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A challenge ahead for the regulators as 'too much regulation' is the top banana skin for the second year in a row Back  
The key message coming from banks in this year's 'Banana Skins Survey' is a challenge to the regulators to show that their regulatory processes are delivering not only a robust regulatory framework, but the right balance of cost and benefit, writes Chand Kohli in an analysis of the report which rates banks' main concerns about the financial system over the next two-three years.
The Banana Skins survey is carried out annually by the Centre for the Study of Financial Innovation in association with PricewaterhouseCoopers, and attracts respondents from a wide range of institutions in an increasing number of countries - this year 468 respondents from 60 countries including a representative sample from Ireland. The survey asks respondents to describe their main concerns about the financial system over the next two-three years, to rate a list of potential risks, and also to rate the preparedness of financial institutions to deal with those risks. The results give a fascinating picture of the concerns of the banking industry.
Chand Kohli

The top three
The Banana Skins survey has been carried out annually since 1996 and the movements in ratings of risks are just as revealing as are the absolute ratings themselves. There has been little movement in the top three risks when comparing 2006 and 2005, with the top two unchanged from 2005 and the third, derivatives, only moving up one place. For the second year running, too much regulation comes out as the top banana skin.

The most frequently mentioned risk was the cost of regulation, particularly since few bankers saw a compensating benefit. Other concerns were the distractions caused by a constant flow of new regulations and the anti-competitive aspects of regulation, especially for smaller banks. In some instances regulation was criticised for being inappropriate, for example focusing on micro-regulation at the expense of the big picture and risks.

The prescriptive nature of regulation, removing judgement and potentially breeding a box-ticking attitude and reluctance to give customers advice, were quoted as sources of concern, and there is growing unease about the politicisation of regulation and interference by governments. Figure 1 shows the top 15 risks highlighted in the 2006 survey.

Brussels was widely blamed for much of the burden and cost with respondents citing the new directive on markets in financial instruments (MiFID) a the key driver here. Basel II also came in for criticism, although many respondents from emerging markets felt that Basel II is encouraging better management practices and controls.

Unsurprisingly, banks and bankers were the most vociferous in highlighting over-regulation as a risk, and particularly so in Europe, although this was also highlighted by non-banking businesses (who placed it second), and it even came in the top 10 (at number 9) from regulators!
Credit risk remains the second highest concern for respondents. Whilst over-regulation comes out top of the risks, many respondents acknowledge that, whilst costly and distracting for business, banks are unlikely to fail through over-regulation. Bad lending, however, can bring down even the largest bank. Allied to this concern over credit is an increased concern over the upward movement in interest rates (up from 12 to 5 on the list). Particular aspects of credit risk highlighted were over-borrowing in the consumer debt market, with consequent reputational damage, irresponsible lending and housing bubbles in the mortgage industry. Credit risk concerns were not confined to the consumer sector, however, leverage in private equity firms and hedge funds, and the extent to which businesses are fully geared, were also highlighted.

Exposure to derivatives, and in particular credit derivatives continue to be a strong source of concern. Bankers were conscious of the potential for volatility in the event of an economic downturn and the possibility of a default by a large issuer, investment bank or hedge fund with a knock-on effect on liquidity in the markets. The complexity of derivative products, leading to difficulty in understanding the market and even in properly understanding and managing risk, were also cited as factors increasing risk. As a side swipe at the insurance industry, bankers were concerned at the exposures of certain insurers to the derivatives market.

The big movers
Although the top few risks are relatively unchanged, there have been some significant moves in the risk rankings. The risks moving up the list were:
Commodities - price volatility driving the risk up 10 places to number 4, with concerns largely stemming from the energy sector (high oil prices, terrorism, political unrest in the Middle East, and China's voracious appetite for oil) and particularly strongly voiced by the G7 countries;
Merger mania - worries coming back relating to increasing market concentration and stretch on management structures, the creation of uncontrollable entities and the elimination of smaller players;
Emerging markets - concerns about stability are again rising, with heavy exposures at fine prices, and particular concerns over Russia and China;
Political shocks - the political tension in the Middle East, continued violence in Iraq, the Iranian nuclear question and North Korea were all quoted in a widespread concern that the banking industry could suffer from unexpected shocks;
Equities - the recent good performance in equities has led to some nervousness that there could be a correction in the market, with a particular effect on the private equity sector.
The decreasing concerns were in a number of the personnel risks where it is felt that improved procedures and controls are succeeding in managing risk.

So what does this mean for the banks?
This year, banks were seen as better placed to handle shocks to the system - 64 per cent of respondents felt that institutions were moderately well prepared or better able to handle the risks, up from 57 per cent last year. Confidence was particularly strong among bankers (73 per cent) but also among regulators - 63 per cent compared with 39 per cent last year, although outsiders were more sceptical, with only 44 per cent thinking that banks were well prepared.
It is clear that, while many of the risks highlighted in the past are now felt to be under control there is still volatility - in the commodity market, through exposures to derivatives and emerging markets and to domestic credit losses, compounded by increases in interest rates. The key message from the banks, however, is a challenge to the regulators to show that their regulatory processes are delivering not only a robust regulatory framework but the right balance of cost and benefit.

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