03 March 2008

Treasury Committee report warns about possible regulation of complex financial products

The UK Treasury Committee issue a report on the last financial turmoil concluding that detailed regulation of products is one response to the problem of product complexity. “If the market and, in particular, the investment banks prove unable to address the problem of overly complex products, then regulation will need to be seriously examined in the future”, the report concludes.

The report examines the causes of the dislocation of international financial markets that surfaced on 9 August 2007, subsequent developments in global financial markets and lessons learnt, as well as the prospects for international action and other developments to promote financial stability and transparency. “We believe that there is an urgent need for enhanced transparency around complex financial products so that investors are able to undertake their own due diligence on the products they are investing in”, it concludes.

Serious flaws in the new financial structure include the growing product complexity and looser under-writing standards, as well as increased uncertainty about where risk ultimately lay within the system, the report notes.

“The fact that senior board members may not have sufficient understanding of products that their organisations are originating and distributing is a major cause for concern”, the report concludes. “There is also heightened ambiguity about where risk is borne within the financial system”, it continues. “This is a serious concern because it exacerbates the risk that senior executives might not fully understand investments or strategies adopted by banks and so lack a clear picture of the risk-profile of their financial institution.”

Many investors did not exercise sufficient due diligence on the  products they invested in and appear to have been overly-reliant on the credit rating agencies, often using ratings as a green light to invest, the report finds.

“We are concerned that many investors were overly-reliant on the ratings provided by credit rating agencies and that some investors misunderstood the narrow scope of these ratings”, the report concludes.

As the report criticizes that the credit rating agency market is not sufficiently competitive or efficient, it “calls upon competition authorities to examine what barriers to entry have prevented greater competition in the industry and how competition within the industry could be encouraged.“

Full report

© Graham Bishop