The financial market today is a byproduct of regulations that were born as a result of the financial crisis. “We believed that the financial system had developed ways for each institution to escape the consequences of bad risks. Each institution had come up with a way to take risks without incurring the responsibility. We believed our job was to change that and to re-connect the taking a risk for the responsibility of the risk. Our hope was to substantially decrease the likelihood of another financial crisis,

The media has attributed much of the cause of the financial crises to the housing bubble in the U.S and how banks had repackaged the underlying loans from these housing assets into highly rated mortgage back securities to sell them to wall street investors thereby transferring the risk from main street to wall street. However Vincent Choo, chief risk officer of OCBC, emphasised that it was more the underlying factors such as inadequate risk management practices adopted by banks rather than complex instruments like such as mortgage back securities or CDO’s

The regulatory reaction to the financial crises via Basel had precisely targeted these factors that were bought up by Choo. At the heart of Basel III, the directives aim to strengthen bank capital, funding and liquidity provisions. For the capital directive, all banks are required to maintain certain levels of regulatory capital against their risk. The leverage directive on the other hand is simpler and seeks to assign a fixed ceiling of exposures to a bank’s capital of a ratio of 33% beyond which a bank cannot breach.

said Barney Frank, U.S. politician (and co-author of the Dodd Frank Act), at the 2016 Asian Banker Summit in Hanoi. This statement is significant not only because it sums up the fundamental concept of disproportionate risk-taking by banks that led to the financial crisis of 2008 but also goes to stress the policies that regulators are putting in place today to ensure that banks are fully cognizant of the underlying risks of their exposures and have adequate means to protect themselves from any adverse outcome that were to blame for the crisis. “Transferring risk from the retail segment to the investor segment such as pension funds, may not be a bad thing because it allows banks to free up their balance sheets. However there are a few important factors that need to be well thought out. First, product suitability for clients. Second, the amount of leverage a bank takes in terms of exposure relative to its capital. Third the modeling and assumptions used to rate these products and calculate the risk behind these products. All of these failed during the financial crises.” For retail and corporate banking these Basel directives are not so much an issue. However, for transaction banking which involves trade financing and letter of credit guarantees, the Basel III regulations can have a material adverse effect on profitability. Brian Stevenson, head of transaction banking at RBS goes on to mention that Basel III makes it “uneconomic to provide transaction banking services”. The greatest impact of Basel III however, are on the more complex banking businesses such as treasury and markets where instruments

such as derivatives, being long dated and complex, require sophisticated modeling methodologies both from a market and credit risk perspective. Azzim Gulamhussen professor of financial institutions at Vlerick Business School, commented that “the first response of Basel was to heighten the capital requirements not only to risky derivatives products but also to the lower rated counterparties”.

The consequences of Basel III has been that banks today are under tremendous pressure to make a choice on whether to continue operating risky businesses which require them to set aside large amounts of capital thereby making their balance sheets expensive. Post financial crises, the allocation of capital is highly scrutinised by senior level management at a group level, and there is a consensus amongst many bankers that Basel III is forcing banks to return to basics and invest in retail franchises while cutting treasury and markets businesses. Azzim supports this argument by stating “It is very likely banks over time in response to Basel III may return to focusing back on retail and corporate banking of attracting deposits, providing short term lending and servicing small to medium enterprises rather than engage in risky activities which tend to lower return on equity (ROE). Hence a lot of banks will have to revise their banking models”.

ROE & revising models

ROE for European banks post the financial crises has certainly been a challenge. In early February 2016, global financial markets watched in bemusement as share prices of top European banks plummeted. This sheer drop far exceeded a similar sell off during the financial crises, with Credit Suisse’s share price dropping by 43%, Deutsche Bank by 39%, Barclays by 32% and UBS 29% (year on year figures as of Feb 11 2016). Major media outlets immediately offered various theories as to what caused the sell-off blaming tumbling commodity prices, low interest rates, China’s slowdown and an overall uncertain global political environment. However the real truth behind the sell off was far simpler than macro events. European investors had simply lost confidence in their banks’ ability to meet the desired return on equity (ROE) and decided to allocate their capital elsewhere.

Top European banks have seen plummeting year on year prices.

Figure 1. Banking share price drop Year on Year as of Feb 2016 end

One of the main reasons why the ROEs have dropped is that European banks have been too focused in dealing with the bottom line instead of growing their top line. This means most European banks have been obsessed with cost cutting along with reducing assets and exposures to lower rated counterparties, all in order to boost their ROE. Barclays for example shed 8,000 jobs in the first four months of 2016 while Credit Suisse took aggressive measure to write down their distressed credit loans by $99 million in Q4 2015.

Most European banks have taken the extreme steps of cutting entire business lines that chew up too much capital. Examples of these can be seen in Barclays Capital exiting the prime brokerage offerings or Royal Bank of Scotland cutting their entire clearing brokerage business. Other banks have resorted to what Azzim referred to as ‘changing their banking model’.

Deutsche Bank is perhaps one such bank that has very much focused on changing their model over the past 18 months. At its peak, Deutsche was considered a powerhouse in fixed income derivatives and at one stage was generating an annual revenue of $13 billion from its fixed income currencies and commodities (FICC) division. Much of this rise in FICC trading was attributed to the previous CEO Anshu Jain. Post financial crisis, Deutsche was challenged with a host of new regulations and banking fines. In June 2015 when the bank suddenly announced that the leadership of Anshu Jain and Jurgen Fitschen would be replaced by John Cryan, it was the first step to acknowledging an overhaul of their investment banking and trading business.

Cryan had been in the initial team that had launched the new Deutsche roadmap for restructuring the entire bank called ‘Strategy 2020’. Under Strategy 2020, Deutsche will look to sustain some of its investment banking advisory and new issues business, transaction banking, wealth management and retail banking. The main cutbacks will come in trading and sales and also activities that are high in risk weighted assets (RWA) and balance sheet usage.

When asked about Deutsche’s change in business model Jens Ruebbert, chief country officer of Deutsche Bank in Vietnam acknowledged that the bank was undergoing a transformation in strategy:

“post financial crisis, the management has decided that we do not need to be a bank that does everything for everyone and everywhere. We will concentrate on clients, markets, products and services which we are good at and where we can add value. Yes, we will pull out of some products and markets but we will also focus more on certain others.”

However Basel III has also provided an interesting twist to the markets businesses. Financial markets are known to be resilient and the same can be attributed to financial market participants who have been carefully studying the Basel III regulations and are putting in place leaner models that absorb less risk based capital, but continue to enjoy the same levels of activity. Frederick Shen, head of business management at OCBC remarked: “I don’t think the universal banking concept is going to die. The client may like to access their corporate accounts as well as have access to trading in markets using the same bank. Therefore, for us, it’s important to have a markets business but ensure that we keep RWA to desired levels in order to improve return on shareholder returns”.

There are many ways banks can reduce RWA (and hence the required capital) for each business line. One of the prime focuses of Asian regional banks for example, is on credit risk; especially when it comes to derivatives counterparties. In order to keep capital low and minimised credit RWA costs, banks in the region are proactively implementing initiatives such as netting, central clearing, trade compression and CSA implementation. Frankie Phua, managing director of credit and country risk at UOB mentioned:, “While simple plain vanilla products can be cleared through CCPs, we will always have bespoke, exotic products that cannot be cleared. For such non-cleared products, we will actively seek to mitigate our counterparty risk and minimise RWA costs through netting and margining agreements (e.g. ISDA and CSAs). Even for CSAs, the trend is moving zero threshold given the RWA impact of setting higher thresholds which would negate the very benefit of having CSAs.”

It has been eight years since the financial crises and the birth of a new regulatory landscape that has changed every aspect of banking markets from trading to risk management and from operations to accounting rules. The new buzzword today is ‘unintended’ consequences of the regulations that many market participants feel make it too expensive to operate in a lot of the financial markets. When confronted on the topic of unintended consequences of regulations, Barney Frank’s profound response is one to carefully think about. “No solution to a complex social or economic problem can be by degrees more elegant than the problem itself” which is an acknowledgement that regulators like him are fully aware of the challenges banks and institutions face in the market place and the price to pay is none the less equal to the crime. One thing is certain: this new challenging banking environment will force banks to be more efficient, leverage of disruptive technology, move towards leaner models and perhaps even move towards new regions in search for growth and yield.

Basel III & RWA: safeguarding or profitability?

One key goal of Basel 3 has been to ensure that sufficient capital is set aside to reflect the underlying risk in any activity it engages in. This capital is also known as Risk Weighted Assets (total risk in terms of market, credit and operational risk). The issue here is the more capital that banks set aside for their total RWA in order to satisfy regulatory requirements, the lower is the Return on Equity (ROE) for shareholders. So while institutions are going to great lengths to ensure accurate RWA is computed and set aside, some banks are also adopting skilled methods to lower or optimize RWA much to the concern of regulators.