Article Detail

Optimal Business Model for Financial Institutions under Post-Crisis Regulatory Environment

Journal 36: Global Finance and Regulation

It has been nearly five years since the 2007 collapse of the U.S. housing bubble but the effects of the subsequent liquidity crunch and financial contagion still linger. Fears over sovereign debt, the prospect of European sovereign defaults, and the once unthinkable disintegration of the euro common currency have only exacerbated global economic instability. For the handful of global financial institutions that have thus far managed to weather the storm, the future holds not only economic uncertainty but also intense regulatory pressure – an incredible number of new supervisory actions, regulations and capital requirements that are at times ambiguous, contradictory, extraterritorial and far from complete. The pressure is only exacerbated by the increasing relevance of the banking institutions of emerging economies and the shift of business towards lightly regulated nonbank and shadow banking entities. It cannot be denied or ignored that while economic conditions may eventually calm down, the regulatory pressures are here to stay.

The current regulatory environment has forced capital markets businesses to keep two to three times, and at some trading desks up to ten times, the level of capital as previously required. As a result, global capital markets businesses have seen their historical return on equity (ROE) of 20% reduced to between 7 and 10% [Bohme et al. (2011), Morel et al. (2012)]. Initially, actions such as regulatory arbitrage, RWA optimization, risk and capital model modification or operational improvements modestly mitigated this ROE headwind. However, newly proactive regulators and supervisors have scrutinized many of these actions, deeming them questionable and deceptive. JPMorgan’s multi-billion dollar loss as a result of attempted capital optimization and tinkering with internal risk models has only served to increase the scrutiny of regulators.

Ultimately, financial institutions must acknowledge the new regulatory paradigm and develop acceptable strategies to improve their ROE to match the historical levels that are expected by investors. In this paper we propose a systematic approach to determine an optimal business model that is unique to each financial institution. This proposed methodology can be used by a financial institution to right-size both its core and stressed business lines.