A regulated new year

Regulators are widely expected to increase their oversight of the financial sector in the coming year, with derivatives likely to come under particular scrutiny. As part of the current series of Class Notes articles, Charles Smithson and Steve Allen review what has been proposed and suggest the changes that may occur

The credit crisis that initially surfaced in 2007 in the form of writedowns on complex structured credit products linked to subprime mortgages has elicited calls for more regulation. Market practitioners seem to accept this inevitability. The latest report from the Counterparty Risk Management Policy Group III (CRMPG III) in August acknowledged that the "case for devoting greater resources to the supervisory effort is clear and compelling".

The question is what form this increased regulation might take. Governmental bodies, academics and practitioners have weighed in with their views about the appropriate direction for regulation. This article highlights a number of their proposals, in an attempt to cast some light on the outlook for financial regulation over the next few years.

Basis for regulation
Some observers have suggested replacing the current rules-based regulatory framework with principles-based regulation, similar to that which exists in the UK. This would mean moving away from dictating how financial institutions should operate their business (in the form of detailed, prescriptive rules and supervisory actions) and towards giving the firms the responsibility to decide how best to align their business objectives and processes with the outcomes specified by regulators.

"We have to move to a principles-based regulatory system rather than a rules-based system. A system of rules and regulations is utterly incapable of dealing with the speed and complexity of the modern financial system. Current Securities and Exchange Commission and bank regulation was unable to stem the current crisis."
Stephen Schwartzman, chairman, co-founder and chief executive, Blackstone Group

Proponents of this proposed change argue that it will reduce regulatory arbitrage.

"By and large, highly prescriptive and complex rules ... tend to make (regulatory arbitrage) less visible, less easy to control and often more insidious. Very complex rules tend to divert substantial resources from productive tasks towards 'management' of regulation ..."
Ricardo Rebonato, head of market risk and quantitative research, Royal Bank of Scotland

Certainly, regulators appear to be considering a move in the direction of principles-based regulation. The Senior Supervisors Group, which comprises regulators from France, Germany, Switzerland, the UK and the US, noted in a report published in March 2008 that it would support efforts to review the Basel II framework "to enhance incentives for firms to develop more forward-looking approaches to risk (beyond capital measures)".

Valuation
Early in 2008, bank supervisors identified weaknesses in financial institutions' valuation practices, particularly for complex products such as collateralised debt obligations. In its March report, the Senior Supervisors Group noted the firms that had performed better had implemented "rigorous internal processes requiring critical judgment and discipline in the valuation of complex or potentially illiquid securities".

In November 2008, the Basel Committee published a consultative document that took the next step.

"Supervisors should evaluate a bank's financial instruments valuation practices including relevant governance, risk management and control practices; and incorporate their evaluation when assessing capital adequacy."
Basel Committee on Banking Supervision

Complex financial products
There is a widely held belief that complexity makes it difficult for investors to understand the types and levels of risks they are accepting. As a way of dealing with this issue, a few commentators have called for the prohibition of complex financial products.

"The banking system should be restored to its basic role of supplying credit to the real economy, with as few complications as possible. We need a system in which banks accept savings and make loans; where investment banks underwrite securities such as ordinary stocks and bonds; and where the complexity of bonds is strictly limited."
Robert Kuttner, co-editor, The American Prospect

A proposed solution almost as draconian as complete prohibition is to have the government certify the safety of complex financial products - in other words, the government could establish a new agency that would regulate financial products in much the same way the US Consumer Products Safety Commission regulates toys, lawnmowers and other consumer products.

"Part of a new regulatory system must be a financial products safety commission, to make sure no products bought or sold by commercial banks or pension funds are 'unsafe for human consumption'."
Joseph Stiglitz, 2001 Nobel Laureate in Economics

Instead of certifying the safety of financial instruments, others propose complex products only be sold to investors sophisticated enough to understand the risks. In its August 2008 report, the CRMPG III, for instance, recommended that "high-risk complex financial products should be sold only to sophisticated investors".

Even if investors are sophisticated enough to understand the risks, it has been argued that complex financial products act as tinder for risk contagion in a crisis. To deal with this concern, some observers suggest complex financial products should attract additional capital charges - capital surcharges. Some proposals envision internal capital surcharges.

"... large integrated financial intermediaries should consider imposing internal charges against the profit and loss of hard-to-value and illiquid transactions, or other methods, such as higher capital charges ..."
CRMPG III

Other proposals seem to suggest regulatory capital surcharges. The Financial Stability Forum, for instance, has indicated that regulators "will strengthen the Basel II capital treatment of structured credit and securitisation activities".

Risk transfer
There is a growing consensus that it will become harder to obtain regulatory capital relief for securitisations.

"... we will use the results of our review ... (to ensure) that the (Basel II capital) framework sets sufficiently high standards for what constitutes risk transfer, increases capital charges for certain securitised assets and asset-backed commercial paper liquidity facilities ..."
Senior Supervisors Group

The rationale for the European Commission's subsequently modified proposal that originators hold capital for at least 15% of securitised exposures was to keep the originators' incentives aligned with those of investors. The credit crisis has elicited even more proposals - for instance, requiring the originator to hold a percentage of all the securities issued.

"If the securitisation market is to have a rebirth, some changes are likely to be necessary to give investors confidence. One idea is that the originator should keep a certain percentage (say, 20%) of all tranches. Regardless of what happens, the interests of originators are then aligned with the interests of investors."
John Hull, Maple Financial Group professor, University of Toronto

Risk transfers in which the party transferring the risk retains significant contingent exposure are also attracting attention from regulators.

"Firms that sought to offset the risk of (their retained super-senior CDO) positions by purchasing protection from financial guarantors were subject to a 'wrong-way' counterparty credit exposure because the financial capacity of these counterparties to perform on their contracts is correlated with the value of the underlying positions being hedged ... Several firms did not properly recognise or control for the contingent liquidity risk in their conduit businesses or recognise the reputational risks associated with the structured investment vehicle business."
Senior Supervisors Group

Incentive compensation
There seems to be growing acceptance that the system for compensating traders and managers is flawed and that this contributed to the crisis. In its October report, the Financial Stability Forum noted "widespread concern that inappropriate remuneration schemes may have contributed to the present market crisis". This is echoed in the report by the Senior Supervisors Group.

"An issue for a number of firms is whether compensation and other incentives have been sufficiently well designed to achieve an appropriate balance between risk appetite and risk controls, between short-run and longer-run performance, and between individual or local business unit goals and firm-wide objectives."
Senior Supervisors Group

Some proposals attack the problem ex ante by suggesting compensation be based on risk-adjusted return measures. In October 2008, the UK Financial Services Authority (FSA) advised the chief executives of financial institutions that it considers calculating incentive compensation "on the basis of revenues, without any counterbalancing risk controls" as "bad or poor practice". The FSA went on to say it considers "good practice" to be calculating incentive compensation using "risk-adjusted return" (where the measure is "likely to be based upon economic capital calculation, and should take proper account of a range of risks including liquidity risk"). Other proposals attack the problem ex post by delaying payout of the bonus until the risks play out. In the same October 2008 letter to chief executives, the FSA said it considers "good practice" to be deferring a major proportion of the bonus element so the impact on the business unit's long-term profits can be established.10

Over-the-counter derivatives
Largely instigated by the Federal Reserve Bank of New York, the counterparty credit risk issues associated with over-the-counter (OTC) credit derivatives have been a major topic of discussion in 2008.

"The problem isn't derivatives per se but a certain kind - derivatives that spun a massive web of OTC contracts, relying on the solvency of countless banks and other institutions, and ultimately endangered the entire financial system when they fell apart. Some kinds of derivatives, such as those maintained by futures exchanges using procedures that effectively eliminate the risk that the other party in the agreement will default, are more useful - and far safer - than others."
Robert Shiller, Arthur M Okun Professor of Economics Yale University

"... for futures contracts - the standardised on-exchange cousin of OTC derivatives - clearing has worked extraordinarily well in managing credit risk... For regulated futures exchanges, the clearing and settlement mechanism serves to lessen the likelihood that large losses by a trader will cause a contagion event... Importantly, no US futures clearing house has ever defaulted on its guarantee. Just as significant, the clearing process provides transparency to regulators..."
Walter Lukken, acting CFTC chairman

For OTC credit derivatives, all signs point to the establishment of central counterparty clearing being a foregone conclusion.13 The Financial Stability Forum, for instance, has stated "market participants need to move ahead urgently to put in place central counterparty clearing for OTC credit derivatives".

One open question is whether regulators will require that the central clearing requirement be expanded to include OTC derivatives, in addition to credit derivatives.

"By reducing the centrality of any one institution to the system's stability, a stronger infrastructure also contributes to reducing moral hazard. A critical priority in this area is to address weaknesses in the operational infrastructure of OTC derivatives markets. The work undertaken by the Federal Reserve Bank of New York to this end should be commended by all the jurisdictions. The objective of this work is to move the OTC derivatives markets on to a platform where trades can be captured and settled in an orderly way."
Mario Draghi, Bank of Italy governor and Financial Stability Forum chairman

Another open question is whether the regulators will stop there or whether they will push for centralised trading - in other words, trading on a regulated exchange.

"New regulations should be adaptive and focused on financial functions rather than institutions, making them more flexible and dynamic. An example of an adaptive regulation is a requirement to standardise an OTC contract and create an organised exchange for it whenever its size - as measured by open interest, trading volume, or notional exposure - exceeds a certain threshold."
Andrew Lo, Harris & Harris Group professor, MIT

Hedge fund exposures
The difficulty in measuring counterparty risk of hedge fund exposures continues to worry regulators, even though individual firms are developing processes to deal with the problem.

"In the case of hedge funds, the counterparty may have little transparency in terms of underlying fund volatility, leverage, or types of investment strategies employed, which creates a significant challenge... Firms continue to be challenged by the opacity of risks for certain counterparties, such as hedge funds, and have developed enhanced processes to identify, measure, monitor, limit, control and report the risks from these counterparty relationships."
Basel Committee on Banking Supervision

But the danger of systemic exposure to similar positions across hedge funds and across hedge fund counterparties is leading to some calls for regulatory monitoring of these positions.

"Without access to primary sources of data... it is simply not possible to derive truly actionable measures of systemic risk... In particular, I propose that hedge funds with more than $1 billion in gross notional exposures be required to provide regulatory authorities... with the following information on a regular, timely, and confidential basis: assets under management; leverage; portfolio holdings; list of credit counterparties; list of investors."
Andrew Lo, Harris & Harris Group professor, MIT

Charles Smithson is the founding partner at Rutter Associates. Steve Allen is an affiliate at Rutter Associates and teaches at New York University's Courant Institute of Mathematical Sciences. Email: [e-mail], [e-mail]