As investors start 2011, they will have more insight into the regulatory reforms that financial services institutions are facing. But plenty of questions remain.
Over the past year, regulators and policy-makers have hammered out some concrete changes to the regulatory regime facing large global banks, including imposing higher capital requirements and introducing liquidity minimums and leverage limits.
These changes are aimed at improving financial stability and offering protection against a replay of the recent global financial crisis. The changes also are designed to deal with risks in the system better by altering the capital treatment of trading exposures, securitizations and off-balance-sheet vehicles.
The Bank of Canada lauds the changes. The December 2010 issue of its Financial System Review<\/i> says that the regulatory changes will \u201craise the quality, consistency and transparency of the capital base\u201d and generate overall macroeconomic benefits by reducing the frequency and severity of financial crises, leading to smoother economic cycles and less risk of resource misallocation.
As with most regulation regimes, these benefits come at a price. Specifically, the reforms will require an increase in the amount of common equity that banks must hold \u2014 and the changes will impose constraints on banks\u2019 operations that will increase their cost of capital. In turn, the banks may try to recoup these higher costs by widening their lending spreads.
In addition, the competitive position of Canadian banks internationally is expected to deteriorate somewhat. Says a research note by New York-based CreditSights Inc.: <\/b> \u201cOur view is that Canadian banks should be sufficiently capitalized following these new rules, but their excess capital position vs U.S. and global peers is likely to shrink.\u201d
Beefed-up capital requirements<\/b>
Despite these negative effects, the final agreement on the revised capital rules \u2014 and the time frame for implementation \u2014 is an improvement over the situation of a year ago. Now, the banks have a better idea of the beefed-up capital requirements they will face. And as these reforms aren\u2019t scheduled to take full effect until 2019, bank officials know they\u2019ll probably have plenty of time to generate additional capital through earnings.
In the meantime, the banks can start deploying some of their existing excess capital \u2014 either by investing it in growth or by returning it to shareholders via increased dividends. A couple of Canada\u2019s big banks did just that in late December, when they announced sizable U.S. acquisitions. (See page B7.)
The fact that the banks are once again comfortable enough to resume their growth plans suggests that investors can also now focus more on evaluating bank strategies and less on how the banks\u2019 capital structures may be affected by prospective rule changes.@page_break@That said, the regulatory issues facing the financial services sector are far from resolved. Although the size and timing of changes to the basic capital requirements have been finalized, other elements of the regulatory response to the crisis have not.
For example, there are still discussions underway about adopting additional countercyclical capital buffers, whereby banks would be required to accumulate additional capital in times of strong growth to cushion the lean years.
\u201cSystemically important\u201d firms<\/b>
Other mechanisms for ensuring the solvency of the financial system being bandied about include the possible introduction of contingent capital instruments (debt that would convert to equity under certain circumstances) and the possibility that institutions could be deemed \u201csystemically important,\u201d and thus subject to further constraints to ensure they would not fail.
The prospect of additional capital requirements, regardless of the reason for them, would be negative for the affected firms.
However, until these issues are finalized, they simply represent residual regulatory uncertainty for the banks themselves and an ongoing risk for investors to keep in mind.
In addition to the changes to the global capital rules, the U.S. banking industry is facing a variety of other fundamental reforms \u2014 including efforts to ramp up consumer protection \u2014 which are expected to weigh on bank profits in the years ahead.
Several Canadian banks already have sizable U.S. operations and have targeted the U.S. market for future growth, given the prevailing constraints on growth in the domestic business, so they also will be affected by these ongoing reforms.
Meanwhile, Canadian securities regulators have begun consultations on initiatives to increase oversight of the over-the-counter derivatives market and the credit-rating business. These areas were singled out for reform in the wake of the financial crisis.
In addition, life insurers face the prospect of changes to their capital adequacy regime. Federal regulators recently revised the capital rules for segregated fund guarantee exposures in an effort to capture the market risks that have emerged in these products.
The revised guideline applies to new seg fund business starting in 2011, but the Office of the Superintendent of Financial Institutions has indicated that it is reviewing its approach to seg fund exposures generally \u2014 an exercise that may yet lead to broader changes to the capital treatment of these investment vehicles.
OSFI indicates that this work is likely to take a couple of years to complete, probably stretching into 2013. \tIE<\/b><\/p>\n","protected":false},"excerpt":{"rendered":"
Reforms, such as raising capital requirements and imposing liquidity minimums, are intended to prevent a repeat of the recent global financial crisis<\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[3013,3018],"tags":[2361,3212],"yst_prominent_words":[],"acf":[],"_links":{"self":[{"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/posts\/316996"}],"collection":[{"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/users\/4"}],"replies":[{"embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/comments?post=316996"}],"version-history":[{"count":1,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/posts\/316996\/revisions"}],"predecessor-version":[{"id":363279,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/posts\/316996\/revisions\/363279"}],"wp:attachment":[{"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/media?parent=316996"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/categories?post=316996"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/tags?post=316996"},{"taxonomy":"yst_prominent_words","embeddable":true,"href":"https:\/\/www.investmentexecutive.com\/wp-json\/wp\/v2\/yst_prominent_words?post=316996"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}