The next step

Reform of financial regulation is proceeding at breakneck pace, with the result that the coming year represents something of a watershed for the sector. The impact of regulatory decisions being taken at the national level, regionally and globally, will be felt for a decade or longer.

It is more important than ever that the industry speaks consistently and with a unified voice, to ensure that the very real concerns about the potential impact of some of these decisions on one of the cornerstones of the global economy are heard.

Articulating the industry's views is a priority for AFME, with its membership base of investment banks and wholesale financial markets firms operating in and from a European base. Our organisation is only one year old, and one of my priorities as the new chief executive is to work with our counterparts at the Securities Industry and Financial Markets Association in the US and the Asian Securities Industry and Financial Markets Association in Hong Kong, to ensure a consistency of approach and advocate a level playing field. Together we form a global alliance, the Global Financial Markets Association, which can provide a truly worldwide perspective on the issues affecting our members.

These members, who include the world's leading investment banking groups, fully appreciate that regulatory change is necessary and are committed to playing their part in the process. For too long the industry has said "this won't work" rather than "here are some positive ideas for change". We recognise that we need to have a constructive engagement with politicians and regulators to avoid the unintended consequences of regulation and the potential pitfalls of protectionism.

We also need to make it clear that we recognise the role we must play in the economic recovery. There is too little understanding of the part that the wholesale markets play in supporting, advising and in providing financing assistance to governments and companies.
We must do a better job of ensuring that the public, the politicians and the policy makers understand the contribution that this industry makes, wherever it operates, in tax, employment and community and charitable services. In the UK alone, there are more than one million jobs in financial services, many of them outside London. Given the highly mobile and flexible nature of the investment banking industry, we should not be surprised if one consequence of patchwork regulatory change is that firms reconsider investment decisions and where they locate their people. We must ensure that this potential impact on employment, not only in the financial sector but also in the wider economy, is taken into account when public policy decisions are being made.

The future of this industry is far too important to be subject to quixotic decision making. There is a pressing need for our industry to show that it is not resistant to change and to be seen to contribute constructively to the process of reform that is already underway.

Ready for reform

Governments, directly and through their national regulators, have demonstrated their determination to reform regulation of the financial system. However, although ours is a global industry, the variation in the regulatory and political climate in which global firms operate is striking. This imbalance from one region to another will be reflected in the impact that reform has on individual firms, potentially bringing unintended long-term consequences.

At the global level we now know the likely shape and outcome of the Basel process, and the G20 in Seoul moved further in the direction of identifying global systemically important financial institutions. There is a widely held view in the industry, which AFME supports, that never again should any government need to prop up, in extremis, an ailing bank. Beyond that, there are quite different applications of the main public policy objective, which is to avoid any repetition of the 2008 crisis and its impact on consumer confidence and the taxpayer.

In the US the Dodd-Frank legislation will be enacted despite the change of political control in the House of Representatives. There is also the Volcker Rule and the establishment of a consumer protection body.

In Europe, from January 2011, we will have a new regulatory structure with the creation of the Systemic Risk Board and the three new European Supervision Authorities to cover the securities markets, banking and insurance. In the UK, 2011 will bring the dis-establishment of the Financial Services Authority and the report of the Independent Commission on Banking.

Repairing the reputation of the investment banking industry is going to be a long haul. Some 40% of voters leaving the mid-term elections in the US simply blamed 'Wall Street' for the financial crisis. Political opinion in the UK and Continental Europe remains febrile, particularly in relation to compensation. But despite this challenging environment, we must continue to focus on addressing the fundamental issues that the crisis raised.

We have encouraged regulators and officials to consider resolution mechanisms, such as bail-ins, contingent capital or both for when firms do fail, as some inevitably will. We don't pretend to have a complete answer on how to ensure that we never again witness the disorderly collapse of a firm like Lehmans, but we are determined to provide positive and thoughtful ideas in this and other areas.
It is this new attitude, together with a clear focus on the potential unintended consequences of some of the regulatory and political changes, that will characterise AFME's work over the next year.

Making sure there is no 'next time'

AFME's report, Prevention and Cure: Securing Financial Stability after the Crisis, considers progress made in reforming financial regulation since the 2008 crisis and proposes ideas for further steps that could be taken to specifically reduce systemic risk and avoid taxpayers being called upon to support failed financial institutions in the future.

The report proposes that systemic risk can best be tackled through a combination of sound prudential regulation and enhanced supervision, a robust mechanism to tackle failure and a consistently high standard of risk management and corporate governance within financial institutions.

It also argues that there should be no need for individual firms to be designated as 'systemically important' and subjected to additional capital-based controls, nor would any risk management benefit be achieved by limiting banks by size, scale or function.
The study, developed with input from more than 250 industry experts, demonstrates how, as an alternative to capital surcharges, the supervision of such firms could evolve in a post-crisis world and what an enhanced supervisory regime might look like.

On a firms' own governance procedures, the report considers the relationship between the board, the executive management, and those who have the job of advising on risk management, and concludes that the responsibility for managing risk within financial institutions must be placed unequivocally on the institutions' own boards. Among the suggestions for achieving this are the establishment of a board-level risk committee and the appointment of a chief risk officer, empowered to assess financial risk issues independently of a firm's management.

In the light of concerns about transparency and volatility in the markets, it reviews the various options for making them more efficient and reducing risk without stifling the fundamental need to trade. Here, it suggests that the key is to avoid applying a one-size-fits-all approach to diverse markets and instruments. Oversimplification of products and processes may undermine the objective of reducing risk.

Finally, the report looks at what happens when firms do fail, as they will in a functioning economy. This section reflects AFME's previous paper, The Systemic Safety Net: Pulling Failing Firms Back from the Edge, which was published in August 2010. This discussion paper outlined bail-in and contingent capital as two possible mechanisms by which failing firms could be recapitalised without recourse to taxpayer funds. AFME's more recent report notes that each of these ideas needs further development, including the participation of investors.