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  • Writer's pictureWilliam Webster

Regulatory volatility - what happens if the tide turns?

When I see board risk packs there is more on liquidity, market and credit risk than ever before. That's a good thing, it promotes discussion.

One of the key ingredients is the ability to look forwards rather than backwards. Indeed the question "what will the balance sheet look like over five years" is routinely asked as part of the capital and liquidity process.

However looking forwards is not easy. Forward prices are a poor indicator of future spot rates. Economic models fair no better; take a look at the Bank of England's fan charts. Tomorrow's weather will probably be like today but who knows what next week will bring?

Markets have grappled with these problems for years. When the perception of risk is low more is put on the table and when it's high everyone gets stuck in the exit at once.

Nothing new here but with "the light touch" being as popular with regulators as a 1980's "Relax" T-shirt, regulatory volatility is high and it's something we don't have much experience of, that is until recently. It can lead to two things.

First it can materially affect the way we look at risk. Second, reversal of direction by regulators can turn a sensible strategy upside down. Let's look at an example.

Liquidity risk management has been materially altered by regulation. The way liquidity is measured, managed and reported has been transformed. But could it be turned upside down again?

Could net stable funding ratios alter the relative size of buffers and the restrictions within?

If this happened what could be the cost if you wanted to alter your buffer? If interest rates increased at the same time what difference would this make? Of course it's not just liquidity that's affected it is almost every area of the balance sheet.

Higher regulatory volatility means past decisions (the business you currently have) is now more risky. Furthermore today's decisions face a more uncertain future.

As a result of these regulatory ambiguities clients face a dilemma. Sitting on the fence waiting for things to unfold is an option but the current level of uncertainty can present some very attractive opportunities. Do you tread water and risk drowning or swim for the shore which may be currently beyond reach?

Given that treading water is only a temporary respite swimming must take place.

Before striking out a board should ask "what is the potential exit cost should future regulatory decisions make today's decision unattractive?" and "Can we afford this?"

Routinely asking questions about the potential cost of regulatory changes is not easy and I'm not going to pretend you can put a "value at risk" on it. But the discussion is worth having and may help you pin point excessive regulatory exposures before they happen.

In other words if you swim and half way through the tide turns can you survive?

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