A new type of regulatory risk in banking

Banks no longer have the option to put off strategic decisions because of regulatory uncertainty. A bank that does nothing will clearly be a loser, says Hank Prybylski, a partner and advisory leader in Ernst & Young’s Americas Financial Services Office.  

 

Years of banking crises, capital liquidity issues and a massive regulatory shift with a strong focus on customer protection and systemic risks have forced banks into retrenching their activity. During that time, banks found it difficult to determine their strategy because they did not know the rules.  

“If I don’t know the regulatory capital requirements, I cannot figure out which businesses I need to be in. I can’t really move ahead,” says Hank Prybylski of Ernst & Young. “That period has really passed.”  

He believes the next four or five years will bring a significant repositioning in the banking industry.  

Although there is still uncertainty, the main direction of new regulation has been set, and bank executives are asking how they need to adapt their business model to a new set of rules. 

While regulatory risk used to mean fines and reputational damage in the case of non-compliance, regulatory risk today means failure to adopt a new business strategy reflective of the regulation, Prybylski says.  

The strong focus on regulatory capital has changed the metrics used by banks to allocate capital and manage risk. Banks used to optimise their return on economic or risk capital, both by making portfolio decisions and effectively allocating risk and return and by innovating high value products for customers.  

But with regulatory capital as a binding constraint, return on regulatory capital has become the dashboard of decision-making, driving the allocation of liquidity, says Prybylski.  

With increasing capital constraints, most banks are looking to shrink, by determining which businesses they should or should not be in. In the interim, the lack of strategic focus leads many financial institutions to concentrate on cost and efficiency ratios. 

“If you don’t know where you are [on the growth stage], the only thing you can do is cut costs,” he says. 

How banks organise their business is also becoming increasingly important. Domestic regulators, concerned about shielding their taxpayers from foreign bank failures in their local market, are forcing banks to structure their international business in subsidiaries rather than branches. In practice, this subsidiarisation is expensive for banks as they have to hold large amounts of capital in each market they are active in.  

A bank’s legal entity strategy, and the ability to take advantage of different tax positions around the treatment of capital, is therefore becoming a competitive factor, says Prybylski. 

He further expects significant consolidation of the industry on national and regional levels. While globally systemically important financial institutions are not in a position for major acquisitions, larger domestic and regional banks will look to increase their scale. 

“Nobody wants to be the smallest D-SIFI [domestically systemically important financial institution],” he says, referring to categories used to determine higher capital and liquidity requirements and maximum leverage ratios. “You have all the cost of being a D-SIFI but not the benefit of scale.” 

In addition, there are many regional leading banks, for example in Brazil, China, Canada or Australia, that came out of the financial crisis relatively unscathed. These comparatively capital-rich banks will be tempted to expand their market by following their customers in adjacent markets or globally.  

For all banks, it is imperative to be dominant in the market segments they operate in. “You need to be number one or number two in every customer segment to make money,” Prybylski says.  

Senior executives have to decide whether a market is essential to serve a core customer and where the opportunities are to expand into new markets. This also touches on the cross-selling potential of certain services, despite a higher cost of capital. For example, asks Prybylski, can a bank really execute its investment banking advisory if it exits the fixed income trading business? 

At the same time, he says, most banks realise there is only enough business to support the top four or five activities. “So if you are sixth, seventh or eighth, how long can you run before you pull the plug?” 

To be successful, financial institutions need to understand what their customer connections are by effectively leveraging transaction data for customer information.  

Retailers and consumer product companies have long harnessed transactional data and combined it with customer information from market research and social media to help them with customer segmentation and product development.  

Prybylski calls on banks to follow this strategy and says the most successful financial institutions will be data management and analytical companies.  

Despite the risk inherent in a major data engineering project, banks have to invest into information technology infrastructure to clean up their risk and compliance data, for example, to be able to provide US customer account information under the US Foreign Account Tax Compliance Act.  

Banks that have to spend time and money on transactional data for risk and compliance, should spend that little bit more to get the analytical data that they need to drive their business, he says. 

The velocity of change in the industry is a significant opportunity for banks. “If customers are changing their behaviour, the banks that get it right will be the ones that grab the customers. And it is those core customers that are really going to be the growth engines of the future,” Prybylski says.  

But banks need to overcome the segmentation of data in various business, risk and compliance functions by adapting their organisational model and consolidating its risk, finance and customer analytics under a chief data officer function.  

This change in architecture is also needed because the biggest limiting factor to the use of customer data are privacy risks, which need to be managed effectively.  

 

Hank Prybylski spoke at the Cayman Islands Bankers Association event at the Westin Grand Cayman Resort on 10 July.  

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Hank Prybylski

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