FSA Senior Officials Favor Systemic Risk Regulator and Realignment of Compensation Away from Risk

In wide ranging testimony before the Treasury Select Committee, two senior UK FSA officials endorsed a macro prudential systemic risk regulator, called for regulation of hedge funds, and recommended stronger risk management at financial institutions. At the same time, they favored Paul Volcker’s position on the importance of preventing financial institutions large enough to pose a threat to the entire system from engaging in risky behavior such as running hedge funds or trading on their own accounts. Essentially saying that financial institutions will be allowed to be complex only if they are not systematically important.

FSA Chair Adair Turner said we must accept that there will be some large complex financial institutions which will be doing some things associated with investment banks like making markets in government bonds, but will not be doing nearly as much proprietary trading as they have done in the past. He also emphasized that regulators and corporate management failed to focus on the fact that the structure of compensation could play a crucial role in the incentives to take risk. It is now imperative to integrate incentive structures into risk management.

The chair also expressed a need for a systemic risk regulator that would be a mixture of the central bank and the FSA, a joint effort. This would be macro prudential regulation with an eye to overall financial stability of the markets.

Responding to a question on the threat to prime brokers from potential hedge fund failures, the FSA Chair said that this is a limited threat at the moment. But it is also an area in which the FSA wants to gather more information. Contrary to the belief that hedge funds are all incredibly highly leveraged, he said, some of them are reasonably highly leveraged and quite a lot of them are not terribly highly leveraged, and leverage has already come down quite significantly over the last year.

Echoing these comments, FSA Chief Executive Hector Sants said that the Hedge Fund Standard Board itself said leverage has come down. In addition, the prime brokerage industry has seen significant change, that having been a major factor in the demise of Bear Stearns and Lehman's, so they have adjusted their systems in the light of those events. There is a risk, there is always a risk, he reiteratd, bu it is a diminished one.

Mr. Sants added that the FSA regulates hedge fund managers in the UK. While the FSA would like global standards of regulations to come up to UK standards, the FSA would also like to increase its ability to asses the financial stability impact of hedge fund failures. The overall global regulatory architect would benefit from greater visibility of systemic risk. The FSA needs to work with the US in particular to achieve that.

Chairman Turner also favors forcing credit default swaps trading through clearing systems and central counterparties, so that you net out not only on a bilateral basis but a multilateral basis a lot of the huge, nominal value of these instruments. In this regard, the FSA is deeply involved in discussions with the Federal Reserve Board the EU Commission about how to progress that. It is important to realize, he noted, that about 75% or so of the credit default swap market is probably not of a sufficiently standardized form that it would be possible to put into a central counterparty clearing arrangement, because these are bespoke and therefore are, almost by definition, over-the-counter products. However, in that segment where progress can be made, there is a clear belief that it should be driven.