International financial services reform to test Australian industry

Australia may have escaped the brunt of the global financial crisis, but as Janine Mace discovers, changes in the financial services industry on an international level mean that testing times lie ahead.

While the Australian financial services industry escaped the global financial crisis (GFC) without many of the disasters that befell financial services globally, changes are afoot around the world that will make life far more testing for many in the industry.

The wealth management industry is facing challenges not only from unsettled markets, but also proposals for regulatory reforms that could alter the industry at every point – from capital requirements through to distribution models and fee structures.

The reform proposals are so numerous and far-reaching that many in the industry feel under siege.

New York-based Ernst & Young (E&Y) partner, Alan Fish, recently co-wrote a paper titled ‘Positioning for success – Redesigning the asset management model’. In it, he noted:

“Essentially, investment managers face growing demands from all sides at a time when assets under management have fallen sharply.

"Clients want better performance, more information and greater portfolio transparency – and at lower fees.

"Regulators want more oversight and reporting, which imposes higher costs and further constraints.

"To meet these demands, firms must be able to get timely and comprehensive data related to their trading activity, portfolios and operational and investment risks.”

Living up to all those demands is a tough call, and one that is likely to make life harder in the years ahead.

This view is endorsed by E&Y’s Oceania sector leader for asset management, Graeme McKenzie.

“The GFC has changed a lot of things, and some of them are long-term structural changes,” he says. “People are now more cautious than in the past.”

The Institute of Chartered Accountants of Australia has also noted the trend, and recently released a paper, titled Reforming International Financial Regulation, which details the severe weaknesses in the regulatory framework uncovered by the GFC and the current push for reform.

According to ICAA general manager leadership and quality, Lee White, proposals for regulatory reform are appearing around the world.

“In some jurisdictions that didn’t fare as well as here, the results have made it quite high up the political agenda,” he notes.

Principal Global Investors (Australia) chief executive officer Grant Forster agrees the GFC has altered the financial services landscape – particularly in countries where the crisis has been most intense.

“It is not a big surprise that the biggest changes are where the biggest damage was done,” he says.

The introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act in the US in July 2010 marks a significant step in this process, even if many of the tougher legislative proposals were watered down during their passage through the US Congress.

Despite this, the legislation is likely to usher in important changes to the wealth management industry. “It will be interesting to see what the knock-on effects will be from the Dodd-Frank legislation,” Forster says.

Repairing the damage

The reforms represent just one thread in a tapestry of global regulatory reform.

“There is a move for improved disclosure and increased requirements across all regimes,” McKenzie explains.

“This is particularly the case in the hedge fund sector, where even prior to the GFC there was concern – especially internationally – about the impact of hedge funds.”

Forster agrees the industry is likely to face some major challenges in the next few years as regulators try to strengthen the stability of the global financial system.

“The US and UK are clearly moving to broader oversight of the financial system to reduce systemic risk. Both the Bank of England [BoE] and the US Federal Reserve will have broader and more far-reaching powers than in the past,” he says.

“The Dodd-Frank legislation will establish the Financial Stability Oversight Council, and everyone will be part of that and will face increasing demands from this new regime.”

In the UK, the BoE is taking over the reins of power in the regulatory system and is establishing a new Financial Policy Committee (FPC) to mirror its Monetary Policy Committee.

According to UK Treasury Minister, Mark Hoban, the FPC will be responsible for looking at the macroeconomic and financial issues that could threaten stability, and the agency will be given the tools it needs “to address the risks it identifies”.

The trend is not confined to the US and UK. “Other jurisdictions are also undertaking some reshaping of their regulatory regime, as both the retail and the investor sectors lost money,” White says.

Issues such as market integrity are also likely to receive far more attention than in the past. Events such as the ‘flash crash’ of May 2010 (when the Dow Jones Industrial Average fell by nearly 1,000 points in 10 minutes before rebounding), have focused the attention of regulators on developments in electronic trading and the potential for market instability.

According to Forster, markets both overseas and in Australia are likely to find themselves under much closer scrutiny. “With the arrival of new trading markets such as Chi-X, ASIC will be looking at ways to protect market integrity,” he says.

White agrees the days of regulators taking a hands-off approach are over.

“The idea of ‘light touch’ regulation is no longer in favour, as the Dodd-Frank legislation in the US shows. The pendulum is swinging away from the light touch regulatory approach,” he says.

More capital needed

Another important issue for the industry will be requirements for more capital.

“The industry will face increasing capital requirements. Previously asset managers and financial planners operated with fairly low capital requirements, but this is likely to change and so there will be pressure on the earnings of those businesses,” McKenzie says.

For the wealth management businesses within larger and more systemically significant entities such as banks, the push for more capital could have significant implications, says White.

This is particularly the case given the pressure for increased bank capitalisation.

The proposed Basel III international standards on bank capitalisation include recommendations to tighten the definition of capital, introduce reduced reliance on ratings and increase the focus on off-balance sheet risk.

White believes the significance of these developments will depend on how far the new international settings go. “What the impact will be only time will show, but it will be a meaningful impact,” he says.

“Internationally no one picked the risks properly, so there is now a lot of talk about systemic risk.

"This means there is likely to be tighter integration between the wealth management industry, regulators and participants to work more closely and determine the risk levels in the system.”

The realisation that some financial entities are now ‘too big to fail’ means many jurisdictions are also considering regulating the size and activities of financial organisations.

In the US, the Volcker Rule – proposed by former US Federal Reserve Chairman Paul Volcker – to restrict US banks from making certain kinds of speculative proprietary trading is an attempt to introduce these types of limits.

Similar proposals are being floated in the UK. The recent Future of Banking Commission report has recommended restructuring the UK banking system.

It proposes “extending the Volcker Rule to prohibit banks that advise clients from trading any form of securities, and separating corporate advice from investor advice” as a way of addressing “many of the problems that integrated banks create”.

McKenzie believes this push to regulate the activities undertaken within financial services entities will change the structure of many organisations.

“There is pressure for segregation of their banking, asset management and even insurance businesses, which may lead to forced splits in Europe, although this is not so much the case here and in the US,” he explains.

Increasing regulatory participation

While the big-ticket reform proposals have been the focus of most attention, other developments are also likely to have a significant impact.

“Communication between regulators around the world will be increased and become much stronger,” Forster says.

To highlight this, he points to the growing interaction and communication between the US Securities and Exchange Commission and European regulators on financial system oversight and the activities of financial entities.

“Increasingly the motivation for the communication is all about the ‘too big to fail’ concept.”

There is also a growing desire to align regulatory regimes.

“Asset management firms need to understand how information is being shared across borders by regulators and also that they have an increasing interest in stamping out regulatory arbitrage,” White explains.

‘Passporting’ of investment products throughout the European Union is likely to usher in full regulatory transparency and information sharing – regardless of where the product originator and target market are located.

“This will lead to a broader level of transparency than ever before,” Forster says.

A more subtle development with significant implications for the wealth management industry relates to tax.

“There is an increasing focus by tax authorities and governments on ensuring they take in as much revenue as possible and ensure there is reduced leakage through tax havens. This is especially the case in the US,” McKenzie says.

“This trend will potentially have an impact here, especially for fund managers selling products overseas.”

Blame the financial crisis

When it comes to the drivers behind the reform push, most experts lay the blame largely at the door of the GFC, although other factors are also playing a role.

For Forster, the GFC is the biggest motivation for the regulatory changes. “Globally it is purely as a result of the ‘too big to fail’ issue. So much of this is aimed at the investment banks for the problems they have created,” he notes.

McKenzie has a similar view, particularly given the voter anger the disaster has generated around the world. “The GFC hurt many people, and governments around the world feel obligated to address this issue,” he says.

“However, the changes are not just due to the GFC. All the factors are interlinked and some are knock-on effects of the crisis.”

Looking at specifics, White believes factors such as the ‘skewing of incentives’ (which was clearly at work in the US sub-prime market) and the loss of independence in assessing products and risks are also motivating regulators to act.

“At the highest level, there was also acceleration in complexity in products in the lead up to the GFC which led them to become too hard to understand, and also allowed them to fall outside the traditional regulatory system,” he says.

“There has been a lot of innovation in financial products, but regulatory oversight has not kept up with this innovation.”

These factors are clearly encouraging regulators to seek to reshape and strengthen the financial system.

There is also the huge problem of restoring investor confidence in both the financial system and investment markets.

“These events have really hurt the confidence of retail and institutional investors,” McKenzie notes.

This is linked to an ageing population in developed markets.

“All governments have recognised the significant problem of an ageing population and how it can be supported to provide pension and health payments,” McKenzie says.

“This is leading to another agenda to instil confidence in the investment and pension system and encourage investors to save for their retirement in the long term. In the past year or two this has become an increasingly important issue.”

Where will it lead?

One of the key messages being sent by regulators and governments is that there will not be a return to ‘business as usual’ in the wake of the GFC.

Forster agrees life for the wealth management industry will be different in the years ahead. “The industry is going to have to perform a bit more,” he says.

“The industry at all levels needs to get more professional in terms of increasing capital and disclosure and investment manager performance being true to label.

"Everybody will have to change at some level, whether it is changes to commissions, increased transparency or the need to prove your value to consumers.

“The increasing professionalism of the industry and the increasing consolidation of asset management firms and assets mean the bar will need to go higher,” Forster says.

McKenzie believes there will still be good opportunities for the wealth management industry. “But companies will need to respond and embrace the changes that have occurred and recognise that the world has changed,” he adds.

The continuing stream of assets flowing in from compulsory superannuation will also ease the pain. “Mandated super is a big benefit for the Australian asset management industry,” he says.

White agrees there will be an impact on the industry’s growth.

“In the short term there will be a bit of uncertainty and disincentive to growth and a return to traditional ways to develop wealth, but as we see a clearer picture emerging there will be opportunities in the medium term,” he says.

However, White stresses this will not happen immediately. “After the regulatory regime becomes clearer, there will be a settling in period before further innovation occurs.”

This will be exacerbated by the fact not all jurisdictions are proceeding with their reforms at the same pace. “New legislation will provide the framework, but time will be needed for participants to determine how it will impact their business,” White says.

The advisory industry is not immune from the waves created by the proposed reforms, but it could find itself well placed.

“The advice industry will continue as wealth management needs financial planning networks. But investors need to see long-term predictable returns and some stability to see confidence rebuilt,” McKenzie says.

Forster agrees consumers will eventually return to investment markets.

“In the long term, you will get it if transparency increases. Then consumers will start to invest again and there will be good prospects for the industry,” he says.