Following on from the publication of its risk related papers at the end of last year, the Basel Committee on Banking Supervision (BCBS) in cooperation with the Joint Forum has produced a new all-encompassing review of international financial market supervision. The review includes recommendations to introduce new data standards across regulatory jurisdictions with the aim of better tracking risk, especially in the alternatives sector, and to establish trade data repositories to capture derivatives data in particular.
BCBS worked on the paper with the other two Joint Forum members, the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), and analysed key issues arising from the differentiated nature of financial regulation in the international banking, insurance and securities sectors. The aim of the endeavour is to reduce overall systemic risk and support the goals identified around regulatory change by the G20 last year. With regards to the banking and securities sectors, the main focus of the group’s work was on the supervision and regulation of financial groups, hedge funds and credit risk transfer products.
The report therefore is a response to the G20 declaration of the G20 during the 15 November 2008 meeting requesting: “A review of the scope of financial regulation, with a special emphasis on institutions, instruments, and markets that are currently unregulated, along with ensuring that all systemically important institutions are appropriately regulated, should also be undertaken.”
The report notes that regulating financial institutions that cross regulatory jurisdiction boundaries in terms of geography and business is currently a difficult task. “Governments, supervisors, and central banks have struggled to evaluate the risks of financial groups and have incurred significant costs in mitigating the potential impact of financial groups on financial stability,” says the report.
The treatment of financial institutions with regards to capital adequacy and risk related regulation varies in each of the three sectors and this poses a problem for large financial institutions involved in more than one category (banking, insurance or securities), notes the report. “The differences in how a financial group is defined, in how entities are included for calculations, and in the methods for calculating group capital adequacy create problems for supervisors in assessing the risks of a financial group, the capital adequacy of the group, and implications for regulated entities within the group,” it states.
The examination of the regulation of financial groups also obviously throws up the issue of entity identification and counterparty risk tracking for firms that operate across multiple jurisdictions and have multiple interdependencies. The report notes that an inability to track intra-group transactions and exposures with regards to counterparty risk is a significant problem, as exemplified by the fall of Lehman Brothers. It suggests that a level of coordination is needed at a high level in order to avoid any disparity. “Differences can create loopholes for financial groups to establish unregulated parent holding companies that end up controlling regulated entities from a completely separate jurisdiction,” it warns.
The activities of these groups needs to be more closely monitored in order to assess the impact and cost that these activities may impose on the financial system, says the Joint Forum. It suggests regulatory reform across the insurance, banking and securities industries may be necessary to address any loopholes. What this certainly will mean is a further focus on entity data standards across the financial markets as a whole this year. One can expect these discussions to be led from the top and this regulatory attention will likely boost any initiatives currently ongoing in the space, such as Swift’s Bank Identifier Code (BIC) work.
As well as counterparty risk, the Joint Forum report also indicates that its members agreed that the lack of a consistent prudential regime for monitoring and assessing hedge funds is a “critical gap in the regulatory framework”. Risk related to hedge funds has been a popular topic of debate over the last couple of years and the report indicates that much more work needs to be done to tackle this subject head on. It notes that more structure needs to be imposed on the hedge funds market with regards to assessing risk and introducing new reporting requirements for these funds.
The report suggests that “systemically relevant” hedge funds (at the larger end of the scale, in other words) should be subject to stricter capital requirements in order to allow them to withstand operational risks they incur. Currently, the picture is a very different one: “Not all supervisors require such fund operators to meet even minimum capital requirements.”
The recommendation of the group is that hedge funds should be compelled to establish and maintain appropriate risk management policies and functions. This includes the management of liquidity risk and stress testing, thus bringing them under the same level of scrutiny as other financial services firms. New, and as yet undetermined, reporting requirements are also on their way: “Meaningful information should be reported to supervisors to enable them to monitor, evaluate, and exchange information on systemic risks on a cross-sectoral basis. To this end, the Joint Forum supports the IOSCO initiatives to develop appropriate reporting requirements.”
This extra level of risk measurement and new reporting requirements for these funds will compel them to invest in risk management and compliance systems previously used largely by the more traditional end of the buy side spectrum. This interest will compel the vendor community to launch more offerings targeted at this sector (this has already begun, as evidenced by our recent discussion with data management system vendor Netik).
Risk is also a key focus in the derivatives world at the moment. Credit risk transfer products have been in the regulatory spotlight since the financial crisis due to the perceived threat they pose to the stability of the financial system. The report indicates that there is broad agreement that these products should be subject to “sound counterparty credit risk management and that more transparency is needed”.
The particular focus of the Joint Forum report is on credit default swaps (CDSs) and financial guarantee insurance products, but the logic can be extended to other instruments in the derivatives canon also. Much like the clarion calls for change that echoed across the derivatives industry throughout last year, the report highlights the need for an improvement in risk management practices and greater levels of transparency. This, again, supports the need for greater levels of standardisation in the entity and instrument data space across the industry as a whole, as well as investment in risk management systems within financial institutions themselves.
The Joint Forum is also throwing its weight behind the idea of a trade data repository for these CDS trades and the report highlights the Depository Trust & Clearing Corporation’s Trade Information Warehouse as a viable example. The DTCC has long been campaigning to establish itself as the single repository for OTC derivatives, but it is likely a European flavoured alternative will emerge in time.
The recommendations also include a call for more transparency around valuations, which will prove a boon for the third party data providers in the pricing space. “Supervisors should encourage or require firm-level public disclosures (to provide transparency for investors) and/or enhanced regulatory reporting (to provide transparency for supervisors). Such disclosures could include, for example, risk characteristics of instruments, risk exposures of market participants, valuation methods and outcomes, and, off-balance sheet exposures including investments with unregulated entities and contractual triggers that may lead to the posting of collateral, claims payment, or contract dissolution,” it states.