NEW REGULATION

• Basel 2.5: The changes to banks’ capital regime introduced over 2009-2010 rejigged the methods that banks must use to calculate the value of their “risk-weighted assets” (RWA) – that is, their total assets adjusted for certain kinds of risk. This shifted banks from a Basel II regime to what the industry calls “Basel 2.5”. It is important because the capital that banks must keep on standby to absorb losses is calculated as a percentage of RWAs. McKinsey has estimated that this shift alone will bring average investment bank returns down from 20 per cent to 13 per cent. Banks are currently shifting over to the new regime.

• Basel III: Drafted during 2010-2011, the Basel III requirements increased the amount of capital that banks must keep aside as a percentage of RWA and refines the definition of capital. The minimum threshold rose from a 2.5 per cent to 4.5 per cent in common equity in addition to 2.5 per cent in other high-quality capital instruments and 1.5 per cent in “non-core” capital the Basel committee defined earlier this year, for a total of seven per cent in core capital and 8.5 per cent in other capital. In addition, “global systemically important financial groups” must hold another 2.5 per cent. Basel III also introduces liquidity rules for the first time, mandating that banks hold enough highly liquid assets to cover their needs over a 30-day period and enough stable liquid assets to cover long-term needs. And it tweaks the way banks must take account of counter-party risk. McKinsey has estimated that these measures will dent average returns by another six per cent. New rules will be phased in over 2013-2021.

• Capital Requirements Directive 4:

European banks also have to take account of the details of CRD 4, which is the EU directive that aims to put into effect the Basel III rules after negotiation with member states over the details. The aim is to make sure that national regulators implement the details of Basel III in a harmonised way, but some member states – including the UK – are trying to lobby for permission to goldplate the rules. Implementation of CRD 4 is likely to be on the same timeline as Basel III.

• Alternative Investment Fund Managers Directive: The first attempt to regulate the hedge fund and private equity sector at a European level covers EU fund managers and non-EU managers that run or market firms in Europe. Requires managers to register with regulators, and to conduct stress tests to estimate the effect of “exceptional liquidity conditions” on the fund’s portfolio.

• Living Wills: Banks are now required to plan for their own an orderly wind up in the event of bankruptcy, to prevent the panic caused by another Lehman. Guidelines are being drafted by the international Financial Stability Board (FSB) but national regulators have also begun discussions with banks. Plans are likely to include measures to keep vital infrastructure like payments systems running and provisions to convert certain debt into equity to impose losses and recapitalise failing banks. The hierarchy of debtholders may change slightly: with depositors given preference over senior bondholders, for example.

• OTC derivatives: New EU and US rules mandate that most over-the-counter derivatives – often complex financial products put together by investment banks – must now be cleared by central clearing houses rather than simply sold directly by banks to clients. The aim is to ensure better transparency in the market. Those OTC derivatives that cannot be cleared centrally – a service for which banks will pay a fee – will see banks pay an additional counterparty-credit risk charge.

• Packaged Retail Investment Products (Prips) regime: An EC drive to harmonise the regulatory playing field covering various retail investment products, in an attempt to improve investor protection. Although consultation papers tend to link the new measures to post-crisis re-regulation, an overhaul of the system has been under discussion for much longer.

• Markets in Financial Instruments Directive (Mifid): The EU’s harmonised regulatory framework for investment firms across Europe, designed to maintain competition across markets and protect investors. Currently under review in the EC, with a final draft proposal due later this year. Applies to all firms that perform investment services.

• Prospectus Directive II: Designed to make it easier for smaller companies to raise equity, by removing some of disclosure and documentation requirements more relevant to bigger firms. Introduces new rules for information that must be included in a prospectus summary, leaving some issuers worried that investors will rely on the summary instead of reading the whole document – and that they’ll wind up liable for missing information. Overall deadline for implementation is 1 July 2012.

• New taxes: After a temporary 50 per cent bonus tax in 2010, UK banks now have to pay a levy on the size of their balance sheet, effective from January this year. After chopping and changing the levy this year, the Treasury has settled on a rate of 0.075 per cent to raise £2.5bn per year from the industry. Germany and France have also introduced levies but most other countries have not.

• Remuneration Code: European banks now have to abide by a the most prescriptive rules governing compensation in the world. It is illegal for banks to pay more than 20-30 per cent of compensation in cash up front. Much of it is instead to be paid in shares or other instruments of a period of three to five years. They are also required to include “clawback” clauses that enable firms to take back awarded pay in certain circumstances. In the UK the rules have been in effect since January 2011 and apply to 2,500 firms and all of their subsidiaries and branches abroad. The US has also introduced a similar but far less prescriptive scheme governing pay rules as part of the Dodd-Frank Act.

• Independent Commission on Banking (ICB): It will not be clear until 12 September what the UK ICB’s, led by Sir John Vickers (pictured) final recommendations are for British banks, but they are likely to include a requirement to impose a firewall between banks’ retail and wholesale operations into subsidiaries that must be separately capitalised – potentially with higher capital requirements for the retail side. McKinsey estimates that this will raise the cost of funding for investment banks by about 94-113 basis points. Only UK banks will have to abide by these rules.

• Short-selling rules: After a series of bans on both naked and covered short selling of financial stocks in 2008 and 2009, everything was relatively quiet on the shorting front until 12 August this year, when France, Italy, Spain and Belgium intervened again to halt short-selling in the shares of banks and other financial companies.

• The Dodd-Frank Act: The most sweeping reform of US financial regulation since the Great Depression of the 1930s, Dodd-Frank tackles most of the above initiatives in one fell swoop – and then some. It introduces oversight rules for financial institutions, creates a new agency to deal with consumer laws, ups capital requirements, provides a resolution regime for systemically significant firms, regulates the OTC derivatives markets, reforms credit rating agencies, cracks down on corporate governance and executive compensation, requires fund manager registration and intervenes in the securitisation market. And that’s before you even start on the Volcker Rule – the Obama-endorsed proposal to ban banks from proprietary trading without their clients’ explicit instructions. Volcker also stops investment banks from owning or investing in hedge funds and private equity, and limits their liabilities – all under the auspices of curbing the activities of institutions deemed too big to fail.

• Further, further reading...

Other initiatives underway include the EU Securities Law Directive, the EU Central Securities Depositaries Review, the Credit Ratings Agency Regulation, the Corporate Governance Code, the EU close-out netting review, the Market Abuse Directive, UCITS V, and harmonisation of EU contract law.

Elizabeth Fournier and Juliet Samuel