Globalaffairs

Issue 13/ February-March 2009
By Priya Nandita Pooran

The past several months have produced a range of challenges for financial institutions and regulatory authorities throughout the international financial system. For the first time since the proliferation of the new range of financial instruments, global regulators have had to confront the weaknesses in these techniques and seek an effective regulatory solution, both nationally and at a system-wide level.

The crisis is almost unprecedented. It is potentially unprecedented in two significant ways. First, in financial terms, the crisis is unprecedented in the difficulties of quantifying the exact losses, the extent and location of risk transfer, the cross-border nature of the transactions at play and the lack of a cross-border mechanism for governing and assessing such transactions (including the extent of risk transfer) on an institution-wide level. Second, the crisis presents unprecedented regulatory challenges. It seriously challenges and questions the efficacy of existing regulatory approaches, requirements, frameworks and institutions. The failures of financial institutions in the months following the difficulties of Lehman Brothers, the fourth-largest investment bank in the US, on Sept. 15, 2008 will inevitably lead government authorities, regulators and law-makers to closely question to the causes of this crisis. They are already injecting liquidity and provide support to institutions. They will also review the role of regulation in the modern global financial system. Although these developments are inevitable and valuable, (in the terms of government support, to a more limited extent), the real value of this crisis lies in the reforms it will force in cross-border commercial transactions, that correct the failures of the present system of regulation and strengthen the international financial architecture to promote stability on institutional, national, regional and global levels.

The early crisis:

The events initially appeared in the banking sector but were clearly symptomatic of much deeper, latent deficiencies in almost all segments of the financial system that were only sporadically emerging. The crisis has undermined the confidence of investors in the global economy but has also brought into question the ability of regulators to keep pace with the growth of and innovations in, financial products and cross-border commercial transactions.
Undoubtedly however, the developments on September 15, 2008 were not merely a symptom or continuation of the formerly referred to sub-prime crisis but the beginning of an entirely new financial crisis, neither limited nor defined by sub-prime mortgage lending, but revealing much larger issues of:

• risk management without regulation;
• the proliferation of financial instruments and transactions without an adequate regulatory framework to correspond to and reflect market practices;
• an approach to regulation suffering from an absence of an appropriate international scope;
• lack of oversight of entities on a consolidated basis and;
• regulation based on outdated and non-commercial concepts of instruments which do not look to the structure, function or effect of such instruments but that rely too narrowly on terminology that does not reflect the current reality of the financial markets.

Thus the new wider financial crisis.

Effectively Meeting the Challenges of the Financial Markets - Proposals for Regulatory Reform

(1) THERE IS A NEED FOR MORE EFFECTIVE INDICATORS OF RISK MANAGEMENT AND RISK TRANSFER - ON AN INSTITUTIONAL LEVEL AND SYSTEMIC LEVEL.

This crisis presents an opportunity for global markets and regulators to assess the effectiveness of risk transfer techniques and practices. It is the first time since the proliferation of the new range of financial instruments that the global markets and regulatory authorities have had to confront the weaknesses in the techniques – weaknesses of risk management, short-term risk transfer and lack of transparency within a global financial conglomerate. The crisis will force the degree and efficiency of risk transfer to be quantified so that the ultimate destination of risk among conglomerates is clear on a consolidated and cross-border basis. The nature and location of risk resulting from many financial innovations and techniques that now abound in the markets and their cross-border impact has previously been given little attention. It will therefore take some time to assess their impact on an even an institution-by-institution basis. Instead, the emphasis has been on short-term risk transfer and capital-raising not on the longer term sustainability of transactions post-closing, the inter-connectedness of such transactions or their impact on the stability of the financial system. Existing measures of capital adequacy have been misleading and are unreliable tools for regulators to assess financial institutions. Regulatory measures are needed that directly address risk management techniques and provide effective surveillance of risk transfer within institutions, system-wide.

(2) THERE IS A NEED TO RE-VISIT THE CIRCUMSTANCES AND CONDITIONS IN WHICH ASSETS ARE PLEDGED AS COLLATERAL AND THE CLASSES OF ASSETS CONSIDERED ACCEPTABLE.

It is essential to re-consider the circumstances under which assets are pledged as collateral, or otherwise used in financial market transactions including rescue packages. The early response to the news that AIG was facing bankruptcy provides a useful example. The initial measures of relief in the situation depended on lenders, private and public, accepting assets of AIG’s US subsidiaries which would not ordinarily qualify as collateral. Thus, the initial package risked repeating the trend in many financial transactions in the private sector and regulated entities that led to the current turmoil: the acceptance, re-packaging or otherwise reliance on poor asset streams and sub-par assets classes to generate liquidity. It repeats the mistake whereby assets ordinarily unreliable for bilateral lending may, by the use of financial guarantors and other techniques, be transformed into pledge-worthy assets. This process shifts the risk to other participants in the process in the immediate term, but on a system-wide basis (and sometime even on an institutional basis) responsibility, risk and asset quality are only superficially shifted. The crisis calls for a re-examination of securitization as a reliable and widely acceptable financing technique. We need to look beyond the immediate provision of relief to examine how liquidity is generated and the extent to which it is prudent to engage in lending practices that deviate from established standards whether for commercial or regulatory purposes. The crisis stems from the fallacy that asset classes that are intrinsically unreliable can be readily converted into reliable income streams in the absence of stringent regulatory controls. A dire need for capital may be a justification for such behaviour but only under the rarest of circumstances. It should be kept out of day-to day, run of the mill financial market activity. It should not be considered the norm.

(3) ADDRESS THE BIFURCATION IN REGULATORY RESPONSE FOR THE BANKING AND INSURANCE INDUSTRIES

A review is needed as to why there is a continuing difference in the regulation of banks and insurance companies and whether there is any continuing justification for this. At present in the US for example, banks are regulated at a federal level but insurance companies at the state level. The roots of the latter may be historical. But that does not justify inadequate regulation of the insurance industry that does not serve the interests of policyholders, investors and the financial markets.

State-by-state regulation of insurers is not only outdated. It promotes a piecemeal, inconsistent approach to regulation, neither efficient nor effective in terms of oversight and regulation. Such a fragmented approach means that too many state regulatory authorities are involved with different requirements for insurers. These requirements often conflict with each other. It results in the imposition of different, even conflicting laws and regulatory requirements of the different states in which an insurer operates. This approach does not serve the private sector. It fails to protect policyholder and investors. It is burdensome and inefficient from a regulatory perspective and is ill-suited to commercial transactions, which are now rarely confined to national boundaries and where state business is insignificant in terms of its impact of the financial markets and on a global basis. This fragmentation at a national level makes an effective global response even harder. Greater harmonization is needed. By this, I mean a greater degree of consistency in regulatory regimes within federal systems and on a cross-border, cross-jurisdictional basis. This will provide a far more reliable means of regulating the banking and non-banking sectors and will provide authorities with a more reliable measure of intra-institutional weaknesses.

It is no longer appropriate to describe the nature of services provided by banks and insurance companies as distinct or that there are lesser risks associated with one or the other. The distinction, if any, only persists in the traditional domain of life/non-life coverage. As providers of credit-protection, insurers and banks are virtually the same, in functional terms.

(4) A NEED FOR A NEW “FUNCTIONALITY” APPROACH TO LOOK BEYOND THE TRADITIONAL LABELS OF FINANCIAL PRODUCTS TO THE SUBSTANCE AND COMMERCIAL EFFECT OF FINANCIAL INSTRUMENTS.

There is a need to adopt a new approach to classifying products for regulatory purposes based on the real, commercial use and effect of these products in the financial markets. Innovations in financial products and the continuing development of new instruments of risk transfer, makes this new approach essential. Pertinent regulation that is in-line with financial market needs is a priority. Regulators must place greater importance on the present role of such products in commercial transactions and in the markets more broadly. The classification and assessment of financial instruments must reflect current rather than historic market practice. This functionality approach would be far more effective and serve the interest of all stakeholders. New financial products, as well as new uses for existing products, could under such a system be vetted or properly classified by a committee or other ad hoc structure.

The need to re-visit the approach to classification of products for regulation applies both to new financial instruments and to traditional instruments that are being applied in new ways. An example of similar market application, but differing regulatory treatment, concerns guarantees and reinsurance. These instruments are now used in the financial markets in many similar ways and to achieve very similar results. But they are subject to divergent regulatory requirements that do not reflect this reality, are covered by separate regulatory agencies with differing requirements. This approach is out-of-line with the real use and effect of these instruments. Traditional bank guarantees and reinsurance, financial guaranty instruments and credit-default swaps can all be used similarly in commercial terms. But at present they are regulated under entirely different frameworks and treated as distinct instruments for regulatory purposes or. In some cases they are not regulated at all. This disparity must be addressed if financial sector transparency, systemic integrity and efficient regulatory scrutiny are to be achieved. The differing regulation for the banking and insurance industries are one example of an area that requires review.

(5) GLOBAL REGULATORY OVERSIGHT AND GLOBAL FINANCIAL REGULATORY AUTHORITY

It is now clear that oversight, regulation and supervision of financial institutions on a jurisdiction-by-jurisdiction basis will not adequately serve the international financial infrastructure. It will not reflect the current market reality, neither in terms of the location of risk and risk transfer, areas of weakness within financial conglomerates nor within the financial system. It thus does not support further innovation and growth in the financial markets.

The recent response to the crisis by the UK, Europe and US all underline the inter-connectedness not only of national actions to bolster the failing banking system. They also show how weaknesses within national financial institutions and systems spill over national boundaries. There is a real need for co-ordinated, cross-border supervision and oversight.

To address this weakness, one important step would be a greater convergence of standards and harmonization in the financial sector across national boundaries. An appropriate body should be set up to ensure the effective implementation of such standards on a global basis.

(6) STRONGER PRE-TRANSACTION POWERS FOR REGULATORS

Enhanced scrutiny of transactions by regulatory authorities prior to transaction closing would provide greater scope for regulatory authorities to exercise control and conduct effective surveillance of financial market transactions.

(7) GREATER LIMITS ON TRANSACTION-BASED COMPENSATION IN THE PRIVATE SECTOR:

There is a need to impose greater limits on compensation within the private sector. While some argue that regulating or limiting such compensation schemes would be overly intrusive and may dampen financial innovation, the current crisis proves that this is simply not the case. On the contrary, to permit the private sector practices that have the effect of encouraging a short-term and volume-based approach to transactions makes the system vulnerable to imprudent and excessive short-term risk-taking. This serves neither the consumer nor ultimately, the financial system itself. It does not promote systemic stability. Senior management might be made more responsible for the accuracy and completeness of all information about market transactions.

Moving Towards an Effective Global Response

Just as the recent failures have been brought about by cross-border transactions and cross-border structures, so any immediate support must provide global support for the financial system. Looking forward however, there is a need for longer-term measures that respond to the international financial system. The crisis provides an opportunity for both countries with developed financial markets and those with less-developed ones to introduce new supervisory practices and regulatory frameworks.

The crisis has shown that issues of capital adequacy and risk management can no longer be assessed on a national basis alone. The issue is not only one of a lack of regulation but also the type, quality and scope of new regulation and its effective implementation. There is a need for co-ordination and consistency, not only in the short-term and in the immediate response to the crisis but going forward in the longer term regulation to ensure the safety and integrity of the global financial system. New standards should be set based on systemic impact and strength. A truly co-ordinated regulatory response to the international financial markets is now needed.

Priya Nandita Pooran
LL.M (London School of Economics and Political Science). The author is a lawyer in England, Trinidad & Tobago and New York. She has specialized in international finance and financial sector regulation. She has worked at the International Monetary Fund in Washington DC as well as at leading international law firms. The views expressed herein are entirely those of the author.

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