As debates rage about the causes and effects of the financial crisis, the one near-certainty is tighter regulation of financial institutions. Here’s a round-up of changes already happening and further reforms on the cards.
The number of dollars world governments are pouring into the financial markets is likely to be matched by the number of words written about how and where it all went wrong. The one near-certainty is that the regulatory landscape is set to change significantly.
Chris Warren-Smith, a partner at law firm Fulbright & Jaworski, takes a look at regulatory changes that have already happened and those that might be around the corner.
Given political responses to the crisis across the globe, one likely outcome is enhanced supervision of the financial markets. In simple terms, for regulated firms this would mean more frequent and robust “knocks on the door” from the regulator.
The FSA promises to apply “stress tests” to institutions in order to ascertain their ability to survive severe economic conditions (using lessons learned in the Northern Rock case). Interestingly, the CEO of the Japanese Financial Supervisory Agency recently reported that this testing had contributed effectively to limiting Japan’s exposure to the worst of the credit crunch. The FSA will also challenge management asumptions relating to risk and capital management and examine liquidity and capital information more closely.
The crisis has already seen a switch on the FSA’s part towards greater pro-activity: the transfer of assets from Bradford & Bingley to Santander to protect deposits and the restrictions imposed on short-selling are two examples. Although exercised in extraordinary times, one can expect this pro-activity to be repeated.
Other changes in the offing include tighter vetting of those in influential positions within the financial sector and greater international cooperation between regulators. In the US, regulators may go as far as establishing mechanisms to remove bad assets (such as CDOs) from the market, but it is unclear whether exposures in the UK and EU merit these types of measures.
Regulators are likely to require enhanced disclosure of investments and positions to ensure that investors (both institutional and consumer) have as much information as possible about what it is they are buying. Greater information will be required where assets are being ‘packaged’. On the buy-side, regulators will look to investors to carry out enhanced due diligence into the investments being undertaken and the risks attached.
In the retail markets, regulators are likely to monitor closely the ways in which lending operations are carried out. One of the FSA’s hot topics remains treating customers fairly, which includes keeping prospective borrowers fully appraised of the implications of the loans to which they are agreeing. In the US, one can expect much tighter rules relating to so-called “teaser rates” used to lure borrowers before the rates are ratcheted up.
The regulators will take a closer look at how assets are valued. The European Parliament has identified this as one of the key elements of market stabilisation and the SEC is looking into the application of the ‘mark to market’ rule in relation to CDOs and similar instruments. Changes to the accounting frameworks, particularly where assets are not traded, may also follow.
Following criticism of credit ratings agencies for their role in the financial crisis, the FSA, European Commission and US regulators are all keen to regulate the ratings process. The ratings market is also likely to be opened up to new competition in a bid to guard against complacency.
Previously unregulated markets may find themselves subject to regulatory scrutiny. The regulators may be asked to bring derivatives and credit default swaps (which in the US, for example, amounted to a US$50 trillion market) under their radar. Government and regulators hope to limit the chances of domino effect in the event of further institutional failure by requiring greater disclosure of underlying ownership.
Finally, the headline-grabbing bonuses which have been blamed for engendering a certain recklessness in the markets may become a thing of the past or at least may have to be rewarded based on longer term assessments.
While the impact of the credit crunch develops on an almost daily basis, business can be fairly certain that more pro-active regulation is just around the corner. The challenge will be to ensure that it is neither unduly intrusive or costly.