G-20 Working Group Proposes Systemic Risk Regulation, Including Hedge Funds, and Reform of Executive Compensation

A G-20 working group has issued a report proposing a massive overhaul of financial regulation involving the creation of a systemic risk regulator and the regulation of all systemically important financial institutions, markets and instruments, including hedge funds, derivatives, and structured securitization vehicles. Effective macro-prudential regulation requires enhancements to a range of supporting policies and infrastructure, including compensation practices that promote prudent risk taking, greater standardization of derivatives contracts and the use of risk-proofed central counterparties; and improved accounting standards that better recognize loan-loss provisions and dampen adverse dynamics associated with fair-value accounting. The full title is the G-20 Working Group on Sound Regulation and Strengthening Transparency.

Defining what is systemically important will be crucial, said the report. The importance of how broadly systemically important institutions are defined was also noted by SEC Chair Mary Schapiro in recent testimony before the Senate Banking Committee. The report said that assessments of systemic significance should take into account a wide range of factors, including size, leverage, interconnectedness, and funding mismatches. In addition, the increased integration of markets globally should be taken into account when assessing the systemic importance of any given financial institution, market or instrument given the potential for cross-border contagion.

More specifically, the G-20 report listed three key sets of data that regulators should consider in analyzing the potential risks posed. First, data on the nature of a financial institution’s activities should be collected, including, in the example of a hedge fund manager, data on the size, investment style, and linkages to systemically important markets of the funds it manages. Second, regulators should develop common metrics to assess the significant exposures of counterparties on a group-wide basis, including prime brokers for hedge funds, to identify systemic effects.

Third, data on the condition of markets such as measures on the volatility, liquidity and size of markets which are deemed to be systemically important should also be collected. It is envisaged that regulators would use a combination of existing information sources, including data collected from key institutions and vehicles. Consideration of what regulatory, registration or oversight framework would best enable this information collection and subsequent action would be determined by financial regulators at the home and host country level.

The data collected would likely include the size, investment style, leverage and performance of the hedge fund along with its participation in certain systemically important markets. In addition, since one mechanism through which the failure of a systemically important hedge fund or cluster of hedge funds would be transmitted to the broader financial system is through its counterparties, regulators must develop and monitor common metrics to assess the significant exposures of counterparties, including prime brokers for hedge funds.

Particular consideration should be given to the potential for the shadow banking system and for leveraged institutions such as hedge funds to contribute to systemic risk. The G-20 said that hedge funds or their managers will need to register and provide authorities with the relevant information they require. Oversight and regulation will then be enhanced as appropriate, depending on risks revealed by the analysis of the information obtained.

Regulation could be enhanced either by restricting some of their activities that may present particularly high risks or conflicts of interest, or by assigning appropriate capital charges to reflect non-core activities. Measures for restricting activities of financial institutions could include disallowing the sponsorship or the management of private pools of capital in which the bank’s own funds are commingled with that of clients, and imposing strict capital rules.
The G-20 endorses the sound regulation of credit rating agencies since self-regulation is no longer appropriate. Regulations should prevent conflicts of interest and adequately manage conflicts that do arise. There must also be transparency about the quality of ratings, the ratings methodology, and the rating process, both in general and with respect to a specific issuer or financial instrument.

Moreover, there should be a dual rating scale or an identifier distinguishing between corporate and sovereign debt, on the one hand, and structured financial products on the other. The G-20 also recommend an enforcement component to the registration of credit rating agencies so that regulators can require changes to a rating agencies’ procedures for managing conflicts of interest and assure the transparency and quality of the rating process. Given the global scope of credit rating agencies, the new oversight framework must be consistent across jurisdictions in order to avoid regulatory arbitrage.

The report noted that a key lesson from the current crisis is that accounting standards have not accurately represented the financial situation of entities, as they did not take into account available information on risks. Thus, accounting standards need to be strengthened to better reflect risks through the cycle. Accounting standard setters must mitigate procyclicality by identifying solutions that are compatible with their complementary objectives of enhancing the stability of the financial sector and promoting transparency of economic results in financial reports.

Specifically, the G-20 recommend that accounting standard setters strengthen the accounting recognition of loan loss provisions by considering alternative approaches for recognizing and measuring loan losses that incorporate a broader range of available credit information They should also change the standards to dampen adverse dynamics associated with fair value accounting, including improvements to valuations when data or modeling is weak.

The G-20 also endorsed the Basel Committee on Banking Supervision package of measures to strengthen the Basel II capital framework in order to address weaknesses revealed by the crisis. These measures form part of a comprehensive strategy to strengthen the regulation and risk management of internationally active banks. Basel II will establish stronger capital requirements for banks’ structured credit and securitization activities. Recognizing the need to also mitigate procyclicality, high quality capital should serve as a buffer which would be built up during periods of rapid earnings growth and be drawn down in a downturn.

The increasing complexity of financial instruments also creates challenges for managing liquidity. The inclusion of options in financial instruments and the fact that some instruments have short track records or do not trade actively, increases the difficulty in assessing the behavior of these instruments during periods of stress. The G-20 recommends that financial institutions establish a robust framework for managing liquidity risk, and that they maintain sufficient liquidity, including a cushion of unencumbered, high quality liquid assets.

Enhancing liquidity supervision includes an evaluation of tools, metrics and benchmarks that regulators can use to assess the resilience of liquidity cushions and constrain any weakening in liquidity maturity profiles, diversity of funding sources, and stress testing practices. An effective global liquidity framework for managing liquidity in large, cross-border financial institutions should include internationally agreed levels of liquidity buffers, and should encourage an increase in the quality of their composition

The G-20 endorsed the position of the President’s Working Group on Financial Markets that transactions in credit default swaps not cleared through a central counterparty be registered, with risk management standards for these instruments developed by regulators. There should also be public reporting of prices and trading volume.

The G-20 report also urged the creation of a central counterparty for OTC credit derivatives as an important step towards reducing systemic risk. Clearing and settling credit default swap contracts through a central counterparty means that the two counterparties to the swap are no longer exposed to each other’s credit risk. Hence, well-managed, and properly regulated, central counterparties will contain the failure of a major market participant.

Central counterparties also contribute to enhancing market efficiency by helping ensure that eligible trades are cleared and settled in a timely manner, thereby reducing the operational risks associated with significant volumes of unconfirmed and failed trades. Furthermore, the development of a central counterparty facilitates greater market transparency, including the reporting of prices for credit default swaps and trading volumes.

The G-20 also support central counterparty clearing for other types of derivatives trading over-the-counter. Moreover, in order to foster transparency and to promote the use of a central counterparty and of exchange trading for credit derivatives, regulators should also encourage the financial industry to standardize contracts and to use data repository for the remaining non-standardized contracts. The G-20 also said that central counterparties should be subject to oversight by regulators, including central banks, and satisfy high standards in terms of risk management.

A general consensus has emerged that compensation practices have contributed to the financial crisis by focusing on bonuses linked to short-term profits without adequate regard to the longer-term risks they imposed on their firms. This misalignment of incentives amplified the risk-taking that severely threatened the global financial system. Going forward, compensation systems must be related to risk management. Noting that compensation reform must be mandated industry-wide and not be voluntary and ad hoc, the G-20 views regulation as the proper vehicle for promoting compliance with sound compensation.

The board of directors should be required to set clear firm-wide lines of responsibility and accountability to ensure that the compensation regime promotes prudent risk taking. Shareholders may also have a role in this process. The compensation scheme must also be monitored through a formal mechanism. For their part, regulators should enhance their oversight of compensation schemes by taking their design into account when assessing risk management.