The financial services sector faces its share of headwinds in the next few years, and not least is the threat posed by regulatory reforms adopted in response to the global financial crisis. The industry is now starting to get a taste of just how stiff that wind is likely to be.

With the lingering effects of a synchronized global recession, a deleveraging of household balance sheets and the spectre of still unresolved global imbalances, there is plenty of danger and uncertainty looming for financial services firms. On top of these fundamental economic challenges, the sector may also confront more policy-related pitfalls. In the U.S. and Europe, there are state ownership arrangements to be unwound. There is a basic loss of faith in the financial system to be overcome. And there is the prospect of increased regulation to remedy some of the problems exposed by the crisis.

How industry regulation should change is already under consideration, and the answers will go right to industry firms’ bottom lines. “The global financial crisis will bring about the most significant changes to their operating framework banks have seen in decades,” predicts a recent research report from Germany-based Deutsche Bank. Between the fundamental re-regulation of the industry and other factors, the report suggests that the “growth and profitability of the banking sector are likely to decline.”

Policy-makers have good reason to demand reform. Not only have financial services firms, their shareholders and employees suffered some tremendous losses, but the pain has spilled over into the real economy.

In some cases, taxpayers have been forced to bail financial services companies out. “If there is anyone in [the financial services industry] who thinks that they can carry on as if nothing has happened, they need to think again,” said Alistair Darling, Britain’s chancellor of the exchequer, in a recent speech, noting that the crisis has wrought “a profound social and human cost.”

Realizing the sort of downside risk that can flow from a financial crisis, policy-makers and regulators are now compelled to tighten the reins. In mid-June, the U.S. government unveiled plans to overhaul industry regulation — an effort that is heavy in new content and increased oversight but which doesn’t try to streamline the U.S. regulatory framework as some had hoped. (The proposals don’t contemplate moving to a British-style super-regulator or the Australian “twin peaks” model.)

Several days later, the European Union Council agreed to create a new body to oversee systemic risk, and new supervisory authorities to strengthen cross-border oversight. The EUC also pledged to continue work on new regulation for alternative investment managers, credit-rating agencies, derivatives markets, capital requirements and industry pay practices. Britain’s Darling has promised a plan within weeks.

In Canada, the federal budget included proposed legislative changes to give the government more power to resolve a major financial industry failure, or prevent it, by taking a stake in a troubled firm. Securities regulators have proposed a new oversight regime for rating agencies, and have refreshed suitability guidance.

Ottawa is also continuing to push for a single securities regulator — an idea that was around long before the financial crisis took hold but whose adoption would at least give Canada a national voice at a time when regulation is increasingly a global undertaking.

And with the passage of the federal budget bill, Ottawa has the authority and resources to establish the transition office that would be charged with working toward implementation of a single regulator.

On June 22, federal Finance Minister Jim Flaherty named Doug Hyndman, chairman of the B.C. Securities Commission, to lead the transition office as chairman and CEO.

Hyndman will be joined by Bryan Davies, current chairman of the Canada Deposit Insurance Corp., as vice chairman. Before joining CDIC, Davies, was CEO and superintendent of the Financial Services Commission of Ontario from 2002 to 2005. Prior to that, he was senior vice president of regulatory affairs at the Royal Bank of Canada. The transition office is charged with crafting a plan for a single regulator, including the development of a new federal Securities Act with a year. It will begin operations on July 13.

Plans for a single regulator, and skepticism about their execution, have almost become permanent features of the Canadian securities industry. With the funding and apparent commitment from Ottawa this time around, there has been an unusually high degree of optimism about this latest effort.

@page_break@Whether a single regulator happens or not is unlikely to have a huge impact on the industry’s profit prospects. More important from that perspective is likely to be reforms that bring tougher regulation to areas of the markets previously scrutinized lightly (such as derivatives and structured products) and other efforts that will simply make business more costly (raising capital requirements or limiting economies of scale, for example).

As policy-makers dissect all the various parts of the financial system that failed, they have discovered that transparency was lacking, global banks weren’t being required to hold enough capital against the actual risks they were taking, they had too much leverage and the importance of liquidity was being overlooked.

In response, there have been calls for greater standardization of over-the-counter products. As well, there have been proposals for capital requirements that are higher and better capture the market risk firms are taking.

All of these issues are addressed in the proposals recently released by the U.S. government, which hopes to see them adopted internationally. In addition to purely domestic reforms, such as giving the U.S. Federal Reserve Board authority over systemically important financial services firms, setting up a new council of regulators to oversee systemic risk and establishing a new consumer protection agency, the U.S. proposals call for international co-ordination to boost capital requirements, increase standardization and oversight in OTC derivatives markets, enhance liquidity risk management and intensify supervision of systemically important firms, among other things.

According to Brad Smith, banking analyst with Blackmont Capital Inc. in Toronto, these proposals could not only spell weaker profits in the U.S. financial industry but may lead to higher capital requirements here in Canada, too. In a research note, Smith indicates that if the proposals pass in their current form: “The future operating cost of manufacturing and distributing financial products in the U.S. will rise and the amount of capital required to be held to support operations will be higher than in the past.” He notes that U.S. institutions will be most directly affected by the proposals, but that its intent to seek global changes leaves “little doubt that similar capital pressures are likely to emerge amongst our domestic banks over time.”

Bank of Canada governor Mark Carney already appears to support some of Smith’s predictions. In a recent speech, Carney suggested that the capital adequacy regime must be reformed to make capital requirements more dynamic, leverage should be limited and more derivatives trading should be moved onto exchanges, among other things.

The debate over just what the new global rules will require is underway. And while it will likely be some time before changes are actually adopted, there’s no question that such changes are only going to lean against industry profitability. “Overall, this new and additional regulation will result in a renaissance of more traditional business models,” the Deutsche Bank report predicts. “Banks will be less able to achieve growth and will, hence, on average also be less profitable.”

Another open question is whether banks should be allowed to get “too big to fail,” as many of them were found to be in the latest crisis.

In the U.S., the answer appears to be yes, as many of the reform proposals are geared toward creating a new oversight structure for large, systemically important firms. As a result, New York-based research firm CreditSights Inc. believes that “big banks still have a strong mandate under the Obama proposal.”

The answer is not so clear elsewhere, however. Mervyn King, governor of the Bank of England, recently mused that it doesn’t make sense to allow large banks to combine both basic commercial banking business and risky investment banking, with an implicit guarantee against failure. “Privately owned and managed institutions that are too big to fail sit oddly with a market economy,” he said, suggesting that the existence of such firms may require regulators to consider steps such as limiting deposit guarantees, imposing higher capital requirements on such firms and establishing a procedure to wind down this sort of firm in an orderly manner if it fails.

As policy-makers continue to search for answers, the financial services industry is only hoping that they don’t go too far in the other direction, completely stifling growth.

This risk is spelled out in a recent working paper by Joshua Aizenman, an economics professor at the University of California, Santa Cruz, that argues that the paradox regulators face is that a prolonged period without a crisis can breed complacency, which reduces the demand for regulation, ultimately leading to a costly crisis, which can then invite excessive regulation.

To avoid these excesses, Aizenman recommends several things, including increasing regulators’ independence from politics, centralizing regulation to reduce the opportunities for arbitrage, increasing regulators’ transparency and accountability, and adopting global standards to limit regulators’ freedom to be swayed by local conditions.

So far, the reform efforts may be embracing global rules but not increased centralization or political independence. That doesn’t bode well for an industry that already faces big economic hurdles. IE