Financial services firms are ahead of the curve when it comes to risk management practices. Sometimes, individuals and business units within of these firms overreach when it comes to risk, and the world suffers an economic crisis on par with the Great Depression. However, that’s no reason to stop trying to learn from many other individuals and business units within the industry that remain on the leading edge of risk management thinking and doing. Have you heard of “regulatory arbitrage,” for example?
The Dodd-Frank Act is expected to yield a suite of regulations likely to require financial services institutions to significantly enhance governance and control mechanisms. Instead of simply reporting on risk management, firms will now be required to show the effectiveness of the process and controls from which this data is generated. Moreover, the new regulatory environment is one that is more focused on transparency. From an operational standpoint, this means firms will have to pull more information and examine it in more ways, and then report these findings quickly and clearly to the various stakeholders, including regulators and investors. Lastly, there is an increased need for understanding and managing counterparty exposure, stress testing portfolios, and creating the ability to perform “what if” analyses on demand, with little forewarning and preparation time. For example, when a major event happens, such as the BP oil spill or the disaster in Japan, firms need to be able to quickly and easily report their exposure to the situation and also provide the underlying analytical support.
However, going back to an earlier point, what is known is that there is a new emphasis on the ability to actively demonstrate compliance instead of simply providing reports to regulators. Further, while regulatory reporting thus far has occurred on well-established timelines, we have seen an increased propensity for ad-hoc analytic and reporting requests from regulators. This is not to say this is necessarily a “new thing” but there is a greater emphasis. This has certainly impacted the way firms approach risk management.
Sandeep Vishnu: Yes, absolutely. The regulatory mandates being discussed have the potential to be tremendously disruptive to financial intuitions. As such, banks will identify the best regulatory channels for their business and take the appropriate actions to ensure they fall under this umbrella. This will also occur internationally. For instance, the Volcker Rule clearly prohibits proprietary trading desks at banks. These intuitions are already winding down these operations and in some cases might move proprietary desks overseas. Again, going back to the talent issue, the effectiveness and profitability of banks will depend on finding the right balance in labor. Banks will look for favorable labor climates that have a mix of local talent and also a legal environment friendly to relocated personnel.
To get a better understanding of that term as well as risk trends within the financial services sector, I checked in with Sandeep Vishnu, a partner in the North American finance risk & compliance group at Capco Economics, a global business and technology consultancy dedicated solely to the financial services industry.
Eric Krell: What is “regulatory arbitrage?”
Sandeep Vishnu: In the simplest terms, regulatory arbitrage is identifying and positioning a firm under the most beneficial regulatory regime. This can occur both domestically and internationally. For instance, in the United States, regulatory agencies tend to overlap and firms can take advantage of this by structuring their business to align with the regulator that is most favorable to the firm’s overall business objective. The same can be true internationally when firms choose to relocate or incorporate businesses in countries or regions that are less restrictive and/or permit activities that are prohibited in their current domicile.
Eric Krell: Do you see the use of regulatory arbitrage increasing? If so, why?
Eric Krell: What are banks’ top talent concerns right now?
Sandeep Vishnu: A major talent concern banks need to address is how they will make the structural changes needed to comply with regulation, once a clear regulatory mandate has been established. Financial institutions will design a new global operating model in order to maintain their overall business objectives while still complying with new regulations. However, it is one thing to design a global operating model and quite another to be able to implement it effectively and sustain it. This requires aligning the appropriate talent to get the job done.
Eric Krell: What are the top risk-management issues you see among your clients today?
Sandeep Vishnu: In a word: regulation.
Institutions will need to ask themselves what their plan is for post-restructuring to attract and retain the level of talent that made firms successful in the past. Part of the answer to regulatory reform might be relocating domestic talent to areas that have more beneficial regulatory environments. However Economics, actually convincing this talent to move is another matter and could prove to be quite problematic as this talent pool might be reluctant to relocate if they can simply move to a less regulated sector domestically, such as a hedge fund, instead. Moreover, in certain regions, firms will be required to absorb a certain percentage of the local talent by law; finding the appropriate talent will be very difficult and, in some instances, might just not be there. Banks considering moving headquarters and business units shouldn’t lose sight of these very real issues.
Eric Krell: How has this changed over the past two years?
Sandeep Vishnu: At the heart of the matter, the degree of regulatory uncertainty is much greater today than it was two years ago. There are over 240 regulations that are still being drafted and it’s anyone’s guess what form the final rules will take. This is having an impact on how quickly financial institutions make significant changes to their operational and technical infrastructure.
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