FICCI – IBA ConferenceSetting a new paradigm in regulationDuncan Martin, Partner, BCG London

September 2010

2

New regulations mean more E, less R, therefore lower ROE

ActivityActivity ImpactImpactMost important new rulesMost important new rules

Trading

Capital

Liquidity

• Much more capital for trading exposures, securitisations and financial counterparties

• Drive to exchange-traded and centrally cleared derivatives• Restrictions on prop trading, hedge funds, private equity

• Higher minimum levels, with active build up in good years ("procyclicality")

• Better quality, essentially restricted to paid in capital and retained earnings

– Hybrid instruments, deferred taxes, and intangible assets will no longer be eligible for Tier-1 capital

– Restrictions on minority interests equity stakes in financial institutions

• Absolute cap on assets based on equity ("leverage ratio")

• Holdings of high quality liquid assets to equal stressed liability run-off • Long term assets to be funded to a greater extent with long term

liabilities

Increase in RWA for trading activities

Lower revenues

Much higher core capital

Smaller balance sheets

Much greater holdings of liquid assets

More long term funding

Source: Basel Committee on Banking Supervision; BCG analysis

1

2

3

Regulations much more strictly enforced

3

Far-reaching effects eg Dodd-Franks in US

Banks

Non-banks

CARD ActCARD Act Reg EReg E DurbinDurbinReg Q repealReg Q repeal

Volckerrule

Volckerrule

New Reg. Bodies

New Reg. Bodies

Retail/Cards1

Capitalmkts

Commer-cial

Overdraft opt-in for debit /ATMs trx and other consumer protection items

Ban on proprietary trading & limit on hedge fund / PE activities

Consumer protection covering:•Billing •Payment•Grace period•Fee limitations•Rate changes

Limit on interchange rate for debit cards

Interest on business checking permissible

Co

ns

um

er

Fin

an

cia

l P

rote

cti

on

Ag

en

cy

Fin

an

cia

l S

tab

ilit

y C

ou

nc

il

Dis

so

luti

on

Au

tho

rity

1. Credit and debit.

Derivatives reform

Derivatives reform

Select swaps activities must be in non-bank affiliate

Move OTC derivatives activities to SEFs and central clearing authorities

Insu

ran

ce

Au

tho

rityOther

CardDitto

B/Ds& HF/PE

Insurers

4

Material consequences, some unintended

First order effects• Higher prices for all financial services• Forced deleveraging leading to credit rationing• Another wave of arbitrage products

Second order effects• Hard to finance long term risky assets eg ports, roads, airports, power stations?• Increasingly national regulation leading to stranded pools of liquidity and capital?

Third order effect: conflicts of interest. Will governments ...• Depend on banks to:

– Hold large amounts of "highly liquid" national debt?– Make large profits to provide tax revenue?

• Apply pressure to:– Banks (especially state-owned ones) to lend in run up to elections?– Regulators to overlook anti-competitive behaviours, show forbearance on stressed institutions, and

restrict new entrants?

5

Pharmaceuticals

Infectious Disease Control/Immunology

Fisheries management

Telecommunications

Aviation

Wildfire Fighting

BCG supported the WEF in "Rethinking Risk Management"

System-Wide Perspective

Transparency

Governance and Culture

Domains Dimensions

6

7777

8888

9999

Governance& Culture

Information Flow & Transparency

System wide perspective

Golden rules for rethinking risk management

1111

2222

3333

4444

5555

6666

Drive Drive diversitydiversity

Simulate Simulate system system disasterdisaster

Let small Let small fires burnfires burn

CaptureCapturedeep and deep and detailed detailed datadata

Make Make innovationinnovationtransparenttransparent

Scrutinise Scrutinise complexitycomplexity

Look Look for troublefor trouble

EmpowerEmpowerthe front linethe front line

Value Value experienceexperience

Drive Drive diversitydiversity

Simulate Simulate system system disasterdisaster

Let small Let small fires burnfires burn

7

Current regulatory changes at risk of making system less safeBail outs have merely suppressed "fire"

• Too many weak institutions still alive• Next crisis will be worse

Regulatory harmonisation reduces diversity• Convergence on single set of standards worldwide• Insurance converging with banking

Increasing centralisation disempowers the front line• Supranational regulators => National regulators• National regulators => Banks• Within banks, Boards, Audit, Compliance, Risk etc all looking over shoulders

Focus on compliance crowds out looking for trouble• Compliance with rules presupposes system stability, and create illusion of control• Finance is inherently unstable; control is merely illusory

Haemorrhage of experienced people condemns us to repeat the cycle

8

In finance, unstable is normal

Complex systems

Non-equilibrium

Non-linear

Dynamic

Adaptive

Multiple, unstable equilibria

Interactions between component inputs and outputs not linear (feedback loops)

System inputs changing through time

Components changes in response to environment and history

• Predator/prey population dynamics

• Social phenomena eg fashion

• Financial markets

Complex systems – such as global finance -- are inherently unstable