Enterprise Risk and Regulatory Compliance May 2014 Stephen O Brien Head of Capital, Liquidity and Risk Policy Westpac Institutional Bank
The 2014 economic landscape shows the first real signs of recovery since the financial crisis In 2013 Outright recession in Europe Uncertainty around the impact of US tapering Protracted monetary easing in Australia In 2014 Advanced economies looking in better shape than at any time since the crisis though imbalances remain (e.g. Western government debt) Emerging markets including China are showing signs of slowing Policy-driven slow-down in China External financing vulnerability for India and commodity exporters Domestic outlook House prices have been rising strongly, construction set to lift as well. Non-mining investment remains weak Mining capital expenditure boom has peaked Terms of trade moving lower Fiscal policy is tightening Labour market indicates net balance is unfavourable for now Interest rates expected to be on hold Currency has firmed 2
While the regulatory change agenda continues to expand, with direct and indirect impacts Capital Market risk Derivative reform Basel III definitions and minimums Basel 2.5 Central clearing Capital buffers Conservation, counter-cyclical Leverage ratio Systemically important banks Stressed VaR, CVA Fundamental review of the Trading Book Interest Rate Risk in the Banking Book Counterparty credit risk SA-CCR, CVA, CCP Margin requirements Variation, initial Trade reporting Bail-ins Related market developments OIS discounting Liquidity risk Supervision and business structure FVA Liquidity Coverage Ratio Recovery and resolution planning Segregation, ring-fencing Other Net Stable Funding Ratio Volcker rule Data Conglomerate supervision Benchmark reviews Supervision Large exposures Remuneration Securitisation Disclosure Trader monitoring Conduct risk / risk culture 3
that need to be navigated in combination with other significant change drivers in the institutional banking world. Regulatory reform and market developments Cyclical Economic growth (developed / emerging) Liquidity flows Government policy Market uncertainty Competitive landscape Lower government / corporate investment Structural Product development Pricing differentiation / margin compression Technology and data Central clearing and trade repositories Balance sheet / capital structure Enterprise risk How can Risk respond to turn change into a sustainable competitive advantage? 4
Several key reforms are finalised but a substantial number of unknowns remain. Implementation 2013 2015 2016 Confirmed Basel 2.5 (CVA, stressed VaR) Recovery plans Derivative reporting Volcker rule Liquidity Coverage Ratio (LCR) Margin for non-centrally cleared derivatives Systemically Important Banks Capital cons. / countercyclical buffer In progress Conglomerate supervision Mandatory central clearing 2017 2018 2019 Capital for central counterparties Leverage Ratio Standardised Approach to CCR (SA-CCR) Internal Model Method to CCR Net Stable Funding Ratio Securitisation Bail-in provisions Large exposures Fundamental Review of the Trading Book Interest Rate Risk in the Banking Book Funding Valuation Adjustment Data management Trader monitoring Resolution plans Conduct risk 5
Derivative reform is a core area where regulatory change is resulting in increasing complexity and cost. Shift from bilateral to central clearing Bank X Bank X Centrally cleared: Variation margin Initial margin Mandatory clearing for some instruments Lower capital requirements Direct membership / clearing agreements (pass-through risk) Non-centrally cleared: Variation margin Non-centrally cleared: Variation margin Initial margin 6
Pricing systems need to be adapted to accommodate complex interactions and marginal impacts in real-time. Impact of collateral and central clearing on derivative pricing Normal bilateral (no CSA) Less frequent bilateral CSA Daily posting bilateral CSA Initial margin bilateral CSA Central clearing with initial margin Regulatory capital requirements Collateral requirements Administration requirements Marginal contribution of a derivative trade Change in Credit Valuation Adjustment (CVA) Change in CVA capital Change in Counterparty credit risk capital Change in margin Change in market risk capital Change in Funding Valuation Adjustment Marginal impacts of new trades will vary by bank in accordance with the composition of the portfolio at any given time. Customers may receive widely varying price quotes for the same transaction. 7
The Fundamental Review of the Trading Book (in consultation phase) is likely to be a game-changer. Capital based on stressed period (vs current + stressed period VaR) Market liquidity factored directly into the calculation through liquidity horizons Shift from Value-at-Risk to Expected Shortfall Revised standard method mandatory calculation, may be required to disclose publicly and may be treated as a floor on capital Diversification across risk factors constrained Model accreditation by trading desk, including desk-level back-testing Additional 'risk assessment tool' for desks with illiquid and/or complex products The standard method will be mandatory for securitisation positions Introduce a new default risk model consistent with the banking book Capital requirements likely to increase Significant additional computational and hardware requirements More onerous validation and accreditation process (by desk) May need to price market risk capital into some less liquid risks? CVA capital charge will move to expected shortfall and remain stand-alone Strengthened boundary between trading book and banking book to prevent arbitrage 8
Regulatory reforms are targeting to reduce risk but may also result in transferring or transforming risk. Regulatory change Potential impacts Derivative reform Initial margin Central clearing New processes Funding and liquidity risk Counterparty credit risk Collateral risk Operational risk Liquidity Coverage Ratio Liquidity risk Increase in liquid asset holdings Sovereign risk Credit and market risk Higher regulatory requirements Risks to financial system Increasing complexity Increasing operational costs Uneven implementation Smaller bank business models may become unviable Barriers to entry for new market participants Concentration risk Shift towards non-banks Arbitrage / inefficient liquidity and capital flows 9
The institutional banking business needs to respond to regulatory change dynamically Product design / offerings Does the risk/reward trade-off under new regulation require significant changes to product design? Are some product offerings now unviable? Pricing To what extent should higher capital / liquidity / implementation charges be reflected in customer pricing? Pricing per trade: dynamically assessing marginal contribution of a particular trade to the portfolio Balance sheet How do we optimise the asset / liability mix to go from the balance sheet we have to the one we want? How do we optimise balance sheet management strategies (e.g. where we book trades) Trader monitoring Implementing adequate monitoring systems and safeguards to mitigate market manipulation risk (eg LIBOR / FX / BBSW) and rogue trading Technology and data How can we leverage technology to stay ahead of the changes while getting the basics right? How can we use new technology to better serve customers? Customer relationships How do we keep our customers informed and prepared, partner with them and make it easy to do business with us? Responsiveness How do we make all of the above seamless and minimise disruption? 10
Keeping pace with (and ahead of) innovation requires a vigilant, flexible approach to anticipate trends and prioritise actions. Key drivers Key innovation trends Evolving customer needs Digital and real-time Easier, faster, simpler Regulatory reform and related market change Payments innovation New market entrants Disintermediation / disruptors Financial Markets e-facilitation Competitor investment Simplification Process efficiency / customer experience Internal demands Competitiveness / internal efficiency Big Data / Analytics 11
The mandate of Risk and Compliance is to steer the business through regulatory change, while avoiding over-reaction. Response Understand changes, implications and interactions Drive regulatory and industry responses to influence change Clarity in communication Risk / return Clearly define risk appetite with supporting limit structures Transparent allocation mechanisms to drive the right behaviours Constantly strive for process improvements and simplification Infrastructure and data Robust, integrated and real-time measurement systems Sustainable and adaptive systems and technology Commitment to data integrity Culture and conduct Risk as an integral part of business strategy: Risk is everyone s business Embedded processes for risk identification, control and escalation Increasing focus on conduct risk, litigation risk and reputation risk Governance Consistency and clarity in policy settings Effective monitoring mechanisms Well-defined roles & responsibilities for Board, senior management and lines of defence 12
To recap We are here primarily to serve customers and fulfil their needs The global and local environment in which we do that is undergoing massive change that will continue for the foreseeable future get used to it and treat it as a glass half full Competitive advantage for those who understand the implications better, generating substantial, sustainable financial outcomes Risk management plays a much more active role in strategy and achieving business outcomes but there is a risk of overkill 13
Thank you 14
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