Last year, World Finance ran an article, ‘The Blame Game’, which tried to examine what degree of fault lay with financial regulators, executives, investors and so on for the banking crisis. It found that none of those put forward as suspects were squeaky clean, but it did point out that some of those in the firing line – regulators, in particular – had at least owned up to some degree of fault, learned lessons and had pledged to make changes.
One year on, we now look to see what changes have been made and what proposals to reform the sector have been put forward – and whether they are likely to work.
Regulation
Through the debacle of the credit crisis, it can be said that banks broke rules that were poorly enforced, or they were not kept in line because rules determining what they were actually doing did not exist. Regulators on both sides of the Atlantic were always at least one step behind what was taking place in the market, making rules for practices that had already moved on and developed into something a whole lot riskier and bearing little resemblance to what they thought was going on. The system of regulators relying on the work of other agencies and organisations to keep each other in check – institutional investors failing to challenge boards so long as returns were good, credit rating agencies assigning triple A ratings to the issuers who bank roll them, external auditors selling add-on services to clients they are meant to independently audit, risk managers failing to understand parts of the business they were meant to provide assurance on – illustrated how incestuous and flawed the process of oversight was. Strong measures had to be taken.
The US has taken a strong lead, say many commentators. On March 11, Senate Banking Committee members from both Democratic and Republican parties said that they had agreed to include in their regulatory overhaul bill a new Office of Research and Analysis that would provide early warnings of possible systemic collapses. The proposed agency, which has sometimes been referred to as the National Institute of Finance, is intended to give federal regulators daily updates on the stability of individual firms as well as that of their trading partners, including hedge funds.
By standardising financial instruments and reporting mechanisms, the agency would give regulators a broader view of the health of participants in the financial markets and the potential for problems to spread. The idea’s supporters say that kind of information was lacking in recent years as the housing bubble burst and troubles spread from firm to firm.
“One of the problems we observed in the recent crisis is that nobody knew who had what,” said Senator Jack Reed, a Rhode Island Democrat who in February introduced a stand-alone bill to establish a National Institute of Finance. “The result was a cascading effect of uncertainty and doubt.”
The new agency would have no policy responsibilities but would instead collect and analyse data, building models to assess relative risks and predict how one firm’s problems might affect others. As proposed, the new agency would be housed in the Treasury Department with a director, appointed by the president and confirmed by the Senate, who would be an ex-officio member of a systemic risk council that would be created by the bill.
The agency would draw its budget from assessments on the largest financial firms.
The agency would gather data from the largest firms and from a broad set of market participants, including all US-based financial institutions, which would be required to report all their financial transactions, regardless of whether the counterparty was based domestically or abroad. The agency would take steps to safeguard proprietary trading information, while also shining a light onto the so-called shadow banking system of mortgage brokers, sub-prime lenders and unregulated hedge funds that contributed to the financial crisis.
While the Senate may be behind some aspects of President Obama’s financial services reforms, Congress is digging its heels in, particularly over his proposals to reform the banking sector. The Volcker Rule (also known as the Volcker Plan), first publicly endorsed by President Obama on January 21, is a proposal by American economist and former Federal Reserve Chairman Paul Volcker to restrict banks from making certain speculative kinds of investments if they are not on behalf of their customers. His plan also prohibits banks from owning or investing in a hedge fund or private equity fund, as well as limiting the liabilities that the largest banks can hold.
But the plan needs the support of Congress, which favours a weaker bill that will allow federal regulators to restrict proprietary trading and hedge fund ownership by banks, but not prohibiting these activities altogether.
The plan (as it currently stands) also has its critics from outside the US. Leaders in Europe and Japan have said that they favour an international agreement on financial services supervision, and not just reform on a country-by-country basis, particularly with regards to the regulation of complex financial instruments – widely blamed for causing the crisis, and now for the economic turmoil in Greece. Several European leaders are pinning their hopes of greater international cooperation on this point at the G20 summit which will take place this summer. UK business secretary Lord Mandelson says that Volcker’s plan is “too difficult” to implement. “Whatever their size, whatever their range of activities, you need good regulation. It’s the principle and practice of regulation you have to focus on, not the size of banks,” he added. Michel Barnier, EU internal market commissioner, has also warned that the Volcker plan could not be imported in the same form to Europe.
Given the UK’s prominence as a banking centre, it was inevitable that it was going to suggest some kind of reform. And it has also recommended substantial changes to the way banks manage risk. At the end of November Sir David Walker published his final recommendations on UK banks’ corporate governance, pay policies, and approaches to risk management. His key recommendations included strengthening the role of non-executive directors so that they can provide an effective challenge in the boardroom, disclosing pay policies including deferring two-thirds of cash bonuses and favouring long-term investment reward schemes (though not capping executive remuneration), and having non-executives chair risk committees which will have the power to scrutinise and, if necessary, block big transactions.
However, some have given Sir David’s review a lukewarm reception. The review’s remit was to look at corporate governance concerns in banks – not to propose broader structural reforms to the financial system. While the review recognises that the “old model” of governance contributed to the crisis, he proposes to have a new model of governance on an old banking model. The review contains no critical discussion of the role of banks and has no real comment on the issue of bankers’ pay – one of the most contentious issues to come out of the entire financial crisis.
Investors
Institutional investors have been heavily criticised during the credit crunch and global recession. Although they had three mighty weapons in their armoury – the vote at the annual general meeting, the option to disinvest, and the ability to issue governance warnings, like the ABI and its “red-top reports” – critics say that they were rarely used, and that pension funds are largely “toothless tigers” or “sleepy”. The Trades Union Congress’ Fund Manager Voting Survey 2008 found that a significant number of fund managers support the large majority of remuneration reports, even when there are contentious issues at stake. It also found that half of the fund managers responding to the survey supported 80 percent or more of the remuneration resolutions on which they voted, despite widespread public and professional condemnation of the levels of executive pay.
Furthermore, investors’ were also criticised for being slow to challenge “positive” financial data. Their over-reliance on the reports and ratings of credit ratings agencies such as Moody’s and Standard & Poor’s led to a burgeoning trade in high-risk investments, such as collateralised debt obligations. Arthur Levitt, a former chairman of the SEC, said in September 2007 as the scale of the crisis was dawning, that “credit ratings agencies play a critical role in the capital markets, but their judgments are guides, not stamps of approval. Too often, institutional investors have been investing in sophisticated credit products on the basis solely of the credit rating and without fully understanding the inherent risks they are undertaking.”
Under the threat of having new duties imposed on them, the UK’s Institutional Shareholders Committee (ISC), which is made up of the Association of British Insurers, the Association of Investment Companies, the Investment Management Association, and National Association of Pension Funds, issued its new Code on the responsibilities of institutional shareholders in November in an attempt to put its own house in order. Made up of seven principles, the code aims to enhance the quality of the dialogue of institutional investors with companies to help improve long-term returns to shareholders, reduce the risk of catastrophic outcomes due to bad strategic decisions, and help with the efficient exercise of governance responsibilities.
The code says that institutional investors should publicly disclose their policy on how they will discharge their stewardship responsibilities, and any potential conflicts of interest. Institutional investors also need to monitor their investee companies. As part of this monitoring, institutional investors should seek to satisfy themselves that the investee company’s board and sub-committee structures are effective, and that independent directors provide adequate oversight, and they should also maintain a clear audit trail, for example, records of private meetings held with companies, of votes cast, and of reasons for voting against the investee company’s management, for abstaining, or for voting with management in a contentious situation. The code also presses institutional investors to publicly disclose more information on their voting procedures, and under what circumstances they would escalate their concerns about a company board and its strategy.
While more disclosure is always welcome, so would greater usage of there three weapons: signs are, though, that they aren’t being used too readily.
Bankers and risk management
The UK’s financial regulator wants to make sure that boards have a proper understanding of risk, and that there is greater accountability within financial institutions to single out those who don’t cut the mustard. In January the FSA reviewed the structure of its “significant influence controlled” functions after finding that they are “not currently sufficiently detailed” to allow the regulator to segregate and capture specific key roles within governance structures.
The FSA plans to increase the number of roles for which executives must be vetted 14 to 22.
The proposals, detailed in the FSA’s Effective Corporate Governance consultation paper, will give the watchdog the power to block the appointments of new categories of financial services personnel. These include the chairmen, senior non-executive directors, chairs of audit and risk committees, as well as those responsible for finance, risk and internal audit.
The regulator began vetting those in “significant influence functions” in 2008 and has the power to refuse candidates if they are not deemed fit and proper. To date the FSA has interviewed 332 candidates and has not rejected any – although 25 have dropped out following the interview. The consultation period closes on 28 April 2010. The FSA hopes to have final rules in place during the third quarter of 2010.
In its review, the FSA found that three of the six current functions capture too broad a range of individual roles which means that it is unable to track and vet individuals who may change roles within one of those functions, even though the competences required for each role might be different.
For example, under current rules an individual approved as a non-executive director may also take on the role of chair of a key board committee without any further assessment of the individual’s competence and capability to perform that new role.
The FSA is also proposing other changes. Until now, the regulator had excluded from the regime those firms whose parent entity or holding compan- was itself FSA-authorised. While some individuals based in FSA-authorised parent entities may already be subject to the approved persons regime and may already be approved for a significant influence controlled function, it does not apply to his actions in respect of the subsidiary. Under the FSA’s proposals, however, such individuals may need to seek approval for the subsidiary as well.
Some lawyers believe that the FSA’s vetting process may also be flawed, particularly the interview process. Alasdair Steele, partner in law firm Nabarro’s capital markets group, says that “we have heard from clients who have been through the approval process that they have been asked misleading questions. For example, one was asked what he considered to be the five key risks facing the organisation he worked for.
This sounds simple, but he could not possibly give a correct answer: he would need to know what the board’s view of risk was, what its’ strategy was, and what its priorities were.”
He adds: “Another was asked what the FSA’s first general principle was. The answer is that ‘a firm must conduct its business with integrity’. But is a candidate unsuitable to be an approved person if he does not know the answer to that specific question? There is a danger that candidates are having unsuitable questions just thrown at them, rather than the FSA trying to ensure that the skills and experience of the person being interviewed relate properly to the role he is seeking approval for.”
Hatfield at Reed Smith also feels that the vetting process for approved persons needs to be more transparent. She says that candidates are not told why they are not suitable for the role they have sought approval for and are dissuaded from appealing the decision because details of their unsuccessful application would be made public. “The issue with vetting directors and non-directors is controversial in that a number of individuals who have been recommended to withdraw their application are not having the opportunity to appeal. They would rather stand down rather than for it to be made public that they had had their application turned down. This may deter a lot of suitable people from applying for senior roles.”
While some may debate the pros and cons of the vetting process, one lawyer believes that the FSA may be focusing on the wrong issue. Ann Bevitt, partner at law firm Morrison & Foerster, believes that extending the vetting new appointees is only a very small part of the good corporate governance picture.
She says: “Given the roles that are now to be vetted, it seems to me that what may be more important than vetting on appointment is an ongoing review of how, and how effectively, the board challenges the executive before decisions are taken on major risk and strategic issues. The additional vetting could be seen as a bit of a knee-jerk reaction to the financial crisis.”
Pay and boardroom accountability
While the Walker Review may not have dealt head on with the issue of banker executive pay – in fact, the only tactic that seems to have worked is forcing them to give their bonuses to charity following public ire, as happened with Michael Geoghegan, chief executive of HSBC, who gave his £4m bonus away – the US has taken a firmer line. And the government, and lawyers, expect it to work. On December 16 2009, the SEC, the US listings regulator, approved rule changes that will force companies to provide more disclosure in proxy and information statements regarding risk, compensation and corporate governance.
Experts say that the rules are designed to provide investors with greater assurance about how directors are chosen and how their remuneration is linked to the risk profile of the business. Harriet Territt, of counsel in the financial and regulatory compliance practice at US law firm Jones Day, says that “the new rules are really giving investors more assurance on the ability of management to identify and manage risks to the business, as well as more information on their backgrounds so that shareholders can judge whether they are appropriate people to act in that capacity.”
The new rules – which came into force from February 28 – require companies to disclose the relationship of a company’s compensation policies and practices to risk management, the background and qualifications of directors and nominees, and the legal actions involving a company’s executive officers, directors and nominees. They also require companies to disclose how candidates for director are considered for nomination, the board’s role in risk oversight, stock and option awards made to company executives and directors, and potential conflicts of interests of compensation consultants.
The SEC hopes that its rule regarding wider disclosure of compensation policies and practices will help investors determine whether a company has incentivised excessive or inappropriate risk-taking by employees. Among other things, the SEC believes that the new rules will require a narrative disclosure about the company’s compensation policies and practices for all employees, not just executive officers.
Kristian Wiggert, partner in the corporate group at law firm Morrison & Foerster, says that it is unclear at this stage what impact the rules will have on improving corporate governance. “As ever with a disclosure-based regime, whether there will be any major improvements in corporate governance will depend on what market participants do with the new information. There is a big debate going on in the US about whether shareholders in US companies have sufficient rights to exercise proper control over management, even with improved information disclosure,” he says.
Credit rating agency reform
Attacks on rating agencies focus on two charges. Firstly, agencies receive fees from organisations issuing debt and constructing debt instruments such as collateralised debt obligations (CDOs), complex portfolios of fixed-income assets that are divided into “tranches”, with each tranche containing assets holding a different level of credit risk. This means that credit rating agencies are being paid by the issuers whose securities they rate. This, critics argue, makes them unable to provide objective information about the risks associated with investing in these debt instruments. Secondly, credit rating agencies’ methods of rating and categorising CDOs do not make it easy enough for investors to see the true levels of risks they carry. The triple-A ratings assigned by credit rating agencies would have led some investors to believe that these complex debt structures were bomb-proof.
But not all AAA securities are created equal. As demonstrated in the current credit crisis, structured products typically perform very differently from traditional corporate bonds, despite the identical symbols.
In July 2008 the SEC concluded that credit rating agencies failed to manage conflicts of interest in assigning top ratings to bonds backed by sub-prime mortgages and other assets. The conclusions were far from complimentary. “The public will see that there have been significant problems,” said Christopher Cox, SEC chairman. “There have been instances in which there were people both pitching the business, debating the fees and were involved in the analytical side”, adding that credit raters were “deluged with requests” for ratings and “the volume of work taxed the staffs in ways that caused them to cut corners” and “to deviate from their models”.
The then European Commissioner for Internal Markets Charlie McCreevy also let his anger be known, saying that the trust placed in many credit ratings to determine capital requirements had now been shown “to be wholly misplaced”. Unlike most regulators at the time, McCreevy was adamant that there needed to be further regulation imposed on credit rating agencies. He added that he was “flabbergasted at the naivety of anyone who thinks these same credit rating agencies should be trusted to abide by a non-legally enforceable voluntary code of conduct drawn up under palm trees – a code that has proven itself to be toothless, useless and worthless time and time again. Fool me once, shame on you. Fool me twice, shame on me.”
Due to a lack of coherent, and industry-wide momentum to suggest reform the EU and US passed their own rules. On July 14 last year the EU passed a directive on credit rating agencies aimed specifically at disclosing more information about how the rating was achieved and ensuring that the issuing of a credit rating is “not affected by any existing or potential conflict of interest or business relationship involving the credit rating agency issuing the credit rating, its managers, rating analysts, employees, any other natural person whose services are placed at the disposal or under the control of the credit rating agency, or any person directly or indirectly linked to it by control”.
Given the furore over categorising the inherent risks in some complex financial instruments, the directive also states that when a credit rating agency issues credit ratings for structured finance instruments, “it shall ensure that rating categories that are attributed to structured finance instruments are clearly differentiated using an additional symbol which distinguishes them from rating categories used for any other entities, financial instruments or financial obligations”.
A week later, the US followed suit. In July 2009, the SEC introduced new rules regarding improvements to the regulation of credit rating agencies to increase transparency, tighten oversight, and reduce reliance on their opinions. The legislation prohibits agencies from providing other services to companies that contract for ratings. The rules also prohibit or require the management and disclosure of conflicts of interest arising from the way a rating agency is paid, and require that credit rating agencies implement procedures to review ratings of an issuer if that issuer hired an employee of a rating agency within a year prior to its rating.
Each rating report must disclose the fees paid by the issuer for a particular rating and the total amount of fees paid by the issuer to the rating agency in the prior two years. Rating agencies are also now required to use different symbols for structured finance products to indicate that these instruments may raise heightened risks.
The SEC also wants more – and improved – disclosure accompanying ratings. The new rules require that each rating must be accompanied by a report that assesses data reliability, probability of default, estimated severity of loss upon a default, and the sensitivity of ratings to changes in the assumptions.
To reduce reliance on ratings, the President’s Working Group on Financial Markets will work with the SEC to determine where references to ratings can be removed from regulations. In its proposed amendments to the regulation of money market funds, the SEC requested comment regarding whether references to ratings should be removed. The SEC also has proposed to require that rating agencies disclose, on a delayed basis, ratings history information for all issuer-paid ratings. Added to that, in order to encourage additional ratings of structured products, the SEC has proposed a rule that would require that issuers provide the same information provided to one rating agency as the basis for a rating to other rating agencies.
Hopefully, such action will promote better corporate governance – until the next crisis exposes the flaws inherent in these reforms.
