Evolving Banking Regulation EMA Edition

FINANCIAL SERVICES Evolving Banking Regulation EMA Edition

Is the end in sight? February 2014

kpmg.com ABOUT THIS REPORT This report is part of a regional series developed by KPMG’s network of regulatory experts. The insights are based on discussion with our member firms’ clients, our professionals’ assessment of key regulatory developments and through our links with policy bodies in each region.

For other regional reports, please contact [email protected] or see www.kpmg.com/regulatorychallenges

© 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. EVOLVING BANKING REGULATION – EMA EDITION FEBRUARY 2014

CONTENTS CHAPTERS

02 Foreword Half way there? 01 04 Executive Summary

06 Regulatory Pressure Index 04 This heat map illustrates the scale of the challenge posed by key areas of regulatory reform. 8 49 The Financial Stability Abbreviations Landscape An update on EMA region regulatory reforms. 38 Data and Reporting Banks face wide-ranging demands from regulators and others for reporting and 02 disclosures. 05

18 Structure The cost of doing business will dramatically increase due to structural change requirements. 44 Risk Governance Still much more to be done as banks significantly upgrade governance and risk 03 management practices.

28 Conduct, Markets and Culture Both retail and wholesale banks are struggling – in different ways – with client centricity.

Welcome to this year’s Evolving Banking Regulation for the Europe, Middle East and Africa (EMA) region. Banks are generally moving from the evaluation of regulatory initiatives to implementation, albeit at different speeds and from different starting points. That is why, in this year’s report, we focus on four key areas where regulation, combined with other pressures, is forcing banks to make changes. These are structure; conduct and culture; data and reporting; and risk governance.

Half way there?

ooking back over the last 12 months resolution authorities in some major financial or so, the regulatory reform agenda centres (US, UK and Switzerland) press has notched up some significant ahead with their preferred version of how achievements. These include resolution and bail-in would operate, the the implementation of Basel 3 in more that ‘host’ countries take a step back Europe;L laying the groundwork to reduce and consider how to protect their local systemic risk through measures relating to interests in the event of the resolution of Jeremy Anderson the safety and soundness of both banks and a major international bank. Chairman Global Financial Services market infrastructure and to the effective I fear that the end result here will be resolution of failing banks; advancing the a further retreat into localisation and wholesale and retail conduct regimes; and balkanisation, with local requirements on setting out the supervisory stall for assessing the bail-in capacity of the local operations risk governance, risk culture and risk data. of foreign banks being added to local But as we look forward it becomes requirements on capital, liquidity, funding, clear that the regulatory glass is only half governance and even subsidiarisation. The full, some six and a half years after the senior bankers I speak to, and increasingly financial crisis began in the summer of their major corporate clients, see this 2007. New regulatory initiatives continue localisation of regulatory requirements as to emerge, with no apparent reduction in a serious threat to operating a sustainable frequency. Many banks and their regulators global business model without adding costs have achieved less than they should have or reducing services to global clients. done over the last six and a half years. And, particularly in Europe, there remains concern More regulation to come = continuing that regulatory reforms are hindering the uncertainty ability and willingness of banks to support The continuing debates on the leverage ratio, economic recovery. internal models, stress tests, and simplicity In my discussions with senior bankers versus complexity are leaving both bankers and regulators, some serious challenges and regulators very uncertain about where keep rising to the surface, and seem a long the regulatory reform agenda will come to way from being resolved. rest. This makes it difficult for banks to plan effectively. Cross-border resolution But it is clear from the direction of travel For all the progress made on recovery and that there will be further pressures on resolution planning, and on developing the banks to raise more capital to support their ‘bail-in’ tool, the question of how to resolve business activities, and to exit, re-price or effectively a cross-border bank remains restructure their business lines. The debates unanswered. Indeed, the more that the also call into question whether banks

2 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. will ever be able – or be allowed by their indicators for culture and behaviour, and management, but in a world of limited regulators – to tell their own story to their further pressure on remuneration and budgets this may hold back investment on investors, customers and other stakeholders incentive structures. more strategic and commercial projects. about what risks they take and how they manage these risks. Data Future of banking Another source of great uncertainty, Banks face a myriad of issues around data I commented last year on how KPMG at least for the next 12 months, will be the quality and management. Data demands member firms saw the possible future of Comprehensive Assessment to be undertaken are growing all the time, but ensuring banking. Banks are restructuring in favour of by the European Central Bank before it these data are fit for purpose remains locally capitalised, funded and client-driven takes on direct supervisory responsibility difficult given the fragmented systems and businesses, centred on regional hubs. They in November 2014 for the 120 or so major processes through which the data flow. are striving to introduce a real client focus banks in the European banking union. Good data are all about providing the basis at the heart of their businesses, and the for product design, customer service, risk right culture and people to deliver this. And Culture management and business decisions, but they are seeking to rebuild a relationship However necessary the MiFID 2 and many banks remain seriously constrained of trust with their customers, investors, EMIR-driven focus of the conduct and by their legacy IT and data systems. regulators and other stakeholders. These market infrastructure agenda in Europe has Meanwhile, bank supervisors are developments are a continuing journey, been, it is being overtaken by the impact becoming increasingly frustrated by the and those banks that take a bold, direct of an alarmingly wide range of retail and implications of this for the effectiveness and simple approach are likely to emerge wholesale market misdemeanours. This of banks’ risk management. Supervisory as the industry leaders in the future. in turn is shifting the focus from detailed intensity in this area is already on an I hope you enjoy reading this report, and conduct rules to the culture and behaviour upwards trajectory, and this can safely be that it provides useful insights which you can of banks, with a clear read-across to greater predicted to continue over the next few apply to your business. personal accountability, the development years. This will hasten progress by the and measurement of key performance banks in improving their data and risk

February 2014 / Evolving Banking Regulation / 3 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. EXECUTIVE SUMMARY

The emerging regulatory requirements – including structural reform, conduct, governance and the possible emergence of ‘Basel 4’ – are game changing. The banking industry’s existing business models will in large part have to be discarded. There are likely to be losers. The winners are likely to have been relentless in how they have faced up to and implemented the change required.

Executive Summary

he relentless march of the strategy, business and operating models, has been focused on specific jurisdictions regulatory reform agenda governance and culture. This will have – but however this is measured, it is a continues. The ‘more (and more) significant impacts on the customers of banks. depressing picture. of everything’ series of regulatory Retail banks want to become customer initiatives seems unlikely to abate Structure centric, but are finding it hard to deliver this andT will continue to reshape radically the Regulatory requirements will force radical given legacy systems, culture and the inertia banking sector, in particular in Europe. structural change, including the split of global in the industry. Wholesale banks are still The waves of regulation are swirling around entities into a patchwork of smaller locally getting to grips with what client centricity banks more rapidly than many can manage. or separately regulated subsidiaries. Many might mean (given the past treatment This raises the prospect that there will be more banks have already begun to revise their legal of customers for many business lines as casualties before the financial crisis is over. entity structures and to reduce and restructure counterparties or sophisticated investors). Successful banks will be those who can keep their balance sheets. This, combined with the Supervisors in Europe are looking for ahead of the storm by meeting the demands impact of ‘Basel 4’, will dramatically increase radical changes in banks’ behaviours. The of customers, investors and regulators. the cost of doing business. regulatory bar has been raised significantly, Addressing the myriad regulatory and not only in terms of the outcomes to be The financial stability landscape legal, compliance, capital, liquidity, funding, achieved but also in terms of the clear The first set of challenges for banks, which tax and governance considerations is a articulation of what conduct risk means to this report focuses on, is to meet the current complex, multi-dimensional issue. But, a bank, how it is a core part of the strategy, and prospective regulatory requirements on in addition, banks must also consider and how clearly articulated and implemented capital, liquidity and recovery and resolution the operational complexities. These the governance, controls and key indicators planning. Banks caught in the headlights complexities are often not considered until are from the boardroom down to front of Basel 3 implementation may miss the the implementation stage, but they can line product design, manufacturing and wider picture here, as Basel 3 transforms themselves preclude any number of options, distribution. potentially into a ‘Basel 4’ as a result of or can increase the cost or lapsed time such Only really significant change to the DNA, tougher requirements on the leverage ratio, that some options become unworkable. culture and values of banks can rebuild the risk-weighted assets and stress testing. organisation to meet the needs of investors, The European Central Bank will undertake Conduct, markets and culture customers and regulators. This is reflected in its Comprehensive Assessment of major Much banking practice historically has been the change programmes of many banks, but banks in the European banking union, which ‘product push’ – focused on the desire to sell this sort of change is much harder than (even) may identify further capital deficiencies. rather than a more thoughtful view of what sorting out the core operations. Resolution planning will require banks to would best suit the needs of the customer. It is critical that this change is underpinned issue bail-inable long-term debt and increase This has led in retail banking to the various by a dramatic shift in culture, through tone their funding costs. All of this implies further mis-selling disasters of recent years, and from the top, policies, hiring practices, deleveraging or capital raising. in wholesale markets to the significant and incentive structures, embedding values and The report then considers four areas widespread market abuse issues. demonstrating consequences for behaviours where a combination of regulatory and other Reputationally, this has been a disaster which are no longer acceptable. This is a pressures is forcing banks to reform their for the banking industry. Financially, the issue huge boardroom challenge. For many banks

4 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. only radical surgery will satisfy all these Meanwhile, banks also need to address the Governance and risk stakeholders – few banks today have a new and unforeseeable risks in data privacy The financial crisis itself, and the problems complete answer. and cybercrime, conflicting national laws and and challenges discussed above, point to a the impact of retrospective investigations in need to upgrade significantly the governance Data and reporting an environment where vast amounts of data and risk management of banks. Much work Banks face three major challenges around are indefinitely available. is already underway on this, but much more data management. They need to hold and Key to these challenges are increasing needs to be done. As banks get to grips use the right data to get much closer to the maturity of data analytics capabilities; with their business strategy, risk appetite, their customers. They have to meet the a clear understanding of the ownership, roles risk culture and management they will need wide-ranging and exponential increases in and responsibilities for data management radically different management information demands from regulators and others for (including retention and rationalisation); which only significant investments in core reporting and disclosures. And they need to a clear plan to attack core data quality and critical systems, as well as emerging respond to supervisory concerns that banks issues; and the implementation of more analytic technologies, will provide. do not have the right data, systems and IT flexible technology solutions with greater architecture to enable them to understand, sharing/re-use and better handling of aggregate and disaggregate, and manage unstructured data. their risks effectively.

BANKS NEED TO RESPOND TO MULTIPLE PRESSURES

CUSTOMERS CUSTOMERS • Fewer, more expensive products • More transparency but less flexibility • Offered what the regulator allows, not necessarily what they want or need

INVESTORS • Will not put up more capital without adequate returns • Prepared to accept lower returns if risk is correspondingly lower Become genuinely • Debt coupons will need to reflect the customer-centric threat of bail in Replace product-push with a culture of serving customer interests REGULATORS • Regulatory demands increase the cost of capital • Mistrust of banks, capital markets and shadow banking CHALLENGES • Emphasis on personal responsibility and improved risk governance FOR BANKS Drive RoE above the Meet capital, liquidity cost of capital and resolvability Facilitate issuance of requirements to mitigate new capital through ‘too big to fail’ delivering on strategy, Rebuild trust, not least business model and through cultural change cost reduction

INVESTORS REGULATORS

Source: KPMG International, January 2014

February 2014 / Evolving Banking Regulation / 5 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. REGULATORY PRESSURE INDEX

Regulatory Pressure Index

REGULATORY CHANGE – Key REGIONAL DIVERGENCES 1 2 3 4 5 Low Regulatory High Regulatory Pressure Pressure

2014

2013

2012

2011 2014

2013

40 2012 40 2011

41 2014 40 39 2013 Americas 42 2012

40 2011

EMA 22

ASPAC

THE GLOBAL PRESSURE CONTINUES TO GROW

33.7 2011

36.7 2012

36.7 2013

37.3 2014

Note: The regional numbers are the sum of the scores in each region across the ten individual areas of regulatory pressure. The global pressure index is the (unweighted) sum of the scores for each region, divided by three. 6 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. THE EVOLVING AREAS OF REGULATORY PRESSURE REGULATORY AGENDA 2014 2014 Overall, our regulatory pressure index 2013 2013 stands slightly higher than a year ago. 2012 2012 Six and a half years into the financial crisis 2011 2011 the overall regulatory pressure on banks shows little sign of abating. The implementation EMA ASPAC EMA ASPAC of the initial wave of regulatory reforms is coinciding with the continuing emergence of new regulatory initiatives, such as leverage, structural separation and localised supervision. In some areas, pressure has eased Americas Americas slightly since 2013 where implementation LIQUIDITY SYSTEMIC RISK is in progress: 2014 2014 2013 2013 • L iquidity – reflecting the relaxation to the 2012 2012 Liquidity Coverage Ratio and the balance 2011 2011 sheet adjustments made by the banks themselves; EMA ASPAC EMA ASPAC • S ystemic risk – reflecting the progress made on recovery and resolution planning in the US and some other countries; • Re muneration – where earlier dire predictions on banks’ responses to regulatory restrictions have proved largely Americas Americas unfounded; and CULTURE & CONDUCT MARKET INFRASTRUCTURE • M arket infrastructure – where adjustment to the requirements on the clearing, trading 2014 2014 and reporting of derivatives is under way. 2013 2013 2012 2012 However, the flow of new regulatory 2011 2011 initiatives has increased the pressures on banks, including: EMA ASPAC EMA ASPAC • C apital – the prospect of ‘Basel 4’ emerging through a combination of a higher leverage ratio and a much tougher approach to the weighting of banks’ credit and market risk exposures; • S ystemic risk – the prospect of structural Americas Americas separation through the EU’s proposals to REMUNERATION ACCOUNTING & DISCLOSURE implement the Liikanen recommendations; • Supervision – the increasingly intensive 2014 2014 approach of supervisors across the globe, 2013 2013 2012 2012 and the shift of supervisory responsibilities 2011 2011 in the European banking union to the European Central Bank; • G overnance – the series of FSB and Basel EMA ASPAC EMA ASPAC Committee initiatives on risk governance, and the wide-ranging new requirements on data reporting; • Cu lture and conduct – where large banks

in particular face heightened pressure to Americas Americas improve their culture and conduct. SUPERVISION GOVERNANCE Regionally, the clearest trend over the last 2014 2014 four years is the steadily increasing pressure, 2013 2013 from a low base, on banks in the Asia Pacific 2012 2012 region, as regulatory requirements mount 2011 2011 in areas such as capital, systemic risk, market infrastructure, and the intensity of EMA ASPAC EMA ASPAC supervision. Overall, however, the pressures still remain lower in Asia Pacific than in the Americas and the EMA region.

Americas Americas CAPITAL FINANCIAL CRIME & TAX 7 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 1 THE FINANCIAL STABILITY LANDSCAPE

In this chapter Basel 3 Basel 4 Liquidity ECB Comprehensive Leverage ratio Assessment Risk-weighted assets Recovery and resolution

01 The Financial Stability Landscape

Six years after the beginning of the he regulatory reforms intended global financial crisis, 2013 was a pivotal to improve the resilience of banks year for regulatory reform in Europe. The and markets, to make banks ‘CRD4’ package was finalised, for phased resolvable without recourse to implementation from 1 January 2014; the public funds, and to increase Bank Recovery and Resolution Directive Tthe supervisory intensity on systemically and the ‘MiFID 2’ package reached their important banks, have finally begun to final stages; the implementation of take shape. new clearing rules under EMIR began; Equally, however, even if the direction and euro area integration took a step of travel is all too clear, the list of unfinished forward through agreement on the business remains long, casting a pall of Single Supervision Mechanism and uncertainty over the detail of the regulatory the European Central Bank’s plans to reform agenda. This is particularly true of conduct a Comprehensive Assessment. the leverage ratio and the growing prospect of regulatory restrictions on banks’ use Meanwhile, at a global level, the Basel of internal model-based approaches for Committee published a key paper on the calculation of capital requirements for risk data aggregation and reporting, credit and market risks. In addition, the and the Financial Stability Board Basel 3 minimum capital requirements published a series of papers on risk are being superseded by stress scenario- governance and continued to focus on based requirements. A significant shift to systemic institutions and on progress in a tougher ‘Basel 4’ may yet emerge from implementing regulatory reforms. the finalisation of these areas of unfinished business. It is therefore important for banks to consider all of these moving parts, together with the elements that are already more or less firmly in place. Addressing issues in isolation will not be effective.

8 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. 9 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 1 THE FINANCIAL STABILITY LANDSCAPE

Basel 3 OTHER BASEL 3 RELATED UNCERTAINTIES Basel 3 will be implemented in the EU from 1 January 2014, through the ‘CRD 4 package’ Large exposures Pillar 2 – the Capital Requirements Regulation (CRR) The Basel Committee consulted in It remains unclear how ‘Pillar 2’ capital and the Capital Requirements Directive March 2013 on the measurement of, requirements will adjust as a result (CRD). The CRR largely copies out the core and limits on, banks’ large exposures. of the implementation of Basel 3. In elements of Basel 3 – tighter definitions of The main proposed changes were to: principle, the tougher minimum Pillar 1 capital, greater emphasis on higher quality – Tighten the reporting (by moving to a requirements should mean that banks are capital (in particular CET1 capital: equity and 5 percent of CET1 threshold) and ‘hard’ subject to smaller Pillar 2 capital add-ons, retained earnings), higher minimum capital limits on large exposures (leaving the since there are fewer risks that are not ratios, higher risk weightings on counterparty upper limit at 25 percent of capital, but adequately captured by the Pillar 1 exposures, the counter-cyclical capital buffer, again narrowing the definition of capital minimum requirements. the leverage ratio, the Liquidity Coverage to CET1 capital); Ratio and the Net Stable Funding Ratio. – Define more precisely how exposures should be measured, so the Securitisation In addition, the CRD 4 package provides for: requirements can be applied more The Basel Committee issued a second • The imposition of capital surcharges consistently across countries; and consultative paper on securitisation in on global and domestic systemically – Impose tougher limits on the large December 2013. This proposes higher and important banks. The Basel Committee has exposures of systemically important more risk-sensitive capital requirements announced prospective capital surcharges banks. for securitisations, with a minimum for 29 G-SIBs, to be phased in from 15 percent risk weighting; reduced 2016, and attention is now turning to the Central counterparties ‘cliff effects’ in capital requirements designation of banks of national systemic In a series of papers issued in June 2013, as the quality of the underlying assets importance (D-SIBs); the Basel Committee, the International deteriorates; less mechanistic reliance • An additional systemic risk buffer that Organisation of Securities Commissions on external credit ratings; and greater member states can apply to all, or a subset, and the Committee on Payment and consistency with the treatment of credit of banks to cover medium-term structural Settlement Systems outlined revised risk more generally. Banks will be able or systemic risks. The UK is expected to capital adequacy standards for exposures to choose from three approaches to apply a systemic risk buffer of 3 percent to central clearing counterparties (CCPs). the calculation of capital requirements on at least the major UK banks, bringing They also proposed standards for – an internal ratings-based approach, an the minimum CET1 capital ratio up to counterparty credit risk (where the Basel external ratings-based approach, and a 10 percent; and Committee is consulting on consolidating standardised approach. • T he introduction by member states the two existing non-modelled approaches, or the Commission of more stringent namely the current exposure method and large exposure limits, sector-specific standardised method), and the capital and risk weightings, liquidity and disclosure other support required by CCPs, including requirements on all, or a subset of, banks. for their recovery and orderly resolution. But many uncertainties remain here, the most important of which relate to liquidity, the leverage ratio, and risk-weighted assets.

But many uncertainties remain here, the most important of which relate to liquidity, the leverage ratio, and risk-weighted assets.

10 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. Liquidity Leverage ratio

The Basel Committee signed off on a Banks are already reporting their leverage A higher minimum revised approach to the Liquidity Coverage ratios to their supervisors as part of the leverage ratio would Ratio (LCR) – the amount of high quality ‘parallel run’ period due to continue until become the binding liquid assets that a bank should hold to cover January 2017. Once finalised, the minimum stressed cash outflows over a 30-day period leverage ratio would then become a binding constraint for a larger – in January 2013. This makes it easier for ‘Pillar 1’ requirement from January 2018. number of banks. It would banks to meet the LCR than under the original Meanwhile, banks will have to publish their proposals, by expanding the definition of leverage ratios from the date of publication therefore increasingly high quality liquid assets to include equities, of their first set of financial statements on become a ‘front stop’ residential mortgage-backed securities and or after 1 January 2015, using a common rather than a ‘back stop’ lower rated corporate securities; reducing disclosure template and including a the assumed outflow rates on some types reconciliation statement to their published requirement. of liability; and phasing in the minimum financial statements. LCR requirement from 60 percent in 2015 The Basel Committee will continue to to 100 percent from 2019. assess the appropriateness of a 3 percent In the EU, the CRR imposes a shorter minimum leverage ratio based on total tier 1 transition period, with the minimum LCR capital, and to consider the impact of using Some countries are already moving ahead requirement jumping from 80 percent in either CET1 capital or total regulatory capital of the 3 percent minimum leverage ratio. 2017 to reach 100 percent in 2018, while as the capital measure. In the US the Federal Reserve Board is also requiring banks to meet the equivalent Meanwhile, the Basel Committee proposing a minimum leverage ratio of of an LCR-type requirement from 1 January has relaxed somewhat the initially tough 5 percent for systemically important banks 2014, by holding sufficient liquid assets proposals it consulted on in July 2013 and 6 percent for retail banks owned by a to cover potential net cash outflows on how exposures will be measured. systemically important bank, to be applied under stressed conditions. In addition, the The amendments announced in January from 2018 (although this is not directly European Banking Authority (EBA) has 2014 will allow some netting of securities comparable with the 3 percent Basel 3 figure, issued guidelines on the appropriate run-off financing transactions with the same because the applicable accounting standards assumptions for different types of retail counterparty; avoid the double-counting in the US allow more netting of off-balance deposit, and made recommendations on of derivatives cleared through central sheet exposures). the definition of high quality liquid assets. counterparties; and apply less punitive In Switzerland the largest banks will be Meanwhile, in the UK the Financial Policy credit conversion factors to off-balance required to meet a minimum leverage ratio Committee has asked the Prudential sheet exposures. against total capital of around 4.3 percent Regulation Authority (PRA) to consider Some commentators continue to argue by 2019. And in the UK the authorities are whether additional liquidity requirements are for a minimum leverage ratio higher than reviewing the case for using the leverage needed on systemic grounds to supplement 3 percent, with some suggesting a minimum ratio as a macro-prudential tool and have the LCR. ratio of at least 6 percent. They argue that: already imposed stress tests that use CET1 Work continues on the Net Stable • If the 3 percent minimum leverage ratio is capital rather than total tier 1 capital as the Funding Ratio (NSFR) – essentially a calibrated against the minimum Basel 3 capital measure for the leverage ratio. requirement on a bank to hold sufficient risk weighted capital ratios, then it ought A higher minimum leverage ratio would stable deposits (retail and long-term at least to be set proportionately higher become the binding constraint for a larger wholesale deposits) to fund its long-term for systemically important banks that are number of banks. It would therefore lending. Banks are required to report their required to meet higher capital ratios, and increasingly become a ‘front stop’ rather NSFR positions during an observation period to adjust in line with counter-cyclical capital than a ‘back stop’ requirement. This could running until 2016, after which the NSFR is requirements; have perverse consequences. Banks could due to be finalised and to become a binding • In a world characterised by uncertainty be incentivised to hold riskier assets; the requirement from 1 January 2018. The Basel (where it is not possible to attribute precise capital cost of funding a portfolio of low Committee relaxed the calculation of the probabilities to outcomes), it may be better risk-weighted assets and off-balance sheet NSFR in January 2014, and has so far resisted for policy makers to follow a simple rule exposures, including mortgage lending adopting simpler measures focused more rather than trying to match real world and sovereign debt, would increase; and directly on short-term wholesale funding – complexities; and focusing on a non risk-sensitive measure for example as in the proposal by US Federal • Simple rules (using leverage ratios and would remove an incentive (regulatory Reserve Governor Tarullo that banks that market capitalisations) would have permission for a bank to use internal models are substantially dependent on wholesale predicted better which banks ran into to calculate risk weights) that can be used to funding should hold additional capital. difficulty during the financial crisis. drive improved risk management by banks.

February 2014 / Evolving Banking Regulation / 11 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 1 THE FINANCIAL STABILITY LANDSCAPE

The Basel Committee has already formulated proposals to restrict the extent to which model- based approaches can reduce the capital required against market risk.

Risk-weighted assets In response to these findings, the Basel Committee has already formulated proposals Basel 3 focused mostly on the quality and to restrict the extent to which model-based quantity of capital, and the new minimum approaches can reduce the capital required leverage and liquidity ratios, while maintaining against market risk (see box) and to increase the internal model-based approaches to credit, consistency across banks. Similar proposals market and operational risk. More recently, can be expected on internal-based model however, the Basel Committee and other approaches to credit risk, including: regulatory authorities have been focusing on • Limiting the flexibility of the advanced the risk weightings generated by banks using approaches, for example by setting their own internal models. ‘benchmarks’ for risk parameters (which supervisors could use as a reference The main regulatory concerns here are that: point for assessing firms’ internal model • Some banks have been too aggressive in estimates), or setting more explicit the use of internal model-based approaches constraints such as floors (or even fixed to drive down risk weightings; values) for certain parameters. This • Some banks are reducing their capital would limit the extent to which a bank requirements through ‘risk weighting could benefit from using model-based optimisation’, even if some of this reflects calculations of capital requirements; no more than cleaning up data and the • The imposition of minimum parameters planned rolling out of risk modelling to a to reflect stressed conditions; broader set of exposures; • Additional policy guidance to constrain • Risk weightings generated by internal differences in bank and supervisory models are too complex and opaque; practices; and • A prolonged period of low interest rates • Enhanced Pillar 3 public disclosures by is enabling borrowers to avoid default, banks to improve understanding of how and thereby generating misleadingly low banks calculate risk weighted exposures probability of default estimates; and using internal models. • There is limited transparency – and therefore limited scope for relying on market discipline – in this area.

A series of Basel Committee and European Banking Authority (EBA) reports during 2013 on the risk weightings of banks’ banking book and trading book assets have revealed wide divergences in risk weights. Underlying differences in the risk composition of banks’ assets are found to explain between half and three-quarters of the variations in risk weightings across banks for banking book assets, but only half of the variation for trading book assets. The remaining variation is driven by two main factors – diversity in the models used by banks, and diversity in supervisory guidelines and practices.

12 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. TOUGHER TRADING BOOK REGIME MOVES CLOSER

The Basel Committee has published two The Basel Committee is still consultative documents on a fundamental considering whether to restrict the review of the trading book, in May 2012 benefits of internal models-based and October 2013. The most recent paper approaches in the trading book, narrowed down the range of options to a for example by applying a floor or a single set of proposals which will form surcharge to limit the extent to which the basis for a Quantitative Impact Study. model-based approaches can deliver The main proposals cover: lower regulatory requirements than • A simpler and tougher boundary under the standardised approach. between the trading book and the banking book; The overall effect of these proposals, • C alibrating both internal models-based if implemented, would be to reduce approaches and the standardised significantly the benefit available approach for market risk against stressed to banks through the use of internal market conditions, and changing models, and increase banks’ costs as the basis of calculation from value at a result of both restrictions on capital risk (VaR) to Expected Shortfall (ES) benefits and increased operational measures. This will increase capital costs. The proposals will also increase charges under both approaches; the capital required under the • Extending the assumed time horizons for standardised approach. liquidating exposures in stressed market conditions; These reduced benefits and increased • A tougher approach to allowing benefits costs will drive banks to reassess the from hedging, based on whether a hedge pricing and continuation of product lines, is likely to be effective during periods of with implications for banks’ customers. market stress; More generally, together with regulatory • R estricting the calculation of capital requirements for the central clearing of charges for credit risk on securitisations derivatives and market and regulatory in the trading book to the revised driven increases in collateral, these standardised approach; and proposals will fundamentally change the • R equiring banks using internal models to dynamics and economics of trading. disclose both their internal models-based capital charges (disaggregated by type of capital charge and by trading desk) and the capital charges that would have been required under the standardised approach.

February 2014 / Evolving Banking Regulation / 13 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 1

Basel 4 – Emerging from the mist? | 1

THE FINANCIAL STABILITY For more information on Basel 4 Basel 4 – Emerging from the mist? Financial ServiceS Basel 4 – http://www.kpmg.com/ Emerging from the mist? LANDSCAPE global/en/issuesandinsights/ September 2013 articlespublications/regulatory- kpmg.com challenges/pages/emerging-from- the-mist.aspx

‘Basel 4’ and comparability, and the potential such as capital ratios using market values disadvantages of overly simplistic capital of equity, risk measures based on equity KPMG has argued that a ‘Basel 4’ may requirements. The paper also set out some volatility, revenue-based leverage ratios, already be emerging, even before Basel 3 ideas to improve simplicity and comparability: historical profit volatility, and the ratio of is fully implemented. Key elements of this • R ecognising simplicity as an additional non-performing assets to total assets; and may include: objective against which new Basel • More fundamental longer-term reforms • A higher leverage ratio, and higher risk- Committee proposals should be judged; such as relying on a tangible equity weighted assets, as discussed above; • Mitigating the consequences of complexity leverage ratio; abandoning the use • The gold-plated implementation of Basel 3 in model-based approaches by adding of internal models; imposing capital in some countries, including the US and floors to constrain the results of modelled requirements against income volatility; or the UK; and capital requirements; introducing a more reducing risk and complexity by limiting • Requiring banks to meet minimum refined ‘use test’; and limiting national the use of complex and innovative financial capital ratios after the potential impact discretions in the area of internal models; instruments and restricting non-traditional of severe stress events, and therefore to • Strengthening the leverage ratio by banking business. hold significant additional capital buffers, replicating elements of the risk-based contrary to the intention in Basel 3 that capital requirements – adding ‘buffers’ to Reflecting these themes, the paper also the capital conservation buffer and any the leverage ratio and imposing tougher discussed a re-balancing of the three pillars counter-cyclical capital buffer would be leverage requirements on systemically to place more emphasis on Pillar 2 and Pillar the cushion to absorb a shock. important banks; 3. Pillar 1 minimum requirements could then • Enhancing disclosure by requiring banks be simplified, while shifting some of the In a related development, the Basel to disclose the results of applying their complexity – including internal modelling Committee published in July 2013 a models to hypothetical portfolios; to approaches – into Pillar 2, and while enabling discussion paper on balancing risk sensitivity, disclose both modelled and standardised shareholders, bondholders and market simplicity and comparability. This noted calculations; and to publish additional analysts to exercise a more informed view both the advantages of greater simplicity metrics that might be useful to investors, based on enhanced disclosures by banks.

EMERGENCE OF BASEL 4

IMPLICATIONS FOR BANKS Basel 4 Already emerging? Capital requirements Simplicity Liquidity requirements – Front stop leverage ratio – Less reliance on internal models Disclosure requirements National divergences National standards – National standards Risk sensitivity – Minimum requirements Use of internal models in post stress testing decision making – Systemic risk buffers

stnemeri (capital and liquidity) – Pillar 2 capital

Disclosure

uq – Enhanced requirements to

e aid comparability r yrotagulRe r

Basel 3 Strengthened global capital and liquidity regulations Parallel tracks

Capital reform Large exposures Macro-prudential tools – Quality of capital base Securitisation Structural separation – Quantity of capital – Leverage Localisation Wholesale conduct – Counterparty credit risk SIFI surcharges Retail conduct

Liquidity standards Recovery and resolution EU banking union planning – Liquid assets buffer Risk governance – Structural position Bail-in liabilities Risk data aggregation

Time

14 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. European Banking Union and There is also uncertainty about the Since one key rationale Comprehensive Assessment supervisory, regulatory and macro-prudential stance that the ECB will take once it for making the ECB In November 2014 the European Central assumes its supervisory responsibilities from responsible for banking Bank (ECB) will become the primary banking November 2104. Since one key rationale supervisor of more than 120 ‘significant’ for making the ECB responsible for banking supervision across the banks in the European banking union (the supervision across the banking union was to banking union was to euro area countries and any other member move away from the perceived weaknesses move away from the states that opt in to banking union), and will of some national supervisors, it would be oversee the supervision (which will remain, reasonable to expect the ECB to adopt a perceived weaknesses at least initially, with national supervisory generally tough and intensive supervisory of some national authorities) of all the other banks in the approach. The ECB may also accelerate – banking union. at least within the banking union – moves supervisors, it would be Ahead of taking on its new responsibilities towards greater consistency in how banks reasonable to expect the in November 2014, the ECB will undertake calibrate their internal risk models; in the ECB to adopt a generally a Comprehensive Assessment of the definition and treatment of non-performing euro area banking system (see box), exposures, provisioning and forbearance; tough and intensive focusing on 124 banks in 18 member states and in the use of macro-prudential tools. supervisory approach. that constitute around 85 percent of euro area bank assets. Even if this exercise improves confidence in banks over the medium term, it will increase uncertainty in the shorter term.

THE ECB’S COMPREHENSIVE ASSESSMENT

The ECB’s Comprehensive Assessment reviews; an assessment of the adequacy information for assessing the outcomes, will comprise three elements, which may of banks’ asset and collateral valuations, but it remains unclear how this will operate require some banks to address capital provisioning, and the classification of in practice. shortfalls: non-performing loans; and an adjustment of credit and market risk-weighted assets Capital shortfalls Supervisory risk assessment (although the AQR will not include a full The ECB is encouraging banks to The ECB and the national supervisory assessment of the internal models used by adjust in advance where necessary, authorities are jointly developing a new risk banks to calculate risk-weighted assets). through recapitalisation, asset sales assessment system to capture a bank’s and other measures. If, at the end of the risk profile (including leverage, liquidity, Stress test Comprehensive Assessment, further funding, business model and profitability), The ECB and the EBA will cooperate adjustment is required and the bank has a its position relative to its peers, and its closely on the next EU-wide (not just viable business model then the ECB would vulnerability to shocks. The significant banking union) stress test, to be conducted expect corrective action to be taken over an banks are being required to complete a mostly in the third quarter of 2014. This will appropriate period, using private sources template to feed into this risk assessment. build on the AQR by providing a forward- of capital wherever possible. Public sector looking view of banks’ capacity to absorb support should be a last resort, and would Asset quality review (AQR) shocks under stressed scenarios (including be subject to stringent State Aid rules. Between February and June/July 2014 stressed conditions for sovereign debt In addition to the uncertainty the ECB will examine the asset side of the securities). surrounding the outcomes, which will balance sheets of the 124 banks. This will The results of the AQR and the baseline not be fully dispelled until October be based on harmonised definitions of non- stress test will be judged against an or November 2014, banks will face a performing exposures and forbearance. 8 percent common equity tier 1 capital difficult period between the completion The potential coverage of this review is very ratio (the Basel 3 and CRR minimum of of the AQR in June or July 2014 and the wide, including all risk types and exposures, 7 percent, plus a 1 percent add-on for completion of the stress test some four both on and off-balance sheet. The review systemically important banks). However, or five months later. The ECB does not of each bank will be risk-based, focusing on for the AQR this will be based on the intend to make a public announcement (i) a minimum level of coverage and (ii) the capital definition as at 1 January 2104, of the results of the AQR separately from most risky or non-transparent exposures while for the stress test this will be based the results of the overall Comprehensive of the bank, as identified by the national on the definition valid at the end of the Assessment, but banks that know their supervisor and reviewed and challenged horizon used for the stress test (so probably own AQR results may be under market by the ECB. end-2016 and therefore close to a ‘fully and disclosure rules pressure to publish For these bank-specific exposures, the loaded’ version of Basel 3 and the CRR). their AQR position. AQR will include data integrity validation; The ECB has also stated that the a sampling of portfolios and on-site file leverage ratio will provide supplementary

February 2014 / Evolving Banking Regulation / 15 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 1 THE FINANCIAL STABILITY LANDSCAPE

Recovery and resolution Within the European banking union, it is proposed that the BRRD should be The legislation and regulatory guidance supplemented by a Single Resolution necessary to underpin recovery and Mechanism (SRM). The two main elements resolution planning has been strengthened of the SRM are to establish a single considerably over the last year. The FSB’s resolution board and a single resolution ‘Key Attributes for Effective Resolution’, fund for the banking union, although the published in November 2011, have been details of these remain to be finalised. The carried forward in EU and national legislation, intention is that the decision to place a failing while the FSB’s Guidance papers on bank into resolution would be taken by a recovery and resolution planning (July 2013) single resolution board, comprising national form the basis for more detailed planning resolution authorities and ECB executives, for the recovery or resolution of a major but (under current proposals) subject to the international bank. European Commission (and possibly relevant Meanwhile, the bail-in tool – which national governments) being able to object The bail-in tool – which passes the cost of meeting losses and of to the decision – in which case the decision recapitalising a failing bank on to creditors would be taken by the European Council. passes the cost of by writing down the value of their claims Meanwhile, the single fund (of €50–55 meeting losses and of or converting them into equity – has been billion for the banking union) will eventually gaining momentum. It has been used be fully mutualised, but would operate on recapitalising a failing as one element in the resolution and a compartmentalised basis for the first ten bank on to creditors by restructuring of banks in Cyprus, Denmark years, so any member state in the banking writing down the value of and the Netherlands. Under the revised union that wanted to use this fund would EU temporary State Aid rules for banks, have to rely (to a declining extent over the ten their claims or converting which took effect from 1 August 2013, years) on its own national ‘compartment’ as them into equity – has shareholders and junior (subordinated) debt well (to an increasing extent) as on the overall holders will be expected to meet losses and fund. been gaining momentum. recapitalisation requirements before any Little progress has been made on public funds are injected to support a failing creating a single deposit guarantee scheme bank. Switzerland has already introduced for the banking union, even though that was bail-in powers through legislation, and in announced as a key element of banking the UK the bail-in tool is being added to the union in July 2012. Special Resolution Regime, which was originally introduced in 2009. For banks, the main recovery and resolution In Europe, the Bank Recovery and planning issues fall under four main areas. Resolution Directive (BRRD) is expected to enter into force on 1 January 2016, Banks will need to develop their two years earlier than first proposed. The recovery plans and to provide information Directive covers: to the resolution authorities. • The preparation by banks of recovery plans, and the review of these plans by national The European Banking Authority (EBA) has supervisors; already begun to develop detailed guidance • The provision of information by banks to in these areas, and in the UK the PRA issued national resolution authorities, to enable revised guidance in December 2013. Banks these authorities to construct resolution may then be required to make changes to plans; improve the credibility and effectiveness • Granting powers to national authorities of recovery and resolution plans, including to require banks to change their legal and higher capital and more robust funding to operational structures – and even their underpin recovery, and changes to business business models – to enhance recovery activities and legal entity and operational and resolution; structures to facilitate resolution. • Legislative changes to give national authorities the full range of resolution tools; Banks will be required to pre-fund a • The basis on which the bail-in tool will be resolution fund and/or Deposit Guarantee operated (see box); and Scheme, and to provide additional • Establishing national resolution funds, to funding if a fund or scheme proves to be raise at least 1 percent (around €75 billion inadequate to meet the demands on it. across the EU) of covered deposits by 2025. Banks will need to issue at least the minimum required amounts of bail-inable liabilities.

16 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. This may include requirements to issue subsidiaries of the group, so that in a For investors, one key aspect of the bail-in specific types of long-term debt that would resolution the conversion or writing-down of proposals has been the need for greater be bailed-in after equity and other regulatory this capacity could both recapitalise the group certainty in how the bail-in tool will be used capital, but before other senior unsecured and enable it to meet losses in operating in practice. This includes the conditions and uninsured creditors. This will result in subsidiaries. This would also buy time for under which the resolution trigger will be higher funding costs for banks, not least the authorities during the initial stages of a activated (the point of non-viability of a bank); because the possibility of bail-in will replace resolution, making it less necessary to make the choice of resolution tools by a national the reliance of investors (and unsecured and immediate use of other resolution tools that authority; the order in which different types uninsured depositors) on the prospect of would break up or sell off the business of the of eligible liability would be bailed in; the failing banks receiving government support. group. Instead, a recapitalised group could be choice of a national authority between preserved, albeit under new ownership and writing down the value of liabilities and Some national resolution authorities new management. converting them into equity; and the extent – in particular those in Switzerland, the However, it remains unclear how to which a national authority might make UK and the US – are expecting most the cross-border resolution of a major use of a resolution fund or even government international banking groups to follow a international banking group would operate in support as an alternative to the bailing-in of ‘single point of entry’ approach. practice. Host national authorities may seek liabilities. The BRRD does not remove these to maximise the capital and bail-inable debt uncertainties, and they will have an impact on This would require loss-absorbing capacity to available to them locally, which could turn a the pricing of banks’ long-term debt issuance be issued at parent (holding company) level, single point of entry approach into multiple in particular. and then down-streamed to the operating points of entry.

BANK RECOVERY AND RESOLUTION DIRECTIVE: THE BAIL-IN TOOL

The BRRD sets out in detail how the bail-in National resolution authorities would National resolution authorities will tool would operate as part of a resolution. have the discretion to exclude, or partially have the discretion to set minimum There are four key elements: exclude, liabilities from bail-in on a requirements for the total of regulatory discretionary basis if they cannot be bailed capital, other subordinated debt, and senior Some liabilities are excluded from being in within a reasonable time; to ensure the debt with a remaining maturity of at least eligible for bail-in: continuity of critical functions; to avoid one year, expressed as a percentage of a • Covered (insured) deposits; contagion; or to avoid value destruction bank’s total liabilities. This requirement can • Secured liabilities, including covered that would increase the losses borne by be set on a case-by-case basis for each bonds; other creditors. bank, taking into account the size, risk, • Liabilities arising from the holding of National resolution authorities would be resolvability, systemic impact and business client money or client assets; able to compensate for the discretionary model of each bank. A review clause in the • Liabilities with a remaining maturity exclusion of some liabilities by passing Directive would enable the Commission of less than seven days to payment these losses on to other creditors, provided to propose from end-2016 a harmonised systems; no creditor is made worse off than under set of minimum requirement applicable to • Interbank liabilities with an original normal insolvency proceedings, or through different types of bank. maturity of less than seven days (to a contribution by the national (or single) avoid disorderly runs ahead of a possible resolution fund – assuming that there are resolution); sufficient funds available to follow either of • L iabilities to employees, such as fixed these alternative routes. salary and pension benefits; and However, the use of a resolution • Commercial claims relating to goods and fund could only be as a backstop, after services critical for the daily functioning losses equal to at least 8 percent of total of the institution. liabilities had been imposed on a bank’s shareholders and creditors; and where the The BRRD introduces an expectation contribution of the resolution fund would be that eligible liabilities will be bailed-in in the capped at 5 percent of the total liabilities of following order: the failing bank. • E q u i t y ; In extraordinary circumstances, where • Other regulatory capital; other resolution tools (including bail in) • Ordinary unsecured creditors (including are deemed to be insufficient to preserve bondholders) and large corporate financial stability, government support depositors; may be provided through injections of new • Individuals and SMEs; and capital or taking a bank into temporary • Deposit Guarantee Schemes (but leaving public ownership. insured depositors themselves fully protected, so the cost here would fall on other banks that fund the Scheme).

February 2014 / Evolving Banking Regulation / 17 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 2 STRUCTURE

‘The most rigid structures, the most impervious to change, will collapse first.’ Eckart Tolle

02 Structure

Banks face multiple pressures to any structural changes are reconsider their strategies, business already under way, including models and operating structures. significant deleveraging by These range from structural separation many European banks as requirements to bail-in liabilities, and they strive to improve their from capital requirements to liquidity. capitalM and liquidity ratios. Other changes are being assessed by banks, and may For customers of banks the impact follow as the detail of unfinished regulatory of these changes is stark – banking requirements becomes clearer, and as the products and services have become cumulative impact of regulatory reforms more expensive, and in some cases the becomes fully apparent. availability of products and services has In wholesale markets the end result is been constrained. already beginning to emerge, with a small number of ‘scale’ players becoming even more dominant. In retail markets the end game is less clear, but may involve regulatory protection for local players, operating in less competitive markets.

18 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. February 2014 / Evolving Banking Regulation / 19 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 2 STRUCTURE

EU PROPOSALS FOR STRUCTURAL MEASURES

To meet this structural separation provision, Implications for banks a banking group would have to structure itself into at least two sister banks (the core These proposals represent a deposit-taking bank and a trading bank), so major constraint on how large banks that the two banks are legally, economically can operate, in addition to all the and operationally separate. A core deposit- other national, EU and international taker could not undertake trading activities regulatory reforms. Banks therefore – or own any entities undertaking trading face a strategic challenge to determine activities – while a trading entity could not their optimal business model in take core deposits. Strict intra-group and response to these constraints. extra-group large exposure limits would Large EU banks would have to also apply to core deposit-takers. stop proprietary trading throughout However, even where the structural their groups, and put in place internal separation power is exercised, a core control processes to ensure that trading bank could still carry out trading activities activities do not ‘cross the boundary’ to manage prudently its own risks and between allowable and non-allowable to provide a restricted range of risk activities. The extremely complex and management services to customers. lengthy regulations introduced in the US to implement the ‘Volcker rule’ show These two elements would apply to: how difficult this can be in practice. Following the Liikanen report in October • EU headquartered G-SIBs; Similarly, the structural separation 2012, the European Commission proposed • Banks (established in the EU, or with an of core deposit-taking and trading in January 2014 a Regulation on structural EU parent, or branches of a third country activities is both complicated and costly. measures for improving the resilience of bank) that over three consecutive years It will involve not only the creation of EU banks. have total assets above €30 billion and entities that are legally, economically trading activities exceed €70 billion or and operationally separate, but also The proposed Regulation has two main 10 percent of total assets; and the continuous internal policing of the elements: • Smaller banks if the provisions are boundaries between these entities. deemed necessary on financial stability A separate trading entity (investment A ban on proprietary trading, defined grounds; bank) within a banking group may be as trading for the sole purpose of making • H owever, branches of third country subject to a separate external rating and profits for a bank’s own account, without banks can be excluded if they are subject may find it more difficult and expensive any link to actual or anticipated client activity to equivalent rules from their home to raise funding. It may also find that or to the hedging of client-related positions. regulator. some counterparties are no longer Banks would also be prohibited from willing to trade with it. Some banking owning, holding shares in, or sponsoring The Commission estimates this would groups may find that their investment alternative investment funds. apply to around 30 EU banks and to some banking activities are non-viable as This prohibition would not apply to branches of third country banks. a result of being sub-scale and too trading in sovereign debt issued by EU A member state can request a expensive to operate and to fund when member states. derogation from the Commission from they are separated out from a retail the structural separation requirement (but bank. This could reinforce the pressures A structural separation power for not from the prohibition on proprietary on EU investment banks to pull out of national authorities to prohibit a ‘core’ trading) for a bank if national legislation was some markets, and place these banks credit institution (a bank that takes deposits in force on 29 January 2014 that already at a competitive disadvantage. covered by a Deposit Guarantee Scheme) requires at least an equivalent degree of from undertaking trading activities. separation. The recent French, German and This could be applied if a bank’s trading UK legislation on structural separation may activities pose a threat to the financial meet this test. stability of the bank or of the financial The proposed Regulation envisages a system as a whole, or to any of the timeline under which a list of covered (and objectives of the Regulation (including exempted) banks is published annually from excessive risk-taking and resolvability). 1 July 2016; the prohibition on proprietary Structural separation would have to trading takes effect from 1 January 2017; be applied if a bank’s trading activities and the structural separation provisions exceed a set of assessment metrics from 1 July 2018. (including size, complexity and profitability) – unless the bank can demonstrate that its trading activities do not pose a threat to financial stability or to the objectives of the Regulation.

20 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. Regulation Structural separation does not prevent ring- It is not clear what value fenced retail banks taking on risk through Regulatory initiatives are driving banks’ the asset side of their balance sheets, while structural separation decisions on structure through three main on the other side of the fence trading entities brings in addition to higher routes – direct legislative or regulatory can be systemically important and therefore requirements for structural separation; cannot be simply ignored. And creating capital requirements, the indirect impact of capital and liquidity separate entities within a single banking recovery and resolution requirements; and localisation. group cannot entirely eliminate spill over planning, and the more effects. Structural separation intensive supervision of The most direct regulatory pressure Capital, funding and liquidity systemically important on structure is through the rules being requirements introduced on structural separation – most Although there are wide differences in view banks. notably for Europe with the Commission on the cost of imposing tougher capital, proposals published in January 2014 funding and liquidity requirements on banks, (see box). Some countries – including the the overall impact of regulatory reform UK, France, Germany and Belgium – are initiatives in this area has been – and will developing, or have already introduced, continue to be – substantial. As discussed in legislative requirements for structural Chapter 1, these initiatives include not only separation between differing types of retail Basel 3 itself, but also the capital surcharges, and investment banking activities, while resolution planning requirements and more in countries such as the Netherlands and intensive supervision of (at least) systemically Belgium a succession of failures as a result important banks; requirements to hold of the financial crisis has already led bail-inable debt; the likely outcomes on the to the break-up of universal global banks. leverage ratio, risk-weighted assets and The driving forces behind all these the ECB Comprehensive Assessment; legislative initiatives have been to reduce the and stress testing more generally. size and complexity of previously ‘too big These regulatory reforms are shaping to fail’ banking groups; to limit the extent to banks’ business models and pricing, with which insured retail deposits can be used new minimum capital, leverage, loss to support investment banking activities; absorbency and liquidity requirements and and to enable retail banking operations to new asset class risk weightings determining be more easily carved out and transferred the liability structure and the minimum or supported in the event of a large banking returns required to meet the cost of capital group running into difficulty. Cultural change and other funding. This also reduces the has been added to this list – driven by the flexibility of banks to determine which clients, revelations on the fixing of LIBOR and foreign products and markets they engage with. exchange benchmarks. In addition, as discussed in Chapters Structural separation requirements are 3–5, higher regulatory costs are also being in effect a sub-set of resolution planning, imposed through a host of other regulatory since they place specific critical economic requirements, ranging from retail and functions in an operational, institutional and wholesale market conduct requirements governance structure that would make it to reporting and risk governance. These easier to continue these critical functions costs have to be borne by shareholders, within the resolution of a failing banking customers and market end-users. group. Other critical economic functions may be similarly identified and structured in due course, albeit through less severe forms of ring-fencing. Regulatory restrictions are also being introduced to improve the resilience of markets rather than of individual banks. These include the trading, clearing and reporting of derivatives transactions; and restrictions on central clearing counterparties and their members. However, it is not clear what value structural separation brings in addition to higher capital requirements, recovery and resolution planning, and the more intensive supervision of systemically important banks.

February 2014 / Evolving Banking Regulation / 21 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 2 STRUCTURE

Localisation of finance while accepting that an undiluted global view Host country authorities are focusing is no longer viable after the financial crisis. Host country authorities more on preventing the failure of the local For international banking groups, the main are becoming increasingly operations of foreign banks where they cost of greater localisation is a declining ability are of systemic importance for the local to manage capital, liquidity, funding and bail- unwilling to rely on the system, on maintaining critical local in liabilities at a group level. Holding ‘trapped’ capital, liquidity, funding economic functions in the event of failure, resources in each relevant jurisdiction pushes and regulatory oversight and on protecting local creditors and up the cost of doing business, with an impact taxpayers in the event of the failure of a on the cost of products and services to of the parent bank. foreign bank. Host country authorities are customers. Similarly, booking transactions in therefore increasingly requiring foreign multiple locations reduces the advantages of banks to operate within the host country as netting, the efficient use of collateral, and the subsidiaries rather than branches; to meet efficient use of capital. local standards – on capital, liquidity, stress- One ray of hope here is that within the testing, bail-in liabilities and governance and European banking union the ECB should risk management (either as subsidiaries facilitate a greater emphasis on group-wide or as ‘synthetic branches’); and to limit their capital, liquidity, funding, risk management intra-group exposures and their reliance on and governance requirements, and push shared services. back against the localisation of these Meanwhile, moves to introduce greater requirements. structural separation, home country recovery and resolution planning, and a ‘single point of entry’ approach to the use of the bail-in tool has reduced the confidence of some host country authorities that the local operations of foreign banks will receive support from the home country authorities in the event of difficulties arising in an international banking group. Host country authorities are becoming increasingly unwilling to rely on the capital, liquidity, funding and regulatory oversight of the parent bank. International banking groups face difficulties in accommodating so many national regulators, often with a lack of commonality of objectives and trust between the home and host supervisors. These groups want to be global in terms of products, services and customers, and have generally adopted business, operating and governance and risk models that are consistent with this vision. They are trying to adapt and substantially preserve this vision given its competitive and other advantages,

22 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. What are banks doing? • I mplementing clearer and better Overall, this has resulted in: understood governance, control and • M any banks becoming less diversified Regulatory drivers do not operate in a accountability structures within the key in terms of business activities and more vacuum. Macro-economic developments, operating entities; concentrated in a single country or region; market competition and technological • A more regional ‘hub’ structure and • Some universal (retail and wholesale, or advances are also key factors. And banks are approach to running businesses and some combination of banking, insurance keen to control their own destiny, determine managing risk, including to booking trades and asset management) banks considering their own commercial strategy, or at least and transactions – although it remains whether they can remain universal – and to preserve a high degree of optionality unclear whether this will be a stable end- indeed their hand may be forced by the as regulatory requirements evolve. But point in either commercial or regulatory proposed European legislation on structural whatever the drivers, some key themes can terms; separation; be identified in how banks are responding to • E ither a decentralisation of services to • A smaller number of large-scale players in regulatory and other pressures. individual entities with the group, or the each wholesale market; creation of a ‘resolution-proof’ shared • Potential for the remaining players in each Legal entity re-structuring service provider structured as a separate market to make higher returns; Banks subject to national requirements to entity within the group; and • A more pronounced bifurcation in the ring-fence specific activities are already • S implifying and netting down trades with distribution of banks in each market and planning to implement the necessary major counterparties. location, between a (smaller) number of changes. More generally, the proposed large players and a large number of smaller EU legislation on structural separation and Focus on core activities players – although more mid-size players the emphasis on resolution planning by Many banks have been re-evaluating may emerge from consolidation among the the authorities are leading banks to consider where they want to remain active, in terms smaller players; and their operating and legal entity structures. of markets, geographies and customer • Greater scope for the emergence of local Many banks are taking a cautious approach segments. and regional players, for example in Asia, here, waiting to see how regulatory India and South America, which may be expectations evolve – not least because in Banks need to consider which business reinforced by the increasing importance of many jurisdictions the authorities are yet to activities can succeed in the new financial South-South trade and finance. reach any conclusions on how (if at all) banks and regulatory environment, and which should restructure in order to make resolution activities are ‘non-core’ or ‘marginal’ a credible option. as a result.

Banks need to create a viable business In some cases this choice has been model with: exercised by the authorities, as a condition – a legal entity structure that would of banks receiving some form of state aid, Retail and corporate banks enable the resolution authorities to with banks being forced to sell, transfer or have generally pulled apply their resolution tools and powers withdraw from various types of business. effectively to regulated entities within This has been most evident in Ireland, back most sharply from their jurisdictions; where the entire retail banking market has international business – a financial model that can support the been restructured through the transfer of a costs of the new liability requirements large proportion of assets to a national debt activities, including sales (capital and additional loss absorbing management agency and a marked reduction of overseas business units capacity) where it is needed at different in the number of major retail banks. and a sharp reduction in points in the legal entity structure; and In other cases this has been a commercial – a n operating model that delivers both decision, driven by a variety of factors such overseas lending by many efficiency and operational continuity as profitability and the volatility of profits; banks. of internal and external suppliers in the balance between risk and reward; support of critical functions. customers and markets; the efficient use of capital, liquidity, funding and leverage; Banks also need to consider how to reflect competitive advantages and the comparative the cost of recovery optionality and resolution advantages of the bank’s people, systems flexibility in their pricing. and IT infrastructure; complexity; the degree Some banks are pressing ahead with of understanding of the business; and restructuring, in particular where the operational risk, regulatory risk and taxation. necessary changes to their business Retail and corporate banks have models in response to the financial crisis and generally pulled back most sharply from regulatory expectations are clear. There is no international business activities, including single model here, but the general shape of sales of overseas business units and a sharp restructuring has focused on moves towards: reduction in overseas lending by many banks. • A top level holding company (in part to meet Investment banks have in many cases regulatory pressures for a ‘single point of withdrawn from specific business lines (for entry’ approach to bail-in debt); example some segments of fixed income • Operating subsidiaries that reflect a closer and commodities trading) while seeking alignment between business activities and to maintain a scale presence in whichever legal entities, based on a simplification and business lines they consider to be ‘core’ rationalisation of legal entities; activities. • Meeting local regulatory requirements for capital, liquidity, recovery and resolution, governance and risk management capabilities; February 2014 / Evolving Banking Regulation / 23 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 2 STRUCTURE

EUROPEAN BANKS: BALANCE SHEET ADJUSTMENT

BALANCE SHEETS AND LENDING FLAT PROFITS WEAK OR NEGATIVE SLOW BUILD UP OF CAPITAL, BUT SHARPER REDUCED DEPENDENCE ON INTERBANK DEPOSITS, IMPROVEMENT IN CAPITAL RATIOS BUILDING UP CUSTOMER DEPOSITS

40000 20 2000 14 16000 1800 35000 12 14000 15 1600 30000 12000 1400 10

25000 Percentage 10000 10 1200 8 20000 1000 8000

Percentage 6 5 800 Euro billions 15000 Euro billions 6000

600 4 Euro billions 10000 4000 0 400 5000 2 2000 200 0 -5 0 0 0 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Jun 13 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Jun 13 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Jun 13 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Jun 13

Total assets Return on equity Equity (LHS) Deposits from credit institutions Loans and advances Doubtful and non-performing loans as a percentage of total loans Tier 1 capital ratio Deposits from non-credit institutions

Source: ECB Consolidated banking data (all EU banks)

Balance sheet size and structure Against this background, it is not A combination of regulatory and market surprising that many European banks Many banks in Europe pressures is forcing banks to assess their have been taking steps to reduce their have struggled to capital and liquidity positions against the risk and leverage, and to increase their strengthen their capital. ‘fully loaded’ (not transitional) minimum holdings of high quality liquid assets, in Basel 3 and CRR requirements. The latest particular government bonds. Most have had to rely Basel Committee and EBA analyses (using more on retained earnings end-2012 data) of how banks are measuring Indeed, there is a growing contrast between up against these requirements show this focus of many European banks on than new capital issues. continued progress towards meeting capital capital, leverage, liquidity, funding and requirements, and the favourable impact of regulation more generally, and the focus of an the Basel Committee revisions to the LCR increasing number of US banks on growth, in taking many banks to above a 100 percent the recovery of net income and profitability. LCR. Mortgage growth and margins have been a However, it is also clear that EU banks lone bright spot in Europe. have been slower to adjust than non-EU banks, leaving a high proportion of the Capital – many banks in Europe have remaining shortfalls concentrated in EU struggled to strengthen their capital. Most banks. The 42 internationally active EU banks have had to rely more on retained earnings covered by the EBA analysis show: than new capital issues, although the flow • A shortfall of around €70 billion against a of retained earnings has been constrained 7 percent CET1 capital ratio (and by stagnant net income and low profitability. prospective G-SIB capital surcharges). Low returns on equity, in some cases These shortfalls would be even larger if below the cost of capital, have not provided the ‘target’ also included D-SIB capital attractive conditions for new capital issues, surcharges, ‘Pillar 2’ capital add-ons, and although some large banks have managed to any macro-prudential measures; raise new capital. • An average leverage ratio of 2.9 percent (down from 3.0 percent at end-June 2012), with 18 of these banks showing a leverage ratio below 3 percent; and • An average LCR of 109 percent, but 17 of these banks are below a 100 percent LCR, and 7 of them are below the 60 percent LCR that will apply in 2015.

24 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. BALANCE SHEETS AND LENDING FLAT PROFITS WEAK OR NEGATIVE SLOW BUILD UP OF CAPITAL, BUT SHARPER REDUCED DEPENDENCE ON INTERBANK DEPOSITS, IMPROVEMENT IN CAPITAL RATIOS BUILDING UP CUSTOMER DEPOSITS

40000 20 2000 14 16000 1800 35000 12 14000 15 1600 30000 12000 1400 10

25000 Percentage 10000 10 1200 8 20000 1000 8000

Percentage 6 5 800 Euro billions 15000 Euro billions 6000

Source: ECB Consolidated banking data (all EU banks)

Risk-weighted assets – overall, banks in Funding – in addition to the modest increase Europe have reduced significantly their risk- in capital, other shifts on the funding weighted assets, through a combination of side have included a marked reduction in The reduction in risk- (a) no balance sheet growth; (b) shifts in the short-term wholesale funding, a build-up weighted assets has been composition of total assets, away from non- of customer deposits, and debt issuance. the primary contributor domestic lending and from consumer credit However, this overall picture masks and corporate lending, and into increased differences across countries, with customer to a pronounced holdings of government bonds and modestly deposits falling at banks in Greece, Ireland improvement in capital higher retail mortgage lending; and (c) sharp and Spain; and with marked differences reductions in trading book activities at many between the ‘core’ and ‘periphery’ euro area ratios across European European banks with substantial trading countries with respect to the ability of banks banks. books. These trends seem set to continue, to issue longer-term debt. The proposed with some major banks having announced tighter regulation of money market funds plans for further significant reductions in their may place additional pressure on banks to on- and off-balance sheet assets. Banks are find alternative sources of funding, while getting smaller to become less risky, more at some point many banks – especially in capital efficient and more profitable on both Greece, Ireland, Italy, Portugal and Spain – an accounting and a risk adjusted basis. will need to wean themselves off the liquidity Part of the explanation of these balance support they are still receiving from the ECB. sheet shifts may lie with the weakness of the economy in most European countries, and hence lower demand for borrowing by corporates and less willingness of banks to lend to customers perceived to be risky. But a significant part is the result of the pressures on banks to meet capital and liquidity ratios.

Capital and leverage ratios – the reduction in risk-weighted assets has been the primary contributor to a pronounced improvement in capital ratios across European banks, while modest increases in equity combined with flat balance sheets and reductions on trading books have resulted in some improvement in leverage ratios.

February 2014 / Evolving Banking Regulation / 25 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 2 STRUCTURE For more information on regulatory reform

Cost reduction Impact on customers

Banks are seeking to reduce their At a micro level, customers of banks are The cumulative impact costs, not least in an attempt to offset being faced with a higher price and reduced of regulation in Europe the cumulative impact of regulatory availability of banking products and services. may have gone past the reforms on the costs of funding, In retail banking this has fed through in compliance, reporting, risk management terms of higher margins on lending, while ‘tipping point’ to a situation and governance. This is becoming in wholesale markets the shift to fewer where the costs of more critical in an environment of lower providers of each product has resulted in returns, especially in investment banking. both higher prices and reduced choice for regulation exceed the customers. Meanwhile, some customers benefits. Many large investment banks have already are being cut off from products and services announced cost reduction plans, or at least (irrespective of price) on the basis that the strategic reviews, where a key issue will risk to the bank is too great – be it prudential, be to reduce their cost: income ratios from conduct or wider reputational risk. the bloated levels they reached in many These price and supply decisions reflect banks. More benign economic conditions both the costs of tougher regulation and in 2014 may facilitate an improvement in banks adopting a more risk-based approach the cost:income ratio, through both higher to pricing and markets, with capital and income levels and opportunities for asset and funding costs and other risk factors being business unit sales. allocated to individual profit centres and individual business lines. Many sources of cost reduction are being International corporates want banks that explored, including: can facilitate trade finance, make payments, • Greater efficiency of processes and data provide credit, book trades and provide risk management, through investment in IT management services on a global basis, in systems; support of global trade and investment. But • Clo sing branches and relying more on the trend toward the localisation of finance is centralised and increasingly automated making this more difficult and expensive to and industrialised front to back office provide. processes; At the macro level, tougher regulatory • Focusing more on the overall profitability requirements are reinforcing the downward of products and services, and on where a spiral in Europe of weak or in some cases bank has a competitive advantage, rather negative economic growth; increasing than justifying new or incremental products government debt and continuing public and services on the basis of their marginal sector and central bank support for some contributions to profit and loss; banks; decreasing lending by banks to • Simplifying products and services, and corporates in particular; and increasing taking a more risk-adjusted approach to arrears and non-performing loans. costs and revenues; There is scope to break out of this • G reater automation of some controls, downward spiral through stronger including compliance and internal audit, economic growth, the potential profitability based on a re-assessment of risk tolerance of banks lending into the upturn, private in these areas; investors being more willing to subscribe • Simplifying legal entity and operating new capital for banks and to accept lower structures; return on equity, and enhanced investor • Reducing staff numbers; perceptions of the soundness of banks in • Reducing variable remuneration, on the the European banking union once the ECB’s basis of weak economic conditions and Comprehensive Assessment has been regulatory constraints on remuneration; and completed and acted upon. But none of • Off-shoring and near-shoring. these positives can be taken for granted. Moreover, the cumulative impact of regulation in Europe may have gone past the ‘tipping point’ to a situation where the costs of regulation exceed the benefits. These costs have to be paid, and to a large extent it will inevitably be the customers of, and investors in, banks who pay these costs through higher prices and lower returns. The much greater reliance on bank financing in Europe than in the US accentuates this impact on customers and investors.

26 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. 1 | The cumulative impact of regulation

KPMG in the Netherlands – KPMG in Belgium Moving on

FINANCIAL SERVICES The cumulative impact The cumulative The cumulative impact http://www.kpmg.com/ impact of regulation of regulation of regulation global/en/issuesandinsights/ An analysis of the effects of the increase in and accumulation of regulations on the services provided by the Dutch banking sector http://www.kpmg.com/NL/ http://www.kpmg.com/ articlespublications/better- September 2012 en/Issues-And-Insights/ kpmg.com BE/en/IssuesAndInsights/ regulation-in-banking ArticlesPublications/Documents/ ArticlesPublications/Documents/ PDF/Banking-and-Leasing/The- The-impact-of-regulation- cumulative-impact-of-regulation.pdf revised.pdf © 2012 KPMG Advisory N.V.

THE CUMULATIVE IMPACT OF REGULATION

Detailed analysis by KPMG member actions, such as reducing costs, repricing In the central scenario this would firms in the Netherlands and Belgium has loans, issuing new capital, retaining require: provided a bank and customer perspective profits by not paying dividends, changing • A 9 percent reduction in the size of on the cumulative impact of regulation. the structure of assets (holding more the balance sheet; This work involved four key stages: high quality liquid assets) and liabilities • A n increase in the price of loans by • Qualitative discussions with local banks (raising long-term wholesale funding), and 80–90 basis points; about which regulations were likely reducing the size of the balance sheet. • N o payment of dividends; to have the greatest impact on banks’ • A 5 percent reduction in costs; and financial position, business model, Three core findings emerged from this • Replacing the equivalent of 2.5 percent operating model and change capacity; analysis. of total liabilities with long-term • I dentifying from this qualitative analysis wholesale funding. the four most significant regulations – In the absence of any management CRR/Basel 3, Financial Transactions Tax, actions, many banks would fail to meet Such a set of management actions bail-in debt and the pre-funding of deposit minimum regulatory requirements and would have significant implications guarantee schemes; would see their return on equity fall for customers of the banks and for • Quantitative analysis of the impact of below 8 percent. the financing of the wider economy, these four regulations on banks’ capital, in particular though less and more leverage and liquidity regulatory ratios, A radical set of management actions expensive credit and the provision of and the impact on net income, profitability would be required to enable the banks fewer risk management products and and cost:income ratios in the absence of both to meet all the minimum regulatory services. any actions by the banks; and requirements and to achieve an 8 percent • Assessing the extent to which banks return on equity. This could not be could mitigate the impact of these achieved by cost reductions alone, but regulations by taking management would require a combination of actions.

Impact of regulation on the wider economy

Regulation versus economic growth As KPMG has argued elsewhere, the relentless introduction of more and more regulation may already have taken many economies, especially in Europe, beyond the ‘tipping point’ to a position where the costs of regulation exceed the benefits – C in terms of the permanent downward drag on economic growth B D exceeding the benefit of avoiding future periods of financial

instability. growth The relationship between regulation and economic growth may be illustrated by a simple chart, plotting these two variables. A Up to a point, regulation promotes economic growth, because the negative impact of regulation on economic growth in normal times Economic is more than offset by avoiding the severe costs of financial crises. But there is an inflexion point beyond which the negative impact of regulation on economic growth in normal times begins to exceed the benefits of regulation. Regulation The really difficult question is establishing where the ‘tipping point’ lies, There is general agreement that before the financial crisis we were at point A, where too little regulation contributed to the costs of financial crises on economic growth. Official estimates of the Basel 3 capital and liquidity reforms moved regulation up to point B, leaving scope for additional regulatory reforms before reaching the ‘optimal’ point C. However, the evidence in Europe in particular suggests that we have moved beyond point C to point D, where excessive regulation is so damaging to the wider economy that the net impact of regulation on economic growth has become negative.

February 2014 / Evolving Banking Regulation / 27 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 3 CONDUCT, MARKETS AND CULTURE

‘Integrity has no need of rules.’ Albert Camus

03 Conduct, Markets and Culture

A series of conduct failings in both retail he ‘product push’ approach to and wholesale markets have emerged banking – focused on the desire to in the last few years. This will intensify sell, rather than a more thoughtful the introduction of international and view of what would best suit the national regulatory initiatives in the needs of the customer – has led conduct area, over and above the Tin retail banking to the various mis-selling progress made on the ‘MiFID 2’ package disasters of recent years and in wholesale and related EU and national initiatives. markets to significant and widespread market conduct issues. For customers the end result in both Most banks are looking to become retail and wholesale markets is likely more customer centric, and have begun to to be very similar to the impact of make some progress in addressing cultural prudential requirements – more and behavioural issues – but this journey expensive products and more restricted is far from complete. Significant change choice. in the culture and values of many banks is required to meet the needs of customers and regulators. At a more detailed level, while most wholesale banks have embarked on projects to meet the new requirements of EMIR and MiFID 2, some retail banks are waiting for the detailed implementation of MiFID 2 at the national level before instigating major changes. However, other retail banks are already focusing on the prospective shift in Europe to a more ‘product life-cycle’ approach to regulation, and considering the implications of this for product design and development, customer treatment and channels of distribution.

28 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. February 2014 / Evolving Banking Regulation / 29 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 3 CONDUCT, MARKETS AND CULTURE

RETAIL MIS-SELLING PROBLEMS FROM ACROSS EUROPE Conduct failings In addition to earlier large-scale mis-selling A survey undertaken by the Joint Committee of the European Supervisory episodes that have now moved into a Authorities, and published in November 2013, reported actual or potential remediation stage (such as the mis-selling problems arising from the selling of complex products with potentially volatile of Payment Protection Insurance (PPI) in outcomes to retail consumers: the UK, where remediation costs exceed £12 billion), other cases of actual or suspected mis-selling to retail customers have emerged across a wide range of countries (see box). TYPE OF PRODUCT COUNTRY Meanwhile, in wholesale markets a number of major international banking groups Highly (and increasingly) complex products, such as Belgium, Denmark, Estonia, have been fined for their involvement in the structured products Germany, Italy, Latvia, Spain rigging of LIBOR (and other interest rate Complex hedging products designed to protect Latvia, Spain benchmarks), and for colluding in doing so, borrowers on flexible rate mortgages and criminal proceedings have begun against some individual traders. Regulators and other Self-certified and interest only mortgages UK authorities are also investigating a possible conspiracy to shift foreign exchange market Mortgage insurance products Poland prices, and possible market misconduct in swap, commodities and energy markets. Loans to individuals that are exposed to exchange France, Hungary In addition, some banks may have rate risks, the extent of which is often unknown to the mis-sold interest rate swaps to SMEs and consumer municipalities (in the UK, Germany and Italy), while a number of banks have been found Unregulated collective investment schemes, UK, Germany to be seriously deficient in their anti-money which invest in assets that are not always traded in laundering and client money procedures established markets, are therefore difficult to value, and controls. may be highly illiquid, and have risks to capital that are These failings have multiple causes, generally opaque including cultural failings, a push for revenue at the expense of customers and Units in funds based on hedging strategies Belgium counterparties, ineffective governance Product wrapping which prevents consumers from Finland and controls, poorly designed processes, comparing features, prices and charges and thus from inadequate training and an under-investment making well-informed investment decisions in enabling technology. There is no single answer to these failings. Banks placing financial instruments such as hybrid Spain, UK These failings have resulted in large costs products with their own retail clients, where the risks for many banks, including from fines, the were in some cases not disclosed or sufficiently high costs of remediation, the cost of staff, explained and some consumers claim that they were systems and other resources to address the given the impression that the investment was a problems, the drain on management time protected deposit and attention, and reputational damage. Close scrutiny from supervisors and other Insurance products linked to complex underlying France authorities may lead to the discovery of structures additional problems, and further costs to some banks. Expensive and opaque unit-linked insurance and Netherlands Indeed, in many respects these failings pension products may prove to be as important to banks and Structured insurance products with investment Norway their regulation as the initial financial crisis. elements that are often sold cross border but contain They have been a reputational catastrophe only 1 percent of mortality risk for both the banks involved and the wider banking sector.

In many respects these failings may prove to be as important to banks and their regulation as the initial financial crisis. They have been a reputational catastrophe for both the banks involved and the wider banking sector.

30 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. MIFID 2: RETAIL CONSUMER PROTECTION

Retail – Product and sales lifecycle

Sales concept, Product introduction Sales organisation Advice, point of sale, Order execution, Termination/ product design to sales documentation after sales Expiry of product or Governance/Strategy Product provider Conflicts of Interest Inducements/ Best Execution disposal selection Commissions by client/ investor Relevant products Marketing Client reporting Product introduction Suitability, process Appropriateness, Product manufacturing Staff, in particular Execution-only Complaints handling process Supervisory powers advisers Information/Disclosure After sales services Product Sales targets, documentation incentives Documentation Supervisory powers Supervisory powers Supervisory powers Supervisory powers

Note: The coloured boxes refer to existing or amended requirements from MiFID 1, while the white boxes are new requirements under MiFID 2.

Regulation: the retail conduct agenda • S trategy – the importance of a clear focus on consumers; Global • Pr oduct governance – the need for There is a need for product The G20 prioritised consumer protection product manufacturers to design, target manufacturers to design, as one element of its post-crisis regulatory and document products in a way that target and document reforms. The Organisation for Economic reflects investor needs; Co-operation and Development (OECD) • A dvice – transparency in the distinction products in a way that developed a set of high level consumer between independent and non- reflects investor needs. protection principles, which it published independent advice; giving advice on in October 2011, and in September 2013 the appropriateness and suitability of the OECD published a more detailed products; and the banning of commission analysis of the approaches taken by national on investment products being paid to authorities under three of these principles independent advisers or to discretionary – disclosure and transparency; responsible portfolio managers; business conduct; and complaints handling • B est execution – on non-advised sales; and redress. This has provided national • P ost sales service – including complaints authorities with a useful check list against handling; which to consider possible gaps in their • B anning products – ESMA (and the approaches to consumer protection, and EBA for structured deposits) and national to consider how they might bring their authorities have the power to prohibit or consumer protection framework into line restrict the marketing and distribution of with international good practice. financial instruments; and • T hird country regime – member states Europe can prohibit the cross-border marketing Meanwhile, progress has been made in of services by an investment services the EU on consumer protection legislation. provider, even if the provider is approved in Most importantly, the ‘MiFID 2’ package of another member state. a Regulation (MiFIR) covering mostly market infrastructure and a Directive (MiFID 2) was agreed in January 2014. The main aspects of retail consumer protection covered by the Directive are:

February 2014 / Evolving Banking Regulation / 31 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 3 CONDUCT, MARKETS AND CULTURE

There is a growing recognition that transparency and disclosure to retail customers is not sufficient, because retail consumers remain in a weak position in terms of their lack of understanding of many financial products.

The European Securities Market Authority JOINT COMMITTEE PRINCIPLES ON MANUFACTURERS’ (ESMA) has already begun to develop technical standards for implementing the PRODUCT OVERSIGHT AND GOVERNANCE MiFID 2 package. Meanwhile, the European Commission published a proposed Regulation in July Partly in response to the mis-selling • Endorse at executive board level the 2012 on key information documents for concerns listed in the box on page 30, product oversight and governance investment products – usually referred to the Joint Committee of the European processes; as ‘PRIPS’ (packaged retail investment Supervisory Authorities published (in • Identify the target market of the product; products). The initial proposal focused November 2013) eight principles on analyse its characteristics; and ensure narrowly on disclosure and transparency, the responsibilities of manufacturers in that the product meets the identified but the European Parliament in particular designing, bringing to market, distributing, objectives and interests of that target has been seeking to extend this proposed operating and reviewing products. market; Regulation so that it covers a wider range One key objective of these Principles • Undertake product testing to assess how of products and addresses issues such was to strengthen controls in product the product would function in different as product complexity, the level of costs manufacturers before products are scenarios, including stressed scenarios, and charges, and the powers of national launched, and thereby to prevent products to ensure that the product is aligned with authorities to intervene in retail financial and services that may cause consumer the interests and objectives of the target markets. detriment from reaching the market or from market, and leads to fair outcomes; More generally, there is a growing being sold to consumers for whom the • Ensure that the charges and features of recognition that transparency and disclosure products would be unsuitable. the product are transparent for the target to retail customers is not sufficient, because This pre-emptive approach, focusing market; retail consumers remain in a weak position in on the product life cycle, would represent • Select distribution channels that are terms of their lack of understanding of many a significant shift in many countries, and appropriate for the target market and financial products, the imbalance of market would be much more intrusive for banks disclose clear, accurate and up-to-date power in favour of financial institutions, and acting as product manufacturers or product information to distributors; the problems caused by various conflicts of distributors. • Monitor periodically the functioning and interest in retail financial markets. operation of the product to ensure that Below the legislative level, the European The Principles state that a product it continues to meet the objectives and Supervisory Authorities (ESAs) are beginning manufacturer should: interests of the target market; and to enter the consumer protection agenda • Take appropriate action when issues in a more purposeful way, both individually • Establish, implement, and review on that may lead to consumer detriment and collectively. The Joint Committee of an ongoing basis product oversight and have materialised or can be reasonably the ESAs has developed a set of high- governance processes, in particular to anticipated. level, cross-sector principles on financial ensure that the interests and objectives institutions’ internal product approval process of target markets are duly taken into (see box). account, and to address conflicts of interest;

32 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. National There has already been movement in some Regulation: the wholesale conduct and A combination of the MiFID 2 approach countries towards a more intrusive retail market infrastructure agenda to investor protection and the Joint conduct regulatory and supervisory regime. Committee principles is clearly mandating The Bank of Spain has increased its focus EMIR and the MiFID 2 package and encouraging national authorities to take on the retail conduct agenda, at the same The structure of the wholesale market in the a ‘product life cycle’ approach to consumer time as some of its prudential supervisory EU is also undergoing significant changes. protection. This moves away from the more responsibilities for banks move to the ECB; The European Markets Infrastructure traditional focus on point of sale, and places the Central Bank of Ireland has announced Regulation (EMIR) is essentially directed the regulatory and supervisory viewpoint on that retail conduct will be one of its top three at reducing systemic risk through the product design, the match between product priorities for 2014; and many countries (for centralised clearing of derivatives. It also features and customer needs, and whether example Finland and Ireland) are placing covers trade reporting, trade repositories products are designed to be suitable – and greater emphasis on anti-money laundering and the performance and activities of central remain suitable – for the intended consumer requirements. counterparties (CCPs). EMIR entered into market. This may narrow the current force in August 2012, and many of the spectrum of approaches at the national level. Financial Transaction Tax detailed regulatory and implementing The UK stands at one end of this technical standards developed by spectrum, with its long-standing emphasis The February 2013 proposal from the ESMA were finalised during 2013. Full on the importance of the product life European Commission for a Financial implementation will stretch through 2014 cycle (dating back to the six consumer Transaction Tax (FTT) to be adopted by and possibly beyond, and some of the outcomes specified under the FSA’s Treating 11 Member States envisaged a start date of details remain to be determined. Customers Fairly initiative nearly ten years January 2014. However, it remains uncertain However, a continuing failure to achieve ago); the implementation of the Retail whether a FTT will be introduced and, if international consistency between the Distribution Review from the beginning so, when and in what form. Discussions US and EU regimes for central clearing of 2013; the more recent emphasis of the continue on the possible scope of the FTT and trade reporting continues to add cost new Financial Conduct Authority (FCA) on in terms of types of financial instrument and uncertainty for both banks and their ‘conduct risk’ and on early intervention to and geography, with a narrower application customers in implementing the necessary prevent mis-selling; and its proposed new equating to a smaller projected revenue; changes. Shared regulatory objectives client money rules. while MiFID 2 and the proposed ‘Liikanen’ have not prevented differences in the In the middle of this spectrum, some structural measures may provide better scope of instruments covered by the US countries have issued detailed conduct focused constraints on banks’ trading and EU legislation; which non-financial requirements in relation to specific types activities. counterparties are covered by some of the of product, such as the rules in Italy on the If it is introduced, the most significant requirements (the EU regime includes a selling of illiquid financial instruments, while impact on banks is likely to be on systems, threshold test); trade reporting, including the Netherlands has banned commission products and processes. Business models the products covered, the data that must payments on MiFID products. may have to be amended, or in some cases be provided and the timing and substance Austria and Germany stand towards the abandoned altogether. Some banks are of disclosure; clearing venues; and the other end of the spectrum. There is still no actively considering their options, while regulation of CCPs. concept in Germany of ‘conduct risk’ as an others are waiting for the details to be Attention therefore remains focused established risk management category, while decided. Either way, the uncertainty is on the July 2013 ‘Path Forward’ efforts the regulator, BAFIN, is rules-based, prefers unhelpful. by the European Commission and the US not to base regulation on high level principles, Commodity Futures Trading Commission and is waiting for the MiFID 2 package to be to achieve greater convergence of approach finalised before implementing it at national across the US and the EU, although this level. There have, however, already been has made relatively little concrete progress moves, for example in Germany, to promote to date. The most likely outcome here is fee-based independent advice. that the practical impact of the international In Germany and other countries at a differences will be minimised to some extent similar stage of development of the retail as third countries achieve ‘equivalence’ conduct agenda, the MiFID 2 package is with the EU regime or are allowed to adopt therefore likely to bring about a significant ‘substituted compliance’ in place of the change through substantially increased US regime. scrutiny of long-standing sales practices and incentives systems, and through the introduction of new rules on product A combination of the governance. MiFID 2 approach to investor protection and the Joint Committee principles is clearly mandating and encouraging national authorities to take a ‘product life cycle’ approach to consumer protection.

February 2014 / Evolving Banking Regulation / 33 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 3 CONDUCT, MARKETS AND CULTURE

A STRUCTURED APPROACH TO IMPLEMENTING EMIR

Trade strategy Trade initiation Trade execution Settlement and clearing Ongoing management

Product type Financial counterparty Eligible for clearing CCP Margin and collateral

Location Non-financial Bilateral Exchange of collateral Risk management counterparty Pricing Other regulated trading Bilateral Asset servicing, lending & platform custody New services Accounting

Reporting

Strategic Assessment and Reporting Optimisation Risk Mitigation & Collateral & Liquidity Asset Servicing and Implementation Support Management Management Segregation

> Baseline impacted > Baseline impacted > Review and advise > Current state analysis of > Impact analysis of products/ pricing, processes for trade options for using tri- existing documentation, proposals for segregation, businesses, entities by and position reporting, partite confirmation organisation, system and including related business key jurisdiction including existing data processes processes activities > Review existing product quality and availability > Design a new trade > Re gulatory Impact (e.g. securities lending) and booking strategy > Identify gaps, overlaps confirmation process assessment EMIR/Dodd > Develop options for > I dentify emerging entity with related reporting and associated control Frank revised terms, pricing, requirements, including > Prioritised action plan framework for trades not > C ollateral models, service offerings and registration to meet compliance covered by third party valuation and usage delivery model platform > Fit for purpose deadlines > Industry Benchmarking/ > B aseline existing policies assessment of existing > Review opportunities > R eview and advise on Maturity matrix and process options around use of operating and compliance to optimise process – > Data Validation – > Identify gaps, including model reducing cost, increasing third party compression existing remediation services completeness, accuracy, > Revised operating effectiveness availability, frequency needs model, linked to strategic > Design new delivery > R eview and optimise > R eview existing dispute resolution > Optimise reporting and objectives model intraday views relationships and procedures for derivatives contractual terms > Phased plan reflecting > Phased plan to deliver valuation and collateral > Target Operating Model entity and regulatory compliance and ongoing exchange definition > Prioritised priorities improvement implementation plan

Meanwhile, MiFID 2 and MiFIR: • Provide for non-discriminatory access to • E xtend the scope of MiFID 1 to non-equity trading venues and CCPs, and for third instruments such as bonds and derivatives; country access. Taken together, EMIR • Add new rules around trade initiation and and the MiFID 2 package execution, adding new trading venues As with EMIR, it will take at least two years are already driving and strengthening requirements on how to develop and finalise all the detailed venues are organised; technical standards, so full implementation significant changes in • Introduce an obligation to trade those will not be until 2016. market dynamics as the derivatives that are eligible for central Taken together, EMIR and the MiFID 2 clearing on regulated platforms; package are already driving significant increased transparency • Expand the scope of transparency changes in market dynamics as the increased and corresponding requirements for trade pricing and pre- and transparency and corresponding increases in increases in capital and post-trade reporting; capital and margin raise costs for market • Address areas of market turbulence in participants. margin raise costs for recent years such as high frequency trading market participants. and commodities trading with new position limits and controls; • A dd powers to ban or restrict inappropriate market practices; and

34 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. MIFID 2: WHOLESALE MARKET MEASURES

Wholesale –Trade lifecycle

Trade strategy Trade initiation Trade execution and Settlement, clearing Data, reporting, Delivery or confirmation management close out

Governance/Strategy Market access Exchange and other Clearing house/CCP or Reporting obligations trading platforms bilateral Products/Pricing (Non-) Financial Data consolidation and Counterparty Pre and post trade Collateral delivery supply transparency Algorithmic trading/ high frequency trading Position controls Supervisory powers Margins, collateral and limits Supervisory powers management Supervisory powers Supervisory powers Risk management

Supervisory powers

Note: The white boxes are new under the MiFID 2 package, while the coloured ones are amended from MiFID 1.

What are banks doing? Some universal banks are questioning In both retail and wholesale markets banks the combination of the provision and the are ending up with high cost operating In retail markets, many banks are not distribution of retail financial products in the models, and large increases in risk and viewing MiFID 2 and related EU legislative same group. For example, some UK banks compliance staff, and this is being reflected proposals as a high priority – both absolutely have pulled back from offering advice to in the pricing of products and services. and relative to everything else that is going customers because the regulatory risks are In addition, the regulatory pressures on on. Many banks are yet to even fully scope too high to justify the costs of this service, anti-money laundering, tax and client assets how MiFID 2 will affect them, despite the except for high net worth customers. This is are all pushing up the costs of various forms almost agreed final rules. These banks are also consistent with retail banks shifting to of client ‘on-boarding’, the refreshing of client waiting for the details to be finalised and a more automated and less branch-based details, and the continuing monitoring of implemented nationally. approach – although automation does not clients and the transactions undertaken with In addition, the focus in some countries necessarily reduce conduct risk. them. Some banks are pulling back from on the remediation of previous mis-selling some customers and customer types as a and the backward-looking focus of (some) In wholesale markets, although some result of the risks and costs involved. This is supervision is crowding out more strategic, banks have been slow to react to EMIR also making it more difficult for small banks forward-looking thinking. Some banks view and the MiFID 2 package, other banks to survive, because some of these costs this as a process of working through every have already responded to actual and have a disproportionate impact on smaller past product and service. prospective changes to wholesale market banks, which cannot then pass on these structures by re-shaping their wholesale additional costs to their customers in a highly Some banks are beginning to take market businesses, and focusing more competitive market. a more strategic and forward-looking carefully on which instruments, clients Banks are also looking for ways to reduce approach, as part of a review of and markets they interact with. They are both costs and conduct risk through the ‘conduct risk’ and/or a shift to a more also looking for ways to industrialise automation of trading and processing. For customer-centric approach. Such banks revised operations under these new rules example, the automation of foreign exchange are focusing on the product life-cycle, to drive out costs and retain margins. trading and of the reporting of prices and including product design and product transactions could reduce conduct risk. governance; product complexity and This is already favouring larger players charges; inducements; distribution who have the scale to justify significant channels; conflicts of interest; and investment in technology and process taking a more outcomes-driven view of and bear the costs of acting as ‘clearing customer satisfaction. members’ – the gatekeepers to central counterparties. Central counterparties This should result in a less product-driven themselves are also having to invest heavily, and more customer-centric approach. under scrutiny from both these clearing Laying the foundations of trust will depend members – who set their own capital at on providing more transparency, simplified risk through membership – and regulators. products and better quality advice, regardless of the sales channel.

February 2014 / Evolving Banking Regulation / 35 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 3 CONDUCT, MARKETS AND CULTURE

Calls for culture change are commonplace. Successful implementation is much rarer. It is clear that historical practices were wrong, and need to be changed. A fundamental change in culture and behaviour is an essential step on the road to rehabilitation and the creation of a sustainable and safer banking sector for the future. Some banks are beginning to undertake significant reorientation of their business models and their treatment of customers. Hand in hand with cultural change comes the need for banks to understand, monitor and manage talent risk more effectively. For a sector that is so familiar with risk management as a discipline, the extension of the existing risk framework and practices to incorporate people and talent is a powerful way to underpin lasting cultural change.

Banks need to show that the root causes of the behaviour that caused the crisis are being addressed, by demonstrating that they are re-balancing stakeholder interests when making core business decisions. Previously, banks demonstrated a disproportionate focus on profit and employee remuneration at the expense of benefits to the customer or market practice. In future, successful, Culture sustainable business models will be Calls for culture change built on the fair balance of stakeholder It is widely argued that fundamental culture interests. are commonplace. change is needed in many banks if the Successful implementation lessons of the crisis are really to be learned Many global banks have started top to is much rarer. and if a more stable, publicly-acceptable bottom cultural change programs. This banking industry is to emerge. Banks are approach often includes: therefore under considerable pressure to • A new ‘tone from the top’ – clear and public reform their cultures and behaviours, and to commitments from the chairman and regain trust with regulators, customers and CEO that the old ways of working are not the public. acceptable, and that the journey towards a ‘new bank’ will include major culture This is driven by a combination of: change; • Regulatory and supervisory considerations, • N ew, high profile value statements and reflecting the perceived failings in culture codes of conduct usually including a that led (or failed to prevent) some banks to principle of ethical, responsible banking take excessive credit and market risks and and the importance of fair and high quality to do so on the basis of inadequate capital, service for customers; funding and liquidity; to mistreat their retail • A redefinition of the skills and behaviour and wholesale customers; to fail to manage needed to deliver the business strategy, conflicts of interest appropriately; and to in an environment focused on risk engage in inappropriate market conduct; management, transparency and ethical • Shareholders, customers and other market behaviour; participants, all of whom see negative • R eformed mechanisms (including reward consequences from investing in, or structures) to stop unwanted behaviour transacting with, banks with poor standards being reinforced through misaligned reward of culture and behaviour; and promotion processes; and • O ther influential players such as politicians • Changes to risk culture, through a and the media, for whom banks have made strengthening of the role of the Chief Risk themselves too easy a target; and Officer and of the risk management and • Banks’ self-interest in improving their compliance functions. culture and behaviours and learning some of the lessons from the financial crisis – the only way in which banks can roll back the remorseless tide of new regulation is to demonstrate that they have changed sufficiently to make at least some of this regulation unnecessary.

36 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. However, this may not be sufficient Impact on customers to drive fundamental change in culture In both retail and and behaviour throughout banking Customers should benefit from banks organisations. This will require, at least: becoming more customer-centric, wholesale markets, the • A true commitment from senior improving their customer treatment, and squaring of the circle on executives to transformational change, enhancing their culture and behaviours. including a review of the core beliefs Some customers may also welcome a costs, regulation and and routines that exist within the bank. shift to simpler products sold through more revenues will inevitably To be effective it is vital to have visible transparent and fairer distribution channels. mean that most and authentic role-modelling of values, However, these improvements also with leadership demonstrating decisive involve costs. In part these arise from higher customers will end up action to prevent the re-emergence of compliance costs and the frictions added by paying more for banking unacceptable behaviour; regulatory requirements to operating models • S ome high impact, symbolic actions and business models. This will lead to higher products and services; that demonstrate that the bank is taking prices, fewer providers and distributors, and and some customers culture change seriously, and that there in some areas to a reduced range of products will find their choices is no going back. These actions could and to simpler products. Banks are refusing include pulling out of certain business to deal with some customers because the constrained as banks activities, and stopping the sale of, or economic costs and regulatory risks of doing pull back from markets, redesigning, products that are perceived so are too high. to be contentious or unfair; In the retail market this raises the geographies and even the • A radical overhaul of traditional norms possibility of a different ‘tipping point’, in types of customer they are and routines. This should include which regulation has an adverse impact prepared to deal with. variable remuneration incentives – on the amounts of saving, investment and removing them in some cases, and at protection that consumers undertake. One least adopting a meaningful balanced particular problem here is that many of these scorecard approach, with a genuine products have to be sold to consumers input from the risk and compliance rather than being willingly bought – so one functions; impact of tougher regulation is simply to • A structured approach to managing reduce the extent to which banks actively sell people risk, and the incorporation of these products, resulting in what has been talent risk into wider risk management described as the ‘stability of the graveyard’. governance and reporting; and In both retail and wholesale markets, the • The articulation of clear measures and squaring of the circle on costs, regulation performance indicators for judging and revenues will inevitably mean that success in changing culture and most customers will end up paying more behaviours, and the communication for banking products and services; and of these measures and indicators both some customers will find their choices internally and externally. constrained as banks pull back from markets, geographies and even the types of customer they are prepared to deal with. Meanwhile, there will be a direct impact Hand in hand with of EMIR on non-financial end-users, who will have to assess which requirements cultural change comes apply to them and which legal regime a the need for banks to derivatives trade would fall under; to monitor their operations to ensure that they are understand, monitor and maintaining compliance, in particular whether manage talent risk more or not they are exempt from requirements; effectively. and where applicable to report derivatives trades, or to monitor the processes under which third parties do this on their behalf, and to undertake internal risk management. Banks may become less willing to offer bespoke transactions, and to do so only at higher prices.

February 2014 / Evolving Banking Regulation / 37 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 4 DATA AND REPORTING

‘The price of light is less than the cost of darkness.’ Arthur C Nielsen

04 Data and Reporting

Banks face three major challenges anks face three main pressures around data management: to hold for change in their data and and use the right data to serve their reporting: customers; to meet the wide–ranging • The exponential increase in and exponential increases in demands external reporting requirements; from regulators and others for reporting B• Regulatory pressure to improve their and disclosures; and to respond to internal aggregation and reporting of risk supervisory concerns that banks do data; and not have the right data, systems and IT • Business pressures to make better use of architecture to enable them to manage their data and to improve the efficiency of their risks effectively. their data handling.

This is creating massive costs for banks, and tough decisions over the prioritisation of competing IT projects. Some banks run the risk of building a castle on the sand here, given the absence of existing robust systems. Meanwhile, banks also need to address the new and unforeseeable risks in data privacy and cybercrime, conflicting national laws and the impact of retrospective investigations, in an environment where vast amounts of data are indefinitely available.

38 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. February 2014 / Evolving Banking Regulation / 39 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 4 DATA AND REPORTING

Regulation and supervision This myriad of reporting and disclosure requirements also has an immediate impact The key questions for One clear consequence of the financial on banks’ procedures for data capture, crisis has been an exponential increase data reconciliation (across systems, and supervisors therefore in the amount and granularity of data that between regulatory reporting and financial relate to the ability of banks are being required to report to their statements), control processes, regulators (see box) and/or to disclose directly and review and governance procedures. banks to aggregate risk to investors and other market participants. This is being reinforced by the growing data quickly, accurately, Every new regulation brings with it additional emphasis of supervisors on the quality and across all risk types, reporting requirements, as does the increase and accuracy of reported data and other in supervisory intensity and coverage, and information, which in turn has led to an activities and geographies. the growing emphasis on stress and scenario increased focus on individual responsibility testing. This places considerable costs on for reported data, on banks’ internal banks in terms of the people, systems and assurance processes (including the quality assurance processes necessary to role of internal audit), and on governance support this reporting. (how a bank’s non-executive directors

INCREASE IN REGULATORY REPORTING REQUIREMENTS

Banks face an exponential increase in regulatory reporting requirements.

MIFID 2 RECOVERY AND MARKET DISCLOSURES ANTI-MONEY In the retail area, the changing RESOLUTION PLANNING Enhanced ‘Pillar 3’ disclosures LAUNDERING AND TAX investor protection framework Banks are having to provide very by banks, including standard Although the details differ, there will impose information detailed information on recovery templates and greater are growing data and reporting requirements on how clients are plans, and to assist resolution transparency on internal model- demands on customer due classified, how the suitability of planning by the authorities. based approaches. diligence, customer classification, products is assessed, and how and the reporting of specific intermediaries are remunerated information to various authorities. for recommending particular products.

INDIVIDUAL NATIONAL SUPERVISORS Multiplicity of detailed national MACRO-PRUDENTIAL INCREASE IN reporting requirements introduced OVERSIGHT REGULATORY since the financial crisis. National, regional and international REPORTING macro-prudential authorities are REQUIREMENTS increasing rapidly their collection COREP of system-wide data, including on inter-connectedness within The EBA has developed extensive the banking system, and the role and detailed common reporting of banks in securities financing templates covering own funds, transactions and in funding the asset encumbrance, large shadow banking sector. exposures, the leverage ratio and the two new liquidity ratios. Take effect from 1 January 2014.

STRESS TESTING EMIR AND MIFID 2 OTHER CRR/ FINREP Regular reporting is increasingly Banks operating in wholesale CRD4 REPORTING The EBA has developed detailed being supplemented by one- markets face multiple data REQUIREMENTS templates for the reporting off requests to banks to supply and reporting and disclosure Ranging from corporate of financial information to data for stress-testing and requirements in areas such as governance arrangements to the supervisors, covering assets, other purposes. The ECB’s pre- and post-trade information, country-by-country reporting of liabilities, off-balance sheet Comprehensive Assessment will best execution, reporting of profits and taxation. exposures, equity, income and be a large-scale example of this. transactions to trade repositories, expenses. Take effect from and various reporting and data 1 July 2014. requirements on daily mark-to- market positions, collateral, and counterparties.

40 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. gain assurance about the quality of reported data). RISK DATA AGGREGATION AND REPORTING There are also wider issues for banks here, relating not just to data capture but also to how the full range of reporting In January 2013 the Basel Committee these principles, and many reported that requirements are identified, and to how published 14 Principles on the aggregation they are facing difficulties in establishing data are used to ‘police the boundaries’ in and reporting of risk data. strong data aggregation processes, and terms of meeting regulatory requirements, are therefore having to resort to extensive including how activities and transactions The Principles cover: manual workarounds. are categorised in order to ensure that • The importance of Boards and senior Banks self-assessed the highest they are undertaken in the appropriate management exercising strong compliance on the principles relating to the legal entities. governance over a bank’s risk data reporting of risk data: report distribution, Banks will need extensible and scalable aggregation capabilities, risk reporting and the comprehensiveness, clarity and data to meet all these requirements, perhaps practices and IT capabilities. This usefulness of reports. ultimately in the form of a single ‘data includes However, the Basel Committee tape’ that can be captured and interrogated – the documentation, validation and found it odd that risk data reporting by supervisors and other authorities. robustness of these capabilities and scored better than governance, since Supervisors have also become processes; the governance principles should be increasingly frustrated by the inability of – the design, build and maintenance of preconditions to ensure compliance with major banks to aggregate their risk exposures data architecture and IT infrastructure the other principles; and that some banks quickly and accurately at group level, both for to support risk data aggregation rated themselves fully compliant on internal reporting purposes and for meeting capabilities and risk reporting practices comprehensiveness but materially non- information requests from supervisors. both in normal times and during compliant on one or more data aggregation These supervisory concerns are not limited periods of stress. principles. This raises a question as to to the state of banks’ IT architecture and data • The accuracy, integrity, completeness, how reliable and useful risk reports can gathering – they also extend more generally timeliness and adaptability of aggregated be when the data within these reports to the internal reporting of risk data and the risk data. This includes and the processes to produce them have use of these reports as an input to properly- – t he adequacy of the systems and significant shortcomings. informed risk and business decisions. controls that generate risk data and its The Basel Committee concluded that The key questions for supervisors aggregation; and banks need in particular to: therefore relate to the ability of banks to – the capability to adapt rapidly to • Upgrade significantly their risk IT aggregate risk data quickly, accurately, changes in key risks and regulatory systems and governance arrangements, and across all risk types, activities and requirements. with an emphasis on formal and geographies; and to the ability of banks to • The accuracy, comprehensiveness, documented risk data aggregation produce and use high quality management clarity, usefulness, frequency and frameworks, comprehensive data information both routinely and in response distribution of risk management reports, dictionaries that are used consistently to emerging risks as an input to high quality including to the Board and senior by all group entities, comprehensive decision making. management. This includes policy governing data quality controls, The Basel Committee issued a set of – p rocedures for monitoring the accuracy and controls at each stage of the life Principles on risk data aggregation and of data and model reliability; cycle of data; reporting in January 2013, and challenged – making good use of forward-looking • Improve the accuracy, completeness, G-SIBs to self-assess themselves against assessments of risk; and timeliness and adaptability of their these principles during 2013 (see box). – reviewing the usefulness of risk risk data, with less reliance on manual G-SIBs are expected to meet these management reports to senior processes, and quality checks on Principles by 2016, while D-SIBs should do management and the board. risk data that are as robust as those so within three years of being designated as • The need for supervisors to review supporting accounting data; and a D-SIB (it is left to national supervisors to and evaluate a bank’s compliance with • Generate relevant data on a timely basis undertake this designation). Supervisors may these principles, to take remedial action to meet evolving internal and external risk apply the Principles to other banks (and to as necessary, and to cooperate across reporting requirements. non-banks) on a proportionate basis. home and host supervisors. These self-assessment findings are Banks’ self-assessment against the reinforced by the conclusions of the principles Senior Supervisors Group, published in January 2014, which examined the quality The Basel Committee published in of banks’ large exposures data. The Group December 2013 a self-assessment by found that banks’ progress towards the 30 G-SIBs of their progress in meeting consistent, timely and accurate reporting the risk data aggregation and risk reporting of large exposures failed to meet both principles. supervisory expectations and industry The results show that the three best practice. principles with the lowest reported compliance related to data aggregation: data architecture and IT infrastructure, the accuracy and integrity of data, and adaptability. Nearly half of the banks reported material non-compliance on

February 2014 / Evolving Banking Regulation / 41 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 4 DATA AND REPORTING

What are banks doing? • The use of IT to streamline data make improvements. The design and management and to make it more implementation of the necessary Risk data efficient – it will be too expensive to improvements will follow, much of which Many banks are struggling to meet all these rely on manual processes and work- will require large-scale and expensive Principles, although the extent of the gap arounds; projects to introduce a new IT infrastructure. will depend on how stringently the Principles • Bringing together risk and finance data; These projects will need to be integrated are interpreted by national supervisors. • T he internal reporting of aggregated risk with related initiatives in areas such as In Germany and Italy, the Principles have data, including to senior management corporate governance and risk governance, already been incorporated into legislative and the Board, and the use of this stress and scenario testing, management requirements on the minimum standards for information for decision-making; and information, IT enhancements and external banks’ risk management, and into the areas • Governance (at Board and senior reporting (both to regulators and to other to be considered as part of the end-year audit. management level) procedures for stakeholders). These enhancements will risk data aggregation and reporting, then need to be supplemented by the Banks should be reviewing: including a bank’s IT capabilities in provision of assurance through external • T he quality and harmonisation of the these areas. reviews of data management, data risk data they collect; aggregation and data reporting. • T heir ability to aggregate risk data Many large banks are currently at the effectively, including across legal gap analysis stage of self-assessment, entities within a banking group; identifying areas where they need to

RISK DATA AGGREGATION AND REPORTING: FROM PRINCIPLES TO ACTIONS

IT ARCHITECTURE • R isk data models unified or automatically reconcilable across banking group with unified naming conventions • Unified level of detail of data across the group to enable fully flexible reporting • R isk and accounting data to be reconciled Supervisory Governance • High degree of automation for risk data review and infrastructure aggregation • Strive for single source of risk data for each risk type

12 13 14 Effective 1 2 DATA QUALITY FRAMEWORK Risk Data The principles • Effective data quality management Aggregation translate into including automated measurement four key areas 9 10 11 and Risk 3 4 5 6 7 8 methods and escalation procedures Reporting of impact • Comprehensive data governance for risk data including data owners from business and IT • Documentation of reporting and Risk reporting Risk data reconciliation processes practices aggregation • Automatic and manual quality checks in the reporting process

RISK REPORTING • A daptable and ad hoc reporting capability with drill-down into various risk dimensions, stress testing • C omprehensive, timely, dependable and adaptable risk reporting capability across all units and all material risks

1 Governance 8 Comprehensiveness ORGANISATIONAL AND 2 Data architecture and 9 Clarity and usefulness IT MANAGEMENT • Risk reporting and aggregation to be IT infrastructure 10 Frequency mapped into IT strategy/ implementation 3 Accuracy and Integrity 11 Distribution roadmap 4 Completeness • Independent validation of standard 12 Supervisory review compliance 5 Timeliness 13 Remedial actions and • F ull business continuity capability for 6 Adaptability supervisory measures risk reporting 7 Accuracy 14 Home/host cooperation

42 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. Many banks will struggle to deliver the The IT infrastructure of many banks Impact on customers required improvements within the deadlines requires immediate and expensive set by the Basel Committee, given the need attention from a group-wide perspective If banks are successful in making better use to redesign systems. This may crowd out before it becomes wholly unsustainable of customer data there should be benefits for other systems and IT improvements for – as is demonstrated by the increasing customers from banks designing, marketing banks’ strategic and commercial purposes. frequency of system outages. and distributing products and services in ways that better meet customer needs; Exploiting data The pressure is growing on banks to break improvements in the ease of interaction with Banks hold vast amounts of data, but out of this unfortunate state of affairs, banks; and faster and more accurate levels these data are usually held in multiple not least because banking is increasingly of service. forms and places that do not communicate a technology business, and many of the Meanwhile, investors should benefit effectively with each other or with central potential competitors of banks may come from bank disclosures that make it easier to data processing centres. As a result, banks from firms who are much more adept at understand the risks that banks are taking, find it difficult to gather and exploit data technology, at the exploitation of customer how they measure and manage these risks, on their customers. This in turn makes it data, and at providing high levels of customer and how much capital they hold against difficult for banks to connect effectively service. these risks. with their customers; to identify profitable But there is also a cost point here – banks areas of business (by products, customers, Harnessing technological advances would need to spend substantially on systems business lines and geographies); and to drive enable banks to: over next three to five years. There may be a simplification. • Streamline their operations and reduce payback eventually, but the up-front costs will operating costs; be borne by customers and shareholders. Banks need to exploit better the • Connect better with existing and new technological advances that are enabling customers across a multitude of existing more effective customer profiling in both and emerging communication channels, the retail and wholesale sectors. thereby enhancing customer satisfaction and loyalty; Indeed, the disconnect between banks and • Build better defences against the rising their customers may be widening, not least threat of cyber crime (be it internal or relative to rising customer expectations external attempts to siphon funds from based on their experiences with firms the bank or ‘denial of service’ attacks from in other industries who have performed various potential sources); better than the banking industry in using • Introduce greater industrialisation of technological advances to understand their processes in order to simplify, standardise customers better and to communicate more and consolidate operations and thereby effectively with them. to reduce complexity, reduce costs and enhance customer service; Banks therefore need to extract more • Introduce automated smart systems which value from their data, not only to deliver may provide at least part of the solution to a against their aspirations to become more number of AML, tax and trading concerns, Banks need to exploit customer-centric and less product-driven, and may provide scope to transform better the technological but also to remain competitive both compliance and internal; with other banks and with potential new • Reduce the costs – be they financial, advances that are entrants to banking markets. regulatory or reputational – that emerge enabling more effective eventually from poor data and IT systems, customer profiling in both The real competitive advantage here will not least because these poor data and come from the successful integration IT systems facilitate bad decision-making the retail and wholesale and analysis of all sources of customer and inappropriate behaviours; and sectors. and market data to develop a better • Contribute effectively to the moves in understanding of customer needs and some countries towards a new core thereby to enable banks to serve these banking system. customers more effectively, efficiently and profitability. Equally, however, the familiar concerns But even if banks begin to place more remain. The up-front costs of IT and data value on data and invest more in data projects arise at a time when banks’ analytics, they will remain constrained by profitability is weak and pressures for their IT infrastructures. These infrastructures cost reduction are strong. Banks need to are typically characterised by multiple decide how much change to introduce – disparate, aging and increasingly unreliable shortcomings need to addressed, but the systems that have been stitched together search for perfection raises the spectre of during a period of mergers and acquisitions, costs exceeding benefits. And regulatory entry into new areas of business, and a poorly reporting requirements are already crowding managed series of IT enhancements in out other IT and data projects. different areas of a bank’s business.

February 2014 / Evolving Banking Regulation / 43 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 5 RISK AND GOVERNANCE

‘Risk comes from not knowing what you are doing.’ Warren Buffett

05 Risk Governance

anks need to do more in the area A key lesson of the financial crisis was of risk and governance. New risk that the governance of many banks was management and risk reporting ineffective, resulting in poor quality procedures are being introduced, decision-making and poor quality but roles and responsibilities have oversight of risk by bank Boards. notB always been fully determined, leading to both underlap and overlap. Many banks need Fundamental change is required across radically different management information all aspects of risk governance. Standard which only significant investments in core setters have begun to define what good and critical systems will provide. And most risk governance looks like, while banks banks have not yet reached a stage where have begun to move towards higher their risk management function is genuinely governance standards. strategic and forward-looking. But in many banks this remains unfinished business.

44 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. February 2014 / Evolving Banking Regulation / 45 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 5 RISK AND GOVERNANCE

SOUND RISK GOVERNANCE PRACTICES

A thematic review undertaken by the here to the Basel Committee principles on • The reporting lines of the CRO (direct FSB of 36 banking groups across the G20 risk data aggregation and reporting. to the CEO, not through the CFO) and a area showed that these firms had made distinct role from other executive functions improvements since the financial crisis in The FSB used examples of good practice and business line responsibilities; risk governance, not least in: to develop a set of sound risk governance • The importance of CRO involvement in • A ssessing the collective skills and practices for banks to aspire to, and for all significant group-wide risks (including experience of the Board; national authorities to use as a basis for treasury and funding) and in key decision- • U ndertaking more frequent and more assessing risk governance in major financial making processes from a risk perspective demanding Board effectiveness reviews; institutions. The FSB also recommended (including strategic planning, acquisitions • Instituting a stand-alone risk committee; that international standard setters and and mergers); and national authorities should adopt more • The independence, authority and scope of • Establishing a group-wide CRO. consistent approaches and should toughen the risk management function; and their standards to reflect these sound risk • The independent assessment of the risk However, these groups had made less governance practices. governance framework, including both an progress in: enhanced role for internal audit and the • Establishing and implementing a clear risk The sound risk governance practices use of external third parties. appetite statement; identified by the FSB include: • Defining the responsibilities of the risk • The independence and expertise of the The review found significant gaps in all committee and its interactions with the Board; the banking groups in its sample, so banks audit committee; and • T he role of the Board in establishing and should not assume that they are performing • Strengthening risk management functions, embedding an appropriate risk culture well against these criteria. in particular IT infrastructure and the ability throughout the firm; to aggregate risk data efficiently and • The membership and terms of reference effectively. The review drew a clear link of the risk and audit committees;

Regulation and supervision are also requesting enhanced reporting on the role of the CRO; and the independent banks’ risk management practices, including assessment of risk governance. Since the financial crisis, many national information on exposure limits, stress CRD4 also contains a set of corporate authorities have strengthened their rules and testing, Board and sub-committee minutes, governance requirements, which focus guidance on corporate governance and risk and reports on risk governance from external primarily on: governance, reflecting both local initiatives auditors and other third parties. and new international standards from the However, the implementation of these Roles and responsibilities of the Board FSB, the Basel Committee and the OECD. initiatives has been uneven, both across and its committees – The Board should national supervisors and across banks. approve and oversee strategy, risk strategy New rules and guidance have typically Some of the most stringent reforms have and internal governance, and there should included requirements on banks to: been in Ireland, which has introduced new be independent risk and remuneration • Undertake more detailed Board oversight rules on corporate governance for banks committees, composed entirely of non- of risk and risk management; and insurers. In the UK, recent legislation executive directors. • S trengthen the composition of the has introduced a new senior management Board and its sub-committees, including regime to strengthen individual accountability Board composition – There should be the independence, expertise, time at the most senior level in banks, shift the limitations on the number of directorships commitment and diversity of non-executive burden of proof when conduct or prudential which may be held by members of the Board directors; failings arise at banks, and introduce a at any one time; a separation of the roles of • C larify individual responsibilities and criminal offence of misconduct by senior Chairman and CEO; and appropriate Board accountability; bank management. In Germany, minimum skills, diversity of experience, honesty and • Establish a risk committee of the Board; standards for risk governance have been integrity. • E nhance the risk management function and introduced (based on earlier EBA guidelines), the role of the Chief Risk Officer (CRO), in requiring all banks to check that they fulfil Remuneration – Banks should set a terms of independence, expertise, stature, all their regulatory, tax and accounting remuneration policy which is consistent authority and scope; and obligations and that large banks appoint with sound and effective risk management • Undertake independent assessments of a Board member to be responsible for and business strategy. Individuals in the bank’s risk governance framework, compliance. And banks in Italy have to self- compliance and risk management should be through Board effectiveness reviews, assess themselves against rules based on remunerated appropriately and independent internal audit assurance reviews and third the EBA guidelines. of the performance of the business they party assessments. Based on these regulatory and control. Variable remuneration should supervisory developments, and on a review be assessed on a multi-year framework, Meanwhile, supervisors have increased of risk governance practices in major banking guaranteed variable remuneration should be their supervisory efforts by engaging more groups, the Financial Stability Board (FSB) avoided except in exceptional circumstances, frequently and intensively with the Boards published in February 2013 a set of sound and variable remuneration should not be and senior management of banks. This risk governance practices (see box), focusing more than 100 percent of base salary (unless has included more frequent and intensive in particular on the role of the Board and a figure of up to 200 percent is agreed by on-site reviews of risk governance, including the role of non-executive directors; the shareholders). meetings with non-executive directors. They group-wide risk management function and

46 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. In November 2013 the FSB extended its on banks to define and implement a risk Many banks will struggle guidelines on risk governance with two further appetite framework. papers: a set of Principles for an effective to meet the Principles for risk appetite framework (see box below), This increased supervisory interest an effective risk appetite and a consultative document on Guidance to in risk culture will require banks to supervisors on assessing the risk culture of demonstrate that they have: framework, in particular financial institutions (see box on page 48). • Embedded a clear set of values and with respect to defining Many banks will struggle to meet these culture at all levels of the organisation; a risk appetite for non- Principles for an effective risk appetite • Learnt from risk culture failings; framework. Banks are already grappling • Clearly allocated risk ownership; financial risks; setting risk with the challenge of robustly defining a risk • Encouraged internal challenge to limits across business appetite for non-financial risks; setting risk perceived poor behaviours; and limits across business units and entities; and • Implemented a remuneration units and entities; and embedding risk appetite within a wider risk framework that genuinely reflects embedding risk appetite culture. performance against compliance and within a wider risk culture. Meanwhile, for many banks the risk management. implementation by supervisors of the Guidance on assessing risk culture As with corporate governance more will represent a significant increase in generally, progress on developing global supervisory intensity, and a shift in the standards for risk governance may not result direction of supervision into areas that in consistent calibration and implementation some supervisors may not have focused across jurisdictions. It is not clear to what on in the past. This will be even more extent monitoring through country and pronounced if this approach to supervision peer reviews by the FSB and the Basel extends down into D-SIBs and beyond. For Committee will deliver greater consistency, example, the Bank of Italy issued in July given the complexity and diversity of large 2013 a substantial update of the rules for banks and different national supervisory the banking sector, including a requirement approaches.

RISK APPETITE FRAMEWORK

The FSB’s Principles for an effective risk A risk appetite statement that: Risk limits that interact with the risk appetite framework recognise that the • I s linked to the bank’s short- and long-term appetite because they: concept of risk appetite was not always strategic, capital and financial plans; • Constrain risk-taking within risk appetite; well understood, quantified or embedded in • Establishes the amount of risk the bank • Are established for business lines and business management. The Principles state is prepared to accept in pursuit of its legal entities, and include material that the framework should: strategic objectives and business plan, risk concentrations at the firm-wide, • Be driven by both Board leadership and taking into account the interests of its business line and legal entity levels (e.g. the involvement of management at all depositors and shareholders as well as counterparty, industry, country/region, levels; capital and other regulatory requirements; collateral type, product); • B e communicated, embedded and • Determines for each material risk the • D o not default to regulatory limits, and understood across the bank, including maximum level of risk that the bank is are not overly complicated, ambiguous, being embedded into the bank’s risk willing to operate within, based on its risk or subjective; and culture; appetite, risk capacity, and risk profile; • Are monitored regularly. • Act as a brake against excessive risk- • I ncludes quantitative measures that can taking; be translated into risk limits applicable to A set of supporting roles and • Allow for the risk appetite statement business lines, legal entities and groups; responsibilities – the Principles include to be used as a tool to promote robust • Includes qualitative statements for risks detailed job descriptions that outline the discussions of risk and as a basis upon that are not easy to measure, including roles and responsibilities of the Board and which the Board, risk management and reputational and financial consequences of senior management with respect to the internal audit functions can effectively poor management of conduct risks across risk appetite framework. and credibly debate and challenge retail and wholesale markets; management recommendations and • Ensures that the strategy and risk limits decisions; of each business line and legal entity • Cover subsidiaries and third party align with the bank-wide risk appetite outsourcing suppliers that may be outside statement; and the direct control of the bank; and • Is forward looking and subject to scenario • Be adaptable to changing business and and stress testing to ensure that the bank market conditions. understands what events might push the bank outside its risk appetite and/or risk The FSB then define the three key elements capacity. of an effective risk appetite framework as:

February 2014 / Evolving Banking Regulation / 47 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. CHAPTER 5 RISK AND GOVERNANCE

What are banks doing, and what more do Oversight and accountability ASSESSING RISK CULTURE they need to do? Banks are beginning to respond to pressures from their supervisors to provide real clarity Banks have made progress in improving of accountability across core business The FSB’s proposed Guidelines are governance and risk governance, but most activities and processes. This requires end- intended to support supervisors in taking banks need to make further progress in to-end oversight and ownership of these a judgemental, outcomes-focused and these areas. activities and processes. However, senior forward looking approach. Supervisors management in many banks have struggled should understand an institution’s risk Focus on risk to agree such accountability. culture, in particular whether it supports At Board level, more attention is now being appropriate behaviours and judgements focused on understanding risk, on setting Banks need to develop and implement within a strong risk governance framework. risk appetite, and on controlling, measuring, the necessary ownership of, and To achieve this, supervisory interaction monitoring and reporting risk. This includes accountability for, their core business with Boards should be stepped up, based a reinforcement of the Board with non- activities and processes. And they on high-level sceptical conversations with executive directors who bring a deeper need to reach a position where they the Board and senior management on the experience and expertise of banking and can attest with confidence to the clarity bank’s risk appetite framework, and on risk management; a more active role for the and effectiveness of these roles and whether the bank’s risk culture supports Board risk committee; a closer consideration responsibilities. adherence to the agreed risk appetite. of risk maps and risk related management Supervisors will be expected to focus information; and a more active role for the Role of the CRO on four key ‘risk culture indicators’, looking CRO in discussing risk with the Board risk Many banks have reviewed and revised in particular for behaviours or attitudes committee and/or the Board itself. the role, responsibilities and reporting lines that are not supportive of sound risk However, at many banks the shift from of the CRO, and in doing so have generally management, and intervening early the pre-crisis problem of inadequate and enhanced the CRO function. In line with the to address these culture observations fragmented oversight – with information FSB guidelines, CROs increasingly report and thereby the potential build-up of not being properly reported upwards from directly to the CEO rather than through the excessive risk. overly-independent business divisions – to Chief Financial Officer (CFO), and have much much improved group-wide risk data being greater access to the Board and the Board The four indicators are: reported to the Board on a timely basis, risk committee. remains incomplete. This relates closely to Tone from the top – how the the problems in risk data aggregation and However, in some banks this remains bank’s leadership ensures that its core reporting discussed in Chapter 4. work in progress, with issues still to be values are communicated, understood, resolved around: embraced and monitored throughout As the volume and nature of internal • How a CRO can establish a genuinely the organisation. This includes leading and regulatory risk reporting grows many group-wide view of risk, in particular by example, assessing the impact of the banks will need to invest further in risk with respect to (i) the capital, funding high level values on behaviour throughout data, systems, and architecture. and liquidity issues that have the organisation, ensuring common traditionally been the responsibility of understandings of risk, and learning from Meanwhile, the localisation agenda the CFO; and (ii) the operations of a bank risk culture failures; and the need to place additional emphasis – be they specific business activities or on specific risks such as liquidity, conduct geographies – that have traditionally Accountability – a clear allocation of and reputational risk will make it even more been managed independently; risk ownership, escalation processes, and challenging for a CRO, senior management • How banks can establish an enhanced internal enforcement procedures; and the Board to form a group-wide view group-wide view of risk alongside the of the risk profile and to manage the global local view of risk that continues to be Effective challenge – encouraging business across regional, national, product required by many national regulators; challenge and dissent, and organising the and legal entity lines. As the cost of capital and how banks can meet the strategic risk functions to provide access of risk and and funding increases there will also be an challenge of having to balance compliance to senior management and increasing need to consider the risk adjusted centralised group risk management, the Board; and return on particular products and services. decision making and control with the need to demonstrate that the Incentives – basing remuneration on Banks also need to consider how local Board of each regulated entity adherence to risk appetite and to desired risk governance adds value within the remains accountable for the viability, cultures and behaviours, and appropriate organisation and to define clearly the role sustainability and resolvability of that talent development and succession and mandate of functions and individuals entity. planning. with regard to risk management • The bifurcation of reporting (and the responsibilities. consequent need for some form of matrix management) between business Given all these responses to regulatory and lines and risk management, at all levels other pressures, many Boards have asked of a bank, including reporting to the In many major banking whether they have sufficient time to consider Board; and groups there has been strategic and commercial decisions. • The capacity and ability of CROs – and a significant shift in the the risk management function more generally – to take a forward-looking relative importance of the and strategic view of risk. There needs business units and risk be a strong proactive view of risk, not just a reactive and backward-looking management. monitoring of limits and procedures.

48 / Evolving Banking Regulation / February 2014 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. APPENDIX

Risk management In many major banking groups there has been a significant shift in the relative importance of the business units and risk Abbreviations management. More risk management is now embedded in the ‘first line of defence’ (the business units), which has shifted from being almost entirely revenue-driven to being more risk constrained and obligation-driven. Some banks have also restructured the second and third lines of defence, with the second AML Anti-Money Laundering line (including risk management) becoming AQR Asset Quality Review more dominant, more powerful, and more BAFIN Federal Financial Supervisory Authority in Germany centralised; and with an enhanced third line BRRD Bank Recovery and Resolution Directive (including internal audit) to provide more CCPs Central Counterparties robust assurance that systems and controls CEO Chief Executive Officer are operating effectively. CET1 Common Equity Tier 1 However, risk management remains CFO Chief Financial Officer under-resourced in some banks, and in some CFTC Commodity Futures Trading Commission cases the shifts in the first and second lines of defence are far from smoothly embedded. COREP Common Reporting Framework CRD Capital Requirements Directive CRO Chief Risk Officer A renewed focus on an effective three lines of defence approach to CRR Capital Requirements Regulation risk management may call for further D-SIB Domestic Systemically Important Bank investment and up-skilling within the EBA European Banking Authority first line, while an independent second ECB European Central Bank line refocuses its priorities around EMA Europe, Middle East and Africa advice, framework design, effective EMIR European Market Infrastructure Regulation challenge and risk aggregation to identify ESAs European Supervisory Authorities concentrations and correlations across ESMA European Securities and Markets Authority the bank. Regulatory reforms designed EU European Union to improve the independent assessment FATCA Foreign Account Tax Compliance Act of the effectiveness of risk governance FCA Financial Conduct Authority may also call for significant investment FSA Financial Services Authority (UK) and up-skilling in the third line, to provide FSB Financial Stability Board positive assurance on the effectiveness of FTT Financial Transaction Tax risk policies, processes and controls. G-SIB Global Systemically Important Bank LCR Liquidity Coverage Ratio LIBOR London Interbank Offered Rate MiFID Markets in Financial Instruments Directive MiFIR Markets in Financial Instruments Regulation NSFR Net Stable Funding Ratio OECD Organisation for Economic Cooperation and Development PPI Payment Protection Insurance PRA Prudential Regulation Authority SRM Single Resolution Mechanism

At many banks the shift from the pre-crisis problem of inadequate and fragmented oversight – with information not being properly reported upwards from overly- independent business divisions – to much improved group-wide risk data being reported to the Board on a timely basis, remains incomplete.

February 2014 / Evolving Banking Regulation / 49 © 2014 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. kpmg.com

Jeremy Anderson Giles Williams Chairman Global Financial Services Partner, Financial Services KPMG Regulatory Center of Excellence T: +44 20 7311 5800 EMA region E: [email protected] T: +44 20 7311 5354 E: [email protected] David Sayer Global Head of Banking Clive Briault KPMG Senior Adviser, Financial Services T: +44 20 7311 5404 Regulatory Centre of Excellence E: [email protected] EMA region T: + 44 20 7694 8399 Michael J Conover E: [email protected] Global Sector Leader, Capital Markets Simon Topping KPMG in the US Principal, Financial Services T: +1 212 872 6402 Regulatory Center of Excellence E: [email protected] ASPAC region KPMG in China Bill Michael T: +852 2826 7283 EMA Head of Financial Services E: [email protected] KPMG in the UK T: + 44 20 7311 5292 Pam Martin E: [email protected] Managing Director, Financial Services Regulatory Center of Excellence Americas' region KPMG in the US T: +1 202 533 3070 E: [email protected]

[email protected] www.kpmg.com/regulatorychallenges

© 2014 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. Printed in the UK. The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

Produced by KPMG’s Global Financial Services Practice in the UK. Designed by Mytton Williams Publication name: Evolving Banking Regulation EMA Edition Publication number: 131030 Publication date: February 2014