Evaluating global booking models after the Brexit

Posted by Irena Gecas-McCarthy, Advisory Principal, Deloitte & Touche LLP, David Wright, Advisory Managing Director, Deloitte & Touche LLP, Monica Lalani, Advisory Principal, Deloitte & Touche LLP, Ken Lamar, Independent Senior Advisor to Deloitte & Touche LLP, Simon Brennan, Director, Deloitte UK, Vishal Vedi, Partner, Deloitte UK, Richard Rosenthal, Advisory Senior Manager, Deloitte & Touche LLP, and Alex LePore, Advisory Senior Consultant, Deloitte & Touche LLP on July 27, 2016

In light of the recent United Kingdom (UK) referendum to leave the European Union (EU), strategic decisions about foreign banking organizations’ (FBOs) business models are as critical as ever. You might be wondering, in a blog series focused on Enhanced Prudential Standards (EPS), why we would lead with a discussion of FBOs’ booking models and the Brexit?  This is important, because underpinning the EPS framework was the construction of an explicit ring-fence through the establishment of an Intermediate Holding Company (IHC).1 The IHC forced large FBOs to locally inject and maintain capital and liquidity resident in the US IHC entity. The consequences of this ring-fencing will only ramp up in intensity as CCAR and stress testing requirements become effective and force FBOs to hold additional capital. The net effect of these changes is substantial. Increased and localized capital requirements force FBOs to rethink what businesses are profitable and can be sustained in the current regulatory and market environment within and outside the US. FBO executives have recognized the significance of these issues.2 The question now becomes: how do they continue to demonstrate progress and adapt to change?

In preparation for these requirements, FBOs have worked on optimizing their footprint within and outside of the IHC by looking at interconnectivity among interbank and intra-affiliate flows and evaluating how products and activities are currently booked. A few FBOs have already adjusted their group strategies in light of US constraints and exited businesses that would not surpass the profitability threshold established by the increased capital requirements.  However, most FBOs have kept their US businesses intact and are striving to fine tune their strategies in ways that maximize profitability relative to new capital requirements. But those efforts are just the beginning.  Add to capital requirements other constraints related to recovery and resolution planning, derivatives regulations, and additional ring-fencing requirements, among others, and the regulatory drivers for re-evaluating business and booking models will further intensify and prompt further change.

Regulators have acknowledged the impact of the new regulatory framework on considerations related to banks’ business models. Dan Tarullo, widely considered to be the most influential Federal Reserve Board Governor on regulatory issues, recently summarized the state of this strategic assessment process for large banking organizations:

“Each firm needs to make a judgment—and I believe is making a judgment—as to how its business model should evolve given the regulatory requirements, particularly on capital and liquidity, that have been put in place . . . We don’t have anything specific in mind and, in a sense, that’s the point.  The point is we should put in place a set of regulatory requirements which are designed to make the firms safer and sounder and the financial system more stable, and then allow each firm to make its decisions on its business model working within those regulatory requirements.”3

Enter Brexit. For many of these large FBOs, London is leveraged as a central booking center for derivatives and other investment banking products. The decision to leave the EU may challenge how London is leveraged as a booking center, and will also impact decisions around how London and other centers are used for booking, settlement, and risk management, and influence the dividing line between booking model strategies and legal entity strategies.  FBOs could be forced to establish a presence in the EU with the associated capital and liquidity consequences, which would likely increase costs as they could lose the passports that enable them to easily conduct business across the EU.  .  Although it remains too early to predict how the UK will resolve issues related to passporting rights and equivalency with EU regulations, impacted firms should understand the potential effects from different possible scenarios and be ready to make changes if appropriate, with a particular focus on the worst case scenario of the UK becoming a “third country” to the EU.

FBOs must consider whether and how to exit certain markets and geographies that appear to be unsustainable going forward.  These issues present arguably the most existential questions for FBOs regarding the future of their institutions.  Although the issues themselves are Brexit-neutral, the Brexit underscored the importance of addressing them.

It all begins with understanding the ‘what’ and the ‘why’ of an FBO’s own booking practices.  That means understanding the products in which the bank transacts and the legal entities involved, how trades are executed, how risk flows through the group, where risk ultimately sits, and how the risks are then managed – as well as why things are set up in that way.  In our experience, some of the necessary components for generating this clear understanding are often absent:  documentation is not robust (including with respect to transfer pricing, where regulators expect firms to implement a framework in a consistent manner across the corporate structure4), booking-related policies are inconsistent, and there is limited understanding and transparency of booking practices as a whole at a high level. In particular, the relationship between governance, origination, risk management, booking, and the supporting operational infrastructure is not well understood end-to-end, especially across legal entities and branches, or between jurisdictions. It’s safe to say that, over time, industry booking practices have evolved based on ad hoc siloed decision-making, and not through a robust understanding of existing enterprise wide practices and holistic strategic analysis.

Another reason for FBOs to focus on these issues is that banking regulators are asking direct and challenging questions of banking groups’ booking practices, and are expected to become more systematic in their scrutiny of wider industry practices, such as remote booking practices. Some global banking groups are falling short of supervisors’ general expectations around transparency and documentation of booking models, and are likely to have work to do to meet the new and more demanding regulatory reality.

A key part of the business case for booking model analysis and change is about cost avoidance (both for underlying customers and the banking group) and preventing supervisory interventions that could lead to forced structural or operational changes. But it is critical to try to address the regulatory change environment in a way that extracts the greatest business benefits. Regulatory change should be seized as an opportunity to drive through other overdue business changes. Even without regulatory prompts, there are good reasons to review booking practices and look for efficiencies, such as:

  • More effective use of netting
  • Reductions in intra-group back-to-back transactions
  • Elimination of superfluous legal entities
  • Liberation of trapped capital and liquidity
  • Identification of customer on-boarding inefficiencies or duplications

In a sense, each FBO must think about its US business models and answer the following questions:  “What is the next stage of development of our US Operations?” “How do we operate in the future to provide growth and fulfill our parent’s strategies? “Who do we want to be when we grow up?”  That is, they must identify markets and business lines that will continue to be profitable and allow them to return capital to their shareholders.  Much of this strategic thinking was put on hold during the IHC implementation and the rush to build infrastructure capabilities.  Clearly, those that can be proactive and use the time post-July 1 to strategically evaluate their business and booking models should be ahead of the game.

1Foreign banks with over $50 billion in consolidated non-branch assets in US subsidiaries are subject to the requirement to house US subsidiaries under an IHC.
2Banking Perspective, The Quarterly Journal of The Clearing House, “FBO CEO Roundtable,” Q1 2015, Volume 3, Issue 1, available at https://www.theclearinghouse.org/publications/2015/2015-q1-banking-perspective/fbo-ceo-roundtable
3Wall Street Journal, “A Conversation with Fed Governor Daniel K. Tarullo,” (July 6, 2016), available at http://www.wsj.com/articles/video-hourlong-q-a-with-fed-governor-daniel-tarullo-1467919491.
4Board of Governors of the Federal Reserve Board, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, “Interagency Guidance on Funds Transfer Pricing Related to Funding and Contingent Liquidity Risks,” (March 1, 2016), available at http://www.federalreserve.gov/bankinforeg/srletters/sr1603a1.pdf.

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