Covid-19 Puts Financial Regulation Under Stress

Business continuity plans, social distancing measures, economic stimulus and liquidity constraints are hindering banks’ abilities to stay consistent with regulators’ expectations, says Peter Guy.

Sales of “The Plague” – originally published in 1947 by Albert Camus – have been revived this month. He wrote, “There have been as many plagues as wars in history; yet always plagues and wars can take people equally by surprise.”

Similarly, the Covid-19 pandemic is suddenly threatening economies and markets in a way no other crisis has before. The new financial regulatory order created after 2008 is looking light on the order as the public health crisis deepens and strains the entire international regulatory system.

Business continuity plans, social distancing measures, economic stimulus and liquidity constraints are forcing banks to push their limits with regulators. Since 2008, financial regulations have dominated the centre of banking operations, management and governance. However, Covid-19 has rippled across societies, economies and finance in ways that have not yet been fully determined.

Considerable and evolving regulatory adjustments

To date, most financial regulators are offering and accepting flexible, best efforts adjustments and interpretations for regulated institutions and persons, depending on the jurisdiction. Considerable and evolving adjustments are being made to everything from workplace arrangements and client call recording rules to capital requirements and loan classification norms.

MAS (Monetary Authority of Singapore) issued an advisory on 7 February asking financial institutions to adopt the additional measures recommended by government agencies when executing their business continuity plans. Stating the importance of maintaining effective internal controls across their operations if offsite team arrangements are implemented, among other management changes, still left much to be openly interpreted.

In the US, FINRA (Financial Industry Regulatory Authority) is providing temporary relief for member firms from certain rules and requirements. Members are asked to provide written notification to FINRA on a best efforts basis after establishing a new temporary office or other space sharing arrangement.

Crowded trading floors are susceptible to breeding the virus so many employees are told to work from home. Regulations are unclear as to whether traders can make markets and service clients from home instead of the dealing room as required under FINRA Rule 5310. Firms must exercise “reasonable diligence” to determine the best market for the security, and buy or sell in that market so that the resultant price to the customer is as favourable as possible under prevailing market conditions.

FINRA states that reasonable diligence required for best execution is assessed in the context of the characteristics of the security and market conditions, including price, volatility, relative liquidity and pressure on available communications. No one has challenged whether or not these activities and outcomes can be accomplished outside an approved trading desk.

Remote offices and telework arrangements during a pandemic may also demand other methods from employers to supervise their employees. FINRA and other regulators expect employers to establish and maintain a supervisory system that is “reasonably designed” to supervise staff from an alternative or remote location during the pandemic. Yet, there are no clear guidelines on how to achieve this or how to maintain appropriate computer security standards.

When failing economies strain financial regulations

Restarting economies will require massive bailouts and specialised loans provided by governments, through banks and other financial agencies. Bankers already realise these loans will likely compromise their lending, liquidity and capital standards. Even KYC and AML requirements may have to be relaxed in order to distribute funds into the economy at the scale required.

Direct government intervention in financial markets will mean a socialisation of losses on a record setting level, even as post-GFC banks were reorganised to instead conduct bail-ins. TLAC (total loss-absorbing capacity) bonds that qualify as tier 1 capital for G-SIBs under the Basel standards may need reinterpretation in order to meet looser capital requirements.

US regulators have also allowed US banks up to two more years before they must hold more capital for reserves against loan losses as required by the new CECL (current expected credit loss) accounting standard. The Federal Reserve, FDIC (Federal Deposit Insurance Corporation) and the OCC (Office of the Comptroller of the Currency) – which together regulate national banks – also announced they would speed up the roll out of a new methodology for measuring counterparty credit risks in derivatives transactions.

The move will likely reduce the amount of capital lenders must hold against such transactions because it acknowledges significant reforms made towards the safer management of the derivatives markets since the 2008 financial crisis. They include the enforcement of settlement rules, trading margins and deposits.

So far, major banks have withstood the economic stall. Some critics have credited the Volcker Rule, which redefined and eliminated proprietary trading activities. Meanwhile, opponents of the Rule say the ban on proprietary trading has reduced liquidity in certain asset classes and contributed to the broad volatility experienced in recent markets. But, it has certainly made banks easier to regulate and reduced the controversy of mark-to-market assets, particularly when the concepts of net assets and book value have today become moving goalposts.

On 19 March, the ECB (European Central Bank) allotted EUR 115 billion (USD 124 billion) to be structured into a three year long term lending facility. This represented the first tender since it relaxed terms to encourage commercial banks to borrow. Facing a deep recession and a market collapse, the ECB last week decided to grant banks access to more funds in its targeted longer term refinancing operation (TLTRO). It also reduced the interest rate to as low as negative 0.75%, essentially paying lenders to take money if they loaned it on to the real economy. The EUR 115 billion take up came after banks said they would repay EUR 92.6 billion of a previous TLTRO facility before it was due.

Fresh standards for risk management and governance

Italian banks operate the weakest balance sheets in the Eurozone and illustrate how more lending in weak business and economic conditions would impact regulations. Italian mortgages and SME loans are packaged in securitisations pledged to the ECB under TLTRO, where the ECB provides long term loans to banks and offers them an incentive to increase their lending to businesses and consumers.

To sustain access to the facility, the securitisations must maintain a given rating standard. A major payment interruption in a mortgage portfolio should lead to downgrades and a reduction in liquidity for Italian banks. There is also a capital component given that these securitisations are consolidated.

The revised definition of defaulted asset rules and IFRS 9 (as it guides how financial assets, financial liabilities and contracts to buy or sell non-financial items are measured and classified) mean that banks have to provision quickly against the worsening quality of these loans. While some jurisdictions (China, India, Bangladesh, Malaysia) have offered relaxations and workarounds to loan classification standards.

The EBA (European Banking Authority) has meanwhile said that IFRS 9 “includes sufficient flexibility to faithfully reflect the specific circumstances of the Covid-19 outbreak and the associated public policy measures”, urging banks distinguish between a risk to the whole life of a loan and measures to address temporary liquidity constraints.

Still, it is likely that Italian banks will have to support liquidity in their securitisations and – eventually – their government will have to step in to recapitalise them to offset higher provisioning requirements.

Asian governments, regulators and financial institutions will face their own unique domestic challenges as they recapitalise their financial systems, extend loans to big and small businesses and incentivise consumers to spend and revive their economies. How regulators adapt rules to encourage new growth while adhering to the central role of regulations will set fresh standards for risk management and governance.

For more information on stress-testing and reporting tools that can help provide deeper insights into capital, credit, market and liquidity risks FIs face in light of the on-going coronavirus pandemic, register for our webinar on 23 April.

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