Sunday, March 22, 2009

UK FSA Sets Out Blueprint for Massive Financial Regulatory Reform

UK Financial Services Authority Chair Adair Turner has set out a broad plan for overhauling financial regulation that envisions increased reporting requirements for unregulated financial institutions such as hedge funds as part of a pan-European systemic risk regulator. The plan envisions the retention of securitization under a reformed model, with no return to a Glass-Steagall like separation of banking and securities activities. The Turner plan also proposes the regulation of credit rating agencies to limit conflicts of interest and inappropriate application of rating techniques. The plan also calls for national and international action to ensure that executive compensation policies are designed to discourage excessive risk-taking.

A central theme of the FSA blueprint is that regulation must have a more macro-prudential focus. Thus, the FSA recommends the creation of a new European Union regulator, which would replace the Lamfalussy committees. This new body would be an independent authority with regulatory powers, a standard setter and overseer in the area of macro-prudential analysis, while leaving the primary responsibility for supervision at member state level.

While hedge funds are able to apply redemption gates in the event of significant investor withdrawals, the activity of hedge funds in the aggregate can have an important procyclical systemic impact on financial markets. The simultaneous attempt by many hedge funds to deleverage and meet investor redemptions may well have played an important role over the last six months in depressing securities prices in a self fulfilling cycle. And it is possible that hedge funds could evolve in future years, in their scale, their leverage, and their customer promises, in a way which make them more bank-like and more systemically important.

Thus, the report recommends that regulators be authorized to gather much more extensive information on hedge fund activities; and then consider the implications of this information for overall macro-prudential risks. Regulators must also be empowered to apply prudential regulation, such as capital and liquidity rules, to hedge funds or any other category of investment intermediary judged to have become of systemic importance.

Extension of prudential regulation to hedge funds raises the issue of the geographic coverage of regulation, noted the report, since many hedge funds are legally domiciled, principally for tax purposes, in offshore financial centers, even if the fund managers are legally domiciled and located in the UK, the US, or Switzerland. The report recommends a global agreement on regulatory priorities to include the principle that offshore centers must be brought within the ambit of internationally agreed upon financial regulation. Tighter effective controls in offshore centers will, however, become more important over time as regulation is improved in the major onshore locations and as the incentives for regulatory arbitrage through movement offshore therefore increase.

The report also takes aim at flawed valuation methods that contributed to the crisis. The development of complex securitized products necessitated the development of sophisticated mathematical techniques for the measurement and management of position-taking risks. The financial crisis revealed severe problems with these techniques. Thus, the report recommends significant changes in the way that VAR-based methodologies have been applied. Even more, there is the fundamental question of the ability in principle to infer future risk from past observed patterns.

At the very least, the report urges that VAR models be buttressed by the application of stress tests that consider the impact of extreme movements beyond those which the model suggests are at all probable. Deciding just how stressed the stress test should be, is however inherently difficult, and not clearly susceptible to any mathematical determination approaches.

An underlying assumption of financial regulation in the US and the UK has been that financial innovation is by definition beneficial, since market discipline will winnow out any value destructive innovations. As a result, the SEC and FSA have historically not considered it their role to judge the value of different financial products, and thus have avoided direct product regulation, certainly in wholesale markets with sophisticated investors.

But the report considers the possibility of the direct regulation of financial products identified as having potentially adverse financial stability effects, using credit default swaps as an example. Regulators should not treat it is as given that direct product regulation is by definition inappropriate, said Mr. Turner, but should be willing to consider over time whether particular markets have characteristics sufficiently harmful, and benefits sufficiently slight, as to justify intervention.

The FSA believes that regulatory reform must address issues relating to the proper governance and conduct of credit rating agencies and the management of conflict of interest. Legislation to achieve this aim is now being formulated by the European Union with regulation likely to enter into force in late summer 2009.

The FSA supports the aims of this legislation. As the draft legislation currently stands, credit rating agencies will be registered and financial regulators such as the FSA will play a supervisory role, coordinated at European level via colleges of supervisors, which will ensure that appropriate structures and procedures are in place to manage conflicts of interest and to reinforce analyst independence. This supervisory oversight should extend to requiring that rating agencies only accept rating assignments where there is a reasonable case based on historical record and adequate transparency for believing that a consistent rating could be produce. It is also important that the European legislation be matched to compatible global standards; and the FSA is working through IOSCO to achieve this goal.

Compensation policies created incentives for some executives and traders to take excessive risks that resulted in large payments in reward for activities which seemed profit making at the time but subsequently proved harmful to the institution, and in some cases to the entire financial system. In future the FSA will therefore include a strong focus on the risk consequences of compensation policies within its overall risk assessment of firms, and will enforce a set of principles which will better align compensation policies with appropriate risk management.

An initial draft of the Code which sets out these principles has already been published. Key principles within the Code include firms ensuring that their compensation policies are consistent with effective risk management and compensation committees reaching independent judgments on the implications of remuneration for risk and risk management. Another principle is that compensation should reflect an individual’s record of compliance with risk management rules, as well as financial measures of performance.

The effectiveness of the Code will depend on gaining widespread international agreement to publish and enforce similar principles in all major financial markets. Acting alone, the FSA cannot influence the policies of foreign firms operating in the London market, nor the practices followed in other financial centers where UK firms operate. Thus, the FSA has engaged with the Financial Stability Forum to forge that international agreement, and the FSF will shortly publish principles closely aligned with the FSA’s approach. Achieving international mechanisms to ensure application of the principles by all major financial authorities will be a crucial subsequent step