Having come through the global financial crisis better than most, Canada’s financial services industry is being held up as a model for the rest of the world. Although that may not be a bad idea in many respects, the one trait that already looks painfully familiar is the pace of regulatory reform, which is slow, fraught with regional dissension and looming as a major source of uncertainty.

At this time last year, the financial crisis was at its most intense — major financial institutions were crumbling, and governments around the world were forced to ride to the rescue of the global financial system, which appeared to be on the verge of utter collapse. In short order, a meeting of the 20 largest nations was convened, with the goal of co-ordinating action to prevent the global economy from sliding into a depression. Among other things, it was agreed that co-ordinated fiscal stimulus was required in addition to the massive monetary easing that had already taken place.

The G-20 met again this past spring, reaffirming commitment to fiscal stimulus while also starting to sketch out the sort of regulatory reforms that are believed to be necessary in the wake of the crisis — including higher capital requirements for banks, a counter-cyclical component to capital, leverage limits, liquidity standards and a rejigging of compensation systems to avoid some of the perverse incentives existing in the run-up to the crisis.

Although the broad outlines of these reforms were agreed upon fairly readily, the details, which will actually affect the structure and profitability of the industry, have not come quite as easily. The G-20 leaders would get their next chance to hammer out some details at their meeting scheduled for Sept. 24 to 25 in Pittsburgh (after Investment Executive goes to press).

In the run-up to that meeting however, consensus has been slow to emerge. The basic causes of the crisis, and the sort of remedies that are necessary, might be generally agreed upon; but the wide array of problems that have been revealed leave plenty of room for dissension on how to proceed at a practical level. Local priorities and political and cultural differences all weigh on efforts to agree to global solutions and how to implement them.

The same sort of considerations had dogged the efforts to deliver fiscal stimulus. Although it was one thing to agree that fiscal stimulus was needed, countries had clashed over how much was required. They had differing national budgetary constraints to consider. And the details quickly became contentious as some governments unveiled their stimulus packages and were, in some cases, swiftly accused of protectionism by others.

In terms of regulatory reforms, all the same forces pulling against a global consensus still exist, but the exercise is even more fraught with difficulty because there are many more issues to resolve, numerous complications to consider and powerful vested interests entrenched against meaningful change, all of which makes agreement much tougher to achieve.

Policy-makers in some jurisdictions are focusing on tougher capital requirements as the top priority, while others are making a bigger push for an overhaul of industry compensation practices.

The danger presented by the continued existence of firms that have been proven “too big to fail” has also given rise to various ideas for curbing that risk. The obvious answer is to break up those firms rather than allowing them to compete freely with the large, inherent advantage of a government backstop. However, that is much easier said than done — and it doesn’t appear to be receiving serious consideration.

Instead, policy-makers are looking for other ways to avoid a repeat of this crisis. For example, a recent policy paper from the Federal Reserve Bank of Cleveland argues that if firms that governments will have to bail out when they fail are going to be allowed to exist, those firms should face higher regulatory burdens in the name of economic efficiency and to level the playing field with smaller firms not likely to enjoy such protection.

The paper proposes five criteria that could be used to identify systemically important financial institutions: size, failure contagion potential, risk correlation, concentration and market conditions. It then recommends that the degree to which firms are considered systemically significant by these various measures (implying that these firms would receive government support if they ran into serious trouble), should, in turn, dictate the intensity of regulatory oversight they receive and the amount of a “regulatory taxes” they must pay to offset the advantage that comes with an implicit government guarantee.

@page_break@Whether this sort of approach wins favour with global policy-makers remains to be seen. In the meantime, in the weeks leading up to the G-20 meeting, the technocrats who are charged with hammering out the details of global regulatory reform have been holding their own meetings to try to move the ball a bit farther down the field.

In early September, the oversight body of the Basel Committee on Banking Supervision met and made some progress on the issues of revising capital requirements, limiting leverage and setting liquidity standards, but participants have said that concrete proposals won’t be ready until the end of this year — and the details aren’t likely to be finalized until the end of 2010.

Some financial services industry observers see the long time it is taking to agree on these sorts of changes, and get them implemented, as a necessity because the global financial system, despite having pulled back from the brink of collapse, is still fragile.

Moreover, the global economic recovery is tentative at best, as evidenced by the fact that central banks are keeping the world flooded with liquidity. (The Bank of Canada, for one, has promised to keep interest rates at rock-bottom levels through mid-2010). And there is
still the threat of dubious assets lurking on some balance sheets. Therefore, raising capital requirements and making other fundamental changes to banks’ regulatory requirements at this point could undermine economic recovery.

Indeed, following the Financial Stability Board’s pre-G-20 meeting in Paris in mid-September, it declared that financial markets are healing, but cautioned that they remain fragile and credit is still scarce. The FSB maintains that banks should be conserving capital to support lending and prepare for the dawn of higher capital requirements: “There is a risk that a revival of concerns about the sustainability of the recovery could trigger renewed banking-sector strains and turbulence in asset markets.”

The FSB will submit two reports to the G-20 meeting: a progress report on its efforts since the London summit this past spring, and an assessment of what it sees as the next steps for improving financial regulation. The FSB says that “good progress” has been made, but that “much work remains to be done to implement the reform agenda in full.”

That agenda includes not only the issues of capital adequacy, liquidity, leverage and systemic stability but also revising accounting standards, improving industry compensation practices, expanding oversight of the financial system, strengthening the over-the-counter derivatives market, restarting securitization markets and developing mechanisms to ensure adherence to international standards

With such a long menu of fundamental changes in progress, some fear that waiting until a global economic recovery is clearly entrenched risks allowing the momentum for essential but painful reform to be lost. Although stability is the priority, there is also some fear that the political will required to push through reforms that are sure to reduce industry profitability and curb individual compensation will wither once the crisis has been rendered a distant memory.

After all, there’s no doubt that the effect of the reforms being contemplated will be negative for the industry’s overall profitability, as they will certainly consume capital and reduce leverage — although these effects probably won’t be felt equally by all firms.

“Large banks with sizable investment activities will be the most affected by the increase in capital charges, and it is likely that their return on equity will be significantly reduced,” notes a recent report by Moody’s Investors Service Inc. , which adds that more conservative retail banks will suffer much less impact.

The corresponding benefits of these lower returns to the big banks will be lower risk, greater systemic stability and, presumably, less risk that taxpayers will be called upon to subsidize big financial services firms. The Moody’s report adds that such changes should turn out to be positive for banks’ credit ratings.

However, the whole reform enterprise remains wracked with uncertainty, in terms of both what the new regulatory regime will look like and how it will be applied in various jurisdictions. “The details of some key measures that would strengthen the banking system — including the creation of countercyclical capital buffers, better quality of capital and the introduction of a leverage ratio — are still under discussion,” the Moody’s report observes. “While specific proposals are expected to be agreed [upon] in the next few months, any implementation is still a long way off as priority is being given to banks channelling funds to ailing economies.”

Certainly, the industry doesn’t appear to be in any hurry to see serious reform. The global banking lobby group, the Institute of International Finance, was calling on the G-20 leaders to use their September meeting to reinforce their commitment to policies that support the financial system and economic recovery. The IIF says that these policies must remain in effect “until clearer signs of a rebound in underlying private demand emerge accompanied by indications of an impending turnaround in bank credit flows and job markets.”

In the meantime, the IIF suggests, leaders should be devising, and disclosing, strategies for withdrawing the monetary and fiscal stimuli and for phasing out government support for financial services firms once economic stability is assured.

The IIF is also calling on the G-20 to establish a new senior task force responsible for developing a strategy aimed at creating more sustainable patterns of global savings, investment and growth. The IIF warns that without a concerted effort to address these issues, the global financial system, and the economy, may well be headed back to “a world of global imbalances and instability.”

But not every banker fears the prospective new regulatory environment. Speaking at an investment conference in mid-September, Rick Waugh, CEO of Bank of Nova Scotia, has suggested that a new, more stringent capital adequacy regime would actually bring the rest of the world closer to the Canadian model; he adds that because Canadian banks are already positioned where the rest of the world appears to be heading, this could be viewed as a competitive advantage.

Indeed, the Canadian banks have distinguished themselves throughout the financial crisis by taking comparatively modest writedowns and by not having to take capital injections from the government. And their latest earnings announcements suggest that they all have healthy capital positions — with Tier 1 capital ratios ranging from 10.4% for Scotiabank to 12.9% for Royal Bank of Canada.

Although many of the world’s banks have been looking to build up their capital in recent months, the discussion in Canada has turned to how the banks are going to deploy it (whether they may undertake acquisitions or return some to shareholders through higher dividends or share buybacks).

However, a report by New York-based research firm CreditSights Inc. cautions that the Canadian banks may not be as overcapitalized as they appear from their Tier 1 ratios. For one thing, the report points out, our banks are on the new Basel II system, which relies on some internal risk weighting: “As a result, capital ratios are less comparable among banks, as they could be using different risk weights for the similar asset classes.” IE