It is no secret that banks have been under increasing levels of pressure on regulatory and reporting requirements for some time. The increasing cost and complexity of prudential requirements, structural reforms, reporting standards, balance sheet assessments and contingency planning, driven by various international and domestic policy makers, has placed considerable burdens on compliance, finance and risk management functions over the past decade.
Those hoping that the regulatory agenda will ease off anytime soon, however, are likely to be severely disappointed. You need look no further than the EU Commission announcement of 23 November on banking reform detailing measures to increase the resilience of EU institutions and enhance financial stability. In fact, 2017 promises to be one of the toughest years yet for finance and regulatory reporting, amid ongoing uncertainty in the geo-political and regulatory environments, many new developments take place all at once.
Key challenges around prudential regulation include the implementation of IFRS 9 (deadline 1 January 2018), the introduction of an additional Bank of England enhanced stress testing regime (the new ‘biennial exploratory scenario’ which will accompany the Bank’s existing annual cyclical scenario) and the move to implement ring-fencing requirements (deadline at the end of 2018). These sit alongside other initiatives with considerable reporting requirements not least of which is the adoption of MiFID II (now due for January 2018).
To comply with the barrage of regulatory demands, many banks must also cope with designing optimally granular datasets to satisfy anacredit as an aggregate financial stability policy tool for the ECB. Yet a different data set for stress testing is required by the EBA, PRA, the US and Asian regulators. And further sub divisions for subsidiaries, ring fencing and intermediate holding companies.
Meeting any one of these requirements would be significant enough in terms of cost and complexity. This at a time when banks are managing a challenging day to day environment and under pressure to reduce fixed costs associated with their compliance and risk management functions. Taken together, and during a time of great political and public policy uncertainty, it soon becomes apparent that the demands on businesses could reach unprecedented levels. Whilst the PRA and other regulators want to ensure that banks don’t go overboard with complex methodology, as evidenced in the recent guidance issued around implementation of IFRS 9, the multiplicity and depth of demands present a major operational challenge to deliver against. Execution risk in the implementation of regulatory requirements will be significant.
This situation raises multiple questions. Are banks suitably placed to deliver against the various reporting requirements made of them? How will they find the skills and put in place the necessary processes, models and capabilities to comply with IFRS 9 and the new stress test scenarios during a time of great uncertainty? What are the longer term consequences resulting from the adoption of these new requirements? For example, the impact on business planning and forecasting processes such as Anacredit? Can banks implement a common approach between accounting and risk management? And, importantly, how can banks manage the compliance driven agenda while maintaining sufficient return on equity (ROE) and profitability in a challenging environment?
In attempting to answer these questions, we have examined, below, the individual challenges that banks will face over the coming year and assess how they are likely to interrelate.
The Implementation of IFRS 9
IFRS 9 is the new accounting standard for calculating loan impairments and provisioning, which will need to be implemented for annual periods beginning on or after 1 January 2018. It represents a shift from the current incurred loss model to a forward-looking system of provisioning based on lifetime expected loss modelling. Instead of calculating expected loss (EL) for the year ahead, it will require multi-year forecasts of individual loans under different scenarios. The regulator wants to take a benchmarking approach and to continue with this after 2018 implementation. This could be achieved through hypothetical portfolios.
Regardless, banks will, for the first time, need to provide long-term forecasting on their provisioning, based on empirical evidence and modelling, rather than making assumptions that all loans will be repaid until evidence to the contrary is identified. This shift should provide a more longer-term and consistent approach to EL calculations and, in theory, should lead to better decision-making on lending and provide better alignment between accountancy models and risk management functions. There is some concern amongst regulators that different approaches to forecasting could undermine computation of core tier 1 capital.
This shift, however implemented, will add considerable complexity for banks in their impairment forecasting calculations and stress testing. The IFRS 9 requirement for lifetime provisioning must be estimated for each type of liability and in aggregate and by segment. Complications arise as these provisions could be inconsistent on the level of data granularity required for assessing business models, reporting and stress testing. Integrating IFRS 9 into the base case of all forecasting is analytically complex and it also adds in operational complexity.
It will require additional resources in the provision of data analytics for the necessary benchmarking and modelling. Most credit quantitative analysts sit in risk yet the implementation of IFRS 9 requires quantitative credit modelling. Banks will therefore have to integrate finance and risk to execute and maintain all projects requiring forecasts of provisioning. Organisational and data infrastructure must be better integrated.
These changes may have wider impacts, such as on the capital requirements of banks and the volatility of capital. They will also have to be implemented during a time of considerable macroeconomic uncertainty though there is recognition on the part of the regulator that implementation will be difficult.
The 2017 Stress Tests
The regularity and scope of stress testing from central banks and supervisors has increased significantly in recent years – reflecting their ongoing concerns over capital adequacy and adding considerable pressure on banks’ risk management teams. This regime is likely to become even more challenging in future – as last month, the Bank of England confirmed that it will be conducting a minimum of two stress test scenarios for major banks in 2017. In addition to the annual cyclical scenario that was introduced this year, 2017 will see the introduction of the ‘biennial exploratory scenario’.
The Bank of England has not yet disclosed publicly whether IFRS 9 requirements will be accommodated within the 2017 tests. For the 2016 tests, banks were asked not to model the impact of IFRS 9, but this could change next year as the IFRS 9 deadline approaches. Our view is that given how critical ECL (expected credit losses) are over the life of any loan, banks will likely be required to demonstrate how they estimated expected losses over the life of the stress and thus at least demonstrate that they have made progress on IFRS 9 project prior to completion. This will place enormous pressure on the project itself and place significant pressure on those banks which are already challenged by the implementation process. Regardless of the role of IFRS 9 in the 2017 tests, banks should consider how they could best use the new IFRS 9 infrastructure to enhance their approach to stress testing. They will, for example, need to consider how the new system of expected loss modelling will impact on RWAs and Core Tier 1 Capital under a range of scenarios – although it should be noted that IFRS 9 and Basel Standards do not map together perfectly due to the level of aggregation and granularity of data.
Banks should start to consider the likely scenarios that will emerge from these two stress tests. While the annual cyclical scenario is intended to assess the risks to the banking system emanating from the financial cycle, the new exploratory scenario will assess banks’ resilience to a wider range of potential threats (details of both scenarios will be published in Q1 2017). While it is not yet certain, we may assume that some of the macroeconomic risks associated with Brexit would be incorporated in the annual cyclical scenario – given that they are ‘known’ risks. Banks may need to model the potential risks that a ‘hard Brexit’ would have on their balance sheets, including a potential slowdown of the economy, the deterioration of trading terms, the risk of further Sterling devaluation and the resulting impacts on inflation, interest rates, fiscal policy and the UK housing market.
The biennial exploratory scenario will look at wider sources of shock and instability that are either emerging or latent – whether macro economic, political, geo political, environmental or technological. The scenario could include, for instance, the collapse of the Eurozone, a sustained period of negative interest rates, instability in Eastern Europe associated with Russian aggression, a populist uprising in a major European country, a natural disaster or a serious and damaging cyber attack on globally systemic financial institution.
Regardless of the exact nature of the scenarios, the two tests are likely to represent some of the toughest tests banks have ever faced in assessing their capital adequacy.
Structural Reform and Regulatory Uncertainty Associated with Brexit
Many banks have been working on the implementation of long-standing regulatory requirements concerning structural reform and conduct for the past few years. Major reforms include ring-fencing rules which will require banks to separate their retail and investment functions by the end of 2018. Other key regulations include MiFID II, which sets out a broad range of rules concerning the use of financial instruments and must be implemented by January 2018. The regulatory timetable for these rules has been known about for some time but have now been significantly complicated by Brexit and the policy and regulatory uncertainty associated with it.
In terms of ring-fencing, there are likely to be significant complications. UK ring-fencing law allows deposits, assets and entities from other European Economic Area (EEA) countries to be included inside a bank’s ring-fenced entity. Should the UK leave the EEA and/or single market, then it may prevent current EEA operations from being included inside the ring fence, which is likely to cause significant upheaval to existing plans.
There are broader concerns about the timetable of Brexit and the risk of a prolonged period of uncertainty. At the time when many of these regulations are due to be implemented, the UK’s negotiations to leave the EU will not likely be complete. This is far from ideal. In the longer term, there is also the prospect of regulatory divergence and fragmentation between the UK and the 27 remaining states once the UK has left the EU. The lack of regulatory equivalence between the two jurisdictions could become a major issue for compliance teams. We are already seeing some evidence of this manifesting in the latest proposals from the Commission in respect of TLAC and proposals to review resolution.
Meeting the Regulatory and Reporting Challenge – Operating Models Under Stress
With the implementation of IFRS 9, new stress tests and ring-fencing, against a backdrop of Brexit negotiations, the compliance and reporting agenda for 2017 looks formidable. These challenges, taken individually, would be considered significant enough for banks in terms of cost and complexity to implement. Taken together, however, the reporting requirements alone over the coming 12 months could quickly become unmanageable for many firms. As well as posing a logistical challenge for finance and others (particularly if banks do not possess the right skills), the cost of compliance will cause further pressures on banks’ ROE and cost/income ratios during a time when they are required to drive down central costs and manage the consequences of a low return environment.
The scale of this challenge may force banks to consider a broader strategic review of their business models in order to cope with the costs and resources associated with the compliance driven agenda. This could require some fundamental decisions about balance sheet optimisation and areas of focus in terms of their customer proposition.
It may prompt banks into taking more strategic decisions on the resourcing and operations of their core functions and supply chain costs. One potential solution involves the outsourcing of key functions – including certain reporting activities and risk management – to specialist organisations or ‘industry utilities’ which can provide the appropriate level of expertise in managing the complex data sets and the analytics involved in reporting, in a cost-effective way. Digitalisation and automation of risk processes must also be on the agenda. For example, IFRS 9 presents an opportunity to develop modelling ‘centres of excellence’ drawing on offshore capability and capacity.
Our experience of working with banks and capital markets institutions makes clear that this fundamental shift in the operating model of the risk function, whilst challenging to implement, is both desirable and necessary not only for regulatory compliance but also to underpin the profitability of the current model. As they face up to the regulatory and reporting demands of 2017 and beyond, banks will need to think strategically and creatively about the management of these multiple and complex challenges to ensure the sustainability of their business models.