from smaller and second tier participants increased and magnified risk taking across the industry as they were unable to truly diversify or properly hedge risk. A lot of them wanted to copy those positions and strategies, but didn’t possess the skill set to manage the risk.”
The rise of distributed computing and advanced systems also lowered the barriers to entry for taking risk. “Ironically, technology sometimes served as an enabler of taking more risk making market participants more confident in the way they were managing and controlling their strategies.”
What is motivating US and UK regulators?
Ziff elaborates the key elements behind today’s ongoing regulatory campaign. “Regulators are closely monitoring six risk areas:
1. Risk capital must be high enough such that if regulated financial institutions and their risk management systems fail to perform they must retain sufficient capital to ensure survival. “Regulators are still trying to garner enough faith in banks’ risk management methodologies. Regulators want a bank to survive a systemic risk event without punishing the shareholders. As a result, regulators are adding to the minimum capital floors for the market in an upcoming release. Safety margins are enforced by pricing risk capital. Quality of capital will be enforced through the pricing of risk weighted assets that begin with tier one quality.
2. OTC derivatives were seen by many as a major contributing cause of the global financial crisis. Regulators are working diligently to shift derivatives trading from the interbank market to exchanges. And even exchanges are being asked by bank counterparties to ‘have skin in the game’. So in the event of a counterparty default an exchange needs capital to ensure the integrity of the clearing process. Thus, more capital is required in all phases of risk taking.
3. Compliance has become one of the most demanding resource activities on market participants. For example, FATCA has far reaching consequences for any bank globally dealing with US clients.
4. Proprietary trading is in the process of being shut down under major US and UK requirements at banks. Some proprietary traders have left to work at major investment entities including private equity, hedge funds and asset management firms. But, most importantly the end of bank proprietary trading has made a profound impact on the profile of risk capital at those banks.
5. Remaining risk takers and engines at banks must use advanced methodologies that reflect market and credit risk methodologies. From a transparency perspective, regulators are looking to see intraday risk exposure.
6. After 2012, US and UK regulators especially ramped up fines and enforcement action. Regulators wanted to send the message that the mortgage crisis, the Libor and FX rate fixing schemes could not be replicated and if they were, would be accompanied by even larger penalties. Hence, fines and penalties have become their own type of risk category for financial institutions.”
Ziff elaborates how the role of risk taking has rapidly evolved. “Some key aspects of risk are being shifted to the buy side, that is, asset managers, sovereign and pension funds, infrastructure, hedge and credit funds.”
Unintended regulatory outcomes in Asia
The outcome of these regulations has ushered a new age of financial entrepreneurs. “Innovators such as Alipay are adapting and exploiting the phenomena that regulated financial institutions are no longer the focal point of the financial world. Due to some regulatory initiatives, hybrid entities, hedge funds and other buy side entities have begun to undertake roles and responsibilities formally dominated by banks, including financing, lending and other activities.”
Since the crisis receded into history, Ziff said, “There is a large segment of investors in Asia who are looking to place their capital outside of Asia, and seeking expert management.”
Asia-Pacific regulators are guided by domestic priorities as well as US and UK demands. “The primary goal of ASEAN countries is to achieve growth. Asian and Latin American governments realise that US and UK authorities have been required to handle a full set of regulatory requirements, which have dampened risk. Asian regulators are looking to establish a better balance if possible, since their banks are not exclusively focused on economic growth, but also social issues including reducing poverty, increased housing, education and infrastructure.”
Asian banks are meeting regulations relative to their own risk profiles. “In emerging markets many banks are proposing to meet Basel III by using the standardised approach and not advanced guidelines because their major businesses do not have the same risks as their global peers. These banks tend to have as much as 90% of their businesses engaged in traditional commercial and retail banking activities.”
“In Asia, regulatory approaches are quite comprehensive, but the issue is always enhanced governance. Most Asian banks are working on gaining a better understanding of risk appetites, outcomes and consequences. Most of them have a reduced global role especially in capital markets. As a consequence they are less likely to be ensnared in challenges by overseas regulators.”