In the wake of an unprecedented global credit crunch, the financial services industry is now facing the prospect of similarly unprecedented global regulatory reform that is likely to hamper the sector’s earning power.

The reform agenda is a long one, encompassing capital requirements and accounting rules to governance practices and market infrastructure. Given the scale and scope of possible reforms and the inherent uncertainty about their precise content, timing and the market’s reaction, the ultimate impact on both firms and investors is uncertain. However, it is clear that the commitment of governments and financial services firms themselves to reducing risk in the financial system will lower earnings potential in the financial services industry.

The global crisis has revealed systemic vulnerabilities that laid hidden when times were good. The amount of risk that firms were taking wasn’t well understood and firms’ exposures weren’t well disclosed. Factors such as market liquidity were undervalued; structured products became inordinately complex. And many in the financial services industry enjoyed incentives that encouraged short-term profits at the expense of sustainable earnings.

As a result, policy-makers are seeking to bolster oversight of market elements, such as structured products and credit-rating agencies, that have otherwise faced little or no outside scrutiny.

Global banking regulators are also considering changes to capital requirements, while setters of accounting standards are looking at altering their rules. Both are designed not only to shore up companies’ balance sheets but also to soften the excesses of the credit cycle, which can be inadvertently amplified by the way capital charges are levied and regulations such as fair-value accounting rules are applied. Regulators are also pushing companies to increase balance-sheet transparency and to reform their compensation systems to avoid excessively risky, short-term behaviour.

The principles behind these reforms reflect the global action plan upon which the members of the G20 governments — Argentina, Australia, Brazil, Britain, Canada, China, the European Union, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey and the U.S. — agreed at a meeting this past November. The plan is being pushed by co-ordinating bodies such as the Bank for International Settlements and theInternational Organization of Securities Commissions. But, that said, it will be up to national governments to devise and implement the reforms.

The G20 has agreed to introduce some measures by the end of March and to report on its progress at the end of April. So far, the G20 countries have largely concentrated on stabilizing the financial system, which has led them to take actions to ease rather than toughen the regulatory requirements facing financial services firms.

Governments in the U.S., Britain, Europe and elsewhere have been forced to supply capital to some of their largest financial services institutions by acquiring stakes in them. They have also adopted a variety of other actions designed to alleviate the market pressure on the banks. These include pledging to buy troubled mortgage-backed assets, guaranteeing interbank lending, boosting deposit guarantees, easing asset valuation rules and capital rules, and expanding the provision of market liquidity.

In addition, standards setters recently loosened fair-value accounting rules in an effort to give global banks a reprieve from taking big writedowns on assets whose markets have temporarily seized up. The hope is that when liquidity returns to these markets, such assets will see decent valuations once again — without the necessity of reporting huge losses in the meantime.

However, analysts remain cautious. A recent research report from Toronto-based Blackmont Capital Inc. notes that the fact banks are taking advantage of the opportunity to reclassify assets is a signal that these assets are likely to remain impaired in the coming year: “While such anticipated value recoveries cannot be ruled out, limited visibility as to the exact nature of reclassified securities, coupled with the apparently severe valuation compression that took hold during the fourth quarter alone, suggests to us that a cautious approach to value recovery assumptions is in order.”

On the capital front, banks worldwide are feeling pressure to raise their capital levels. But this impetus is coming from the market, which appears to be demanding a Tier 1 capital ratio of 10%, up from the current average of about 9.5% in Canada and the regulatory minimum of 7%.

@page_break@“We think that 9% is the new floor for Tier 1 capital, with 10% the new competitive target,” notes a recent report from UBS Securities Canada Inc. of Toronto. (The Tier 1 capital ratio is the ratio of a bank’s core equity capital to its total risk-weighted assets.)

But this is not a regulatory imperative. A mid-December statement from Canada’s Office of the Superintendent of Financial Institutions said that it has “not pushed for higher capital ratios across the board” and added that it views capital as “a cushion that should be available to be drawn down when faced with unexpected losses.”

But OSFI has attempted to give the banks more latitude to boost their capital levels in response to market pressures by raising the limit on the proportion of capital that can be supplied by innovative and preferred instruments to 40% from 30%.

According to the UBS report, analysts do not believe that the Canadian banks require a 10% Tier 1 ratio, given the generally high quality of their loan books, earnings and capital. But, the report notes, if 10% is what the market is demanding, that is what will happen. However, the report notes, the result would have “negative implications for earnings dilution and returns on equity, especially for smaller banks.”

But if regulators are being cautious about getting tough in the middle of the credit crunch, the industry can expect them to swing to stricter measures once the worst of the global financial crisis has been traversed.

The Bank of Canada, along with other Canadian authorities, is committed to adopting the measures proposed by the Basel-based Financial Stability Forum. The BofC reports that regulatory oversight of banks’ liquidity arrangements is being strengthened and enhanced stress-testing procedures are being implemented for risk-management and capital-planning purposes.

The BofC is also calling on domestic banks to improve disclosure, particularly regarding their valuation techniques, and for the provincial securities commissions to help drive improvements in the transparency of structured products.

In other areas, there may not be much for Canadian authorities to do but wait for major players in the U.S. and Europe to come up with solutions. The risks inherent in the operation of the over-the-counter derivatives markets, for example, are most likely to be addressed by international efforts to move some of that trading onto exchanges and to develop a central clearing counterparty to mitigate the counterparty risks that have become apparent in these markets.

“More generally, the financial crisis has added urgency to the need to rethink elements of the regulatory regime,” notes the BofC in its Financial System Review, which was released in December. The article adds there is work underway in Canada and around the world to identify the forces that may exacerbate the highs and lows of the credit cycle and to develop possible options for mitigating them.

For example, policy-makers are looking to devise a capital adequacy model that would lean against the economic cycle and the credit cycle rather than enhancing these cycles. Such a system would require banks to build up capital buffers during boom times, hopefully preventing excessive lending. And it would ensure banks have excess capital to provide a cushion when market conditions deteriorate so that they aren’t forced to dump assets or severely curtail lending. The mechanisms that are being considered include linking capital requirements to macro indicators of market conditions.

Although these sorts of changes may well be in the offing, they aren’t likely to be important considerations for clients in the short term. For now, markets are already demanding higher capital levels and regulators may well follow suit. But devising a system that forces banks to build capital cushions in good times isn’t likely to be relevant this year, as weak conditions are expected to prevail for the foreseeable future.

In all likelihood, the development and adoption of major regulatory reforms will be a long-running project rather than something that can be completed in a few months. Indeed, UBS’s recent research report says that UBS expects regulatory reforms in response to the credit crunch to evolve over the next decade in three possible areas: supervision, transparency and deleveraging.

Specifically, the UBS report foresees tougher oversight for financial services firms in securitization, wholesale funding, concentration risk and counterparty exposure. It also expects tougher transparency and disclosure standards and a push for lower leverage at financial services institutions, all of which may hamper the firms’ earning power.

“A major regulatory backlash,” the UBS report concludes, “would probably have adverse ramifications for the banking industry in terms of growth prospects, profitability and returns.” IE