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Graham Bishop's Personal Overview.
The torrent of analyses about the causes of the financial turmoil is abating and giving way to concrete policy proposals. But the speed of broad reactions remains disturbing – though understandable from a political perspective. But it takes time to work through the detailed mechanisms that will prevent such problems by rectifying the incentive structures in parts of the financial community. The IOSCO final report on the sub-prime crisis contains devastating and wide-ranging criticisms.
“many institutional investors and investment banking firms had inadequate risk modelling and internal controls in place, relied heavily (or even exclusively) on external credit ratings for their risk analysis, had inadequate balance sheet liquidity even when adequately capitalized… concerns have been raised regarding the role fair value accounting principles and its role in providing adequate information about the strength of financial firms facing illiquid market conditions. Also, some financial firms appear to have inadequate human and technological resources to model their financial positions using fair value accounting principles under illiquid market conditions.”
Can all of these really be resolved in the remainder of 2008? However, the FSF will publish later this year proposals for establishing higher capital requirements for complex structured credit products; strengthening the capital treatment of liquidity facilities extended to off-balance sheet vehicles; and strengthening the capital requirements in the trading book.
Commissioner McCreevy pointed out that “the recent turmoil alerted us to the importance of cross border cooperation in the regulation, oversight, and supervision of financial institutions” and raised many questions about how a cross-border crisis would have been handled. So the Commission has started a full review of the supervisory framework under which Europe's 40 cross border institutions currently operate. The European Parliament’s ECON committee is debating a report – under a procedure whereby the Commission is obliged to respond (the Rule 39 process). It proposes a mandatory structure but has already been criticised by other political groups in the Parliament. Nonetheless, the candidate Commissioner in autumn 2009 can expect to be asked about his/her attitudes during confirmation Hearings!
Perhaps Europe should take a leaf out of the US book and be willing to accept failures of financial firms. As US Treasury Secretary Paulson put it “Perhaps the most difficult question is how to create an entity that performs the function of the market stability regulator…To avoid moral hazard, we must limit the perception that some institutions are either too big or too interconnected to fail…To do that, we must strengthen market infrastructure and operating practices in the OTC derivatives market and the tri-party repo system and clarify the resolution, or wind down, procedures for non-depository institutions.” Is the corresponding analysis underway in the EU?
The credit rating agencies (CRAs) continue to be demonised by the politicians even though the causes go far beyond CRAs – as explained in the IOSCO final report, for example. However, IOSCO agreed on changes to the Code of Conduct, demanding CRAs differentiate ratings of structured finance products from other ratings, provide better information on the rating process and disclose – in some cases - their annual revenue structure to avoid conflicts of interest. Commissioner McCreevy announced that meaningful but targeted regulatory measures are now necessary for rating agencies operating in the structured credit markets in Europe, including registration, external oversight and much better internal governance. Moreover, the French finance minister plans to push for registration of credit ratings agencies that want to operate in Europe when France takes over the Presidency of the European Union. The SEC also voted to formally propose a comprehensive series of credit rating agency reforms to bring increased transparency to the ratings process.
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o T2S: ECOFIN decided that the ECB should further explore the advantages and disadvantages of establishing a separate legal entity to further ensure responsiveness to market needs and limit potential conflicts of interest.
o Solvency II: ECOFIN is finding the supervision of insurance groups operating in several member states particularly difficult given the innovative nature of the Commission's proposal, the different circumstances in the member states and different views on how to ensure policyholder protection. Seven of the 313 Articles in the Directive remain unresolved, including the treatment of equity risk, minimal capital requirements, surplus funds and participations. Some insurance companies are now questioning if the Directive will be enacted.
o Consumer finance: Key elements for 2009 will include ‘Consumer Contractual Rights’ and ‘Collective Redress’, where the Commission will come forward with a communication which will outline the future strategy.
o Equity trading – more MiFID impact: Both NYSE Euronext and Nasdaq are trying to offer their clients access to the roughly 40 dark pool networks that have sprung up and Liquidnet, claiming to be the world’s largest operator of dark pools, is in talks with both. LSE created ‘Baikal’ MTF with Lehman Brothers for the execution of non-display orders. A group of the largest banks and brokers in Sweden are teaming up to launch an alternative trading facility - called Burgundy - that will provide trading in Nordic equities and compete directly with Nasdaq OMX and other exchanges. Chi-X Europe is extending trading services to Norwegian and Danish stocks. NYSE Euronext announced a new fee package that will reduce fees by up to 30% for high frequency trading in Europe and also acquired 25% of the Doha Securities Market.
o Reportedly, not a single additional hedge fund firm has signed up to the voluntary compliance standards since they were launched in January. Yet pension funds are pouring money in –despite their "towering fees", as Watson Wyatt put it. Total alternative assets managed on behalf of pension funds by the 99 largest investment managers shot up 40% in 2007 to $822bn.
Amidst the rush of activity in the EU – in conjunction with its Trans Atlantic partner – market participant should not overlook developments in Japan. The Japanese Parliament enacted the legislation for the ‘Plan for Strengthening the Competitiveness’ of Japan's Financial and Capital Markets”. The measures are intended to ensure that Japan's financial and capital markets appropriately meet the various needs of investors and fund-raisers, both domestic and foreign, making the markets more attractive to their participants and raising the competitiveness of Japan's markets.
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Graham Bishop