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EY the Banker Jan 2015 From Regulation to Results

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  • January 2015


    The Banker







    Banks face a continued onslaught

    of regulation in 2015 as politicians

    ne-tune forthcoming legislation

    to toughen up the banking system.

    Farah Khalique investigates.





    Differences in the content and timing of

    rules on resolution planning, structural

    reforms and derivatives are threatening

    to unravel cross-border banking models.

    Philip Alexander reports.




    Conduct risk the risk of staff

    acting unprofessionally, unethically or

    illegally has become a major concern

    for supervisors and banks, as Michael

    Imeson reports.





    The UK banking industry is opening

    itself up to new entrants in the hope

    that this will stimulate greater

    competition in the market. Jane Cooper

    discovers early signs that innovative

    new players could be doing exactly that.


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    RegulatoRs weRe alReady

    woRRied about Risk

    cultuRe because of the

    excessive Risk taking

    pRe-cRisis, then we have

    had all these behaviouRal

    issues post-cRisis

    Patricia Jackson, page 8


    Regulation and stRategy



  • introduction



    The Banker


    January 2015



    Regulation and stRategy

    Banks must keep aBreast of regulatory

    change and make tough decisions in order

    to satisfy regulators demands and maintain

    business as usual. the year 2014 was a year

    characterised by billion-dollar bank fines,

    endless consultations and tough talk from

    politicians, but 2015 looks set to be the year

    that banks gain clarity on new banking rules

    and can start to implement change.

    theuKs Financial Conduct authority is

    set to introduce the new senior Managers

    and Certified Persons Regime in 2015, to

    replace the existing approved Persons

    Regime, which will impose greater responsi-

    bility and accountability on individuals.

    the new legislation is a game-changer

    for investment banks, say experts, because it

    removes the presumption of innocence and

    will force banks to think more carefully

    about how they take risk.


    under the new proposals, a senior person

    can be found guilty of misconduct if a con-

    travention occurs in an area for which they

    are responsible, unless they can show that

    they took reasonable steps to avoid the con-

    travention. the burden of proof is on the

    senior person to show their innocence, even

    if they were not knowingly concerned.

    Will dennis, managing director of com-

    pliance at trade body the association for

    Financial Markets in europe (aFMe), says

    that there remains an element of ambiguity

    as to senior managers responsibility and

    also around who is subject to the rules of

    conduct senior managers or certied per-

    sons. the issue facing banks is the huge

    amount of training for persons who will be

    subject to the new rules of conduct, accord-

    ing toMrdennis.

    if its a wide set of people then obviously

    a lot of training has to be done. it is not clear

    yet for banks, but to put in place all these

    changes in a matter of months is quite a big

    regulatory ask and requires changes to

    employment contracts and systems, he

    says, adding i think it will make banks

    decision making more risk averse because

    individuals [must] think carefully about the

    decisions theymake.

    the new regime is estimated to come

    into effect in the latter half of 2015, most

    likely the fourth quarter. Meanwhile, the uK

    treasury opened a consultation in novem-

    ber 2014 to extend the new rules to senior

    managers at uK subsidiaries of foreign

    banks as well.


    six banks were fined a total of $4.2bn in

    november for colluding to manipulate for-

    eign exchange benchmarks, and the banks

    are now keen to put the scandal behind

    them. But the trend of bank nes is increas-

    ing, says Pierre Pourquery, partner in nan-

    cial services at ey.

    Regulators have made it explicitly clear

    in their rhetoric that they are keen to punish

    previous bad behaviour and stamp out

    nefarious practices. a challenge for banks in

    2015 is demonstrating to regulators that

    potential conicts of interest on the trading

    oor are properly managed, without putting

    themselves in jeopardy.

    one problem is that when banks are

    coming up with a new framework of con-

    trols to deal with conflicts of interest on

    trading oors, they identify issues that can

    expose them to a future legal suit, says Mr


    identifying potential conicts of interest

    on the trading oor is a tricky issue for banks.

    For example, a foreign exchange trader may

    appear to be conflicted when pre-hedging

    aheadof a client transaction.Howcana trader

    demonstrate that pre-hedging by the bank is

    always in the best interests of the client?

    Will Dennis,managing director of compliance,

    Association for Financial Markets in Europe




    Banks face a continued onslaught of regulation in 2015 as politicians ne-tune

    forthcoming legislation to toughen up the banking system. Farah Khalique investigates.

  • January 2015


    The Banker



    We are discussing thiswithmany banks,

    which are wondering now what to do and

    how to implement new controls. one solu-

    tion is to put a limit on the hedge, but i am

    not sure this is the answer and there is no

    best practice guidance, saysMr Pourquery.

    conflicTsof inTeresT

    it is also paramount for banks to identify

    potential conicts of interest between differ-

    ent desks, and to prove to regulators that

    they understand andmanage this risk.

    an options salesperson might sell a dig-

    ital option to a client, for which the payout

    is contingent upon the price of an underly-

    ing bond. arguably, a bond trader at the

    same bank could be persuaded to intervene

    in the market and move the price of the

    bond when the option is set to expire, in

    favour of the bank.

    Mr Pourquery says: one suggestion is to

    forbid trading at the point of expiry, but

    banks cant stopmakingmarkets. therefore,

    some clients are not necessarily protable

    anymore because of the risk, and the cost

    and complexity attached to new controls.

    Banks have until January 30, 2015, to

    respond to the uK Financial Conduct

    authoritys latest consultation on reinforc-

    ing condence in the fairness and effective-

    ness of the fixed-income, currency and



    Banks are also under pressure to put aside

    more capital to prevent another global nan-

    cial crisis. in november 2014, the Financial

    stability Board (FsB) proposed that banks

    hold total loss-absorbing capacity (tlaC)

    equivalent to 16% to 20% of their risk-

    weighted assets or twice the Basel simple

    leverage ratio (6% of unweighted assets).

    david Clark, a former banker at rms

    including HsBC and Bankers trust, and

    now chairman of the Wholesale Markets

    Brokers association, believes that banks

    putting aside more money for capital is

    very signicant indeed, and begs an awful

    lot of questions.

    the two things that jump out at you are

    where the money is going to come from, and

    how much will it cost. Cost of capital will go

    up, it is already more than 10% for some

    banks, saysMr Clark.

    the introduction of functional living

    wills for banks is taking an extremely long

    time to roll out, so the obvious solution is for

    regulators to ask banks to put up more capi-

    tal, says Mr Clark. the FsB will finalise

    banks tlaC in time for the g20 leaders

    summit in turkey in 2015.

    the key challenge for banks is to issue

    enough subordinated debt to meet regula-

    tors demands, according to gilbey strub,

    managing director in resolution and crisis

    management at aFMe.

    one of the concerns of banks is whether

    there is enough capacity in the market to

    absorb new issuance in the timeframe, and

    whether investor mandates will permit

    investing in subordinated debt. its changing

    the wholemarket, he says.


    the 14 principles of the Basel Committee on

    Banking supervision (BCBs) paper 239

    introduce a global framework for risk data

    aggregation and reporting, which banks

    have to comply with by January 2016. a

    study published in december 2013 found

    that one-third of global systemically impor-

    tant banks would not be ready to comply by

    the deadline.

    the problem facing a number of banks is

    their ability to collect data, according to

    Bradley Ziff, chief risk advisor for technology

    firm Misys. Banks use multiple pieces of

    Regulation and stRategy




    software that they buy, and occasionally

    build, and then replace. its a case of rip and

    replace versus work with what youve got.

    Banks need the ability to collect clean data,

    which is a challenge for a lot of these institu-

    tions, he says. the next big step is going to

    be setting up proper limit structures which

    many institutions do not have yet, in terms of

    assets and risk limits.

    But the biggest challenge for banks, from

    a data aggregation perspective, is the com-

    putation of stress-testing, says eysMr Pour-

    query. the bigger a bank, the more complex

    its systems and data. stress testing requires

    strong processes and it to gather all the nec-

    essary data at a granular level.

    For the stress tests expected in 2015,

    especially the us Comprehensive Capital

    analysis and Review, it will be the impact of

    interest rates on macroeconomic variables

    that are taken into account when stress test-

    ing, predictsMr Clark.


    ultimately, banks must fortify their three

    lines of defence, according to many industry

    experts. the first line relates to the front

    ofce, where managers on trading desks and

    credit teams monitor risks the bank is tak-

    ing. the second line comprises more senior

    risk managers who report to the board. the

    third line refers to internal and external

    auditors that oversee a banks operations.

    the key for banks is utilising data and

    technology to better manage risk. For exam-

    ple, monitoring traders conversations to

    nd key words that point to erroneous activ-

    ity can be like looking for a needle in a hay-

    stack. But technology that can perform a

    semantic search, instead of just searching for

    key words, can prove to bemore fruitful.

    in addition, banks need to increase the

    second line of the three lines of defence by

    10% to 15%, according to Mr Pourquery.

    Regulators say the risk should be owned by

    the front ofce, which in effect has created

    another line of defence focused on control.

    now we have more lines and more peo-

    ple, as well as it, infrastructure and data

    infrastructure. in addition, banks have large

    cost-cutting programmes of about $1bn to

    $2bn per bank. the inter-effect of these two

    [scenarios] will most likely drive banks

    towards a new model in terms of how they

    operate, saysMr Pourquery.

    a new role of chief control officer is

    emerging, but banks must ensure that there

    is accountability across all three lines of

    defence. it is a problem when there is no

    clear accountability because everyone has a

    little responsibility, saysMr Pourquery.

    When banks are coming

    up With a neW frameWork

    of controls to deal With

    conflicts of interest on

    trading floors, they

    identify issues that can

    expose them to a future

    legal suit Pierre Pourquery

  • banking models



    The Banker


    January 2015

    In Its fIrst consultatIon on total loss-

    absorbIng capacIty (tlac) to ease the res-

    olution of the worlds largest cross-border

    banks, the Financial Stability Board (FSB)

    included the concept of pre-positioning.

    This means 75% to 90% of the resources

    needed to recapitalise the local subsidiaries

    of a global parent known as material sub-

    sidiaries of the resolution entity would be

    held in the local jurisdictions. Speaking at

    the Financial Times/Banker banking sum-

    mit in November 2014, Credit Suisse invest-

    ment banking co-head Gael de Boissard

    depicted this as a signicant departure from

    the previous efforts, especially in the Basel

    Committee on Banking Supervision, to

    develop genuinely global standards.

    TLAC is the rst time under the [capi-

    tal] framework that we have a fundamen-

    tally national concept. Thats new, and in a

    way we have accepted the reality that we

    have seen through the development of the

    resolution and recovery planning process of

    a fundamentally domestic-based thinking,

    saidMr de Boissard.

    Alongside TLAC and resolution plan-



    Banking models

    Differences in the content and timing of rules on resolution planning, structural reforms

    and derivatives threaten to unravel cross-border banking models, writes Philip Alexander.




    ning, a number of key jurisdictions such as

    theuS,uKandEuhave implemented or are

    considering bank structural reforms that

    prohibit deposit-taking institutions from

    engaging in proprietary trading or impose

    ring-fences within universal banks to enable

    easy separation of retail banking and trading

    desks in the event of resolution.

    Banks are trying to retain the advantages

    of being global, but they also have to make

    statements about how they would implement

    structural reforms, such as the Bank of Eng-

    lands requirement to see ring-fence plans by

  • January 2015


    The Banker






    asian approaches


    moregradually thantheUSor

    Europeto implementderivative

    rulesandresolutionplanning, in

    part reecting the lowerdegree

    ofnancial complexity in the

    region.But thisdoesnotmean

    theywill necessarily followa

    similarpath to theUSorEurope,

    ordevelopany formof regional



    declared itopenly, it seems likely

    that the largestAsiannancial


    porewould like toseethem-

    selvesaspotential tradinghubs.

    Atpresent,derivatives trading


    risk inAsianmarkets than in the

    USandEUbefore thenancial

    crisis.Thatmeansthere is lim-




    regulatoryaffairsat theAsia

    Securities Industry&Financial


    What ismostuseful is to

    build risk-worthy infrastructure,

    especiallycentral clearingcoun-

    terparties [CCPs].There isa


    sideandsell-side thatAsian


    sent.That isnotso important


    small collectorsofsystemic risk,

    butas theyevolve theywill need


    of resilience,shesays.


    forAsia-Pacicnancial ser-



    apragmatic lineonwhether


    in their jurisdictionsneedtobe



    thedistributionofcapital in

    these twomarkets,whereas

    otherssuchas India,South

    Koreaand Indonesiaaremore

    likely topush for ring-fenced

    capital in the localmarket.Even



    arestill likely to facerequire-

    ments to implementasset

    maintenanceratios thatwould

    trap liquidity in thosebranches.



    housesexploringwhether it is


    ateasingleAsianbooking loca-

    tion inastand-aloneex-US

    subsidiary forunclearedover-

    the-counterderivatives trading

    suchas foreignexchangeswaps.


    muchcapital theywouldneed in

    agiven jurisdictionandbalance

    thatwith theneedfora reputa-

    ble regimethatmakespeople

    comfortablewitha transaction.

    Thosebanks thatalreadyhave


    groundaremore likely to look

    insteadatamultiple location



    ForAsianbanks thatare

    becomingcross-border regional

    players,thescale involved is



    (Asean)hasablueprint to form


    in2015.This includes the




    compliant regulatory regimes




    co-operationhas focusedon


    standingrather than fullmutual



    thatenabledMalaysianbanks to

    operate in Indonesia,deals for



    Connect initiative. It isanexcit-

    ing time,Asianregulatorsare

    trying tobuildcloser linksandto

    learn fromtheroll-outofcross-

    border ruleselsewhere,saysMs


    banking models

    January 2015. it is questionable whether

    structural reforms are necessary if we have

    resolvability through TLAC and other initia-

    tives, but regulators have a deep-seated belief

    rightly or wrongly that trading is inher-

    ently riskier than lending activities, says

    Thomas Huertas, partner and coordinator of

    Eys global regulatory network.


    The FSBs intention is that the TLAC propos-

    als should improve the co-operation between

    jurisdictions, because it will give everyone

    more visibility about howa cross-border bank

    would be resolved. But Koos Timmermans,

    vice-chairman of the board at iNG Bank, is

    concerned that the top end of the FSBs pro-

    posed range for pre-positioning of internal

    TLAC (90%)may be going too far. He fears it

    could create incentives for host supervisors to

    bail in subsidiaries early, knowing they have

    almost enough resources locally to recapital-

    ise the subsidiary completely.

    That incentive would be even stronger if

    banks were able to move pre-positioned

    TLAC to other, more damaged subsidiaries.

    Moreover, the FSB proposal would leave

    supervisors with the discretion to add fur-

    ther TLAC requirements under theBasel pil-

    lar two (supervisory oversight) process.

    The pre-positioning of TLAC could lay

    the groundwork for home-host coordination

    as long as the FSBs proposed balance is

    maintained. But if host countries start to

    demand that the subsidiaries they regulate

    hold larger amounts of capital downstream,

    the overall pattern does not work, because

    the sum of what banks would have to keep in

    the subsidiaries would exhaust the ability of

    the parent to hold a sensible amount of capi-

    tal, saysMrHuertas.


    Mr Timmermans other concern is that pre-

    positioningofTLAC inmaterial subsidiaries is

    likely to encourage host supervisors to require

    the creation of a subsidiary where a branch

    previously existed. The process of resolution

    planninghas started this trend already.

    Mostbanksare evaluatinghowtomigrate

    to a global subsidiarised model and how fast

    and far that needs to go. Very few have an

    expectation that they will be able to continue

    operating on an integrated cross-border basis

    governance, capital, liquidity and the resolu-

    tionplanning requirementsall drive towardan

    appreciation that firms in resolution are

    addressed on a jurisdiction-by-jurisdiction

    basis. The comfort level in most jurisdictions

    for relying on co-operation with other coun-

    tries is fairly low, says Marc Saidenberg, a

  • 6|

    The Banker


    January 2015

    principal at Ey and former director of supervi-

    sorypolicy at theNewyorkFederalReserve.

    The uS has required foreign banking

    operations (FBos) to collect their American

    subsidiaries into an intermediate holding

    company (iHC) that will carry its own capi-

    tal and liquidity requirements, and could be

    bailed in separately. That challenge could be

    further intensied by the uS stress-testing

    process. Mr Saidenberg believes for some

    foreign banks the effective capital that Fed

    stress tests will require in the uS will exceed

    whatwould be required by their home super-

    visors, although the use of stress tests is rap-

    idly spreading around the world.

    The new environment is leaning toward

    a change in funding model for some rms.

    Pre-crisis, many were comfortable sourcing

    dollar liquidity in the uS to nance dollar

    assets globally, with little or no capital or

    liquidity attracted to those activities in the

    uS. For groups that face solo capital require-

    ments or scrutiny of trapped capital in their

    home jurisdiction, this is going to challenge

    their model, saysMr Saidenberg.


    Most banks are already operating interna-

    tional retail banking services as a collection

    of subsidiaries, so the pressure to subsidi-

    arise is mainly a concern for the economics

    of wholesale banking, says Mr Huertas. if

    wholesale banks cannot operate an overseas

    branch structure to reach their clients, they

    will naturally want to see if the clients can

    reach them via an international financial

    centre, such as London in the case of Europe.

    if the clients can come to the nancial

    centre, that makes things manageable. But

    whether this works for everywholesale prod-

    uct is something that is in the process of

    being determined. We are working with

    some institutions to try to solve this prob-

    lem, and the solution generally depends on

    how their home country regulation is going

    to change, saysMrHuertas.

    The focus on how to resolve global sys-

    temically important banks is also running

    parallel to difculties between uS and Eu

    regulators in their efforts to provide equiva-

    lence regimes for post-crisis derivatives

    rules. derivatives are global products, and

    the industry is certainly keen to avoid dupli-

    cate but differing regulation in the two larg-

    est nancial market jurisdictions.


    in November 2014, the uS Commodity

    Futures Trading Commission (CFTC)

    extended its no-action relief for non-uS

    swap dealers to comply with certain dodd-




    taxing times

    Bank regulation isnot the


    abouta lackofcross-border


    alsoworriedabout the implica-

    tionsofpoorlycoordinated tax

    systems.TheOrganisation for


    Development (OECD) launched

    anactionplan tocombat tax


    (BEPS) inJuly2013,andhas


    tionpaperson the implementa-

    tionof its 15proposedactions.



    bane inNovember2014wel-



    nalising thiswork in2015,

    including transparencyof tax-

    payer-specicrulings foundto

    constituteharmful taxprac-



    standard for thereciprocal

    automaticexchangeof tax


    Wearemoving fast to limit


    rulesarechanging,and if they

    donotchangeat theOECDlevel,

    countrieswill changethemin

    theirown jurisdictions.Thenew

    ruleswill beknownbytheendof

    2015,andagood investorwill

    anticipate theenvironment,

    becausethedirection isclear,


    torof theOECDscentre for tax


    Whatmatters to thenan-

    cial sector is somedegreeof

    alignmentbetween thedirec-

    tionof travel on taxand the

    many initiatives in the regula-

    torysphere.But thathasnot

    happenedso far,according to

    EYinternational taxpartner


    TheOECDprocess is run-

    ningseparately,and isnotnec-

    essarily focusedonsomeof the

    speciccharacteristicsof the

    nancial servicessector,says


    Areas likely tobeaffected



    cross-borderbanks thathold

    theircore functions inone

    entity thatprovidesservices

    internationallyacross thegroup.

    Bankswill alsoneedtounder-

    standthe interactionbetween

    specicnancial contractsand



    inagiven jurisdiction.

    Someof these issuesmay

    notnecessarilyhave largedirect

    consequences in termsofan

    increasedtax take,but theywill


    ofcompliance inworkingoutall

    theactivitiescarriedoutby the

    banksstaff,andwhere those

    activitiesare takingplace.

    Approaches toreportingvary,


    reportbybusiness line rather

    thanbycountry,which iswhat

    will be requiredbytheOECD


    banking models

    G20members praised progress on the tax base erosion and prot shifting

    action plan at a recent meeting in Brisbane (pictured) in November 2014

  • banking models

    January 2015


    The Banker



    Frank rules on trading via uS-regulated

    swap execution facilities (SEFs) if they used

    any uS personnel to handle a trade even if

    the client is also a non-uS entity. This still

    leaves the nal rules unknown, but one uS

    derivatives lawyer says the extension will be

    very welcome, as the deadline was already

    too close for banks to be able to comply.

    The extra-territorial guidance in 2013

    was already contentious, and the CFTCs

    interpretation of it came as a major shock.

    Many non-uS banks use New york as a cen-

    tralised location for handling Canadian and

    Latin American trading operations all that

    business would have had to move out of the

    uS in 2015, says the lawyer.

    NewCFTC chairman TimothyMassad is

    becoming more closely involved in the agen-

    cys guidance on extra-territorial issues. As

    well as the treatment of foreign banks, the

    impact of SEF rules on uS bank operations

    overseas are also in play.

    Non-guaranteed afliates of uS banks

    are treated as non-uS entities, but the

    CFTCs denition of guarantees could poten-

    tially be broad enough to swallow up many

    types of relationship, says the lawyer.

    Moreover, the SEF rules are just one part

    of the uS extra-territorial equation. The Vol-

    cker Rules prohibition of proprietary trading

    has generated significant confusion among

    foreign banks. The rule is due to come into

    force in July 2015. uS banks are allowed to

    make markets in uS treasuries without fall-

    ing foul of the proprietary trading ban, but

    the treatment of foreign banks and sovereign

    bonds is prompting serious concerns.

    depending on which part of the rule you

    examine, it is unclear if a foreign banking

    organisation with a uS subsidiary can trade

    its home sovereign debt anywhere or only in

    the uS, which would be a very strange situa-

    tion. There also seems to be an implication

    that local sovereign debt can only be traded in

    the home jurisdiction, which would raise

    questions about, for instance, trading Ger-

    man bunds in London, says derek Bush, a

    financial institutions regulatory partner at

    ClearyGottlieb inWashington,dC.


    The uK structural reform set out in the 2013

    Banking Reform Act, including a ring-fence

    around core retail banking and essential

    operations, is due to come into force in 2018,

    so there ismore time to iron out any ambigui-

    ties. Concentration limits will apply to the

    ring-fenced bank, so that its ability to nance

    its non-ring-fenced units will be constrained.

    Possible Eu structural reforms, along

    the lines set out in a report by Finnish cen-




    tral bank governor Erkki Liikanens expert

    group in 2012, are at an earlier stage of

    development. The European Council and

    European Parliament are still debating

    whether to adopt the Liikanen Reports pro-

    posed separation of trading desk operations.

    Ring-fencing any part of a bank and

    requiring it to be separately funded and capi-

    talised is a complicated requirement tomeet,

    which unbundles long-established treasury

    mechanisms internally, so that each new

    function has to manage itself, says Glenn

    Leighton, a managing director of balance

    sheet solutions in the nancial institutions

    group at Barclays investment bank.

    TheuKapproach, however, seems easier

    to implement because of the location of the

    proposed ring-fence. inside the fence, the

    banks retail and small business franchise

    will provide deposit funding. outside the

    fence, larger corporate and international cli-

    ents will have deposits that can fund the

    entity, potentially together with individual

    savings over the deposit guarantee cap. in

    Liikanen, by contrast, the trading book is

    potentially supposed to be ring-fenced as a

    specic entity.

    The trading book is not an entity, it does

    not have its own separate systems or people,

    it is just items within a portfolio that are not

    separately distinguished. The trading book

    has no natural customer base in the sense of

    customers coming into branches or retail

    funding. individual derivative positions

    could be the aggregate of several customer

    trades or the positions of internal market

    riskmanagers, saysMr Leighton.

    From an international perspective, the

    operations of uK-headquartered banks that

    are outside the European Economic Area

    will need to be placed outside the ring-fence.

    Mr Huertas says this has sent a signal in

    itself to other jurisdictions, inuencing the

    introduction of the uS FBo rules and the

    domestic lifeboat rule for Swiss banks that

    would separate their international opera-

    tions in a resolution.

    That is also consistent with the legisla-

    tion of many countries that sets the supervi-

    sors objective as promoting financial

    stability in the domestic jurisdiction, rather

    than internationally, saysMrHuertas.

    Mr Leighton at Barclays says uK groups

    that are run as a federated set of subsidiaries

    will have existing financing arrangements

    formuch of their international business, eas-

    ing the transition to ring-fencing. But for

    banks running a bolt-on branch network or

    complex offshore structures, the intra-group

    lending limits will make that more difcult

    tomanage, he says.

    Banks are trying to retain

    the advantages of Being

    gloBal, But they also have

    to make statements aBout

    how they would implement

    structural reforms

    Thomas Huertas

  • ConduCt risk



    The Banker


    January 2015

    improve their risk culture, and guide super-

    visors on how they should be supervised.

    One of the foundations of a sound risk

    culture, says the guidance, is that employees

    in all parts of an institution should conduct

    business in a legal and ethical manner.

    Effective risk governance is another founda-

    tion: the board of directors, the riskmanage-

    ment department and the compliance

    function should have an important role to

    play in conduct risk control.

    In addition, the Basel Committee is con-

    sulting on a revision to its corporate govern-

    ance principles for banks. The consultation,

    which ends on January 9, 2015, has a strong

    focus on risk management. It includes pro-

    posals to strengthen the guidance on risk gov-

    ernance, including the riskmanagement roles

    played by business units, risk management

    departments, and internal audit and control

    functions (the three lines of defence), as well

    as the importance of a sound risk culture.

    One of the responsibilities of a banks

    board, says the Basel Committee, is to have a

    role in writing the banks risk appetite state-

    ment, which should include qualitative

    statements to address reputation and con-

    duct risks as well as money laundering and

    unethical practices.

    Regulators have moved into the policy

    area and are telling banks that the three-lines-

    of-defence principle of risk management has

    not worked, says EYsMs Jackson, who is also

    editor of the just-published bookRisk Culture

    and Effective Risk Governance. In effect, it

    has been reduced to only one line of defence,

    she says. Only the risk function is controlling

    the risk, while the frontline which should be

    the rst line of defence is just interested in

    revenue generation. Regulators are saying

    that the frontline has to own the risk.

    Ted Price, advisor, risk governance, for

    the Americas at EY, adds: Supervisors are

    struggling with how to assess risk culture

    and conduct in nancial institutions because

    it is out of their comfort zone. They are used

    to auditing things they can touch and feel,

    whereas culture is largely intangible. Super-

    visors are therefore putting together differ-

    ent kinds of assessment frameworks, and

    some have considered hiring psychologists.


    The European Banking Authority (EBA), in

    its June 2014 Risk Assessment of the Euro-

    pean Banking System, noted that detrimen-

    tal business practices of EU banks continue

    to affect consumer condence in banks and

    have an increasingly adverse impact on insti-

    tutions involved.

    It added: Inappropriate conduct such as

    risk culture because of the excessive risk tak-

    ing pre-crisis, then we have had all these

    behavioural issues post-crisis, says Patricia

    Jackson, head of nancial regulatory advice,

    Europe, theMiddle East, India andAfrica, at

    EY. It has really made the regulators con-

    cerned about the conduct of rms vis--vis

    their customers and the markets. Boards are

    concerned too because the nes and the rep-

    utational damage have been substantial.


    The Financial Stability Boards Guidance on

    Supervisory Interaction with Financial

    Institutions on Risk Culture: A Framework

    of AssessingRisk Culture, published in 2014,

    has done a lot to help banks understand and

    The huge penalTies levied on banks in

    recenT years for poor standards of behav-

    iour, failures in operational controls, regula-

    tory breaches and illegal activity has created

    a new term in the lexicography of risk man-

    agement: conduct risk.

    The inability of banks tomanage this risk

    has resulted in severe cases of benchmark rig-

    ging, product mis-selling, sanctions busting,

    failures in anti-money laundering proce-

    dures, rogue trading, insider dealing and

    other transgressions. As a result, some banks

    have been ordered by criminal prosecutors,

    regulators and others in authority to pay hun-

    dreds of millions often billions of pounds,

    dollars or euros in nes and compensation.

    Regulators were already worried about



    Conduct risk

    Conduct risk the risk of staff acting unprofessionally, unethically or illegally

    has become a major concern for supervisors and banks, as Michael Imeson reports.




    On the dark side: banks inability to manage conduct risk has resulted in a number of high-prole scandals

  • RegulatoRs weRe alReady

    woRRied about Risk

    cultuRe because of the

    excessive Risk taking

    pRe-cRisis, then we have

    had all these behaviouRal

    issues post-cRisis

    Patricia Jackson

    ConduCt risk

    January 2015


    The Banker



    mis-selling of banking and other products to

    consumers, failures with regard to rate

    benchmark setting processes, and alleged

    manipulation of markets for credit default

    swaps has already been mentioned in previ-

    ous reports. However, the scope of alleged

    inappropriate practices is widening, and the

    magnitude of previously identied detrimen-

    tal practices, for example related to foreign

    exchange trading business, is increasing.

    The EBA said that individual banks had

    paid out in the form of compensation,

    redress, litigation and similar payments

    aggregate amounts of more than 1bn in the

    previous year. Such rising conduct costs in

    some cases substantially affect protability

    of institutions concerned, it says. As a result,

    there is a need to keep conduct risks high on

    the supervisory agenda.

    In conclusion, the EBA recommended

    that risk cultures should be adjusted and

    that banks should better integrate conduct

    of business concerns in their governance and

    risk management arrangements. Current

    arrangements, it said, frequently fail to iden-

    tify conduct of business concerns as there

    often is no internal institutional denition of

    conduct risks, and most risk models applied

    in institutions fail to capture conduct risks.

    The EBA also includes conduct risk in its

    draft guidelines for common procedures and

    methodologies for the supervisory review

    and evaluation process (SREP) under the

    Capital Requirements directive IV. The nal

    guidelines will be issued shortly, for national

    supervisors to follow from January 1, 2016.


    TheUKs Banking ReformAct 2013 not only

    introduced structural changes to the coun-

    trys banking sector but took action to

    improve bankers behaviour. The measures

    taken included a criminal sanction for reck-

    less misconduct if it leads to bank failure, a

    more stringent approval regime for senior

    bankers run by the Prudential Regulation

    Authority (PRA) and Financial Conduct

    Authority (FCA), and the creation of the

    Banking Standards Review Council (BSRC).

    The PRA and FCA are currently review-

    ing the responses to a joint consultation

    paper CP14/13 Strengthening accountabil-

    ity in banking: a new regulatory framework

    for individuals which will replace the

    Approved Persons Regime (APR) with

    somethingmuch stricter.

    The behaviour and culturewithin banks

    played a major role in the 2008-09 nancial

    crisis and in conduct scandals such as pay-

    ment protection insurance mis-selling and

    the attempted manipulation of libor, says

    the paper. The new framework will mark a

    fundamental change in the regulators abil-

    ity to hold individuals to account.

    The APRwill be replaced with:

    A Senior Managers Regime, which will

    clarify the lines of responsibility at the top

    of banks, force banks regularly to vet their

    senior managers for tness and propriety

    and impose tougher penalties.

    A Certication Regime, which will apply

    to a wider range of staff than under the

    APR, will require banks to assess the tness

    and propriety of staff who are in positions

    where the decisions they make could pose

    signicant harm to the bank or any of its


    A new set of conduct rules applying to

    all bank employees except those in exempt

    positions such as security guards or canteen

    staff which lay down expected standards of




    The regulatory push is being complemented

    by industry initiatives, chief of which is the

    creation of the BSRC to promote high stand-




    ards of behaviour and competence across the

    UK banking sector standards that cannot

    be enforced by regulation alone.

    Strictly speaking, the BSRC is not a true

    industry initiative because it is was recom-

    mended by the Parliamentary Commission

    on Banking Standards, after which the UK

    government told the UKs six biggest banks

    and the biggest building society,nationwide,

    to set it up.

    The banks appointed Sir Richard lam-

    bert, former director-general of the Confed-

    eration of British Industry, to get the ball

    rolling. In May 2014 he published a report

    stating exactly how the board should be

    organised and what it should do. The report

    said that the council should contribute to a

    continuous improvement in the conduct and

    culture of banks and building societies doing

    business in theUK.

    dame Colette Bowe was appointed the

    BSRCs chairman in november 2014 by a

    selection panel chaired by the Bank of Eng-

    land governor Mark Carney and which

    included the Archbishop of Westminster.

    Executivemanagers are nowbeing recruited.

    In the rst half of 2015 it should be able to

    report on the state of banking standards and

    good practice.


    The Centre for Commercial law Studies at

    Queen Mary University of london has

    recently set up an Institute for Regulation

    and Ethics and is carrying out research into

    conduct risk.

    More should be done at corporate gov-

    ernance level to make sure that the direc-

    tions from the top actually reach the foot

    soldiers below, says dr Costanza Russo, the

    Institutes deputy director. Banks have real-

    ised that complying with rules is no longer

    enough. Some are sending very clear mes-

    sages that aggressive selling is not an

    accepted practice, and most of them have

    sent their employees back to school to attend

    ethics and compliance trainingprogrammes.

    However, conduct will not improve unless

    the culture changes too.

    EYs Ms Jackson agrees that ethics

    courses are important. But banks must still

    have hard frameworks in place to ensure

    accountability, to set the risk appetite and to

    improve risk transparency.

    If you go down the ethics training route,

    it has to be explicit case-study based train-

    ing, so that when issues come up people

    know exactly what to do, says Ms Jackson.

    You have to make sure that everyone in the

    organisation lives by those values they cant

    always put prot rst.

  • new approaches to banking



    The Banker


    January 2015

    Bank, says: It is a lot easier, but it is not

    easy. He should know, this is the second

    time he has been through the process of set-

    ting up a bank in theUK.


    When Mr Thomson set up Metro Bank in

    2008, it was the rst time in more than 100

    years that someone had created a new stan-

    dalone bank in theUK. Although the regula-

    tor at the time the Financial Services

    Authority (FSA) had received applications

    for new banking brands, these were all set up

    as subsidiaries of existing companies, which

    already had a banking licence. For example,

    Life has got easier for anyone wanting

    to set up a new bank in the uk. Simpler

    regulation, cheaper technology and political

    pressure on the industry to encourage more

    competition in the banking sector are just

    some of the reasons why the UK is nowmore

    likely to see new entrants to themarket.

    According to one news report from April

    2014, 29 companies are in the process of

    applying for a banking licence in the country.

    This includesnames such asAtomBank, Star-

    ling andLintelBank, all ofwhich are currently

    being considered by theUKs regulators.

    Of the new licencing process, Anthony

    Thomson, founder and chairman of Atom

    Banking: thenextgeneration

    New approaches to banking

    The UK banking industry is opening itself up to new entrants in the hope that this will stimulate greater competition

    in the market. The early signs are that innovative new players could be doing exactly that. Jane Cooper reports.




    Egg, an online bank launched in 1998, was

    created by the banking arm of UK nancial

    services provider Prudential; First direct

    was a branchless brand from UK bank

    HSBC; and Ing direct was a subsidiary of

    dutch banking group Ing.

    In setting up Metro Bank, there were a

    number of challenges owing to the length

    and the opaque nature of the authorisation

    process, saysMr Thomson.

    Another challenge, he says, related to the

    amount of regulatory capital the FSA

    required a new bank to hold. A minimum

    gure was not xed and it kept asking for

    more and more, which is not efcient from

    Taking steps forward: UK regulators are now far more welcoming to those hoping to set up a new bank in the country

  • new approaches to banking

    January 2015


    The Banker



    the shareholders perspective, he says.

    Access to the payments systems also proved

    difcult for a small, new player.

    now, Mr Thomson notes, there is a pay-

    ment systems regulator in the UK, which

    ensures fair access to payments systems for

    players of all sizes.

    Since his experience with Metro, Mr

    Thomson says there has been a real sea

    change in the attitude of the UKs regula-

    tors. Since March 2013, he says the process

    has been simpler and clearer.


    There are now two regulators in the UK

    the Financial Conduct Authority (FCA) and

    the Prudential Regulation Authority (PRA),

    which replaced the FSA in April 2013. But

    new bank hopefuls need only apply once to

    the PRA, which is the lead regulator for

    banks. There are also now two options for

    banks to apply for authorisation: option a

    and option b. Option a is suitable for com-

    panies that already have investors, capital

    and technology in place to set a new bank

    up quickly.

    With option b, banks are able to able to

    overcome the old problem of having to make

    plans without a licence. Previously, it was

    difcult to attract investors and raise capital

    without a banking licence and it was equally

    difficult to get a banking licence without

    investors and plans in place.

    Option b is a staged mobilisation route,

    and is the option that Atom Bank, Starling

    and Lintel Bank have all opted for. Firms can

    be authorised based on their business plan

    but are restricted from operating as a bank

    until they have raised the necessary regula-

    tory capital. By gaining regulatory approval

    first, it makes it much easier for banks to

    thenmobilise the funds from investors.

    Atom, for example, has already been

    authorised with restriction and is now in the

    process of raisingmore capital. In december

    2014, it announced another investor Jim

    Oneill, the former chairman of goldman

    Sachs Asset Management who invested

    25m ($49.1m) in the bank, which plans to

    launch in 2015.


    Another new entrant to the UK market is

    Starling, which also plans to launch in 2015.

    Anne Boden, the banks CEO, says option b

    makes things a lot easier before that you

    could not hire people or make contracts,

    without a banking licence.

    Ms Boden explains that there are now

    numerous opportunities to discuss an appli-

    cation with regulators. A number of meet-

    Delivering something

    the customer wants is

    the most important thing.

    Banks have Been far too

    focuseD on solving their

    own proBlems [rather]

    than solving customer


    Anne Boden




    ings are offered, such as a coffee meeting to

    discuss the proposition, then the applicant

    can send in a business plan and discuss it

    with the regulators, then there is a challenge

    session. After an applicant has gone through

    all these stages, it can then hand in its formal

    application, explainsMs Boden.

    UK regulators are now farmorewelcom-

    ing to those hoping to set up a new bank, an

    attitude borne out of a wider political drive

    to encourage more competition in the coun-

    trys banking sector. Politicians from all par-

    ties have been calling for the dominance of

    the big four high street banks Barclays,

    HSBC, Lloyds and RBS to be reduced,

    especially since two of these players, Lloyds

    and RBS, needed taxpayer bailouts at the

    peak of the nancial crisis.


    One initiative, the current account switching

    service,was launched in theUK inSeptember

    2013, and is aimed at motivating more con-

    sumers to consider switching their current

    account to another bank. It was thought that

    one of the factors stiing competition in the

    UKwas the reluctance of many consumers to

    switch to anewbank, becauseof theperceived

    difficulties in changing payments to a new

    bank account. The scheme simplies the pro-

    cess of changing current accounts and also

    guarantees the payments, with a promise to

    reimburse customers for any charges that

    occur for erroneous transactions.

    The current account switching service

    was a technology project implemented

    across the banking industry in theUK.How-

    ever, it is not the only new technology mak-

    ing life easier for new entrants; other

    advances are also helping to make it easier

    for new challengers to enter themarket.

    now, explainsMrThomson, it is possible

    for start-up banks to rent the technology

    infrastructure necessary to run a bank rather

    than having to buy it or build it themselves.

    Atom Bank has opted to use Fiservs soft-

    ware for its operations. Fiserv is one of the

    rst providers of a simple off-the-shelf tech-

    nology package for start-up banks, but Mr

    Thomson anticipates that more technology

    providers will start offering similar solutions

    in the future.

    Ms Boden says that Starling has decided

    to build its own technology and is aiming to

    bring techniques found in Silicon Valley

    and used by the likes of Facebook, google

    andnetix to theUK banking sector.


    While the UK has seen a number of chal-

    lenger brands entering the UK banking

  • 12


    The Banker


    January 2015

    is an e-money institution that has an

    e-money licence from theUKs FCA.

    Peter Cox, executive chairman of Contis

    group, explains how the company ts into

    the payments ecosystem. The company is a

    shareholder and principal member of Visa

    Europe and is also a Visa-certied processor,

    he says, which means that Contis processes

    all the transactions for the cards it issues

    under its e-money licence for its client

    brands. Contis is also connected to the regu-

    lar banking payment rails, which allows

    funds to be paid into and out of the Ffrees

    account via the regular banking network.

    We brand ourselves as the home of alter-

    native banking, says Mr Cox, who explains

    that the companys solutions are also used by

    more than 100 credit unions, as well as by

    other brands in theUKand theEU.

    Ffreesmakes itsmoney from transaction

    andmonthly account fees. Although such an

    idea would be unusual to most UK consum-

    ers whose free bank accounts have been

    cross-subsidised by exceptions charges the

    Ffrees proposition is attractive to low-

    income people who have been stung by bank

    charges for being overdrawn. not being able

    to go overdrawn is marketed as a key benet

    of the Ffrees account.

    space such as Virgin, TSB and Williams &

    glyn Ms Boden argues that these all use

    traditional banking models. And, although

    they are new brands, they have been borne

    out of older entities. Virgin, for example,

    expanded into a retail bank by acquiring

    northern Rock. And TSB and Williams &

    glyn are brands that have been spun off from

    Lloyds Banking group and RBS group,

    respectively, in line with an agreement with

    European competition regulators.

    In return for state aid during the global

    nancial crisis, Lloyds and RBS agreed that

    they would sell off some of their businesses.

    They both opted to separate out these busi-

    nesses by reviving old brands, which will be

    sold off at a later date.

    Ms Boden also points to another trend in

    the banking sector: There is a huge amount

    of disaggregation in nancial services lots

    of people are providing parts of the value

    chain. What we are going to do is one thing:

    we will do current accounts.

    Banks typically offered a range of bank-

    ing products to their customers, but now

    consumers can get their nancial products

    from other sources. This couldmean a credit

    card from personal credit card provider

    MBnA, a peer-to-peer loan from peer-to-

    peer lending service Zopa, or a current

    account from another niche provider.


    Alex Letts, CEO and founder of UK-based

    Ffrees Family Finance, talks of a compo-

    nentisation of the industry, where different

    nancial products can be provided by differ-

    ent players and not a single bank. Ffrees

    offers a current account, which is targeted at

    the unbanked segment in the UK. Although

    it functions in the same way as a bank

    account, the Ffrees solution does not need a

    banking licence behind it.

    European regulations through the

    E-Money directive allow the creation of

    electronic money institutions that can issue

    e-money. Prepaid card programmes have

    proliferated under this regulation and

    the Ffrees account is an evolution of such

    a product.

    In 2009, the second E-Money directive,

    which was implemented in the UK in 2011,

    made it easier to become an e-money issuer.

    There are now no initial capital require-

    ments for small institutions that have less

    than 500,000 of e-money outstanding, on

    average. Institutions with more than this

    must hold initial capital equal to 2% of their

    average outstanding e-money total.

    The Ffrees account is provided and

    licenced by Contis Financial Services, which




    new approaches to banking

    The account is not a deposit account

    such as those offered by banks with banking

    licences and so it does not pay interest on

    the balances. Another difference is that pre-

    paid programmes are not covered by the

    UKs Financial Services Compensation

    Scheme. However, customers funds are

    held in a segregated account, so if the issuer

    of the prepaid programme were to run into

    trouble, it would be protected from the

    companys creditors.

    When asked if Ffreeswould ever consider

    applying for a banking licence,Mr Letts says:

    This is not in our thinking. The whole point

    of running on the e-money rails is to be able

    to create a business model that out-competes

    the banks and the new challenger banks with

    their streamlined services in the core current

    account business. It means we dont carry the

    regulatory and capital burdens that the

    deposit takers face.We do not intend tomake

    a land-grab for the other services offered in

    the banking ecosystem.We intend to own the

    heart, not the limbs!


    Ms Boden says that Starling has a stream-

    lined strategy, with the current account at

    the heart of the banks operations. The

    mobile banking proposition will help peo-

    ple with their personal nances. For exam-

    ple, when a cheque comes into the account,

    the bank will notify the customer and will

    also alert them if it is more or less than they

    were expecting.

    Wewill predict for them howmuch they

    will have left until the end of themonth, says

    MsBoden. The target group is 18- to 35-year-

    olds, who Ms Boden says usually manage

    theirmoneywell for the rst twoweeks of the

    month but, after that, things may get prob-

    lematic. We are helping people so they do

    not go overdrawn, she says.

    When asked what the key to building a

    new sustainable bank is, Ms Boden says:

    delivering something the customer wants is

    the most important thing. Banks have been

    far too focused on solving their own problems

    [rather] than solving customer problems.

    For Mr Thomson at Atom, success and

    sustainability rest on two things. The rst, he

    says, is the strength of the proposition and

    having a good business plan. The other is the

    strength and experience of the management

    team, as well as the oversight and govern-

    ance through a high-calibre board of non-

    executive directors.

    Putting together a team and building a

    strong proposition in this way is not easy, but

    at least now with simpler regulation in the

    UK it does become a lot easier.

    [the regulator] kept

    asking for more anD

    more [capital], which

    is not efficient from the

    shareholDers perspective

    Anthony Thomson

    BKR SUP COV 0115EY_BKR_050115_p001EY_BKR_050115_p002EY_BKR_050115_p003EY_BKR_050115_p004EY_BKR_050115_p005EY_BKR_050115_p006EY_BKR_050115_p007EY_BKR_050115_p008EY_BKR_050115_p009EY_BKR_050115_p010EY_BKR_050115_p011EY_BKR_050115_p012