Liquidity Risk Management. Baird Stephen

less leverage, all of which now prevail against the backdrop of structural market reforms that have eliminated or severely curtailed previously permissible, seemingly profitable businesses.

      In this brave new world, the leaders will need to separate themselves from the laggards by employing more astute financial analysis and discipline over appropriately calibrated investment horizons, rather than the financial engineering and short-termism that characterized banking industry returns over the decade preceding the financial crisis. Banks seeking to be “end-game players” will need to structure optimal asset mixes that enable them to achieve higher returns while meeting minimum regulatory liquidity and capital requirements. Strategies being considered with respect to products and services, industry concentrations, regional focus, customer segments, distribution channels, and pricing should be driven first and foremost by mission appropriateness, sound management practices, competitive positioning, and institutional capabilities that leverage technology and human capital. Leading institutions are starting to address regulatory requirements up front during strategy formulation rather than merely downstream as an afterthought or with just a compliance mind-set, allowing them to better leverage the platforms and architecture that they are building for both business and regulatory objectives.

      Bigger may not Necessarily be Better – and the Answer is Different for each Institution

      Present day rules and regulations facing banks in relation to liquidity and capital, and the supervision thereof, clearly establish explicit and implicit higher thresholds for larger firms, particularly those deemed to be systemically important. Larger firms are held back from becoming even larger and further exacerbating the risk of being “too big to fail.” Smaller firms may feel the need to bulk up, as a result of market opportunities, out of competitive necessity, or because of the need to acquire additional scale to increase the productivity of higher liquidity and capital levels.

      While institution size will continue to remain important, across-the-board scale for its sake alone may not necessarily be the correct answer either. Rather, combining selective scale with operational excellence is the right approach to take. Achieving the optimum asset mix referred to earlier will require continual refinement due to differences in business models, competitive positioning, barriers to entry, customer needs and preferences, institutional capabilities, legacy factors, and jurisdictional regulatory requirements. What will work for one institution is far from guaranteed to be the right answer for another, and firms will need to take a candid view of their competitive positioning and the general business environment.

      The liquidity rules under the LCR and the Net Stable Funding Ratio are considered more advantageous for banks that rely on retail deposits and long-term funding than those with heavy reliance on short-term or wholesale funding or with concentrations of certain customer segments. The increased stress testing and regulatory capital requirements favor those banks with portfolios that show less deterioration under market downturn scenarios. The leverage ratio constraints would suggest that banks work harder to optimize the relative levels of their risk-weighted assets (used for regulatory capital calculations) and actual assets, a relationship known as RWA density. And the upcoming requirement to hold a minimum amount of Total Loss Absorbency Capacity (TLAC) for systemically important institutions adds even more complexity to determining the right mix of a firm's capital stack.

      Over the last few years, many firms have focused on their competitors' actions in relation to the new financial services rules and regulations, so they could develop their own approaches in a similar manner that did not stray from the mainstream. Leading institutions, in contrast, met the challenge of these new regulatory requirements, sometimes even as first movers, by proceeding forward with internally generated conviction, ingenuity, and resolve. They have been quick to understand and incorporate the impact of these new regulations into refining and redefining their business strategies. It is these attributes, rather than the “me too” mind-set, that will be required to establish the right strategic direction for each institution as well as identify the tactical steps for superior execution.

      Regulations may vary Across Jurisdictions, but Strong Risk Management is Fundamental and Good Business Practice

      For much of the 1990s and into the mid-2000s, financial services rules and regulations grew out of, and often codified, the advances in risk management that were being innovated and implemented by the industry itself. However, the financial crisis of 2007–08 exposed the gap between risk management theory and the actual practice of implementing and embedding risk management techniques and discipline into the actual running of businesses. The ensuing raft of regulations issued by various national agencies after the financial crisis attempted to strengthen the safety and soundness of the banking sectors in individual countries by pushing firms to close the gap between theory and practice; however, it can be debated that some of these requirements have added costs to banks without conferring appropriately commensurate benefits.

      The resulting fragmentation of rules has posed compliance challenges for global firms that must meet these requirements in multiple jurisdictions, even as some areas remain open for interpretation and further clarification. At the same time, banks also have often taken a piecemeal approach to meeting the requirements of various rules and regulations. This has proved to be less cost-effective and efficient than would be the case if they were to take a holistic view of regulatory requirements and business imperatives in advance of upgrading fundamental risk management practices. Most supervisory agencies will acknowledge their intent is to encourage firms to constantly improve risk management capabilities that will justify their costs by allowing business units to continue to perform prudent, value-added risk intermediation to earn an appropriate return. Firms that effectively leverage sound risk management capabilities will be better positioned to achieve business objectives, all while meeting different and changing regulatory requirements, rather than by merely seeking conformity to the average and minimum compliance with the rules.

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      Shyam Venkat is a principal in PwC's New York Office, and Stephen Baird is a director in PwC's Chicago office.

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      Shyam Venkat is a principal in PwC's New York Office.