After the crisis: Should law firms self-impose capital adequacy standards?

Should law firms take inspiration from the banking sector, and self-impose capital adequacy standards? A rather trite and self-satisfied answer would be that the banking sector has largely created its own crises over decades (and centuries), that its problems are varied but largely specific to the sector, and that law firms have nothing to gain by emulating the approach of banks.

An alternative response, and perhaps more realistic and humble, would be to acknowledge that law firms are subject to competitive and financial pressures unlike any they have previously experienced, and their instinct for self-preservation should cause them to embrace best practice wherever it may be found. As such, partners should require and empower a self-regulatory regime of the highest standards.

Regulatory reach

The banking sector has no choice about capital adequacy and is subject to the progressive constraints of the Basel agreements in their various iterations. Taking the point a little further, the question could be posed about the role of the Solicitors Regulation Authority (SRA) as regulator in England and Wales and whether some form of fixed rules should apply to law firms.

Admittedly, problems with law firms do not present the same potentially cataclysmic consequences as failure in the banking sector. Nevertheless, the SRA's main duty as regulator is to protect clients, and financial failure of a law firm presents the greatest risk to clients (excepting malpractice or defalcation).

As it happens, the SRA has pretty far-reaching powers and, increasingly, the will to intervene where it perceives that problems are building. However, the current regulatory regime is clearly a work in progress; the SRA is still working out how to reliably identify the key issues and make interventions (formal or informal)
in a sufficiently timely manner to avoid serious problems.

The SRA's current focus, whatever its remit and intentions may be, is necessarily much more on resolving current crises than avoiding future problems. But, whatever the intent of the SRA, law firms should look out for themselves. In future, capital adequacy standards would be essential as a comfort and protection to owners, clients and other external stakeholders alike. So, what should these standards be?

Capital adequacy regime

'Capital adequacy' is possibly too narrow a concept, as is the objective is not merely to ensure that the firm can meet its financial commitments at any given moment but also to allow it to survive and thrive in future. Capital adequacy benchmarks are only really beneficial within the context of a sensible financial strategy, which itself should be aligned and
integral to the competitive strategy
and culture of the firm.

In considering what the scope of a capital adequacy regime (whether self-imposed or super-imposed) should be, it is instructive to look at the Basel III framework, which is in the course of implementation via the European Commission's Capital Requirements Directive IV (CDR IV). It is, of course, extremely detailed and complex but,
in essence, the framework covers
the following.

• Capital requirements - including detailed definitions of classes of capital (tier 1/tier 2). Minimum capital requirements are set by a process of judgement and calculation regarding: credit risk, operational risk, market risk, settlement risk and credit valuation adjustment risk.

• Leverage ratios - capital as a percentage of all material exposures, on and off balance sheet, with strict rules about netting.

• Liquidity rules - considering the availability of liquid funds to meet commitments on a 30-day horizon (liquidity coverage ratio) and stable funding structures over a one-year horizon (net stable funding ratio).

• Supervisory review - (1) internal strategies and processes, control mechanisms, governance structures and resources (e.g. skills, experience, training); and (2) supervisory review evaluation process carried out by
  the regulator.

• Disclosure rules - including risk management objectives and policies, levels of exposure to various risks and remuneration policies.

• Large exposures - standardised approach towards exposure to a client or group of related clients, and
  flexing of capital required to meet higher risks.

The (comparatively) large size and similarity of financial institutions linked to the major systemic risks presented to our economic model mean that formal, comprehensive and complex regulation is warranted and will include certain industry-wide inflexible capital ratios.
For example, for 2014, this would be:

• common equity - 4 per cent;

• tier 1 capital - 5.5 per cent;

• total capital - 8 per cent, plus
  capital buffer of 2.5 per cent; and

• final capital ratio - 10.5 per cent.

These are set to increase annually.

Even the largest law firms do not have the scale or potential to negatively impact our economy to warrant such complex and directive regulation, nor could they afford to pay for it. However, the example of the banking sector is instructive because it has identified what is important and how banks should be seeking (or be forced) to protect themselves.

For each of those areas identified in CDR IV, a parallel exists with equal relevance for law firms. Those which promote themselves as a serious business (not a lifestyle-driven club) should understand the need to pay particular attention to these areas. Understanding also that the SRA is evolving its understanding and capability, they should aspire to see the law firm regulatory model develop in this way.

Law firms are not banks. In England and Wales, as in Scotland and elsewhere, the gulf between the largest and the smallest firms is huge. Likewise, the
range of practice areas and sectors
served means that, even within the standard partnership/LLP entity, there
is no definitive law firm model. As such,
it is unlikely that standard rules or ratios will be readily accepted or applied.

Nevertheless, it is appropriate for firms to be regulated or to self-regulate in three broad interrelated areas: capital, liquidity and debt. The world is becoming a tougher place, the risks are greater and the competitive challenge is keener.

If I were a regulator, or a partner looking to hold the firm's management
to account, there are some things I should like to see. Figure 1 is not exhaustive or definitive (and ignores some very important profitability measures), but offers a suggestion of the areas which are important to measure, assess, or
form judgements upon.

 

It is not for me to say what the benchmark ratios should be: after all, many of these elements are mutually compensating. For example, an improved cash cycle means less debt and/or less capital are required. Efficiency and convenience have a trade-off in risk management. Equally, you can have too much capital and too little debt.

The important thing is that the firm regulates the risks (for itself and for its clients) by regularly considering the key information which can identify emerging problems. Risk management is a mindset, and firms should always be aware of
what risks exist, and what risks should
be accepted or avoided.

Regular (monthly) monitoring of these measures will show trends: most will be within clear bands of tolerance (which should be predetermined as part of the firm's financial oversight policy). Weakening trends should be picked up and investigated: anything which indicates material deterioration of the financial condition should be corrected.

Off-sheet risks

Banking regulators spend a lot of time looking at off balance-sheet risks. In the law firm context, this should also receive consideration.

Firstly, regarding partners' capital funding, it has been the custom for many years for partners/members to borrow the amount which must be subscribed, because it is attractive from a tax perspective to do so, and to borrow is much quicker than building up capital by annual increments from allocated profit.

Larger firms have been in the
habit of arranging borrowing facilities
on their partners' behalf, often with the firm's principal banker, and subject to various undertakings from the firm
about repayment of capital. Interestingly,
these very arrangements have become less attractive to the banks due to the impact of Basel and the risk weightings thereby applied.

Similarly, it is time for law firms to take account of the additional risk in such arrangements. Just as banks will no longer view these partner capital loans as separate and unconnected from exposure to the firm itself, firms should view these loans as facilities where there is at least some implied obligation to repay, where the burden must be supported by the ability of the firm to support debt, and as commitments which use up a significant element of the firm's borrowing capacity, and should be thus be included in debt gearing calculations.

Secondly, a number of recent high-profile law firm insolvencies have had a very significant property-related element. Without wishing to open up the Pandora's Box of leases and sale and leaseback structures, it is clear that the full risk of such arrangements has neither been understood nor taken into account when finance committees have considered the firm's financial governance and risk appetite. Firms need to put much more effort into this and seek more advice.

Risk management

The SRA does not seem to want to push its nose into any firm's business where it does not need to. But, when it feels so inclined, it has the power to be very demanding. Any firm not subject to such scrutiny should nevertheless set for itself the highest standards of risk awareness, assessment and management.

To be clear, in order for firms to be fully in control of their own destinies, clear and consistent self-regulation and financial oversight is key. Risk comes in many categories: economic, market, client, refinancing and so on. Those firms which have gone to the wall had, very likely, partners who had not the slightest idea of what risks they were exposed to and how costly it would ultimately be for them.

This needs to change: law firms have to become much more professional. The qualities and experience required for a capable financial oversight committee is a subject for another day, but that committee should be armed with big teeth!

William Arthur is principal and chair at KermaPartners (www.kermapartners.com). He was global director of professional services at Barclays Bank from 1999 to 2006.