Thursday, January 15, 2009

Former Fed Chief Volcker Unveils Plan for Reforming Financial Regulation

Former Federal Reserve Board head Paul Volcker has unveiled a plan for the reform of the regulation of the financial markets that envisions a macro prudential regulator and more robust regulation of credit rating agencies. Also, the plan states that fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets. Mr. Volcker is a top adviser to President-elect Barack Obama.

The plan recommends a framework for national-level consolidated prudential regulation and over large internationally active brokerage firms, investment banks, and financial institutions. In addition, money market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value (NAV) at par should be required to reorganize as special-purpose banks, with appropriate prudential regulation, government insurance, and access to central bank lender-of-last-resort facilities.

Those institutions remaining as money market mutual funds should only offer a conservative investment option with modest upside potential at relatively low risk. The vehicles should be clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV. Money market mutual funds should not be permitted to use amortized cost pricing, with the implication that they carry a fluctuating NAV rather than one that is pegged at US$1.00 per share.

Managers of private pools of capital that employ substantial borrowed funds should be required to register with the SEC or other appropriate regulator, with provisions for some minimum size and venture capital exemptions from such registration requirement. The prudential regulator of such managers should have authority to require periodic reports and public disclosures of appropriate information regarding the size, investment style, borrowing, and performance of the funds under management. Since introduction of even a modest system of registration and regulation can create a false impression of lower investment risk, disclosure, and suitability standards will have to be reevaluated. Moreover, for funds above a size judged to be potentially systemically significant, the prudential regulator should have authority to establish appropriate standards for capital, liquidity, and risk management.

Regulatory standards for governance and risk management should be raised, with particular emphasis on enhancing boards of directors with greater engagement of independent members having financial industry and risk management expertise. Also, it is imperative to coordinate board oversight of compensation and risk management policies, with the aim of balancing risk taking with prudence and the long-run interests of and returns to shareholders;

The reforms must also ensure that risk management and auditing functions are fully independent and adequately resourced areas of the firm. The risk management function should report directly to the chief executive officer rather than through the head of another functional area.

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