Overregulation a major issue for banks

Bankers and banking industry observers say the biggest risk facing global banks is overregulation, according to a recent international banking report.

That’s because excessive or ill-considered regulations result in unintended consequences that shift rather than reduce regulatory risk, which endangers not only banks but the global economy, too.

“The cost of this enhanced compliance and regulatory regime is huge,” says Diane Kazarian, national leader, banking and capital markets practice, with PricewaterhouseCoopers LLP (PwC) in Toronto. “And it affects the time and focus [bank executives need] to actually run their businesses.”

However, some banking industry observers say that despite the unavoidable but minor drawbacks, tighter banking regulations will result in a stronger and safer global financial system that’s less likely to endanger the global economy with recurring crises.

“Any concern with overregulation is a problem created by the banks,” says Michael King, assistant professor of finance with the Ivey Business School at Western University in London, Ont. “The regulations that we’re seeing now are a response to weaknesses and irregularities that were exposed during the [2008] financial crisis.”

In May, the London, England-based Centre for Study of Financial Innovation, in association with PwC, released The Banking Banana Skins 2014, a biennial report on global banks based on a survey of 656 bankers, risk managers and bank observers from 59 countries. The banking insiders, including 45 executives in Canada, were asked to rank a list of potential risks for the financial system over the next two to three years; regulation was ranked as the No. 1 risk.

The raft of new and still evolving global regulatory regimes, including the international standards agreed upon by the Basel Committee on Banking Supervision and imposed by the Dodd-Frank Wall Street Reform and Protection Act in the U.S., among others, have introduced a high degree of regulatory uncertainty into the global banking industry, survey participants said. In addition, inconsistencies in how different jurisdictions implement global regulatory standards creates challenges for financial services institutions that operate across borders.

“If you think about what you want in a conservative, stable industry, it’s a high degree of certainty,” James Darroch, associate professor of policy with the Schulich School of Business at York University in Toronto. “If you’re getting regulatory creep, that creates uncertainty.”

Overzealous regulation also may introduce new risks into the system rather than reduce risk overall by driving business into less regulated or unregulated channels, creating complex issues for regulators and policy-makers to try to anticipate and address.

“With regulation, we’re often fighting the last war,” Darroch says. “And when you do that, you’re creating a new war somewhere else.”

Finally, the weight of regulation may hobble the ability of financial services institutions to innovate and drive economic growth at a time when the global economic recovery remains fragile. This is especially true in jurisdictions in which banks may be expected to help to stimulate economic growth – by increasing lending to small businesses, for example – while adjusting to new regulations that limit how those banks may operate.

However, banking executives may be overstating the risk of overregulation. The suggestion that its re-emergence as a top risk facing the industry may simply reflect the fact the global economy has begun to stabilize. In the 2012 Banking Banana Skins report, banking insiders ranked macroeconomic risk as the top risk. This year, macroeconomic concerns ranked third.

“In 2011-12, you had the sovereign-debt crisis in Europe, there was talk that Greece and Italy might go bankrupt, the U.S. had lost its AAA bond rating – people were panicking all over the place,” says Laurence Booth, professor of finance at the Rotman School of Business at the University of Toronto. “Now that those risks have subsided, and we’re growing again, banks are look at regulations and the issues that follow from all those changes.”

As well, there is a sense that as new rules affecting bank compensation start to take hold and regulatory standards, such as Dodd-Frank, are implemented, bank executives are starting to feel the real bite of regulation, King says: “That’s why bankers are complaining [now].”

In addition, as banks struggle to drive profitability in an economic environment of low interest rates and low volatility, they look at regulation as a scapegoat, King suggests: “What they haven’t accepted is that there’s a new normal that involves higher capital requirements, and that bank profitability is going to be lower.”

In Canada, where the financial services system has demonstrated stability and resiliency through recent turmoil, banks generally have benefited from a positive, co-operative relationship with the domestic regulator, the Office of the Superintendent of Financial Institutions (OSFI), and with the Department of Finance Canada. Those open lines of communication are not a feature typical in other jurisdictions.

“[Canadian banks] talk to the OSFI and to the minister of finance,” Booth says, “and I think that’s the critical difference.”

Nevertheless, global regulatory changes, meant to address a variety of issues that may or may not be relevant to Canada, still affect the domestic industry.

“If I’m a Canadian banker, I would be nervous about what’s happening in other jurisdictions,” Darroch says. “Regulators emulate one another.”

As the big Canadian banks increasingly broaden their businesses beyond the domestic market and into the U.S. or overseas, they have to contend with regulatory regimes in those jurisdictions.

“Banks that have very heavy footprints in the U.S.,” Kazarian says, “absolutely have to work with the U.S. regulators as well as the Canadian ones – and that’s the reason why regulation is top of mind here in terms of risk.”