Special issue: Preparing for real change

The halls and meeting rooms in Davos last month were full of heated discussions on the evolving global political, social and economic landscape. PwC were at the summit speaking about our 17th annual global CEO survey which paints a picture of renewed hope on global economic prospects. But this hope is fragile leading as yet to only a small rise in confidence about business growth prospects in 2014. Many CEOs remain very worried about over-regulation and the ability of governments to tackle debt and deficit levels. Yet – for now – serious global risks have been averted and CEOs are thinking once again about growth.

Stable growth depends on stable regulation. But the global regulatory landscape remains a work-in-progress. As we transition to the implementation phase of G20 reforms, the impact of regulations will come to the fore, testing regulators, policy makers and practitioners alike. In this special issue we report on our latest research into a number of important topics. The new EU recovery and resolution framework is central to address concerns over too-big-to-fail financial institutions. We examine the political agreement on the EU framework that politicians reached before Christmas and what that means to banks. We also look at the latest round of reforms from the Basel Committee as it finalises the expansive Basel III framework. Finally, we take a peek into the increasingly complex world of central banking which is risking a crisis of confidence.

We hope that this analysis will help stimulate debate and help you prepare for real change in 2014.

 

New era for crisis management for banks

On 11 December 2013, the European Parliament and the Council reached agreement on the Bank Recovery and Resolution Directive (BRRD). This important piece of legislation sets a common framework across all 28 countries of the EU on how to deal with troubled banks.

The Directive aims to address the patchwork and inadequate nature of existing insolvency procedures for banks across the EU by:

  • preserving systemically important operations when a bank fails to avoid significant adverse effects on financial stability, including preventing contagion, and maintaining market discipline
  • minimising reliance on extraordinary public financial support
  • protecting covered depositors and investors, as well as client funds and client assets.

The Directive will establish a range of instruments to tackle potential bank crises at three stages:

  1. Preparatory and preventative: firms would be required to draw up recovery plans and update them annually.
  2. Early intervention: Authorities would have the power to appoint special managers to a firm either to replace or to temporarily work with the firm’s management to restore its financial soundness and/or to reorganise the firm so as to ensure its viability at an early stage.
  3. Resolution: powers and tools to ensure the continuity of essential services and to manage the failure of a firm in an orderly way. The resolution tools include a sale of business tool, a bridge institution tool, an asset separation tool and a bail-in tool.

The BRRD also sets out common resolution powers and mechanisms for co-operation between resolution authorities in applying resolution tools to financial groups operating on a cross-border basis, with a significant role for the European Banking Authority (EBA). It will establish national resolution funds that can be drawn upon to cover the costs incurred when using resolution powers and tools.

The Directive will apply from 1 January 2015 to all EU banks, although EU authorities have until 1 January 2016 to introduce the bail-in requirements.

The proposals are in line with, and in many areas go further than, the Financial Stability Board’s Key Attributes (2011) which require recovery and resolution plans to be put in place for systemically important financial institutions. The BRRD sets a common recovery and resolution framework for the EU as a whole. Existing national crisis management frameworks will need to be aligned to the BRRD when it comes into force, including the Prudential Regulatory Authority’s (PRA) incumbent recovery and resolution framework. In the Eurozone, the Directive will underpin the Single Resolution Mechanism, a key element of the ‘banking union’, which is still under negotiation in Brussels. But many details of the new regime still need to be clarified by the EBA through the preparation of technical standards and guidelines, over twenty-five of which are due within twelve months of the Directive entering into force (which will be twenty days after publication in the Official Journal).

To help you understand these important changes, we have prepared a hot topic on the Directive, summarising the main concerns and the likely impact for banks.

 

Basel Committee brushes up leverage and liquidity rules.

On 12 January 2014, the Basel Committee took a major step towards completing its ‘to-do’ list on the outstanding Basel III items, with the release of final documents on the leverage and liquidity coverage ratios, and a consultation paper on the Net Stable Funding Ratio (NSFR). It has revised its leverage ratio framework, the non-risk based 'backstop' to risk-based capital requirements, following consultation last year. It has also amended the Liquidity Coverage Ratio framework to include central bank facilities, published guidance for supervisors on the use of market-based indicators of liquidity and fleshed out disclosure requirements for the LCR.  The consultation on the NSFR explores the means to ensure funding stability, reducing reliance on short-term wholesale funding and encouraging funding assessment across on- and off-balance sheet items.  It closes on 11 April 2014.

The leverage ratio stole most of the headlines. Banks will be able to operate under higher leverage ratios according to the revised calculation than they would have under the calculation proposed in June 2013. The Committee reined back somewhat from the principles of grossing up exposures to capture all possible sources of leverage and achieving international consistency. They adopted a more pragmatic approach for certain exposure types and allowed for some recognition of netting in the 'exposure measure' - the denominator of the leverage ratio.

The outcome on leverage ratios was widely reported as a significant victory for the industry, but the real impact of these revisions will depend on the extent to which these relaxations are relevant to existing, or potentially achievable, transaction structures. In Leverage ratio: the impact on securities financing transactions, we consider the potential impact of the leverage ratio on the multi-trillion dollar repo and securities financing markets. These markets play an important role in the efficient distribution of liquidity and collateral around the financial system. They have traditionally attracted minimal capital requirements due to the use of high quality collateral. But the leverage ratio ignores the risk-reducing benefits of collateral, resulting in some cases in substantially higher capital requirements for what is typically low-margin business.

Banks also achieved a significant win on liquidity regulations. The Committee agreed to relax its framework on including central bank facilities in High Quality Liquidity Assets (HQLA). Prior to this relaxation, only jurisdictions with insufficient HQLA to meet the needs of their local banking system could include them. It’s still subject to national discretion but if implemented should ease liquidity pressures on banks.

The revision to the NSFR, the long-term liquidity ratio, keeps the same framework and logic, which is to promote stable funding. It assigns required stable funding requirements and available stable funding factors to assets and liabilities. The new framework is more favourable to retail banks than the previous version. But it is too early to assess precisely the impact on EU banks because we need to wait for final adoption by the Basel Committee and transposition into EU legislation.

 

Central banking in a world of flux

Before the financial crisis, central bankers were triumphant. They had tamed the business cycle, mastered monetary policy, and defeated inflation. The situation is now very different.

As a result of the events of the past few years, confidence in traditional monetary policy has been shaken, forecasting tools are being modified, central bankers' objectives are being debated and the holy grail of central bank financial and operational independence is being tested.

More change is coming. Since the crisis, overstretched central banks have been given additional powers but have also been asked to achieve a wider range of objectives - creating potential conflicts. Some will have to develop policy in untested areas, like macro-prudential regulation and resolution oversight - alongside traditional, yet evolving policy areas, including prudential supervision and financial stability. Others, for instance the European Central Bank, will be operating in uncharted and untested waters on a number of fronts.

Moreover, the effects of unpredictably low interest rates are not fully understood. The traditional monetary policy tool for inflation targeting via interest rates no longer appears effective. But to steer interest rates back to more "normal" levels will be fraught with political challenges. Also, the fire-fighting actions taken during the crisis—when the central banks pumped billions of dollars into the financial system (via Quantitative Easing - QE) to keep it afloat—could come back to haunt them in the near future.

All of these and more suggest that we are likely to remain in interesting times as we continue to navigate our way through the crisis. In September 2013, PwC organised a two day forum, “Living in interesting times—Navigating the new era for central banking”, to discuss these and other issues with invited central bankers and PwC representatives from around the world.

Informed by these discussions, we prepared a report setting out the challenges of a new era of central banking in which longstanding economic and policy making certainties no longer apply and central bankers are taking on responsibilities and an associated public profile that few have encountered before.