The current state of financial reform and changing capital requirements

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Banks around the world are preparing themselves for the wave of reform through Basel Committee proposals and possible legislative action requiring revisions to regulatory capital standards. How well a bank is able to respond to reform will impact its ability to align strategy, risk and capital and to produce competitive risk-adjusted returns.

The current state of financial reform 
The broad structure of financial reform is already taking shape (barring additional country-specific changes in local jurisdictions), and a major component of the reforms will likely be the Basel Committee’s far-reaching proposed overhaul of capital and liquidity frameworks.

Few aspects of banks’ businesses will be unaffected by these changes. The revised regulatory capital framework is likely to:

  • Include higher capital charges on certain activities, including structured products, counterparty credit exposures and trading book portfolios. 
  • Include a greater focus on banks’ own estimates of capital demand through more formalized assessment of key risks and the use of enterprise stress testing as a complement to economic and regulatory capital.
  • Define available capital more narrowly,with an increased focus on tangible common equity.
  • Define standards for capital buffers more explicitly, assessing capital adequacy over a multi-year horizon with an eye toward maintaining market confidence in the industry’s ability to take a hit without constraining credit availability.

Impact on risk management
Regulatory reforms also promise to change the way banks report, assess and assume risk. Strategy and risk appetite will have to be defined more transparently and monitored explicitly. As an additional constraint on risk-taking, a global leverage ratio is also likely to be introduced.

In recognition of the fact that the risk of financial contagion can be reduced, but not eliminated, large, complex institutions may also be required to reduce systemic risk by preparing recovery and resolutions plans (or “living wills”). As a result, supervisory bodies would gain tools to better understand systemic risks and be better informed if or when public intervention is required.

Timing
Although reform promises to be massive in scale and scope, regulators are moving swiftly. The Basel Committee published its consultative paper on proposed framework changes in December 2009. There appears to be strong momentum for the Committee to finalize the standards by year-end 2010, even if questions of calibration remain to be resolved. Implementation would have to proceed then according to local legislative and/or regulatory processes in each jurisdiction.

In the interest of revising the global framework quickly to respond to the financial crisis, some complex issues may be pushed into the future or left to local regulatory discretion. Even after the new regulatory framework is established, banks may experience a lengthy period of uncertainty. Regulatory reform may therefore require a large-scale response from banks over the medium- and long-term, as they adjust to the attendant changes in their operating and competitive environments.

NextThe areas of risk management getting the most attention at global banks 


Download the CFO report “Capital management in banking: senior executives on capital, risk, and strategy” for complete findings.