Regulation and Consolidation in the Financial Industry
Speech by John Tiner
FT Bankers Awards
6th September 2005
Introduction
Good evening. It is an absolute pleasure to be here this evening. Not just because of the prestige and significance of the occasion and the array of banking expertise present here this evening, but also for very personal reasons in that this is only my second day back at work after a prolonged absence though illness.
Awards are clearly a time for celebration. And I know from previous experience as a guest at this occasion that there is plenty for the industry to celebrate and that you bankers know how to celebrate in style. This ceremony also manages to avoid many of the pitfalls of other awards ceremonies. Think for example of Johnny Carson's comments that "The Oscars are 2 hours of sparkling entertainment packed into a 4 hour show".
I also know from personal experience what it feels like to win an award. I was voted recently Regulator of the Year by that august tome, The Compliance Reporter, a publication which is a best seller in New York. This was flattering especially given some of the pressures of my first two years as CEO of the FSA. As Walter Winchell famously put it 'Success is the reward of anyone who looks for trouble'.
While flattered, my pride was somewhat dented by my colleagues at the FSA pointing out how differently the stars of stage and screen receive their Awards – actress Sally Field accepted her award by saying 'You love me, You love me, You really love me!' whereas Sean Penn's parody of Ms Field of 'You tolerate me, You tolerate me, You really tolerate me!' was perhaps closer to the mark. As a regulator, I've no doubt which acceptance speech would be fitting for me. Let's see what acceptance speeches we hear later tonight!
But there are good reasons to celebrate tonight. The Banker gives awards for strong competitive performance - for those who have made significant innovations and advances especially through the use of technology. As regulators we place enormous weight on the value of competition - after all market forces operating effectively deliver the best outcomes for markets, firms and their customers. The regulators' mantra should be to intervene only where there is a bona fide market failure and where the economic argument makes the case for intervention. I encourage all policy markers and regulators to take a rigorous line on this issue.
So there are good reasons to celebrate. But this is a challenging time for the banking industry. Before joining the FSA four years ago my background was in banking, capital markets and derivatives. It may not surprise you that my time at the FSA has been focussed on insurance and savings issues, where the needs have been most pressing. The banking sector has, of course, been incredibly strong – but then this may be as good as it gets. As the lead regulator for several of the world's largest international financial organisations and host regulator for many others, I would like to share with you some thoughts on the competitive pressures confronting the global banking industry, in terms of the business environment and the strategic landscape at a global and European level. I will finish with a few remarks on the proliferation of complexity in many aspects of banking life – product design, accounting practice and prudential regulation, and ask the provocative question 'Will common sense triumph over mathematics'.
The Business Environment
The banking sector continues to look ostensibly very healthy. The Banker in July highlighted that the aggregate return on tier 1 capital for the top 1000 banks was nearly 20%, and that in low inflation economies for the most part. And banks worldwide continue to post record levels of profitability. Certainly from a UK perspective the sector remains strongly capitalised and while asset quality has started to deteriorate, particularly on the retail front, it is doing so from a very strong base and so, overall, presents few prudential concerns.
However, there are growing risks on the horizon. The general good health of banks' balance sheets, the low interest rate environment, and the benign economic cycle have prompted many market commentators to talk about a "wall of liquidity". Banks have been willing to lend "cheaply", but as the economic environment becomes more uncertain and growth slows down, this pricing may start to look increasingly out of line. Over the past few months we have seen increasing signs of such stretch in the corporate market, particularly in leverage finance and private equity. We have the feeling that the market is getting increasingly nervous; prompting the question: which deal will be one too many, and who will be left holding the pieces?
Despite this, we have yet to see banks making a significant tightening in their credit standards - indeed we have heard much anecdotal evidence to the contrary as banks compete over relatively few transactions. There are signs of higher leverage, looser covenants and of weakening collateral requirements in banks' dealings with corporates and with hedge funds.
In the personal sector, there are some signs of the high debt burdens biting on consumption as retail spending slows down. The housing market is also fairly flat and although the much talked about meltdown hasn't materialised, we have seen some banks strategically scaling down their market share.
In the Global economy as well we continue to see signs of instability and potential vulnerability, with the Euro area remaining sluggish, the US increasingly suffering from high oil prices (perhaps now exacerbated by the recent disaster in New Orleans), and China still the unknown in the equation.
So while the central forecast for the next 12 months is still overall positive, we think the downside risks have definitely increased. Oil prices have hit record highs and consequently the risks of a downward adjustment to the outlook have increased. Without wishing to appear like the typical gloomy regulator and spoil your digestion, I would just sound a note of caution on three fronts.
First, sometime within the next two to three years there may well be a recession. This could make this spring's tougher trading environment look benign.
Second, there are some structural elements in the way some banks operate which may be under threat. And perhaps a lack of business realism? Banks have had a very good run. In particular, investment banks have benefited from what I might call the "create your own customer" programme. I refer of course to the tendency of banks to spin- out traders, either on a planned or unplanned basis, from their propriety trading desks into the market as hedge funds. These funds have attracted considerable amounts of third party money and hedge funds now account for a considerable portion of equity and fixed income trading as well as for a growing share of loan participations. Revenues from hedge fund clients in the form of trading commissions and prime brokerage fees have been an important bulwark for major investment banks. But it is unlikely that hedge funds can keep growing at the same break-neck pace of the past few years: and banks need to be realistic about how much more growth can be extracted from these counterparties. Indeed there are signs that hedge fund returns are, on average, declining, and that inflows to hedge funds are slowing, at least in percentage terms.
And, third, the threat of business discontinuity. The events in London this summer highlight once again the need for robust business continuity arrangements. This is a responsibility we all have with our shared interest in maintaining not just the safety of our own staff but the safe and efficient operation of the financial markets.
Strategic landscape
The critical challenge facing most of you here is "Where are banks to find future top line growth?" When I talk with leading firms, they tell me that they plan to increase significantly their market share in key markets. The same firms also tell me that they expect a wave of consolidation to occur. Each of these firms has a story about how it will be the senior partner in any mergers that do take place. While I do not see myself as a crack forecaster, I confidently predict that not all of these stories will turn out to be true! To quote Gore Vidal, "It is not good enough to succeed, others must fail".
Significant forces are still at work to drive through further consolidation in the industry. We have seen concentration rise in the industry over the past decade - the Banker's survey shows for example that the assets controlled by the largest 25 global banks has risen from around 32% five years ago to over 38% this year. But where global concentration is still low in global retail banking, advancements in technology are bringing about the possibility of significant merger-generated cost-savings, that is if the protagonists have the knowledge, determination and flexibility to secure such cost-savings, which has not always been the case.
But aggressive cost-cutting strategies have yielded significant benefits for banks' efficiency and profitability. Outsourcing and off -shoring have played a large part and it seems likely that further off -shoring will further benefit large scale competitors. The challenge is to reduce, or at least contain, costs without damaging earnings quality, customer service or significantly increasing operational risk. Although many banks are tackling their costs successfully, it could nonetheless be argued that the banking system in Europe as a whole is still laden with too high a cost base and so is unnecessarily expensive to its customers.
Allowing competitive forces to operate more freely is, I believe, the best way to ensure banks become, and remain, efficient and can carry out their strategy without constraint. This means every jurisdiction accepting that domestic banks will be subject to the market discipline of knowing that they are possible takeover targets, just as they themselves may seek takeover opportunities abroad. Regulators must be open-minded and pragmatic and the European Commission must ensure competition prevails between member states and not just between market participants in the same state.
In the UK, we welcome the full range of international competitors. The importance of regulators being pragmatic and responsive to market developments cannot be over-estimated. We have been at the forefront of supporting the needs of minority communities. In particular, many in the Muslim community have been unable to access traditional sources of finance because Islamic law prohibits the charging of interest. We have worked closely with the market to find practical solutions to the legal and regulatory hurdles that have prevented institutions from providing suitable financial products. This work has culminated in the FSA being able to authorise the Islamic Bank of Britain last year, the first such institution in Western Europe.
But in a similar vein, we will welcome the growth of 'mega banks' if that is the outcome that market forces deliver. Such developments pose serious challenges to regulators. Building on where we are now, it is becoming increasingly important to develop even closer co-operation between regulators to minimise duplication and avoid confusion about differing sets of requirements, while at the same time enabling regulators to fulfil their responsibilities.
Will common sense triumph over mathematics?
Now let me turn, briefly, to the third and final area of concern. I have phrased this, crudely, as "Will common sense will triumph over mathematics?" This is potentially an inflammatory title - but as you will see I am concerned about the realities of ever more complex financial instruments, accounting rules and prudential capital rules. And in line with my concerns about the strategic challenges facing banks much of the solution lies in the hands of the firms' own senior management.
There is no let-up in the stream of increasingly complex instruments emerging from firms. We should be in no doubt that this is generally a good thing – innovation feeds customer choice and competition. But as the ranks of Quants and rocket scientists in financial firms continue to grow, we must not lose sight of the limitations of complex and sophisticated financial modelling techniques.
As the recent "Corrigan report" on counterparty risk notes, "The fundamentals of managing risk in the face of heightened complexity [are] the time honoured basics of managerial competence, sound judgement, common sense, and the presence of a highly disciplined system of corporate governance".
Senior management must engage properly in assessing risks. They cannot treat models as a black box and rely unthinkingly on their outputs.
A prime warning came from the recent GM/Ford downgrade episode. A number of firms were using tranches of complex CDO structures to put on positions that – according to their models – should not have been affected by the overall level of credit markets. But the market behaviour following the GM/Ford downgrade – which was telegraphed well in advance – was not in line with the expectations built into their models. A number of firms suffered heavy losses. We had more than one plaintive conversation with a firm bemoaning that the market's movement was "unfair". While this event was clearly not terminal for anyone concerned, it was a warning that firms cannot let models be a substitute for thinking carefully and seeking to understand risks. The two must be complementary.
The principles of proper senior management understanding underpin the FSA's approach to implementing the Basel 2 regime. When that regime comes into force – in just over one year's time – firms will have the option of using the output from their own internal models to calculate their regulatory capital. There is no doubt that some of the models that firms wish to use will be highly complex. And the regulatory capital advantages to firms using an internal models approach are likely to be substantial.
The challenge for regulators is to assure ourselves that the models to be used are appropriate and will meet our prudential requirements. We can only do so much testing through using our own quants to review firms' models. This is why any firm applying to us for approval to use its own models must convince us that senior management understand the outputs and the limitations of models. We will be saying more on the detail of senior management understanding later this month.
My final word on complexity and, indeed, of my remarks this evening is on the, topical, but not always very lively topic of accounting for financial instruments. I am pleased to see on my return to the FSA, that so much good progress has been made during the past few months. I hope we all agree that the aim of accounting reform in general – and revision to accounting standards on financial instruments in particular – should be to close the gap between the economic substance of transactions and how they are reported publicly by banks. I have consistently argued for this throughout my career as an accountant from as early as 1988 when I wrote my textbook on accounting for financial products.
I am happy to note that the major disagreements over the application of fair-value accounting are now close to being removed, but also note that less progress appears to have been made in the other key area – hedge accounting. I urge the banking industry to engage with the IASB on the hedge accounting issue in the same pragmatic way in which you engaged on the fair value issue.
The one area which concerns me a great deal from an accounting, regulatory and investor reporting point of view is the valuation of illiquid financial instruments, determining how and when to recognise profits or losses from such instruments and whether, when and how to adjust values for changes in market liquidity and price volatility. This is a very important and topical issue. We are concerned that liquidity risk is properly reflected in the valuation. We will be doing further work on this subject in the coming months and will be speaking to the industry about this.
Conclusion
So ladies and gentlemen, there is plenty to keep you busy, and I hope excited about the business of banking. I realise the regulatory agenda is heavy and may not always fire your imagination, but I am sure that good, thoughtful risk management will pay dividends and mean you have much to celebrate in the years ahead. Thank you.