The View

Banks count the cost of compliance

Financial institutions don’t know how to implement new regulatory frameworks

PUBLISHED : Thursday, 03 December, 2015, 5:28pm
UPDATED : Thursday, 03 December, 2015, 5:28pm

Financial compliance managers and regulators have been struggling to fix the system for the past eight years since the global financial crisis. Yet, regulatory overreach has created permanent gridlock in all areas of banking. Compliance officers privately admit that no one knows how to implement current reforms while new ones are being piled on. The situation will have serious consequences when the next financial crisis hits.

Regulatory changes are always emerging and they are event led. So banks are constantly reacting, trying to meet compliance demands from competing jurisdictions.

The hard truth is that financial institutions are completely bewildered and confused about how to implement the new regulatory frameworks. The result is that bank managers and central bankers have become inward looking and focussed on finding the next evil money launderer and unable to focus on how to protect themselves from the next crash.

While the commonly used analogy is that regulators are like army generals fighting the last war, the reality is that they are stuck in the trenches they have dug themselves. Until regulations stabilise, bank returns and profits will remain uncertain.

The ability of banks to handle the next crisis could be crippled because of excessive regulations that have sucked crucial liquidity out of the markets

An even more troubling observation is that excessive compliance is preventing banks and regulators from preparing for the next crisis. By definition a crisis is unexpected and must be invisible to mainstream financial participants. But we can see signs in the current market. China’s recent admittance to the International Monetary Fund’s reserve currency basket could be a temptation for it to devalue the yuan.

A strong yuan may counter China’s foreign critics, who often accuse Beijing of manipulating its exchange rate to support its exports, but some believe China will be unable or unwilling to hold the line.

Intervention to stave off panic forced the People’s Bank of China to drain the mainland’s foreign exchange reserves at unprecedented rates, but the trend appeared to be halted in October, when the PBOC and commercial banks bought a net 12.9 billion yuan (HK$15.6 billion) of foreign exchange. How markets react to yuan flight after China opens its capital account will sorely test banks.

Banks and governments will have little manoeuvring room for liquidity in the next crisis after eight years of quantitative easing. Try to come to grips with this data snapshot: after four quantitative easing programmes – TARP, TGLP, HAMP, HARP, and direct bailouts of Bear Stearns, AIG, GM and bank supports totalling more than US$30 trillion the US economy only grew by US$954 billion from the beginning of 2009 to 2013.

This equates to a pathetic 7.5 per cent growth rate during a period when the market surged by more than 100 per cent. This hastily constructed fortification and bail out comprised an avalanche of cash and a complicated web of global and local regulations to prevent private banks from another similar meltdown. The “too big to fail” banks have become “too big to save” and perhaps “too big to regulate”.

What is within the power of central banks to fix and manage has already substantially diminished to the point that regulators are only worsening the situation with new rounds of demands for more compliance. The easy fix of a trillion-dollar bailout isn’t available the next time.

The ability of banks to handle the next crisis could be crippled because of excessive regulations that have sucked crucial liquidity out of the markets and slowed down the banks’ ability to respond to risks. While Dodd-Frank was probably right to end proprietary trading by banks, the sudden loss of trading liquidity will translate into more volatility in the next big downturn.

Regulation has become such a power unto itself that compliance managers are under immense pressure to transform themselves from back office processors to traders. Compliance managers may not make the best risk managers, but it appears they will be bank leaders of the future.

The next crash could very well reverberate out of the currency markets where central bankers have little control. If a central bank raises interest rates to protect its currency, those higher rates hurt domestic economic growth. Since 2009, central banks are increasingly being stranded with bad options. They include surrendering to a domestic recession to defend the currency, or allowing the currency to devalue and watching the domestic economy implode as import costs soar and capital flees the devaluing currency.

Peter Guy is a financial writer and former international banker