Although the storm itself may be a couple of years off, banking executives can already see clouds forming over their banks’ future earnings performance. They are concerned that proposed regulatory reforms threaten to crimp the global financial services sector’s profitability. Unfortunately, there’s more uncertainty than clarity about what will be put into place.

Policy-makers reiterated their commitment to reforms designed to shore up the global financial system at the G20 summit in Pittsburgh this past September. These include major changes to capital requirements and financial services industry compensation practices, as well as drawing up plans to deal with the failure of systemically significant financial services institutions.

Perhaps the most important of these various efforts is the drive to revise the capital adequacy rules for large, global banks. The basic goals of policy-makers in this area include increasing the quality and quantity of capital that banks must hold. Policy-makers want to push banks to prepare themselves for bad times by building up their capital positions when profits are high, and are also seeking to make the system safer by limiting banks’ leverage and ensuring they have sufficient liquidity.

The umbrella group for the world’s banking regulators, the Basel Committee on Banking Supervision, has already taken some steps toward these goals, including: changes to the risk weighting given to certain trading-book exposures; amendments to the BCBS’s supervisory standards, which are designed to improve banks’ governance and risk management; and more demanding disclosure requirements. But the BCBS is far from done with its reform plans. In mid-December, it released a draft of proposed amendments to the capital rules.

In particular, the proposals call for a series of changes designed to improve the quality, consistency and transparency of banks’ capital positions. The BCBS is proposing to strengthen capital requirements for counterparty credit-risk exposure due to derivatives, repurchase agreements and securities-financing activities. Furthermore, the BCBS is recommending the introduction of a leverage ratio to help contain the buildup of excessive leverage in the banking system.

The proposals also call for a series of measures designed to create a more countercyclical capital regime. Additionally, there are plans to introduce a global minimum liquidity standard that includes a 30-day liquidity coverage ratio requirement along with a longer-term structural liquidity ratio.

There’s no question that these measures, if adopted, will have a significant impact on banks’ balance sheets and profitability. However, these changes are not likely to be implemented for a couple of years, and the proposals don’t set out specific numbers for some of these important measures. As a result, their ultimate effect on banks’ bottom lines is still somewhat uncertain.

For example, the proposals don’t explicitly institute new minimum capital levels, nor do they establish a maximum leverage ratio. The expectation is that the particulars will be decided this year, as the details of the new capital adequacy regime are thrashed out. The BCBS expects to finalize those points by the end of 2010 and to start implementing the new model in 2012.

For now, though, the lack of specificity in the proposals — coupled with their wide-ranging scope — is generating a great deal of uncertainty about the probable impact. A report issued by New York-based research firm CreditSights Inc. calls the BCBS’s proposal “short on detail … but long on change.”

Adds the report: “In combination, the measures regarding the capital base, counterparty credit risk, the leverage ratio and pro-cyclicality look as though they could mean significant increases to banks’ capital requirements.”

The report also notes that other possible changes will not be discussed until the BCBS’s meeting next July.

In the latest issue of the Finan-cial Stability Report, the Bank of Canada says that the “lack of clarity regarding authorities’ intentions for new capital and liquidity standards could create uncertainty during the transition period, delaying the easing in credit conditions and slowing the pace of the economic recovery.”

The BofC also warns that the tougher liquidity standards can be expected to increase funding costs, thereby boosting risk in both funding and liquidity.

In the meantime, the uncertainty over just which changes will be adopted — and what the regulators’ precise demands will be — is expected to weigh on banks and keep them from deploying their capital aggressively.

Even the Canadian banks, which are acknowledged as being well capitalized relative to their global peers, can’t afford to be bold amid the uncertainty of these pending regulatory changes.

@page_break@As a recent research report from UBS Securities Canada Inc. observes: “We think that Canadian banks have strong Tier 1 capital [ratios] and should be able to comply with even the most onerous conditions, especially given the long timelines for compliance in 2012 and significant organic capital generation. However, excess capital could be constrained more than projected.”

Other changes are also being considered. The BofC points out that insurance companies will encounter regulatory changes — particularly in terms of accounting rule changes, which, it says, “could increase the volatility of earnings and capital at [the] companies.”

Canadian financial services firms doing business in the U.S. face the prospect of sweeping regulatory reforms also taking place there in the coming year. The U.S. House of Representatives passed an industry reform bill late last year that calls for the rejigging of the regulatory structure in the U.S., including, among other things: the creation of a new council of regulators to oversee systemic stability; the founding of a consumer protection agency for financial services; hedge fund registration; and greater standardization and exchange trading of over-the-counter derivatives.

The bill still has to go to the U.S. Senate, which will pass its own version of regulatory reforms. The two bills must then be reconciled, and forwarded to U.S. President Barack Obama for ratification.

Despite the work still to be done, the CreditSights report projects that such reforms are likely to be passed in the first half of 2010. And as with the projected changes to global capital rules, the expectation is that the U.S. reforms will hamper bank profitability.

Given the relative strength of the Canadian banks, policy-makers here haven’t been pushed to make major reforms. They have secured the power to deal with the failure of a major financial services institution, moved to beef up oversight and supervision, and are giving greater emphasis to overall systemic stability.

However, Canadian policy-makers haven’t done anything that should significantly affect the bottom line for financial services institutions; rather, those impacts are likely to come from abroad. IE