New rules, new opportunities

Risk and regulation

Sell-side firms have been operating under stricter regulatory requirements since the financial crisis – creating challenges but also paving the way to new opportunities.

Risk now has a higher profile within financial institutions, and there are more tools and technology to deal with it. Whereas previously a single metric – risk-weighted ratio – was all that was needed, firms today need to consider numerous metrics around leverage, liquidity standards, exposure limits, and more.

Ever-increasing reporting requirements have necessitated more technical infrastructure. Compliance costs are now higher, but for companies operating in multiple jurisdictions worldwide, the cost has surged. Financial institutions are spending an estimated $780 billion on compliance annually, estimates KPMG. Banks have paid $300 billion in fines since 2008, and there’s been a 300% increase in regulatory capital buffers since the crisis.¹

The silver lining to increased reporting requirements is the enormous pool of data it creates. Firms are looking for ways to harness and analyze that data, potentially unlocking yet unknown opportunities and business models. That’s a task that’s easier said than done. Many of the metrics are siloed, so it is hard to connect them all to get a sense of the larger firm-wide picture. Maybe in the near future, it will be possible to calculate how a capital-heavy trade will affect a leverage ratio, in real-time, but that kind of capability requires greater front-to-back-end connectivity than what is available now.

Reliance on technology

These various pressures have led to the creation of regtech – a whole new industry that is helping financial institutions stay abreast of and in compliance with all new regulations. Regtech is now one of the fastest-growing areas within financial technology. It encompasses a wide swath of technology, including data analytics, automation, cognitive computing, and cloud computing.

KPMG forecasts that regtech spending will make up 34% of all regulatory spending by 2020 and reach $76 billion by 2022, up from $10.6 billion in 2017. The industry is certainly driving innovation. The top 15 banks own a total of 4,697 fintech patents.²

The rise of fintech firms is pushing financial institutions to rethink what digitization means for risk and control functions – recasting compliance and risk management as a business that produces business value rather than merely a control function.

Despite the huge uptick in spending to comply with regulatory requirements, regtech is still in its early days. It’s easy for financial institutions to invest heavily; harder to get returns that justify the spending.

Taking a holistic view

Firms have invested heavily to improve their risk systems, data quality, the granularity of data, and upgrade technology. However, industry experts say these changes will be less effective if overall risk culture doesn't change.

After all, risk is just as much about people’s behaviors as it is about understanding the quantitative and modeling side. The last financial crisis stemmed in part from an over-reliance on models and tools. Amid efforts to prevent another crisis from happening, regulators and financial institutions have gone on to develop even more models and tools.

Some industry leaders fear this may have gone too far with employees, especially junior employees, getting mired in the minutiae and losing touch with a more fundamental grasp of risk management. There is a lot of focus on the sell side on technology that can quickly pull up information, analyze it and put it into a consumable format – reducing the lag time that still exists today. But so much attention is

 

preoccupied with technology and gathering of information that it can cut into the time spent using these findings to inform decision-making.

Banks are also struggling to reconcile regulations with profitability. Post-crisis regulatory requirements were put in place to respond to shortcomings that were exposed during the financial crisis, such as unsustainable levels of leverage and lack of standards for liquidity risk. Financial institutions need to ensure that they are complying but also need to add volume to the business.

“The market has changed a lot but the job hasn’t. The environment has gotten considerably more complex,” said Phil McCabe, Bloomberg’s Global

Head of Sell-Side Products, noting that the sell side is still tasked with managing return on capital and understanding the associated risks.

Unknown challenges on the horizon

Achieving a holistic view of risk management is not getting any easier as both regulations and technology are getting more complicated every year.

Take the introduction of the Fundamental Review of the Trading Book (FRTB). This suite of capital rules developed by the Basel Committee on Banking Supervision took more than six years to develop and is meant to overhaul how financial institutions measure risk of various assets that are held short-term. FRTB is forcing financial institutions to implement new processes and risk models, with some choosing an internal model approach, while others choose standardized approach, value-at-risk models, or some combination.

Another big change with unknown risks is the shift away from LIBOR as a benchmark by 2022. This

 

transition affects many existing financial contracts, worth an estimated $360 trillion in notional outstanding value.³ Contracts with maturities that extend beyond LIBOR’s discontinuation date will need to fall back on to a replacement rate which will change their values. Financial institutions are assessing the risk of this repricing.

The impact of both FRTB and the LIBOR transition is expected to be wide-ranging, with many unknowns. Industry leaders have some concerns that the influx of new regulations will introduce new risks to the balance sheet, with unpredictable repercussions.

“We have an environment in which none of us know how to manage the interaction of all these metrics. Some of the standardized methods in particular…could create perverse incentives and contradictory incentives,” said Mark Penney, former Head of Capital Management at HSBC, adding that the industry has seen an increase in capital, as well as a reduction in the number of banks in existence.

Meanwhile, new types of uncertainty and risks are 

emerging, some of which fall outside the purview of traditional risk management. Firms now need to consider digital asset bubbles, cyber risk, as well as the increasing use of AI and machine learning in core business functions.

Technology’s growing prominence in risk management comes with both challenges and opportunity. While the technological advances can help assessment, they don’t replace human experience. The most powerful combination is risk technology with experience.

¹ & ². KPMG, There’s a Revolution Coming: Embracing the Challenge of a New RegTech Era, June 2019, p. 5.
^3. New York Federal Reserve, The Alternative Reference Rates Committee second report, March 2018, p. 1.