Thursday, March 13, 2008

President's Working Group Proposes
Major Reforms to US Financial Regulation

In the wake of recent market turbulence, the President’s Working Group on Financial Markets has proposed broad and substantial changes to US financial regulation. The comprehensive reforms are nothing less than a complete overhaul of the securitization process and the concomitant mortgage origination process that relied on the sale of asset-backed securities. The working group recommendations would enhance disclosure, reform credit rating agencies processes, strengthen risk management, promote transparency, and converge accounting standards.

The PWG calls upon the SEC and the federal banking regulators to implement a number of reforms across a wide range of areas. The Basel Committee is also urged to quickly update its guidance on liquidity risk management. The President’s Working Group on Financial Markets is comprised of the Treasury Secretary and the chairs of the SEC, the CFTC, and the Federal Reserve Board.

The working group said that the SEC should require investors and their asset managers to obtain from sponsors and underwriters of securitized credits access to better information about the risk characteristics of such credits, including information about the underlying asset pools, on an initial and ongoing basis. Similarly, the SEC should ensure that investors and their asset managers develop an independent view of the risk characteristics of the instruments in their portfolios, rather than relying solely on credit ratings. For its part, the PWG will engage the private sector to develop best practices regarding disclosure to investors in securitized credits, including asset-backed securities and collateral debt obligations.

The report also calls for structural reform of the process of rating securitized assets. Credit rating agencies would have to disclose what qualitative reviews they perform on originators of assets that collateralize asset-backed securities rated by the agencies. Underwriters of asset-backed securities would have to represent the level and scope of due diligence performed on the underlying assets. The rating agencies should also reform their ratings processes for structured credit products to ensure integrity and transparency.

More specifically, credit ratings agencies should implement changes suggested by the SEC’s broad review of conflict of interest issues. They must also disclose sufficient information about the assumptions underlying their credit rating methodologies so that users of the ratings can understand how a particular credit rating was determined. They should clearly differentiate ratings for structured products from ratings for corporate and municipal securities.

Ratings performance measures for structured securities credit products and asset-backed securities should be made readily available to the public in a manner that facilitates comparisons across products and credit ratings. More broadly, the ratings agencies must work with investors to provide the information they need to make informed decisions about risk including measures of the uncertainty associated with ratings and of potential ratings volatility

Turning to risk management, the PWG said that global financial institutions must promptly identify and address any weaknesses in risk management that the turmoil has revealed. For their part, the SEC and the federal banking regulators should promptly develop common guidance to address the risk management weaknesses revealed by the market turmoil, including improvements to concentration and liquidity risk management, and stress testing, as well as the governance of the risk management and control framework.

For its part, the PWG will form a private-sector group to reassess implementation of the Counterparty Risk Management Policy Group II’s existing guiding principles regarding risk management, risk monitoring, and transparency. The idea would be to modify or develop new principles and recommendations as necessary to incorporate lessons from the recent turmoil, including lessons regarding valuation practices.

The PWG also wants regulators to require financial institutions to make more detailed disclosures of off-balance sheet commitments, including commitments to support conduits and other off-balance sheet vehicles. Similarly, regulators should encourage financial institutions to improve the quality of disclosures about fair value estimates for complex and other illiquid instruments, including descriptions of valuation methodologies regarding the degree of uncertainty associated with such estimates.

The working group wants the SEC to encourage FASB to evaluate the role of accounting standards in the current market turmoil. This evaluation should include an assessment of the need for further modifications to accounting standards related to consolidation
and securitization, with the goal of improving transparency. Additionally, the SEC should encourage FASB and the IASB to achieve more rapid convergence of accounting standards for consolidation of conduits and other off-balance sheet vehicles.

Regarding derivatives, regulators of OTC derivatives dealers should enhance the infrastructure for the rapidly growing OTC derivatives markets. Regulators should urge the industry to develop a longer-term plan for an integrated operational infrastructure supporting OTC derivatives that, among other things, enhances participants’ ability to manage counterparty risk through netting and collateral agreements by promoting portfolio reconciliation and accurate valuation of trades.

Finally, the working group calls on the Basel Committee on Banking Supervision to promptly complete its update of Basel’s 2000 guidance on liquidity risk management, including best practice guidelines to be followed by financial institutions, as well as the oversight principles for regulators. The Basel Committee is also urged to review capital requirements for asset-backed securities and other re-securitizations and for off-balance sheet commitments, with a view towards increasing requirements on exposures that have been the source of recent losses to firms.