Global Financial Firms Propose Recommendations in Light of Securitization Crisis

A consortium of global financial institutions have proposed a code of conduct and best practices as part of reforming the securitization process in the wake of the subprime crisis. The recommendations centered on critical issues involving risk management, compensation, asset valuation, and the rating of structured products. More broadly, the measures also aim at boosting transparency and disclosure. The report was set out under the auspices of the International Institute of Finance

Improved risk management is viewed as the most essential element of the reform effort. The first Principle of Conduct is that a pervasive culture of risk management must be embedded throughout the firm and cover all areas and activities.

In addition, the report contains extensive risk management recommendations. Firms must clarify that senior management is responsible for risk management. In addition stress testing must be integral in assessing the firm’s risk appetite. The report cautions that firms must not rely on a single risk methodology. Another principle in the code is that compensation incentives should mot induce risk taking in excess of the firm’s risk appetite. Yet another principle is that risk disclosures must provide the clearest possible picture of a firm’s overall risk profile and the evolving nature of risks as well as salient features of the risk management process. Moreover, in fulfilling disclosure mandates, firms should ensure that disclosures include the most relevant and material risks or exposures arising under current market conditions at the time the disclosure is made, including off-balance-sheet risks or exposures, especially for securitization business.

The report emphasized that financial institutions involved in the originate-to-distribute process should make sure adequate due diligence is conducted at all stages to maintain the integrity of the process. Indeed, financial institutions should apply the same credit due diligence for structured products that they plan to originate and distribute as they do for similar assets that are to be carried on the firm’s own balance sheet. Investors should demand this and factor it into their investing decisions

The report endorses fair-value accounting as an essential element of global capital markets, fostering transparency, discipline, and accountability. That said, the report recognizes that fair valuation can be problematic in illiquid or rapidly shifting markets. The report recommends that firms conduct independent and rigorous valuation of securitized products and apply expert judgment and discipline in valuing complex or illiquid instruments, making use of all available modeling techniques as well as external and internal inputs, such as consensus pricing services. A principle of conduct is that firms disclose both qualitative and quantitative information about valuations, including the methodologies employed. Firms should also have infrastructure in place to allow them to move from observable market prices to other valuation techniques when necessary given market conditions.

The report also endorses the concept of external review of credit rating agencies’ process for rating securitized products. External review is viewed as essential for the credibility and reliability of ratings. The report supports the Committee of European Securities Regulators’
(CESR) recommendation of creating an international rating agencies’ standard setting and monitoring body. The report also endorses a differentiated separate rating scale for complex securitized products.