EU High Level Group Sets Forth Blueprint for Financial Regulation Reform

The European Union High Level Group has set forth a broad blueprint for a complete overhaul of financial regulation in the European Union based on the twin pillars of harmonization and transparency. The Group envisions an EU systemic risk regulator, as well as a European Securities Commission and a European Banking Authority. A host of recommendations were made, including the reform of credit rating agencies and corporate governance. The Group also wants to see regulation of what it calls a parallel banking universe composed of hedge funds and private equity vehicles.

The High Level Group is chaired by Jacques de Larosiere. Other members of the Group are Callum McCarthy, former Chair of the UK Financial Services Authority and Otmar Issing, a former member of the executive board of the European Central Bank. Commissioner for the Internal Market Charlie McCreevy has been looking forward to the concrete proposals of the Group and promised to respond to their report in an overall Commission Communication on the economic and financial crisis for the Spring European Council. The Communication will set out the contours of the Commission’s regulatory response to the financial crisis.

In its report, the Group asserted that the EU needs to create a macro financial stability regulator. To this end, the group recommended the creation of the European Systemic Risk Council (ESRC) under the auspices of the European Central Bank to form judgments and make recommendations on macro prudential policy and issue risk warnings.

It is crucial that there is an effective early warning mechanism as soon as signs of weaknesses are detected in the financial system. And a graduated risk warning framework for ensuring that, in the future, the identification of risks translates into appropriate action.

As soon as risks are detected that would appear to have a potentially serious negative impact on the financial sector, the ESRC should inform and work with the Commission to develop an action-oriented strategy to deal with serious risks requiring legislative action. Further, a process should be established to regularly evaluate the effectiveness of the regulatory actions that have been agreed on and decide whether other actions are necessary.

Positing that risk monitoring dramatically failed in the crisis, the Group emphasized that going forward the risk management function must be fully independent within the firms. Also, effective and not arbitrarily constrained stress testing exercises must be carried out.

Importantly, incentive compensation must not be tilted towards risk taking. And risk management officers must be paid comparably to officers paid to take risks. For their part, regulators should conduct rigorous and frequent inspection of a firm’s risk management regime.

More broadly, the Group identified corporate governance failures as a major cause of the financial crisis, particularly the skewing of compensation towards excessive risk taking. Most incentive compensation regimes encouraged firms to act with a short-term perspective and make as much profit as possible to the detriment of credit quality and prudence. Managers followed a herd instinct leading to risk even when they should have known that risk premiums were falling and that securitization could not shield the financial system against bad risks.

The High Level Group emphasized that executive compensation incentives must be re-aligned with shareholder interests and long-term, firm-wide profitability. Compensation schemes must become fully transparent. Also, the assessment of bonuses should be set in a multi-year framework of over five years in order to spread out the actual payment of the bonus pool of each trading unit through the cycle and to deduct any potential losses occurring during the period. These standards should apply to proprietary trading and to asset managers. Further, bonuses should reflect actual performance and therefore should not be guaranteed in advance.

Regulators should oversee the adequacy of compensation policies. If regulators find that executive compensation policies conflict with sound underwriting practice, adequate risk management or are systematically encouraging short-term risk taking, they should require the firms concerned to reassess their compensation policies.

The crisis cast into stark relief the difficulty to applying the fair value accounting mark-to-market principle in certain market conditions as well as the strong pro-cyclical impact that this principle can have. The group said that a wide reflection is needed on the mark-to-market principle. While in general the principle makes sense, conceded the Group, there may be specific conditions where it should not apply because it can mislead investors and distort managers' policies.

Differences between business models must also be taken into account. For example, intermediation of credit and liquidity requires disclosure but not necessarily mark-to-market rules which, while sometimes appropriate for investment banks and trading activities, are not consistent with the traditional loan activity and the policy of holding long term investments. Long-term economic value should be central to any valuation method. It may be based, for instance, on an assessment of the future cash flows deriving from the security as long as there is an explicit minimum holding period and sustainable long-term cash flows.

When assets can no longer be marked-to-market because there is no active market for them, firms have no choice but to use internal modeling processes. The quality and adequacy of these processes should be assessed by auditors, said the Group, and the methodologies used should be transparent. Further, internal modeling processes should be overseen by regulators to ensure consistency and avoid competitive distortions. In order to ensure a global level playing-field, the IASB should foster the emergence of a consensus as to where and how the mark-to-market principle should apply and where it should not.

In order to defuse pro-cyclicality, the Group stressed that the financial accounting system should be neutral and not be allowed to change business models by incentivizing firms to act short term. The public good of financial stability must be embedded in accounting standard setting.

The Group said that credit rating agencies must be regulated effectively to ensure that their ratings are independent, objective and of the highest quality. In addition, the rating of structured securities products should be transformed with a new, distinct code alerting investors about the complexity of the instruments.

The Group criticized the Commission’s recent proposed regulation of rating agencies as too cumbersome, with the allocation of work between the home and host authorities, in particular, lacking effectiveness and efficiency. The Group is of the view that it would be more rational to give CESR the job of licensing rating agencies in the EU and monitoring their performance.

A conflict of interest embedded in the current model is that rating agencies are entirely financed by the issuers whose securities they rate and not by the users. A switch from the current issuer pays model to a buyer pays model should be considered at the international level. At the very least, the formulation of ratings should be completely separated from the advice given to issuers on the engineering of complex securities products.

The Group stressed that due diligence by investors and asset managers must accompany reform of the rating agencies. They must not rely simply on credit rating agencies’ assessments. They must exercise informed judgment; and when they do not, penalties should be enforced by regulators.

The Group urged proportionate regulation of a ``parallel banking system’’ consisting of hedge funds, mutual funds, investment banks, and off-balance sheet vehicles. The guiding principle under which this regulation should be conducted is whether a firm’s activities may have a systemic impact on the markets even if they have no direct links with the public at large. This is all the more important since such firms, having no deposit base, can be very vulnerable when liquidity evaporates.