Are We at the Regulatory Abyss?

Are we now nearer the regulatory abyss than ever before? That’s the point in time when managers decide that the risks in a business are too great to accept; it is not an issue of risk versus return. At the abyss, the risks become too high irrespective of the return.

Are we now nearer the regulatory abyss than ever before? That’s the point in time when managers decide that the risks in a business are too great to accept; it is not an issue of risk versus return. At the abyss, the risks become too high irrespective of the return.

If we look at the world of finance over the last five years, we see some horrifying facts. Regulators have become politicized and are now effectively also an arm of the foreign policy compliance process of major countries. Regulators have become judge, jury and prosecutor with no barriers between the roles. And regulation has opened up new risks for financial institutions.

I do not want to comment on the culpability of different banks for sanction breaches, other than that It is clear there was culpability. The question, however, is whether the fines and the process are acceptable. The fines appear high and out of proportion to the profits earned on the delinquent transactions. Importantly, the fines come close to the level where they risk undermining the stability of the banks involved and thus, through contagion, could create systemic risk well beyond the offending parties. But, just as importantly, the fines appear to be an easy option. If there is criminality, it should be punished. Fining, unless it destroys the bank (and that is hopefully not on any agenda), is a way out of the problem. The possibility of penalties, including imprisonment, for individuals will be a greater deterrent against wrongdoing than any fining regime, however onerous, at a corporate level.

Regulators have become too powerful. There is a lack of balance in the relationship between accused and accuser due to the fact that the regulator accuses, decides and penalizes with relative impunity. The risk of being barred from doing business in a world financial market is threat enough to ensure that the accused negotiates a settlement, irrespective of their belief, or not, that the accusations are just. But there is a downside. Banks are withdrawing from areas of activity, both product and geographical. The shadow banking, the naïve banking or the undercover banking sectors that take up the abandoned roles are hard to regulate and at times, ignorant, ambivalent or contemptuous of the rules. Banks are withdrawing from countries where KYC is a challenge but that will not stop cross-border money movement. Banks are ceasing to lend to the poorer segments of the community, but that is pushing the needy into the arms of the loan sharks or the sub-prime specialists. Banks are becoming more wary of short-term exposures, and that is fuelling the growth of the shadow banking sector.

And regulation is a challenge. Bizarrely, although many have voiced concerns, there has been acquiescence to the growing extraterritorial nature of regulation and the creeping scale of regulatory ambiguity. It is clear that FATCA will make it harder for non-resident U.S. nationals, or quasi-nationals, to get banking facilities or be accepted by some investment funds. It is evident that the extraterritoriality of the planned FTT in Europe will lead to synthetic investments in specific offshore, and perhaps other, locations to avoid the tax. Officialdom and their tax experts who believe they have closed the door to avoidance do not understand the skill of the tax avoidance specialists. It is certain that, especially once the ridiculous depo-lite facility is timed out, that AIFMD will be a barrier to entry to many non EU-based funds and could be the catalyst for a major reversal in the globalization process in financial markets. Regulatory arbitrage is already a fact. The mass of similar regulation, all with distinct geographic variances in the severity of the interpretation of that regulation, will drive a fragmentation of the banking, funds and insurance markets.

So how will this impact the custodian? The regulatory trend implies that custody will move from being capital light to capital moderate. The industry cannot assume the risks it has assumed in the last few years, and will assume in the next, without the allocation of added capital. The insurance risk assigned to fund administrators for almost all imaginable risks must require a capital weighting. The total lack of tolerance of regulators for any administrative error in an industry with several billions of transactions per year, still with questions over title to assets at specific points in time, has to create a true risk. And the intraday exposures, that all take so casually, are going to have to be fortified by migration to term commitments, or, at least such commitments for a subset of exposures.

This is not the place to assess what that capital should be but we can all calculate the impact of a few basis points of risk weighting on the assets of the industry. The trouble we face is that revenue is a sensible barrier for operational risks. But capital is needed to cover the growing exposure to event risk in the industry. And the paradox is that such a need is likely to see a curtailment of providers, an increase in supply-side concentration risk and severe constraints on the investment industry as the survivors become ever more prudent.

Regulators should be wary of this trend. But they have themselves to blame. They are the drivers of the trend for they have sought deep pockets to ensure there are no calls on the purse of the State. But perhaps they should have looked for a more equitable balance between the obligations of the providers, and their service providers, and those of the buyers of the different financial services. And, although it may not be popular or easy, perhaps they should eschew negotiation of financial penalties and focus more on personal liability where there is proven wrongdoing.