Regulatory Alert
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Marcus Sephton |
David Sayer |
Output from the London Summit has been released in the following suite of documents:
While the G20 proposals on financial regulation are sound, constructive and provide invaluable direction, real change will not be effected unless there is firm and unambiguous international cooperation. A lack of global co-ordination and consistency of approach across countries opens the door for significant regulatory arbitrage and, potentially, the great danger that we begin to retreat from the results of 20 years of good work towards harmonisation. Global businesses will continue to struggle with the sheer complexity of dealing with different governments and multiple regulatory frameworks, which may, in fact, have the unintended consequence of increasing risk for these firms.
There is a great deal of detailed drafting of regulations and legislation to be effected. This will have to be done with both great care and real speed in order to get it in place in time for the end of the recession.
In the meantime, firms will seek evidence that counter cyclical regulation applies in a recession as well as being drafted to cap off over exuberant booms.
As expected, one of the key issues discussed at the G20 summit was to agree a path forward for increased international cooperation for financial services supervision, in light of our interconnected financial systems and as a result the global nature of this financial crisis.
Any hopes of the G20 creating an international regulator for financial markets were perhaps unrealistic but what has been agreed is that the G20 nations will support independent surveillance of economies and financial sectors by the IMF. The Leaders also agreed that the Financial Stability Forum be given a strengthened mandate and a new legal personality as the Financial Stability Board. The question still remains about what these commitments mean in practice. For example, it is noticeable that the IMF was not awarded stronger powers to address global imbalances that are widely agreed to have contributed to the current crisis. It also remains to be seen whether the new identity and mandate of the Financial Stability Forum will result in any significant authority over the global financial system.
Capital
The recommendations for addressing procyclicality contained few, if any, surprises from what was expected, as the recommendations had been signposted in an earlier announcement by the Basel Committee on Banking Supervision and, from a purely UK-perspective, largely resonate with Lord Turner’s recommendations.
The recommendation to develop proposals for countercyclical capital buffers, for consultation by end 2009, at least appears to be consistent with the FSA’s current approach of reflecting stressed capital add-ons in Pillar 2. However, it does appear to shift the balance from management discretion to a more formulaic approach based on Pillar 1 and use of the variable scalar approach in IRB models, which will have consequences for firms’ capital calculations. The accompanying recommendation of a supplementary simple non-risk based measure also mirrors the Turner Review’s recommendation of a backstop leverage ratio.
The recommendation to revise the market risk framework of Basel II to reduce the reliance on cyclical VaR-based capital estimates, may lead to several consequences:
One of the challenging commitments of the Communiqué is that all G20 countries should progressively adopt the Basel II framework. While a laudable objective, there remains no timetable for such an implementation. While the EU implemented Basel II with effect from 1 January 2008 for all EU incorporated banks and investment firms through the Capital Requirements Directive, a number of countries including the USA have not yet formally implemented Basel II at all. It is also questionable whether, or how far, other non-EU jurisdictions will want to implement Basel II for all their banks, however small and domestically focused, as opposed to solely those which are internationally active.
Liquidity
It is noticeable that there is little reference in either the Communiqué or associated releases to the supervision of liquidity, which might suggest that there could still be some way to go in establishing broad agreement on a revised approach.
The cooperation between accounting standard setters, supervisors and regulators to develop measures that would enhance both global financial stability and the integrity of financial statements whose function is to present an unbiased and accurate picture of the financial position and performance of individual entities should be welcomed.
The G20 Leaders’ call to improve standards on valuation and provisioning echoes recommendations made by KPMG. In our response to the FASB/IASB Financial Crisis Advisory Group, we recommended that "the Boards should, as a priority, reconsider the current financial asset impairment model, including an examination of the incurred and expected loss approaches for loan loss accounting. Prudential regulatory conclusions should be considered as part of the Boards’ reconsideration."
In developing its recently published Code of Practice on remuneration (the “Code”), the FSA liaised with the Financial Stability Forum (“FSF”) so it is good to see that a similar approach is reflected in both codes – namely that regulation through principles rather than prescriptive rules on pay levels and structures should be used to ensure that risk appetite is reflected in remuneration policies.
One apparent difference between the G20 output and the FSA’s work so far on remuneration is that, whereas the FSA’s Code focuses on remuneration structures in the large banks and broking firms, the FSF principles do not seem to have such limitations in scope. Although extending the scope of the Code is something the FSA intends to consult on, we can expect the UK’s approach to be in line with the emerging international consensus.
The other key message for remuneration from the G20 Communiqué is around increased disclosure. This resonates with the FSA’s approach, although naturally the FSA’s remit covers disclosure from a supervisory perspective rather than public disclosure. Even though the UK’s pay disclosure regime is already at the forefront of international market practice, the FSF’s recommendations could potentially lead to greater disclosure, particularly below Board level.
The time frame for implementation of the new measures proposed by the G20 is Autumn 2009, which is in line with the FSA’s Code and industry end-of-year pay reviews. However, firms should be aware that the FSA’s ARROW process requires a lead time of several months, so companies to which the Code applies in the UK would need to start working on compliance with it much earlier.
The international significance of the remuneration proposals means that much will depend on the detailed implementation of measures by each nation. The FSA is mindful of this and has therefore stated that in deciding on how to proceed with its Code, it will take into account implementation progress at the international level.
Overall, the messages in the G20 Communiqué are broadly consistent with the Turner Review in relation to hedge funds, perhaps going a little further in some areas. There is no doubt that hedge funds will be affected by both the broader reforms to the global regulatory framework as well as the specific measures aimed at hedge funds.
The G20 have proposed that there will be increased information gathering and extension of regulation to hedge funds, in particular those which are systemically or materially important. This follows the same philosophy as Lord Turner’s recommendations. The challenge here will be for the IMF and the Financial Stability Board (the renamed FSF), who will need to produce guidelines around what “systemically important” actually means, and to which markets and jurisdictions it applies.
As suggested, the G20 appears to have gone further than Lord Turner did in the Turner Review in certain areas, such as calling for hedge funds to be registered, further disclosures around leverage and other information to enable assessment of systemic risk and increased international cooperation to enable effective oversight where funds are located in a different location from the manager.
Although the G20 calls for a unified set of best practices through activity undertaken by AIMA, MFA and PWG should be welcomed, there is so far no mention of how UK bodies (such as the Hedge Fund Standards Board) will be involved. The coordination of such bodies will be important if the set of best practices is to be achieved.
The Communiqué and Declaration make no specific reference to the regulation of bank branches and the possibility of regulators enforcing subsidiarisation in circumstances where they are uncomfortable with branch activity. This is a significant difference from the major emphasis placed in the Turner Review on the regulatory and deposit protection problems inherent in cross-border retail deposit-taking and the limited involvement that European host regulators are permitted to play for EU branches. This is of course a result of London's unique position as a major international financial centre with several hundred foreign bank branches, therefore these issues do not necessarily arise for the other G20 nations.
What is emphasised in the Communiqué and Declaration is the importance of colleges of regulators, noting that there are already 25 in place with the intention to establish the remaining ones for significant cross-border firms by June 2009. The efficacy of such colleges will be dependent on the identification of which are the significant cross-border firms. It will also be reliant on the commitment of participants in practice to “wash the dirty regulatory laundry” of their banks and firms in front of other regulators in a transparent manner and for others not to use this information to take inappropriate actions in their jurisdictions as a result.
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