Banana Skins 2005

RMA Journal, The, April, 2005 by David Lascelles

The centre for the Study of Financial Innovation runs an annual survey of banking risks that provides a perspective on what risks we should be worrying about. The recently published 2005 results brought up a new winner: regulatory overkill.

For the first time in Banana Skins' survey's 10-year history, the threat of over-regulation emerged as the most serious risk facing the finance sector. This may seem an ironic finding given that regulation is supposed to be about reducing rather than enhancing risk.

But the survey, which is sponsored by PricewaterhouseCoopers, is well rooted. The CSFI received 440 responses from over 50 countries (including around 180 responses from GARP [Global Association of Risk Professionals] members), and the message was pretty clear the world over: Regulation has reached the point where it is sapping strength from the sector and deflecting management resources from real business, with dangerous consequences. Worst of all, it is creating an unreal world, in which the business preoccupation is with satisfying the regulator, substituting box ticking for real risk management, and encouraging the false sense that, because the regulations have been complied with, risk is under control.

The survey quotes what respondents had to say. From the U.S., one banker said: "No thought is being given to the cost of these regulations to the banking system." From Switzerland: "Regulation will inevitably lead to a more sanitized market, less dynamism, and lower profits unless checked--and quickly." From London: "Interference, regulation, and compliance are out of control." Many respondents also worried about the associated risk that regulation is forcing uniformity of models and risk management systems so that, as one respondent said, banks will "all be on the same side of the boat when it tilts."

The survey also breaks down the results by type of respondent and country. This shows that concern about regulation is not just a complaint from bankers, but one that is shared by outside observers (analysts, consultants, academics) as well as other parts of the finance business (fund managers, stockbrokers, insurers). The only class of respondent that did not rate regulatory overkill as a high risk were the regulators themselves: They ranked it 20 out of the 30 risks on the Banana Skins list. Do they know more than the rest of us, or is there a lesson here for them?

Geographically, concern is strongest in the developed nations--North America, the European Union, and Switzerland. But it is also rising in the emerging markets, though the concern there is less with regulatory overkill than with the competence of regulators and the ability of banks to develop robust risk management systems.

Another high-ranking risk in this year's survey was corporate governance, which came in third. But though some banks are seen to have weaknesses in this area, this Banana Skin earned a high place because it was seen to be part of the regulatory threat. Too much time and resources are being poured into what respondents thought was an exaggerated problem. A U.K. respondent said, "Can no one stop the corporate governance juggernaut? It might look very pretty to politicians, but has little practical use at the working level when so much of it is a box-ticking exercise. It also acts as a deterrent for right-minded people to participate."

Other high-ranking risks were more market related. In second place this year was credit risk, occupying the same place as last year. Rising interest rates, deals booked at wafer-thin margins, and shaky collateral all preyed on respondents' minds. Derivatives, particularly credit derivatives, were ranked fourth (which was a decline from last year, when they topped the list), but concern about the size and complexity of the market is still strong, as was the fact that credit derivatives could soon be facing their first real test if the credit market does enter a serious downturn.

This concern was underpinned by another high Banana Skin, hedge funds (fifth place), whose fast-growing and unregulated role was widely remarked on. One aspect of hedge funds that drew worried comment was the close relationship many of them have with investment banks through "prime brokerage" arrangements that include preferential pricing and even loans. One respondent described these as "the crack cocaine" befuddling market judgment.

The other big market-related risk was currencies (seventh place), specifically, the concern that the U.S. dollar could be in for a steep plunge. A respondent from Washington, D.C., warned, "Markets may not have yet fully factored in the apparent reluctance of the U.S. Administration and Congress to come to grips with the imbalances in the U.S. economy."

On the operational risk front, a strong riser was fraud, particularly the electronic variety, which rose from eleventh place to sixth. Banks are seen to be falling behind the ingenuity of the fraudsters in securing their systems, preventing network intrusion, and protecting their customers' identities.