Can They Contain the Fire?

The one thing of which financial services firms can be certain in these uncertain times is that their world in 2009 will look very different from the one they inhabited before the Crash of 2008.

In a snapshot taken last March of the 10 largest institutional brokers, two-Lehman Brothers, ranked fourth in terms of net capital and Bear Stearns, ranked sixth, according to TowerGroup calculations-have ceased to exist entirely. The largest brokerage firm by net capital, Merrill Lynch, has been taken over by Bank of America, which previously did not make the top 10 list, but which now tops it.

Investment banking institutions Goldman Sachs and Morgan Stanley have been forced to change their status to bank holding companies, subjecting themselves to stricter regulatory oversight, in order to gain greater access to cheap government funding.

Firms changing their status to bank holding companies will face new compliance challenges. In addition to reporting to the US Securities and Exchange Commission (SEC), they will now come under the oversight of the US Federal Reserve.

It will not be the first time these firms have dealt with the Fed, as some of their subsidiaries already report to the body, but it will involve additional reporting and will put a new focus on processes and data integration, says Jeffry Wallis, managing partner at SunGard Consulting Services (SCS). The number of calculations required to comply with the Federal Reserve is significantly greater than that required under the SEC alone, as firms will need to gain more of an enterprise view of their data and risk exposure. "Firms will need to be able to integrate points of view from systems that historically have not had to integrate," Wallis says.

The Fed will be interested in what processes are in place for borrowing money and how that money is held on the books. It will focus more than the SEC on capital reserves, and there are differences in the way capital requirements are calculated for the two different regulators. "In the SEC world, the capital requirements for a fixed-income operation and an equity trading operation are looked at in an almost siloed fashion. But when the Fed starts to look at it from a macro point of view, firms have to bring the data points and real-time risk into understanding so they can calculate that against their reserve deposits at the Fed and make sure those reserve ratios are properly met," Wallis says.

The Fed will be concerned about default and will want to make sure the ratios are never breached, so the ability to meet those ratios on a fairly real-time basis will be important, Wallis says. "It doesn't have to be real-time in the sense that we are used to from a trading point of view. From a bank holding perspective, end of day calculations and trying to pull these data points together is a pretty monumental task. It's a very data-centric challenge," he says. They will have a grace period of two years to comply with new regulatory reporting requirements, according to Adam Honoré, senior analyst at Aite Group.

Fortunately, the last two years have seen an emphasis on credit and market risk which means the sourcing of a lot of this data has already begun. "There is a fair amount of heavy lifting that has already been accomplished by pulling this data into a central warehousing area," Wallis says. However, that data sourcing was done under the SEC regulations so additional sourcing and new calculations will still be necessary to comply with the Fed. "My sense is that the collection of the data is almost 75 percent there," says Wallis.

"One of the reasons Goldman Sachs and Morgan Stanley have remained standing where others have fallen is that they had made huge investments in their risk management and data management initiatives, and that is going to help them tremendously going forward. But that's not to say they don't need wholly new applications to meet their specific banking requirements," adds Bill Nosal, managing director of compliance solutions for SunGard.

Other changes for newly minted bank holding companies include additional scrutiny on future merger and acquisition activity. "A bank holding company has to go through a market competition analysis to make sure it is not dominating the market," says Honoré.

Even firms that are not changing their status or subjecting themselves to additional overseers will face new compliance challenges as regulators find ways to close previous regulatory loopholes.

SEC chairman Christopher Cox decried the lack of regulation of the credit default swaps market (CDSes) in a recent speech to committee members on the turmoil in the US financial markets. "The $58 trillion notional market in CDSes-double the amount outstanding in 2006-is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market," he said. Cox likened the CDS markets to short selling. "Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default," he says.

Cox called upon the US Congress to mandate the regulation of the CDS market, whether by the SEC or another oversight body. The SEC or other regulatory authorities cannot unilaterally decide to regulate credit default swaps without a mandate from Congress. They have no statutory authority to do that because those things are not covered by exiting securities laws, according to an SEC spokesperson. Any sweeping new regulation has to come from the government.

One immediate regulatory impact resulting from this autumn's market turmoil was the temporary ban on the short-selling of selected financial stocks, enacted by regulators around the world to prevent the shares of otherwise relatively healthy firms going into a downward spiral. The ban was lifted in the US after the passage of the Emergency Economic Stabilization Act, also referred to as the economic bailout package, which was intended to bolster confidence in the US markets.

Short-sellers-mostly hedge funds-were blamed for a lot of the loss in market value of investment banking stocks after the failure of Lehman Brothers. An investigation is underway in the US into whether a number of hedge funds conspired to bring down the stock price of a total of six financial firms including Goldman Sachs and Morgan Stanley, by spreading false rumors about the financial health of those organizations. Some 25 hedge funds have been ordered to turn over trading information. Short selling per se is legal, but artificially causing a stock price to fall by spreading rumors is not.

Nonetheless analysts remain convinced that short sellers play an important role in keeping the market honest. "Without a doubt there are continuous cries from institutional investors that short-sellers are vultures, but if you look closely it's more often than not that they tend to be very good assessors of corporate and market valuation," says Sean O'Dowd, senior analyst for Financial Insights.

John Bates, CEO of Progress Apama, a complex event processing (CEP) and algorithmic trading technology provider, says CEP technology can be implemented to monitor markets for suspicious behavior including rumor mongering and suspiciously timed trades. The UK Financial Services Authority (FSA) deploys market surveillance technology from Apama.

In an environment where fingers of blame are being readily pointed, hedge funds make an easy target because of their lack of regulation, and the populist perception of them as greedy speculators.

There have been renewed calls for tighter regulation on hedge funds from various corners. However, analysts maintain that hedge funds are not to blame for the current problem. "Hedge funds didn't have a lot to do with this. This was a housing problem," says Aite's Honoré. Regulators and governments have talked about stricter controls on hedge funds for years, but so far to no avail. "There may be a new regulatory framework that comes out and tries to encompass hedge funds and hopefully this does create a sound regulatory framework with some consistency and some common oversight. But politicians have been incapable of producing that thus far so I doubt that what they produce as a result of this will be much more effective than what exists today," he adds.

The SEC recently announced it was allowing hedge funds and private equity firms to take increasing sizes of ownership in financial firms, something that was limited before. "[US Treasury Secretary Henry] Paulson and his colleagues realize that these firms have at their disposal a great deal of cash so they might want to tread lightly as to how much regulation and compliance they begin to place on these firms," says O'Dowd. On the other hand, if hedge funds and private equity firms do take increasing control over banks, their roles as parent companies may come under increased supervision, even if their trading behavior does not.

The government is considering purchasing large numbers of CDSes to free up banks' balance sheets, as well as making capital investments into banks. "There will need to be a very thoughtful approach as to what new regulation they intend to pass. As we have a number of these institutions and a large amount of security holdings now being managed by the government, they will have to be mindful of what new controls they pass as they don't want to shoot themselves in the foot now that they are the gatekeepers of a large amount of these securities. They will have to consider not only how it impacts the Street but how it impacts what they have," says O'Dowd.

With the upcoming US presidential election, no one is sure what stance the next government will take on regulation. A generally populist, pro-regulation sentiment can be detected during the election cycle, but to what extent this will translate into action after the election-and what shape new regulations might take-remains to be seen. One thing is certain, however. There will be regulatory consequences to the current financial crisis-and the chances are that at least initial reactions will be of the knee-jerk kind, says O'Dowd.

However, lawmakers will have to be careful as to how stringent new rules are, as there are already fears over the heavy cost of compliance making the US a less competitive place to do business. "They will have to be cautious. You don't want to create another Sarbanes Oxley, where it becomes too expensive to do business in the capital markets in the US," says Honoré.

Whatever shape new regulations take, firms will find compliance to be a significant source of cost in the coming couple of years. Compliance currently accounts for between 5.5 percent and 7 percent of a firm's IT budget, depending on the firm, according to Aite Group. Honoré expects it to remain a significant part of IT budgets in 2009, although he does not believe the percentage of overall IT budgets being spent on compliance will increase dramatically. "This isn't the first compliance cycle where it has been a painful spend-anti-money laundering, Basel II, Regulation NMS, the Markets in Financial Instruments Directive (MiFID)-all these cycles caused compliance issues and people dealt with them," he says.

While compliance will remain a constant, risk management spending is expected to go up across the industry. "I would speculate that risk managers will suddenly have access to budget whereas that's probably not something they had in the past-the ability to direct their own IT projects," says Honoré.

Low-latency initiatives will remain front and center as firms are still in an algorithmic-trading arms race, says Rob Hegarty, managing director at TowerGroup. Several top-tier firms will be focused on integrating recent acquisitions in the next two years-Bank of America will absorb Merrill, Barclays will integrate the US investment banking operations of Lehman Brothers, and Wells Fargo will bring Wachovia under its roof. These firms will see increases in their IT budgets as they work to integrate their infrastructures and achieve IT synergies, says Hegarty.

Observers predict fairly dramatic cuts in IT spending in 2009. TowerGroup predicts a 14 to 16 percent decline in sell side IT spending from 2008 to 2009-party due to the decreased number of players and synergies that will arise from large-scale mergers.