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Wall Street Reform Act Includes Key Risk and Data Requirements in Light of Lehman Failure

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The US House Committee on Financial Services’ Wall Street Reform and Consumer Protection Act, which is currently making its way through the US legislative process, is seeking to rectify a number of inadequacies in light of the failure of Lehman, including key provisions around data and risk management. For example, the issue of living wills legislation and the creation of a Systemic Risk Council will both likely compel firms to invest in their data management and risk systems.

The Lehman bankruptcy highlighted the serious challenged posed when attempting to wind up such a large and complex financial institution as a result of the inadequacies of the firm’s data storage systems. As noted by the examiner’s report last month, the firm has a plethora of “arcane, outdated or non-standard” systems on which three perabytes of data was stored, thus making the process of tracking counterparty exposure and key data for unwinding purposes incredibly challenging. The Act is therefore replete with provisions concerning the maintenance of this data for the creation of a “comprehensive orderly dissolution regime for large, interconnected firms”.

As well as winding up considerations, the regulator is placing a greater emphasis on being able to track the interconnectedness of the key players in the financial markets and this in turn is throwing entity data standardisation into the spotlight. In order to be able to accurately track systemic risk, regulators need to be able to spot parent/subsidiary connections easily, which requires the standardisation of this currently rather inconsistent data. The Systemic Risk Council will then be better able to analyse both the systemically important firms and the activities of these firms on a more holistic basis, or so the logic goes.

Risk systems will also need to be updated to take into account off balance sheet activities of these firms, as well as allowing them to produce new reports for capital and liquidity risk requirements. A more holistic approach to risk data is therefore on the cards for US firms, much the same as the result of the requirements of the UK Financial Services Authority (FSA) in this regard. Vendors offering enterprise risk management solutions will therefore keenly be focused on following the progress of the Act through the legislative process.

Transparency and disclosure are two key buzzwords for the US government at the moment and this will mean requirements for firms to produce more granular data in their regulatory reports. This includes details such as counterparty exposure at a position level in the OTC derivatives market and data concerning capital and liquidity risk exposure, to name just a few.

To this end, ratings agencies have also been pulled into the Act and they will need to provide greater transparency into their ratings methodologies in order to avoid any potential conflicts of interest.

The full list of problems and related provisions within the Act are as follows:

Problem: No mechanism to wind down and break up large, interconnected institutions in an orderly fashion.

Act: Ends taxpayer bailouts. Creates comprehensive orderly dissolution regime for large, interconnected firms. Protects taxpayers by requiring costs to be borne by industry, creditors and shareholders, and management. Directs regulators to take steps to control risks and break up firms before they become too large, interconnected, concentrated, or risky.

Problem: Minimal regulation of investment bank holding companies.

Act: Strong, consolidated supervision of interconnected firms, including investment bank holding companies.

Problem: No mechanism to identify and address systemic risks (firm specific or activity specific).

Act: Consolidated supervision of systemically important financial services holding companies. Creates Systemic Risk Council to monitor the financial system for potential risks. Facilitates communication among Council members to enhance overall knowledge of the markets. Requires analysis of both firms and activities for potential risk.

Problem: Risky, undetected off- balance sheet exposures.

Act: Requires the computation of capital requirements for large, interconnected firms to take into account the off-balance sheet activities of the company (Fed authority to exempt a company or certain of its transactions).

Problem: Insufficient regulation of OTC derivatives.

Act: Registration of swap dealers and major swap participants. Required clearing and trading of certain swaps. Reporting of all swap transactions. Regulators must set capital and margin; requirements for swap dealers and major swap participants. Regulators may remove end user exemption if systemically risky counterparty exposure is created.

Problem: Excessive compensation rewarding risky behaviour.

Act: Gives shareholders a “say on pay” – an annual, non-binding, advisory vote on pay practices including executive compensation and golden parachutes. Enables regulators to ban inappropriate or imprudently risky compensation practices. Requires financial firms with more than US$1 billion in assets to disclose any compensation structures that include incentive-based elements.

Problem: Credit rating agencies’ methodologies failed to identify key risks.

Act: Greater transparency in methodologies and ratings in structured and non-structured products. Enhanced oversight by the Securities and Exchange Commission (SEC). Conflicts of interest and liability provisions.

Problem: Gaps in SEC authority.

Act: Increase funding to meet need for enhanced SEC regulation and greater enforcement activities.

Problem: Breakdowns in inter-agency communications.

Act: Specific authority to share reports and other information among relevant regulators. Backup authority if primary regulator fails to act. Systemic Risk Council has authority to recommend increased prudential standards and requirements to primary regulators.

Problem: Excessive leverage and insufficient capital.

Act: Requires the computation of capital requirements for financial holding companies that are subject to stricter standards to take into account all off-balance sheet activities of the company (Fed authority to exempt a company or certain of its transactions). 15 to 1 cap on leverage ratios for these companies.

Problem: Excessive reliance on short-term debt.

Act: Fed may limit the short-term debt of financial holding companies that are subject to stricter standards to prevent these entities from exposure to runs on the bank

The Wall Street Reform and Consumer Protection Act is available to download in full here.

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