Valuation vulnerabilities: Regulatory challenges

There is a large amount of debt and leverage in some sectors of the financial system, coupled with historically elevated valuations for almost all asset classes (from corporate equities to real estate to cryptocurrencies). These areas may be susceptible to correction if rising inflation sends interest rates sharply higher; even relatively small pullbacks could have outsized impacts on asset values in market segments with concentrated or leveraged exposure. Regulatory focus on principles of fairness and competition could separately impose impacts on valuations.

Explore here insights from the KPMG report Ten key regulatory challenges of 2022.

Maintaining focus: Valuation vulnerabilities

Monitor valuation exposures and develop scenario and stress testing to gauge sensitivities.

As financial risks from the pandemic dissipate, regulators are looking to medium- and longer-term vulnerabilities, which can manifest through direct, indirect, concentrated, or leveraged exposures. Regulators are taking note of “exuberance” in asset classes such as residential real estate and financial markets (including corporate equities and “riskier assets” such as cryptocurrencies) as well as the potential for abrupt or steep valuation adjustments based on a variety of factors that may present individually or in concert.

Examples include:

• A slowdown in the economic recovery due to deterioration in the public health situation.
• Persistent inflation and associated monetary tightening.
• Market volatility based on the relationship of social media and retail investors.
• Spillover effects from uneven recovery or financial conditions in global markets.

Asset valuations will also be affected by shifting market demand based on consumer preferences and corporate commitments to climate change. The FRB has set initial expectations relative to climate risk modelling (scenario analysis and stress testing) noting the process will be iterative, marked by data limitations, and evolving metrics.

Ensure effective LIBOR transition management processes and controls.

Federal and state financial regulators have cited the LIBOR transition as a key supervisory priority for 2022. To properly mitigate operational, compliance, legal, and reputational risks, as well as to prevent balance sheet destabilization and adverse financial impacts.

Regulators expect financial services companies to:

• Cease originating new LIBOR contracts after December 2021, and have an established internal governance mechanism in place, including controls, training, and exceptions.
• Be aware of ongoing LIBOR exposures, including identification of all contracts referencing LIBOR, lack adequate fallback language, and mature after the relevant tenor ceases.
• Have and implement a plan for communicating with consumers, clients, and counterparties.
• Ensure operational capabilities across systems, processes, and models support an orderly transition to a replacement reference rate as well as new demands and offerings.
• Conduct due diligence to ensure that alternative rate selections, including credit-sensitive rates, are appropriate for the company’s products, risk profile, risk management capabilities, customer and funding needs, and operational capabilities.
• Monitor emerging market guidance and activity, and reassess product offering optionality and strategy.

Evaluate synthesis and alignment in M&A considerations.

Digital adoption, technology modernization, competition from technology-driven services companies, reach for scale, market consolidation, and, most recently, ESG considerations are driving financial services companies to pursue a variety of M&A transactions as well as partnerships, and/or alliances.

Regulatory factors that may affect potential transactions include:

• A focus on anti-trust enforcement, reinforced by the Administration through Executive Order prompting:
  • DOJ, FRB, OCC, and FDIC to “revitalize” bank merger oversight and develop a plan early in 2022. The Administration specifically calls out the disproportionate impacts that bank closures can have on communities of color and small business access to credit.
  • FTC and DOJ to review horizontal and vertical merger guidelines. FTC in particular has rescinded its Vertical Merge Guidelines and announced other policy changes including those for pre-merger notification, “Second Request” compliance, and prior approval.
• Heightened attention by CFPB and FTC to potential anticompetitive impacts of scale and networks, especially as they relate to serial mergers, the acquisition of nascent competitors, the aggregation of data, and unfair competition in attention markets.
• New policies adopted by DOJ and FTC to strengthen corporate criminal enforcement and accountability related to anti-trust investigations and consumer protection misconduct.

Reinforce rigor of quantifiable and measurable credit standards across the credit lifecycle.

The quantification and measurement of credit risk across market sectors has posed challenges in the pandemic era due to the varying degree of oversight in government policies or programs supporting sector performance.

Going into 2022, regulators will now be looking at:

• Material exposures or concentrations in distressed industries, markets, or consumer products highly affected by the pandemic, including termination of pandemic-related forbearance, changes in market conditions, and any lasting impacts.
• Credit administration, including underwriting practices, accommodation programs, staffing and expertise, and credible challenge from risk management functions
• Application of CECL and, in particular, the effectiveness of the methodology at estimating lifetime expected credit losses. For those banks that have not yet adopted CECL, regulators will evaluate an entity’s preparedness, including implementation plans (and use of third parties) for developing the loss estimation methodology, modeling techniques, and management information systems.
• Monitoring of emerging market trends that can expand access to credit while managing credit risk, such as the use of  algorithms to make lending decisions and incorporating new/alternate credit factors to expand on traditional credit histories, and new products such as buy now/pay later.

Ten Key Regulatory Challenges of 2022

The year 2022 brings high levels of risk and regulatory supervision and enforcement. Regulatory “perimeters” continue to expand, and regulatory expectations are rapidly increasing. All financial services companies should expect high levels of supervision and enforcement activity across ten key challenge areas. Read the full report to learn more.