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The Risk Regulatory landscape for 2022 and beyond: What are the latest developments?

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Many of the issues that led to the economic fall-out during the great financial crisis (GFC) of 2007 and 2008 have been addressed via a plethora of regulations and standards. These include prudential standards such as securitisation regulation, Basel 2.5 market and liquidity risk standards, leverage ratio, margin requirements, better quality and higher capital requirements, additional capital buffers and recovery and resolution. Elsewhere, the change in the calculation of benchmark interest rates (transition from IBOR to risk-free rates), as well as the Market Abuse Regulation[1], Senior Managers Regime[2] and MiFID[3] in Europe and similar rules in other jurisdictions have had a significant impact on how market activities are managed, traded and disclosed, as well as how products are marketed.

Yet, in terms of prudential regulatory reforms, we are still implementing the final parts of the Basel III reforms. These changes include another full review of the market risk rules, updated credit, operational and CVA risk frameworks, as well as implementation of a standardised approach floor to modelled capital requirements. Implementing these reforms will take a few more years, with the EU and UK planning a go-live date in the beginning of 2025. Effectively, addressing the regulatory weaknesses identified after the GFC will be completed over twenty years after the crisis.

At the same time, supervisors are increasingly concerned about emerging risks, such as ESG risks, cryptocurrencies, cyber and operational resiliency. For example the emergence of sustainability targets at the back of the Paris Agreement have resulted in significant need for green investment, estimated at $3 – 5 trillion + a year to achieve the net zero ambitions[4]. ESG poses several dilemmas to the financial services industry, such as potential greenwashing, slow development of data standards and the economic transition. In many jurisdictions, banks are now subject to environmental stress tests, with potential for Pillar 2 capital add-ons to address bank specific vulnerabilities. Furthermore, In Europe the EBA is consulting on how to incorporate environmental risks via a forward-looking perspective into the Pillar 1 framework.

For example the emergence of sustainability targets at the back of the Paris Agreement have resulted in significant need for green investment, estimated at $3 – 5 trillion + a year to achieve the net zero ambitions.

Additionally, the BCBS is developing Pillar 1 minimum capital standards for cryptocurrencies. In the US, the SEC is scrutinising even safe custody of crypto assets. It may be made economically unviable for regulated banks[5] if custodied assets have to be included on balance sheet.

New regulatory issues are emerging also at the wake of the global pandemic and the war in Ukraine. Firstly, it became evident that the bank prudential capital buffers were not released in support of the economy to the degree anticipated by authorities. A combination of complexities in the buffer structure and the solvency and leverage based thresholds resulted in banks largely maintaining their capital ratios. Furthermore, it was not clear how quickly the buffers would need to be rebuilt, making banks hesitant to expand their balance sheets.

The buffer usability is currently being debated at the BCBS, with some authorities suggesting a single CET1 capital buffer based on stress test outcomes to replace all other buffers that sit on top of the minimum capital requirements. Sam Woods from the Bank of England for example suggested[6] that the system-wide capital levels should be based on regulatory risk appetite and allocation of that capital to individual institutions should be set via more robust stress testing. It can be expected that a review of capital buffers will occur in the next few years and that the focus of risk modelling will divert from risk-weights towards stress testing.

Secondly, the FSB identified[7] that there were vulnerabilities in the non-bank financial intermediation (NBFI) that can cause systemic instability. The FSB and IOSCO launched a wide-ranging programme to identify vulnerabilities and potential policy options to improve private sector resilience during stress events. These issues include resiliency of money market and other funds, core bond market structure and corporate bond market liquidity, as well as procyclicality of margin requirements.

The FSB report also highlights that regulation was curtailing dealer banks’ ability to intermediate when investors and corporates ‘dashed for cash’ before fiscal and monetary measures were put in place. Adjustments were made to the prudential framework to provide banks with more headroom. In many jurisdictions, central bank deposits and government bonds were exempted from the Leverage Ratio, relief provided from market risk backtesting multiplier and exposures to central bank liquidity facilities excluded from counterparty credit risk to ensure dealer banks continued intermediating during the demand peak. It remains to be seen if the FSB puts any policy options on the table to address dealer capacity issues.

To conclude, prudential policy-making is not about to end once the Basel III standards are implemented. However, it will become a more complex web of macro- and micro-prudential considerations that supervisors will assess and apply to bank prudential requirements.

References:

[1] MAR aims to increase market integrity through the prohibition of insider dealing, unlawful disclosure of insider information and market manipulation.

[2]FCA senior managers regime: https://www.fca.org.uk/publication/corporate/applying-smr-to-fca.pdf

[3]MiFID: https://ec.europa.eu/info/business-economy-euro/banking-and-finance/financial-markets/securities-markets/investment-services-and-regulated-markets-markets-financial-instruments-directive-mifid_en

[4]GFMA and BCG Report: https://www.afme.eu/News/Press-Releases/Details/GFMA-and-BCG-report-says-pace-of-adoption-and-growth-of-emissions-trading-schemes-is-not-sufficient-to-limit-global-warming-to-15C 

[5[SIFMA and BPI letter to the SEC on SAB121: https://www.sifma.org/wp-content/uploads/2022/05/SIFMA-BPI-Letter-for-the-Record-on-SAB-121-May-2022.pdf

[6]Sam Woods’ speech: Bufferati: https://www.bankofengland.co.uk/speech/2022/april/sam-woods-speaking-at-city-week-2022-developments-in-prudential-regulation-in-the-uk

[7] FSB’s Holistic Review: https://www.fsb.org/2020/11/holistic-review-of-the-march-market-turmoil/

Jouni Aaltonen is Managing Director, Prudential Regulation Division, AFME. Hear him speak at RiskMinds Edge: Managing regulations on 3 August.

 

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