G-20 Endoses Consistent Systemic Financial Regulatory Reform; Financial Stability Board Given Crucial Role

In their final communiqué, the G-20 leaders pledged to pass legislation reforming the financial regulatory system that is consistent across borders and based on high international standards. Yes, it is a global financial crisis, but the G-20 rejected the French President’s desire to have a global regulator that could reach into a country and direct its securities regulation. The United States will pass its own massive financial regulation legislation and the European Parliament will do the same for the EU. Will the legislation be similar, yes, because the broad themes are the same: a systemic risk regulator; regulation of hedge funds, OTC derivatives, and credit rating agencies, and reform of executive compensation to base pay on performance not excessive risk taking. Also, a new Financial Stability Board is charged with monitoring the national reform legislation for consistency.

As reported in the Financial Times, German Chancellor Angela Merkel said that each leader was determined to defend his or her own national interest. And we are all captives of our past. For Germany, it is the hyperinflation of the Weimer Republic and what that produced. For the US, is the Great Depression and how President Roosevelt fought it. So, let us take what we can get, consistent regulation, and realize that global securities regulation remains an elusive dream. As William Faulkner said, the past is never dead, it is not even past.

The communiqué announced the establishment of the Financial Stability Board (FSB) with a strengthened mandate, as a successor to the Financial Stability Forum (FSF), including all G-20 countries, and the European Commission. The Board will monitor the cross-border consistency of the national financial regulatory reform legislation. The G-20 pledged to endorse and implement the FSB’s tough new principles on pay and compensation and to support sustainable compensation schemes and the corporate social responsibility of all firms.

The G-20 will extend regulation to all systemically important financial institutions, instruments and markets. This will include, for the first time, systemically important hedge funds. There will be a systemic risk regulator with macro-prudential risks across the financial system with authority over financial firms, the shadow banking universe, and private pools of capital. In order to prevent regulatory arbitrage, the IMF and the FSB will produce guidelines for national authorities to assess whether a financial institution, market, or an instrument is systemically important.

Hedge funds or their managers will be registered and mandated to disclose information on an ongoing basis to regulators for the assessment of the systemic risks that the funds pose individually or collectively. Registration should be subject to a minimum size. Hedge funds will also be subject to oversight to ensure that they have adequate risk management. Similarly, regulators must require that institutions which have hedge funds as their counterparties have effective risk management, including mechanisms to monitor the funds’ leverage and set limits for single counterparty exposures.

The Financial Stability Board will develop mechanisms for cooperation and information sharing between relevant authorities in order to ensure that effective oversight is maintained where a hedge fund is located in a different jurisdiction from the manager.

The leaders also called on the accounting standard setters to work urgently with regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards. Specifically, the standard setters should improve standards for the valuation of financial instruments based on their liquidity and investors’ holding horizons, while reaffirming the framework of fair value accounting. In addition, the standard setters should reduce the complexity of accounting standards for financial instruments and strengthen accounting recognition of loan-loss provisions by incorporating a broader range of credit information. They must also improve accounting standards for provisioning, off-balance sheet exposures and valuation uncertainty.

The standards setters should achieve clarity and consistency in the application of valuation standards internationally, working with regulators. Within the framework of the independent accounting standard setting process, they must also improve the involvement of stakeholders, including prudential regulators and emerging markets, through the IASB’s constitutional review.

The communiqué also said that robust regulation would extend to credit rating agencies to ensure that they meet the international code of good practice, particularly to prevent unacceptable conflicts of interest. Under the new regime envisioned by the G-20, all credit rating agencies whose ratings are used for regulatory purposes should be subject to regulation, including registration. The regulatory oversight regime should be consistent with the IOSCO Code of Conduct, with IOSCO coordinating full compliance. National authorities will enforce compliance and require changes to a rating agency’s practices and procedures for managing conflicts of interest and assuring the transparency and quality of the rating process.

In particular, rating agencies should differentiate ratings for structured products and provide full disclosure of their ratings track record and the information and assumptions that underpin the ratings process. The oversight framework should be consistent across jurisdictions with appropriate sharing of information between national authorities, including through IOSCO. The Basel Committee should take forward its review on the role of external ratings in prudential regulation and determine whether there are any adverse incentives that need to be addressed.

The G-20 endorsed major changes in executive compensation based on just announced Financial Stability Board principles. Regulation must ensure that compensation structures are consistent with firms’ long-term goals and prudent risk taking. Specifically, firms' boards of directors must play an active role in the design, operation, and evaluation of compensation schemes. Compensation, particularly bonuses, must properly reflect risk; and the timing and composition of payments must be sensitive to the time horizon of risks. Payments should not be finalized over short periods where risks are realized over long periods, said the communiqué, and firms must disclose comprehensive and timely information about compensation. Stakeholders, including shareholders, should be adequately informed on a timely basis on compensation policies in order to exercise effective monitoring. The inclusion of stakeholders in the communiqué portends a role for shareholder advisory votes on executive compensation.

For their part, regulators will assess firms’ compensation policies as part of their overall assessment of their soundness. When necessary, regulators should intervene with responses that can include increased capital requirements. The G-20 also wants the Basle Committee to integrate these principles into its risk management guidance.