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R EGULATORY T RENDS AND M ANAGING P ROFITABILITY IN F INANCIAL I NSTITUTIONS FINANCIAL RISK INSTITUTE CONFERENCE

MODERATOR FRANK MORISANO FEDERAL RESERVE BANK – PHILADELPHIA, PA

SEPTEMBER 19, 2014

SESSION TOPIC Today’s session addresses the implications of regulatory reforms on financial institution profitability.

We begin by addressing the significant relationship that corporate governance, liquidity risk, credit risk, and capital requirements have on revenue as well as the operating costs of complying with global regulations.

Then discuss how regulation is forcing financial institutions to redesign and rethink business models, deploy capital more efficiently, capture growth in emerging markets, and consider changes to compensation.

Gearing for the Future in Risk Management

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SESSION PANELLISTS  Annetta Cortez, Managing Director, ACT Consulting • Founder of ACT Consulting and author of both Winning at Risk: ‘Strategies to Go Beyond Basel’ and ‘The Complete Idiot's Guide to Risk Management’  Jeff Curry, Director, Deloitte Enterprise Risk Services • Director in the governance, regulatory and risk practice  Marti Tirinnanzi, President and CEO of Financial Standards, Inc. • Futures Magazine named her as one of the Top 25 most influential people in promoting transparency and central clearing of derivatives contracts  Frank Morisano, Managing Director, Ma lee Advisory Limited • Published author and experienced lecturer addressing: stress testing, liquidity management, prudent risk taking and independent Board assessment Gearing for the Future in Risk Management

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ANNETTA CORTEZ

Profitability and Compliance: A Losing Proposition?

Gearing for the Future in Risk Management

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The reality has long surpassed the intent •

Basel II and Solvency II were established to better align regulatory practices with risk-based measures prevalent in the industry – allowing financial institutions to use their own models

•

In recent years, the industry has experienced increasing levels of capital associated with “add-ons”, caps, floors and restrictions

•

There is now little or no incentive to move to more advanced approaches

•

Recent discussions in Basel have described plans for additional measures and an interest in creating considerably higher floors Regulatory Capital vs Economic Capital Over Time 4 3 2

1 0

Pre 1995 Economic Capital

Waterloo Associates

1997 Regulatory Capital

2006

2009

2017

2019

Planned regulatory changes

Accompanying this, we have seen a notable increase in FTE, cost of FTE, and systems, all with increasing focus on compliance Risk Management: • •

Understanding & explaining risks Supporting business decisions

Compliance: • •

•

Following rules Meeting regulation Supporting legal issues

2000

Job scope / FTE Investment in IT and Data Waterloo Associates

2006

2010

2018

The response has been slow in coming, but must focus on finding the value-add Challenges • Avoiding the “death spiral” • Motivating risk professionals • Band width and resources to respond beyond the compliance agenda • Supporting business needs • Maintaining relevance

More attention

Waterloo Associates

Response • To date: – Compliance focused- “keeping up” – Devolution to standardized models

• Future?

– – – –

Focus on both tails of the distribution Ex ante RAROC analysis Innovations in scenario analysis Back to the future: • More consolidation?

• Large scale specialization?

Innovation

JEFF CURRY

Stress-Testing, Capital Planning, Enterprise Risk Management, and Governance

Gearing for the Future in Risk Management

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My Focus: Stress-Testing, Capital Planning, Enterprise Risk Management, and Governance over all Three • Some of the most significant, far-reaching --and costly– provisions of the new regulatory regime (not just DFA) are in these areas: •

Stress testing (particularly CCAR, DFAST) • •

• •

$10 billion and up, although we are seeing many institutions below $10 billion developing or enhancing their stress testing capability New, still-emerging function at many banks

Capital Planning • ERM • •

Very related to stress testing, but more (Enhanced Prudential Standards, “Getting to Strong” requirements) Regulators are generally still not happy here See 9/2/14 OCC Guidance and related Bloomberg article: “Banks Ordered to Boost Risk Management to Meet OCC Expectations”

• There are significant costs associated with each of these regulatory hot buttons --- Costs that are over and above those banks may have already incurred to develop these capabilities prior to the new regulatory regime DRAFT

• I will discuss each area - and what we’re seeing in the industry - briefly 2

Then vs. Now (and in the Future) Then: Separate or “One-Off” Processes

Stress Testing

Capital Planning

ERM

Governance

Now (and Going Forward:

ERM

Stress Testing

Capital Planning Governance

DRAFT

3

Stress Testing • Key Guidance: Interagency Guidance on Stress Testing for Banking Organizations (May 2012) • • •

Sets forth stress testing principles and requirements for banks over $10 billion in total assets Impacts all stress testing activities throughout the bank (not just capital stress testing) Requires strong governance framework as well as analytical capabilities/ methodologies

• Capital stress testing (CCAR, DFAST) •

Very costly - Requires new models, new data, new governance, new reporting • •

•

Typically outside consultants used because of significant up-front development Ongoing cost is also significant –requires new expertise/systems/processes

Cannot avoid cost, and there aren’t many corners to cut • •

Regulators are very focused here (generally), and have high expectations for the quality of bank capital stress testing capabilities Weak models or governance will be exposed and criticized •

•

DRAFT

Although we have found some pockets of regulatory coverage around the country that have been surprisingly “soft touch” –so far

Illustration of cost for comprehensive development of capital stress testing program 4

Capital Planning • Key Guidance: OCC: Guidance for Evaluating Capital Planning and Adequacy (June 2012) • •

•

Sets forth guidelines and expectations for small/medium-size bank capital planning Steps up requirements for integration between risk exposure (quantity)/risk management capabilities (quality) and capital • Key related processes: ERM, Risk Appetite Statement, stress testing Requires demonstrably strong governance and planning framework, as well as analytical capabilities/methodologies for capital analysis (explicit linkage to capital stress testing)

• Costs •

Somewhat Costly - Requires new capital planning processes typically, overhaul of capital governance, new reporting • •

•

Cannot avoid cost, and there aren’t many corners to cut •

DRAFT

Typically consultants used because of significant up-front governance overhaul Ongoing cost is evident in need to maintain stepped-up capital management and governance capability Regulators are very focused here (generally); weak governance or planning processes that do not integrate risk management/stress testing will be criticized 5

ERM/Risk Management • Key Guidance: OCC - Large Bank Supervision Manual/Supervision by Risk & Enhanced Prudential Standards/”Getting to Strong” Guidance • • •

•

This and comparable guidance from the other regulatory agencies set forth guidelines and expectations for comprehensive risk management programs ERM, together with Risk Governance, are at the center of all of these processes Requires demonstrably strong governance, and progress toward the development of improved risk analytics and explicit linkage to capital stress testing and planning Still an area of weakness and significant regulatory attention (see 9/2 Bloomberg article

• Costs •

Costly - Requires ongoing attention on improvements in risk management, new personnel/systems, and in dealing with regulatory criticisms • •

• DRAFT

Typically consultants used to gain understanding of leading practices Ongoing cost is evident in need to continuously improve risk data, metrics, governance and reporting

Cannot avoid cost, and there aren’t many corners to cut (sound familiar) •

Regulatory focus is on the rise, with no end in sight 6

MARTI TIRINNANZI

Regulations Governing Derivatives and P&L Implications

Gearing for the Future in Risk Management

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Learn to adjust yourself to the conditions you have to endure, but make a point of trying to alter or correct conditions so that they are most favorable to you.

--William Frederick Book

Catalyst of Crisis • Derivatives Dealers Club • Unmargined Credit Default Swaps • Failure of AIG

• Lehman Brothers • US decided NOT to bail out • Unforeseen consequences

Title VII of Dodd Frank Act on Derivatives-Frank (2010) prior Shad-Johnson Jurisdictional Accord Reduce systemic risk posed by(1981) the swaps

market to the U.S. financial system – Increase transparency of swaps marketplace and improve the conduct of participants • Subjects market participants to registration and oversight • Requires most swaps to be centrally cleared and imposes both record keeping and reporting obligations • Imposes margin requirements

What and WhoSubject are Regulated?

All Market Participants to Regulation Regulates products – Swaps – Security-Based Swaps (SBS)

Regulates entities – – – – – – –

Swap Dealers (SD) Security-Based Swap Dealers Major Swap Participants (MSP) Major Security-Based Swap Participants Derivatives Clearing Organizations (DCO’s) Swap Exec.Facilities (SEF’s) Swap Data Repositories (SDR’s)

Prudential Regulators: CFTC and CFTC • Regulation is divided between SEC & CFTC – SEC regulates security-based swaps, security-based swap dealers and major security-based swap participants • A swap on an “equity” would be regulated by the SEC – CFTC regulates swaps, swap dealers, and major swap participants • A swap on an “equity index” would be regulated by the CFTC

OTC vs. Central Counter Party Prior to Dodd-Frank Bilateral trading and clearing

B

After Dodd-Frank Bilateral trading with CCP clearing

F

C

A

CCP

E

D

E

A

F D

B C

New Swap Purchase methodology created post Dodd-Frank (2010) for Swaps Major Swap Participants And other End Users

MSP’s, others

Swap Execution Facility and Central Limit Order Book

Order Book Execution

Clearing/ MTM Submit to Trade Data DCO

Designated Clearing Organization

Swap Data Repository

CME/Eurex/ICE SDR Printing to “tape”

BLOOMBERG SEF End of Day 9-10-2014 (selected USD Swaps)

Instrument USD SWAP ANNUAL 10YR USD SWAP VS 3M 1YR USD S/A 3M DE14 DE44 USD SWAP SPREAD 7YR USD MAC 3M DE14 DE21 USD SWAP VS 3M 12YR USD S/A 3M DE14 DE24

Open Price 2.637000

Close Price 2.639500

High Price 2.640500

Low Price 2.637000

Settlement Price 2.639500

0.364000

0.364000

0.364000

0.364000

0.364000

55,000,000

3.286000

3.296000

3.296000

3.286000

3.296000

60,000,000

2.305190

2.308960

2.308960

2.305190

2.308960

98,300,000

2.500000

2.500000

2.500000

2.500000

2.500000

170,100,000

2.815500

2.828400

2.834000

2.815500

2.828400

177,500,000

2.763900

2.769000

2.769000

2.763900

2.769000

195,000,000

Total Volume 21,500,000

Outcome of Derivatives Regulation Costs and Benefits?

• • • • • • • •

Transparent pricing Enhanced competition Greater use of technology Deployment of margins Leveling the playing field End of monopoly Accountability Availability of Data

Q&A Gearing for the Future in Risk Management

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