FSF releases update on April recommendations

The Financial Stability Forum (FSF) – - on October 10 released a follow-up to its April white paper, Enhancing Market and Institutional Resilience.

In the earlier paper, the FSF, a group of senior representatives from national financial authorities (including central banks and regulators), outlined 67 recommendations to financial institutions and supervisors on how to respond to the financial crisis. These were based on five principal objectives: to strengthen capital, liquidity and risk management in the financial system; enhance transparency and valuation; change the role and use of credit ratings; strengthen authorities’ responsiveness to risks; and put in place the arrangements for dealing with market stresses.

“The guiding principle of this work is to recreate a financial system that operates with less leverage, is immune to the set of misaligned incentives at the root of this crisis, where prudential and regulatory oversight is strengthened and where transparency allows better identification and management of risks,” the FSF said.

According to the FSF, implementation of its guidelines has been widespread, and will see “concrete results” by the end of the year. But it called for the accelerated implementation of certain recommendations – including centralised clearing for credit derivatives – as well as outlining additional areas of concern.

On the centralised clearing for credit derivatives issue, the FSF wrote: “Market participants need to move ahead urgently to put in place central counterparty clearing for over-the-counter credit derivatives and achieve more robust operational processes in OTC markets.”

Efforts to achieve that goal are already well underway: on October 10, the Federal Reserve Bank of New York held discussions with interested parties on the establishment of a central clearing house for credit default swaps.

The rigid application of mark-to-market accounting rules, even for hard-to-value illiquid assets, has come under scrutiny in the past year, with some observers arguing it has exacerbated the strain on financial institutions.

Acknowledging there might be merit in that view, the FSF called upon accounting regulators to “conclude their work promptly to enhance and converge guidance on valuation of instruments in inactive markets, and accounting and disclosure standards for off balance sheet activities and related risks".

Credit rating agencies (CRAs) have come in for heavy criticism in the past 18 months. One of the FSF’s recommendations in April was for CRAs to differentiate information or ratings for structured finance products from other asset classes. As yet, however, CRAs have not released concrete proposals on how they will do this. The agencies were urged to “enhance efforts to comply with FSF recommendations”.

In terms of new issues that have emerged since the April report, the FSF said it was looking at the coordination of responses and contingency plans for dealing with the crisis. Concern over procyclicality in the financial system was a recurring theme in the latest review, with the FSF stating it would bring forward work to mitigate sources of procyclicality.

Specifically, the FSF is examining the impact of Basel II on the cyclicality of capital requirements, and said it will “explore measures that can strengthen capital buffers during good times and enhance the ability of banks to dip into them during adverse conditions”. Additionally, it said that financial innovation has made the link between valuation and leverage more intertwined. This, the FSF suggests, could be an additional source of procyclicality and may necessitate appropriate policy responses. The FSF will release its findings on procyclicality next April.

Finally, the FSF said it is looking into the appropriate role of regulators and supervisors in reinforcing sound compensation practices or mitigating associate risks; an issue it says could be looked at through the use of supervisory reviews under Pillar II of Basel II.

See also: Fed discusses CDS clearing house options
FSF calls for rating agency changes to aid market