Including updates on remuneration and assessing the impact of MiFID II on fixed income

 

European banks’ Pillar 3 disclosures improve but remuneration disclosures still need work

Overall, the European Banking Authority’s (EBA) review of Pillar 3 disclosures — which require firms to publish certain details of their risks, capital and risk management to improve market discipline — was positive. The EBA found that banks have significantly improved their disclosures in the past year and are better conveying their risk profiles in a comprehensive fashion. Also, the EBA is pleased with the reduction in the time delays between the publication of firms’ annual reports and their Pillar 3 information. They also suggest that while some concerns identified in the 2010 review remain valid, they apply to a reduced number of banks or concern specific requirements of the Capital Requirement Directive (CRD).

However, of 20 large banks sampled, the EBA found that none of them was providing adequate information on staff remuneration. As part of its annual review of Pillar 3 disclosures, the EBA found that 25% of banks sampled provided ‘insufficient’ information on remuneration, 50% needed further improvement, with the remaining 25% failing to publish their data when the assessment was carried out.

The EBA was not surprised by the results, given that the rules around remuneration disclosure are new, and have only been in force since 1 January 2011. However, it is looking for ‘significant improvement’ in the future as it gets tougher on compliance. In particular, the EBA wants banks to publish aggregate quantitative information on remuneration, broken-down by business area, and staff grades (i.e. in particular in terms of senior managers and other important staff whose actions have a material impact on risk). Banks should also provide detailed information on the risk implications of the remuneration process so that stakeholders can better understand the link between pay practices and risk at banks. On a positive note, the EBA concluded that the banks did provide ‘useful’ information on the decision-making processes associated with staff remuneration and gave ‘helpful’ descriptions of the main characteristics of their remuneration systems.

The EBA also highlighted some other remaining areas of concern:
  • Back-testing information for credit risks: only 35% of banks sampled provided quantitative information on back-testing, which was explained by some on confidentiality grounds. For those that did disclose information, it varied significantly between banks and had significant gaps. Therefore, the EBA are calling for clear presentation of the parameters by exposure classes in the future including probability of default ranges, expected losses percentages and meaningful differentiation of credit risk.
  • Counterparty risk: while the EBA have observed some improvements in both the quantitative and qualitative information provided on counterparty risk, the issue of wrong-way risk was not always addressed by banks. When they were provided, they did not seem to be done using the correct approach (e.g. collateral policy perspective versus a more general approach). It also noted that the disclosure of notional value of credit derivative transactions was insufficient. In the future, the EBA want banks to provide information on the risk-weighted exposure value for counterparty risk.
  • Securitisation: a laundry list of gaps was identified by the EBA around securitisation disclosure. While banks provided generic information about their accounting policies for securitisation they typically failed to explain how ‘they interrelated with prudential rules’ and impact their specific activities (e.g. which activities are derecognised or deconsolidated). However, the review revealed some best practices in this area, including, the disclosure of information on the management of securitisation risk and the comprehensive breakdown by exposure type which some banks published.
Given the sheer volume of disclosures required under Pillar 3, particularly for those banks using advanced methodologies for credit risk, internal audits are generally used to fully grasp the full breadth and depth of the information they are required to produce. The main challenges in this regard are ensuring appropriate allocation of responsibility and ownership for Pillar 3. While much of the information to be disclosed is located within the risk management function at banks, financial disclosures will generally rest within the finance department. In many institutions it may not be immediately apparent where the responsibility for Pillar 3 should lie; therefore, the establishment of clear and documented responsibilities for Pillar 3 is a critical first step for firms, particularly where they also have implementation plans underway for IFRS. The EBA, on this subject, has called on banks to step-up their efforts regarding the interrelationship between IFRS and Pillar 3 disclosures with a view to ‘enabling users to gain a better understanding of the overall profile of the bank as provided by both accounting and prudential information’.

Requirements can still vary between Member States. For example, to improve the quality of Pillar 3 compliance, Germany requires an external audit of the processes used to determine and disclose Pillar 3 information (not equivalent to verification of the content). Moreover, in Austria, the external auditor is required to perform similar tests, but in the broader sense of reviewing the bank’s overall control environment. While other Member States don’t have similar requirements, the EBA reported that some banks (Intesa and BBVA) had their Pillar 3 disclosures audited by an external auditor on a voluntary basis (where audit work performed gives reasonable assurance). Independent verification of Pillar 3 disclosures appears a useful endeavour if done correctly. Firms have much to gain under Pillar 3, if it is approached strategically and thoroughly. Banks with strong risk-return profile and robust risk management can use Pillar 3 as a differentiator from their competitors and in turn reduce their costs of capital and debt. Moreover, requiring senior management to quantify and sign-off on risks inherent across their business operations is a useful exercise in itself in terms of building-up knowledge and awareness of risk strategies, notwithstanding the benefits that additional information will have in terms of macroprudential supervision.


 

Assessing the impact of MiFID II on fixed income

MiFID II will bring in new onerous transaction and trade reporting requirements that will place downward pressure on trading margins and underlining profitability in key business lines, notwithstanding the substantial one-off costs associated with restructuring in terms of business models, trading architecture and data management systems. Firms will have to prepare early-on to capture competitive advantages over rival institutions, particularly around planning for the likely decline in over-the-counter trading (OTC) as new rules move derivatives onto regulated venues and central clearing, making it more difficult for investment banks to sell bespoke solutions to clients.

In terms of commercial considerations, we believe investment banks should pay particular attention to the following areas:
  • OTC derivatives: push for all eligible and sufficiently liquid securities to be traded on regulated trading venues (i.e. Regulated Markets (RM), Multi-Trade Facilities (MTF), Organised Trading Facilities (OTF)). Potential for significant margin pressure as price discovery and execution moves from bilateral to regulated venues (e.g. Credit Default Swaps). In 2010, 89% of Fixed Income Clearing Corporation (FICC) derivative notionals outstanding related to OTC contracts, according to the Bank for International Settlements. Corporate clients may face particular issues. Even where they need to execute OTC to avoid basis risk via an imperfect hedge, increased capital charges and collateral requirements may discourage them especially in conjunction with EMIR. This will impact the sale of structured products, a key profit source for investment banks. Inter dealer brokers may push for market share by registering as OTFs.
  • Market making: Systematic Internalisers are required to maintain two-sided quotes on a wider variety of exchange traded instruments. Risk that banks may be forced to provide quotes on illiquid instruments in times of market distress, e.g. most standardised swaps trading 20 times or less per day, according to the International Swaps and Derivatives Association); likewise Barclay, Hendershott, and Kotz have shown that US treasury trading volumes fall on average by more than 90% once a bond goes off-the-run.
  • Volumes: reduced bid-offer spreads may increase trading velocities, and expansion of regulatory oversight / improved price transparency may attract additional, regulated institutional investors into markets that were previously 'off-limits’.
  • Commodities: broader regulatory oversight, with introduction of position limits / reporting and a review of MIFID exemptions for commodities firms, seeking to reduce leverage and volatility in the marketplace. Emissions trading are being brought into scope. Non-bank competitors may be impacted more than the banks.
Compliance with MiFID will be a significant undertaking. The European Commission conservatively estimate that the new provisions could translate to compliance and administrative costs of around 2 billion euros for the financial industry. This figure probably underestimates the myriad of indirect and unforeseen costs that firms will likely face as they implement the new regulation. We believe that investment banks, particularly their fixed income businesses, will shoulder a significant proportion of the burdens that the financial industry will face.

However, costs can be reduced if firms consider interdependencies with other regulations such as EMIR and Dodd-Frank — as part of their MiFID II impact analysis — and integrate their implementation programmes, to realise synergies and minimise implementation costs within an overall regulatory change programme.


 

Basel III implementation advances

Most countries are still in the very early stages in terms of implementing Basel III, according to a progress report released by the Bank for International Settlements (BIS). Major financial powerhouses such as the United States (U.S.), Hong Kong, Japan and Switzerland have still not published draft regulation to detail the planned content of the domestic regulatory rules that will transpose Basel III (in fact the U.S. have still not fully implemented Basel 2/2.5; Argentina has only started to prepare for Basel II). Europe and China have published draft regulation on Basel III, with Saudi Arabia leading the pack in terms of legislative progress with final rules already agreed.

However, concerns remain that some large countries could still negate globally agreed standards, creating opportunities for regulatory competition and arbitrage. Therefore, the BIS have indicated that ongoing monitoring will be given priority in the coming months. In a speech to Bank of Portugal on 14 October, Jaime Caruana, General Manager at the BIS, focused solely on this very issue, indicating that the Basel Committee’s Standards Implementation Group (SIG) had learned to ‘follow-through’ on implementation this time round by, amongst other things, conducting planned peer/ thematic progress reports. SIG is also putting in place a ‘comprehensive’ and ‘robust’ monitoring and review process covering all aspects of Basel III. This review will be built on, firstly, detailing the status of members’ adoption of the capital framework, secondly, ensuring that regulations are consistent with internationally agreed standards, and thirdly, ensuring that capital framework operates as intended.

On the ongoing sovereign debt crisis, Caruana rejected suggestions from some quarters that the timelines associated with Basel III should be slowed-down in light of volatile funding conditions. In fact, he draws the opposite conclusion from recent events, suggesting that the faster banks rebuild and repair their balance sheets, the faster that market confidence will be restored, funding lines to re-opened and capital costs normalise.

European leaders echoed these sentiments on Thursday morning when they agreed to strengthen the capital positions of their banks by building-up a temporary capital buffer against sovereign debt exposures to reflect a 50% haircut in Greece sovereign debt and the market prices of other sovereign exposures. In addition, banks are required to establish a buffer such that the Core Tier 1 capital ratio reaches 9% by the end of June 2012 to restore confidence in the European financial system. National governments, under the auspices of the EBA, will ensure that banks’ plans to strengthen capital does not lead to excessive deleveraging, including maintaining the credit flow to the real economy. Therefore, to raise additional capital to buffer against sovereign debt write-downs, banks may be forced to jettison non-core business operations and hive-off any profitable business units. Such restructuring scenarios are already been being discussed at some large European banks. Société Générale, for instance, plans to free up 4 billion euros in capital through asset disposals by 2013 to increase core tier 1 (CT1) capital. Moreover, the Bank of Ireland was forced to sell its asset management and life assurance businesses and a building society in 2010 to raise its underlying capital base over and above international standards to again, strengthen confidence in the domestic banking system. This strategy may be adopted by other European banks as they also face a number of challenges in raising capital through issuing debt or equity.