Publications & Resources
July/August 2010
Regulatory Changes & Restructuring
Expect the Unexpected: Navigating Today’s and Tomorrow’s Regulatory Landscape
By Mark Olson, Angela Desmond & Catherine Brown
As we enter a period of recovery from the economic crisis, we can expect an array of responses from policy makers at all levels. The breadth of the crisis and the impact on the economy and consumers leaves no doubt that reform legislation will pass. As of this writing, the Senate is considering amendments to a committee bill and the House has passed its own bill.
One of the key purposes of the bills is to better manage the risks posed to our economy by large complex financial institutions and resolve for all time the “too big to fail” problem. While the bills would establish an Oversight Council charged with identifying risks to financial stability and proposing actions to prudential regulators, we do not expect the Council to be executory (i.e., the Council could not mandate implementation). The Federal Reserve, which could lose supervisory authority over state member banks, would have authority to establish stringent prudential regulations for systemically important institutions (essentially financial holding companies with greater than $50 billion in assets), including capital, leverage, liquidity, living wills, concentration limits, risk management and credit exposures disclosure. Even without legislation, large and small financial institutions alike already are being subjected to heightened expectations in many of these areas.
No matter what, expect supervisors to continue to require financial institutions to maintain increased levels of high quality capital buttressed by robust and diversified liquidity plans. The financial markets have become skeptical of any element of capital other than net common equity. The crisis revealed that assumptions about liquidity (particularly short term funding markets) can be flawed. Recent FFIEC guidance on managing funding and liquidity risk emphasizes the importance of effective processes to identify, monitor and control these risks. Recommended tools include cash flow projections, diversified funding sources, maintaining a cushion of liquid unencumbered assets, and having a documented, board-reviewed contingency funding plan.
The bills would establish a consolidated consumer protection regulator with most of the current, and some new, consumer protection laws under its purview. The agency (or bureau within the Federal Reserve) would have new authority to define “plain vanilla” products and issue rules prohibiting unfair, deceptive or abusive acts or practices for sales of those it deems to be non-vanilla. Financial institutions can expect some interim confusion as authorities are transferred to the agency, but in the long run your heightened attention to consumer compliance issues is warranted and you can expect that definitions of unfair and deceptive acts and practices will be expanded. Except for institutions with assets greater than $10 billion and their affiliates, financial institutions still would be inspected by their prudential regulators who would retain their enforcement authority. Note that the Senate bill would authorize the agencies to seek damages in enforcement actions, in addition to ordering restitution and rescission.
The recent crisis has focused greatly on the roles of boards of directors and senior managers in assuring that financial institutions balance the goal of profitability with safety and soundness. There is a perception that many financial institutions did not understand products they were selling or buying, and could not measure risk exposures in particular areas and firm-wide. The importance of boards continues to grow as does the supervisory scrutiny of the competence, independence and compensation of directors. Along side traditional responsibilities for setting a company’s culture and strategic goals, are more granular duties of the audit, risk and compensation committees. Processes for setting and monitoring adherence to an institution’s risk parameters must be established and boards must have access to internal and external resources as necessary to fulfill their responsibilities and to inform their judgment. For example, boards and senior management will be expected to manage concentration risk, and do a better job evaluating credit risk over the life of a portfolio/product. Moreover, there will be little tolerance for not adhering to prudent underwriting standards.
Similarly, we can expect heightened scrutiny of proprietary trading and investment activities and their potential to adversely impact a financial institution’s safety and soundness. Financial institutions will be expected to perform stress tests – and in particular forward looking scenario analysis – for boards to use in setting and monitoring adherence to risk parameters. Even if proposals to limit or restrict proprietary trading are not adopted, institutions will be expected to hold more capital to support their trading books and reduce leverage. With respect to derivatives, boards of directors should carefully consider whether their institutions should sell or buy products that are not standardized, centrally cleared and subject to margin requirements. Although margin requirements increase the cost of these products, they protect against counterparty risk. Boards should (and regulators will) ask about their economic purpose, and be comfortable that the products fall well within the institution’s risk parameters.
In the future financial institutions that have access to the federal safety net will be expected to achieve a more “socially acceptable” balance between the risk a financial product or activity poses to the institution (including the greater impact to the financial system) and revenue/market share. Financial institutions that are not able to aggregate, fund and monitor risk across their organizations are likely to find their activities subject to heightened oversight, including increased capital requirements and perhaps restrictions on activities.
Mark Olson (molson@corpriskadvisors.com) is co-chair and Angela Desmond (adesmond@corpriskadvisors.com) and Catherine Brown (cbrown@corpriskadvisors.com) are managing directors with Corporate Risk Advisors, LLC, specializing in providing consulting and strategic advisory services to financial services companies.
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