Wednesday, January 28, 2009

UK FSA Chair Outlines Proposal for Broad Regulatory Reform

UK Financial Services Chair Adair Turner laid out a sweeping financial regulatory reform plan centered on a macro-prudential systemic risk regulator and a safer and more transparent securitization process. While rejecting a reimposition of the Glass-Steagall complete separation of commercial and investment banking, he said that a way must be found to restrict the systemic risk taking activities of global complex financial institutions.

A key principle of the reforms is to ensure that financial activities are always regulated according to their economic substance not their legal form. Thus, money market funds which want to continue to offer bank-like services and assurances should be reorganized as special purpose banks and regulated as such. Hedge funds posing systemic risks should also be regulated. The chair also said that the value-at-risk standard for valuing financial instruments held by banks and other firms was a flawed model that contributed to the crisis. The management of liquidity risk will be very important, he added.

Other areas of reform that the Chair did not discuss, but which will be in the FSA’s formal proposal slated for March, include executive compensation, rating agencies, and counterparty risk in derivatives. The reforms will also involve finding the appropriate balance between mark to market and accrual accounting principles. Importantly, the FSA must solve the regulation of cross-border financial institutions and the scope for global coordination, and strike the appropriate balance of responsibility between home and host regulators.

The biggest regulatory failure, he said, was the failure to identify that the whole financial system was fraught with market-wide, systemic risk. Regulators were too focused on the institution-by-institution supervision of idiosyncratic risk. Thus, there is a crucial need to create a systemic risk regulator.

His plan envisions the retention of the originate and distribute securitized model, albeit made safer. The new system should be a combination of traditional on balance sheet credit intermediation and securitized intermediation. The FSA plans to formally propose a safer, simpler, and more transparent version of securitization, with less exclusive reliance on credit ratings and more independent judgment, and with less packaging and trading of securitized credit through multiple balance sheets. While changed significantly, the new securitization regime will still play an important role in national and global credit intermediation.

Measuring and managing liquidity risk is also crucial, he noted, and regulation needs to include both far more effective ways for assessing and limiting the liquidity risks which individual institutions face and a better understanding of market-wide liquidity risks. Thus, the FSA proposes a major reform of liquidity regulation, including significantly enhanced reporting requirements and regulations requiring all financial institutions to focus on the combined liquidity effect of their holdings of liquid assets, the maturity of their assets and liabilities, and the term, diversity and reliability of funding sources.

At the core of the risk assessment will be stress testing, rather than models which seek to infer the probability distribution of risks from the observation of past fluctuations. This reflects the fact that liquidity risk assessment is inherently concerned with low probability but extreme events. And crucially the stress tests will need to cover potential market-wide stresses as well as idiosyncratic stresses, reflecting the lesson of the financial crisis that market-wide collapses in the liquidity of specific asset or funding markets can have huge impacts which analysis of individual specific risks will not capture.

The FSA Chair said that the new regime, along with the related reporting requirements, will greatly enhance the FSA’s ability to understand emerging liquidity risks in individual institutions and system wide. Further, the new regime will result in major changes in the extent and nature of maturity transformation in the overall financial system, with banks holding more liquid assets and a greater proportion of those assets held in government securities, an incentive for banks to encourage more retail time deposits and less instant access, less reliance on short-term wholesale funding, and, as a result, a check on rapid and unsustainable expansion of bank lending during a favorable economy.

One of the striking features of the years running up to the crisis was that core banking functions were being performed by institutions which were not legally banks, such as structured investment vehicles and other off balance sheet vehicles, investment banks and mutual funds. These vehicles escaped the capital, leverage and liquidity regulation which would apply to banks and, in the case of SIVs, they also escaped the degree of disclosure and accounting treatment which would have applied if the activities were performed on balance sheet.

Chairman Turner emphasized that it is essential that if an economic activity is bank-like and poses a significant risk to financial stability, regulators be able to extend banking-style regulation. It is also essential that accounting treatment reflect the economic reality of risks being taken.

In line with the recent Volcker report, the FSA will regulate bank-like mutual funds as banks. These are funds that have made assurances that they will maintain a stable net asset value, that they will not “break the buck”, and may in a liquidity crisis act in a fashion which exacerbates that crisis, selling rapidly to meet redemptions and fuelling the deflationary cycle. That is why the Volcker report recommends that money market funds which want to continue to offer bank-like services and assurances should be reorganized as special purpose banks and regulated as such.

With regard to hedge funds, the FSA proposes what the Chair called a ``halfway house’’ regulation under which funds with the potential to pose a systemic risk would be subject to prudential regulation. Currently, while hedge fund managers in the UK are regulated, the fund is usually registered offshore and not subject to prudential regulation.

While acknowledging that hedge funds are not bank-like, and have neither the scale nor the characteristics requiring that individual funds be treated as systemically important, the FSA Chair said that in the aggregate they may nevertheless play a role with systemic effects which regulators and central banks need to understand, but which they currently lack the data to analyze effectively.

Rapid deleveraging by hedge funds has played a role in exacerbating financial instability. It is for these reasons that the Volcker report suggested that regulators should have the power to gather detailed information from hedge funds, so that they can judge their evolving systemic importance. Thus, for funds judged to be potentially systemically significant, the prudential regulator should have the authority to establish standards for capital, liquidity and risk management. This ``halfway house’’ regulation of hedge funds should provide the information and the power to respond to future developments in size, concentration, leverage levels, and practices in line with the principle of focusing on economic substance not legal form.