04.25.2012
By Terry Flanagan

The Specter of Regulatory Risk

Capital markets are highly exposed to the risk that a change in laws and regulations will materially impact a security, business, sector or market.

“The banking industry is front and center as far as regulatory risk, and the insurance industry and pension industry is not far behind,” said Matt Toms, head of U.S. public fixed income investments at ING Investment Management.

Changes in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and change the competitive landscape.

Gordon McDermid, Director, Sapient Global Markets

“There’s an array of issues that need to be addressed be it Dodd-Frank, Solvency II in Europe or pension accounting rules that continue to change,” said Toms. “For investors, having access to a high-quality risk management group and a dialogue and an independent voice with that group is very helpful. For investment managers, it is necessary to be viewed as a world-class player in the industry today.”

Regulatory risk encompasses a cornucopia of direct costs, such as the need to reconfigure systems to satisfy new reporting requirements and the need to hire or outsource legal and compliance functions.

There are also opportunity costs associated with the need to set regulatory capital aside to satisfy upcoming Basel III bank capital adequacy requirements, which are likely to crimp a bank’s ability to put its capital to lending and other more productive uses.

Innovation, in the form of new products and services, can be stifled when regulatory uncertainty looms.

“Regulatory risk will increase that capital intensity of more complex products,” said Alberto Corvo, managing principal for financial services at outsourcing firm eClerx.

“This will lead to a move back to more bespoke, tailored products that reflect client needs,” Corvo said. “Firms will also be looking to broaden their distribution network in search of needs for these types of bespoke products.”

Decisions on whether to exit or enter new lines of business may be skewed by regulatory fiat, such as the Volcker Rule.

“Regulatory risk has a direct and significant impact on productivity in capital markets,” said Gordon McDermid, director at service provider Sapient Global Markets. “Implementing regulatory requirements without impacting earnings will be challenging, especially with Basel III.”

Changes in the regulatory environment over the next few years are going to significantly impact almost all aspects of post-trade operations and operational risk management.

Post-Trade Processes

“The uncertainty is having a major impact on firms that have not traditionally been under regulatory oversight,” said Jeffrey Wallis, managing partner of SunGard Global Consulting Services. “A great deal of work is required to interpret the impact of the regulatory agenda and its impact on their business, technology and operations.”

This is particularly the case for swap dealers and major swap participants defined under Dodd-Frank’s Title VII and corresponding European Market Infrastructure Regulation (Emir) directives.

“Post-trade is an area that many hedge fund managers haven’t had to worry about in the past as they’ve been able to get by on spreadsheets or by leveraging their prime brokers’ tools,” said Matthew Nelson, executive director of strategy at post-trade provider Omgeo.

“As hedge funds continue to expand into new asset classes and markets in addition to bringing on multiple prime brokers, the business has simply become too complex to manage with a spreadsheet.

“They recognize this is a source of both cost and risk and are looking to automate as much as possible.”

According to a survey conducted by Omgeo, 92% of firms will make operational changes in the next year to 18 months, with new regulations as the primary driver.

More than a third of firms will be focused on improving reporting and transparency (35%), while the execution and clearing of formerly bilateral OTC derivatives, collateral and margin management, and overall trade processing were both cited by 13.5% of respondents.

A majority of respondents (56%) said regulations were the primary driver of operational changes, followed by internal goals to reduce costs and inefficiencies (17%) and reducing counterparty risk (17%).

“The cost of clearing and expense associated with additional regulations in certain highly regulated asset classes will increase, which might negatively impact profitability,” said Tony Scianna, deputy head of strategy at SunGard’s capital markets business.

Collateral Squeeze

Signs point to a potential collateral squeeze, as collateral demands are predicted to increase as a result of initial margin requirements for CCPs, new margin rules for uncleared trades and the Basel III liquidity coverage ratios.

“A large part of new regulatory obligations are going to focus on collateral regimes, which will have far reaching knock-on impacts on liquidity,” said McDermid of Sapient Global Markets.

A survey of managers and C-suite risk management professionals from major capital markets firms conducted by software provider Sybase pinpoints concerns relating to Basel III and its impact on the profitability of banks.

A combined 90% of North American and 90% of Asia-Pacific respondents believe Basel III regulations will have “moderate impact” to “significant impact” on profitability. Ninety-six per cent of Europe, the Middle East and Africa respondents agree.

“There is now a confluence of regulatory and business reasons for capital markets firms to upgrade their risk architecture,” said Neil McGovern, senior director of financial services marketing at Sybase.

“In response to regulatory demands, firms need to understand their exposure to counterparties, across asset classes, trading desks and geographies,” said McGovern. “From a Sybase SAP perspective, this manifests itself in investments in technology to aggregate data from multiple systems and analyze it in real time.”

Real-time risk management strategies are key to ensuring effective regulatory compliance, including the proposed capital adequacy requirements in Basel III.

Noted eClerx’s Corvo: “Firms are focusing on improving the efficiency of their capital usage reviewing their risk models and trying to get more transparency on businesses that are capital intensive.”

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