Too many cooks?

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The financial crisis has revealed the failure of regulators to detect major threats to the stability of the financial system in advance. A number of new authorities are now emerging to monitor systemic risk, but is it possible problems could still fall through the cracks? Joel Clark reports

Systemic risk was not always something to which governments or politicians paid much attention, but the financial crisis has forced a change of mindset. The realisation that problems relating to a single market, product or institution can escalate to threaten the stability of the entire financial system has prompted a string of proposals for new watchdogs to identify problems before they become systemic threats. But sceptics remain to be convinced any of the proposed agencies will actually have the expertise or authority needed to prevent history repeating itself.

The rush to beef up the management of systemic risk began in earnest at the close of the Group of 20 (G-20) London summit on April 2, when world leaders announced plans to enlarge and strengthen the mandate of the Financial Stability Forum (FSF), a committee of central banks, finance ministries and supervisors set up in 1999 to promote financial stability. The rebranded Financial Stability Board (FSB) has a renewed focus on assessing systemic threats to the financial system, and identifying and overseeing the actions needed to address them, as well as being an international forum for the co-ordination of regulation and government policy.

But since the G-20 summit, it has become clear the FSB will not be the only international body angling to monitor and contain systemic risks. On May 27, the European Commission (EC) published its own recommendations for a similar board, composed mainly of central bankers and financial regulators, to monitor and track systemic threats emerging across Europe. The so-called European Systemic Risk Board (ESRB) gained European leaders' approval on June 19 and the EC hopes it will become fully functional as early as 2010.

On June 17, the US government threw its hat into the ring, announcing plans to concentrate greater power to regulate systemically important institutions in the hands of the Federal Reserve. It also wants to create a Financial Services Oversight Council (FSOC), to facilitate information sharing and co-ordination among sector regulators in the US and for identifying institutions whose failure could pose a wider threat to the financial system.

In a speech outlining the proposals, President Barack Obama encapsulated what is driving so many simultaneous efforts to address systemic risk: "One of the reasons this crisis could take place is that while many agencies and regulators were responsible for overseeing individual financial firms and their subsidiaries, no-one was responsible for protecting the whole system from the kinds of risks that tied these firms to one another. Regulators were charged with seeing the trees, but not the forest."

But effectively monitoring and regulating the entire forest is not easy. There is widespread concern about a lack of co-ordination between the various proposals. Critics worry plans are being drawn up in isolation, that adding members to the FSB may actually make it less effective and that systemic problems may still not be picked up given the disparate nature of the emerging framework. "There is a tendency among politicians to have excessively high expectations about what can be done in terms of macro-prudential regulation. The addition of many new members to international bodies could also make it difficult to reach consensus," says Peter Praet, executive director of the National Bank of Belgium (NBB) in Brussels and a member of the Basel Committee on Banking Supervision.

The difficulty of managing systemic risk is that major threats to the stability of the financial system usually start out as a series of smaller but connected problems that may run across sectors and geographies. Spotting them in advance would require real collaboration between the numerous authorities that regulate the financial system. To take the example of the securitisation market, one problem in the run-up to the current crisis was that supervisors failed to notice a number of weaknesses that collectively had the potential to bring the market - and ultimately the wider financial system - to its knees. As the structuring of a securitisation transaction entails multiple stages, crossing institutional and geographical boundaries, no single regulator was able to see that a serious systemic problem was building up.

A July 2008 report by the Washington, DC-based Institute of International Finance (IIF), entitled Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations, identified the multiple problems in the originate-to-distribute model. As the number of deals grew and infrastructure was stretched, the report found standards had been weakened to keep costs low and speed up time-to-market. Due diligence and risk assessment had been universally cut by mortgage brokers, originating banks, investors and credit rating agencies, with the collective effect that the market had been severely destabilised and posed an undetected threat to the financial system.

Patricia Jackson, head of the prudential advisory practice at consultancy Ernst & Young in London, chaired the IIF working group on the originate-to-distribute model and remains astonished so many problems in such a fast-growing market went unnoticed. "The securitisation market had grown very sharply and due diligence had been cut across the board to keep costs down. This meant checks and balances along the length of the originate-to-distribute model had been weakened. So why did nobody spot the system had all these breaks? Firms were aware of some of the issues but not all, and regulators too were focused on only part of the issue."

As Jackson points out, regulators will need to be much better set up to quickly expose the next systemic threat before it escalates. Although it probably won't be the securitisation sector next time, any fast-growing international market will need to be closely monitored, she believes, even if it means regulators having to cross regional or institutional boundaries in their analysis.

Having an international body with responsibility for monitoring and measuring risks certainly makes sense, but numerous holes have already been picked in the various proposals. Taken at face value, the changes to the mandate and membership of the FSB have the makings of the kind of international organisation that is required. The composition of the group has expanded gradually since it was first founded, but the rebranded FSB now includes representatives from the central banks, finance ministries and national supervisors of all members of the G-20, as well as Spain and the EC. The group comprises a total of 64 organisations ranging from the UK Financial Services Authority (FSA) and the International Organisation of Securities Commissions (Iosco) to the Saudi Arabian Monetary Agency and the Banco de Mexico.

While some have suggested the enlarged size might make the FSB unwieldy, FSB chairman Mario Draghi believes the new members will strengthen the group's authority. "New members will add broader perspectives to our deliberations and increase buy-in and implementation of our output," he said in a speech at Iosco's annual conference in Tel Aviv, Israel, on June 10.

As for its new mandate, the G-20 statement envisages the FSB should act as a forum for information exchange and co-ordination between regulatory agencies, as well as a monitoring body to detect and identify vulnerabilities affecting the financial system. Draghi describes the new body as "a mechanism for national authorities, standard setting bodies and international financial institutions to address vulnerabilities and to develop and implement strong regulatory, supervisory and other policies in the interest of financial stability".

The FSB was due to meet for the first time on June 26, but the changes to its mandate and membership have elicited some strong support among its members. "People see the FSB as an incredibly significant body and as a regulator I really agree," says Julie Dickson, superintendent at the Office of the Superintendent of Financial Institutions in Ottawa, Canada. "It's a body where, via its membership of central banks, finance ministries and bank regulators, you can have discussions you wouldn't normally have. The FSF has proven that it's agile, can act quickly and can get the right people together at very senior levels."

Co-ordination

As the newly formed board finds its feet, it will need to be careful the EC's emerging ESRB doesn't step on its toes. Although the ESRB is focused on the European market, some have warned co-ordination between it and the FSB is essential. "It isn't clear how these bodies will fit together and how much attention the ESRB would pay to the FSB," argues Mark Kalderon, London-based partner specialising in banking and regulation at law firm Freshfields Bruckhaus Deringer. "There's a lot to be said for putting more weight behind the FSB, but having multiple boards with overlapping mandates could be a recipe for chaos. In the UK, for example, is the really important body going to be the FSB or the ESRB?"

The EC insists when it comes together next year, the ESRB will collaborate closely with other entities looking at similar issues in an international context. But it must still work out exactly what its mandate will be and how it will identify systemic risks. The proposals set out on May 27 and since modified by European Union (EU) leaders state the ESRB would not have any legal powers but would act purely as a surveillance body. It would be made up of governors of the 27 national central banks of the EU, a member of the EC and the chairpersons of three new European supervisory agencies that are also being set up. Representatives of the 27 national financial supervisors will sit on the board as observers only, along with the chairperson of the EU Economic and Financial Committee to represent finance ministries.

Although it was originally planned that the ESRB would be chaired by the president of the European Central Bank (ECB), the latest revisions allow the chairperson to be elected by the General Council of the ECB, as a compromise to those critics outside the eurozone, particularly in the UK, who felt an ECB chair would make the council excessively eurozone-focused. "It's important for the focus to be truly EU-wide and not just eurozone-centric - that's very important for the City of London," says Patrik Karlsson, policy director for EU affairs at the British Bankers' Association (BBA) in London.

According to the EC proposals, the ESRB's main task should be "assessments of stability across the EU financial system in the context of macroeconomic developments and general trends in financial markets". The board would meet on a quarterly basis, with more frequent meetings in times of stress, and should provide early warnings for remedial action when systemic risks are identified.

Despite having been signed off by EU leaders, the ESRB proposal has attracted heavy criticism from the industry. Even if it didn't potentially overlap with the FSB, some have questioned whether a pure monitoring body will really do any good. "The ESRB has no law-making powers, so will essentially be responsible for surveillance of systemic risks," says the NBB's Praet. "But macro-prudential surveillance is something we have done for decades without great success. What you also need is to look at the systemic implications of regulatory and tax changes, to understand the innovation and business models of the financial system."

Other observers worry that even if monitoring and surveillance of systemic risks were enough, the ESRB might still fail to pick up on key issues. Ernst & Young's Jackson believes there could be a tendency to simply collect data and information from financial institutions, which could be wholly inadequate if those firms themselves have failed to identify the risks they are taking on. "Any systemic risk body needs to really measure and model the risk in the fast-growing, opaque markets," says Jackson. "Rather than relying too heavily on the work of their members, the ESRB and the FSB need to be doing their own independent work that actually challenges the standards in different markets. Otherwise, problems such as a drop in due diligence standards could be missed again."

If a body such as the ESRB is to engage in truly effective analysis of the risks in different markets, there is an argument for making it more independent, with far less prominence given to central bankers who might bring their own domestic agendas to the table. "There is a case to say it's risky to have too much focus on central bankers," says the BBA's Karlsson. "Monetary policy played a role in the crisis and is set by central banks, so you have to ask how willing this body would really be to criticise the monetary policy of one of its members."

But central bankers defend their role on the board, arguing they have the most relevant experience in monitoring financial stability. "Central banks should play a key role in the risk boards because they have the most expertise in macro-prudential surveillance, although they should also develop an in-depth understanding of the financial system as well," says the NBB's Praet.

As if the potential tussle between the FSB and the ESRB were not enough, the US government's plans for a regulatory overhaul raise further questions about how systemic problems will be identified. The proposed FSOC, to be chaired by the US Treasury and composed of representatives from the main US regulatory agencies, would be responsible not only for co-ordinating regulation and information sharing, but would also have systemic risk responsibilities similar to those of the FSB and ESRB. Its mandate would be to gather information on emerging risks emanating from US financial institutions and to make timely recommendations to the appropriate regulator when systemic risks are identified. Under the Treasury plan, the FSOC would have the authority "to require periodic and other reports from any US financial firm solely for the purpose of assessing the extent to which a financial activity or financial market in which the firm participates poses a threat to financial stability".

The US proposals will be subjected to intense political wrangling in the coming months and are likely to change before passing into law. But the concern remains, as with the FSB and the ESRB, that the general framework may not be sufficiently robust to pick up on systemic risks. The idea of making the Fed responsible for systemically important firms also raises questions, as observers worry that an already fragmented regulatory system may be complicated further.

"My reaction to Obama's proposals is they are good on substance but poor on structure. By giving the Fed added authority to supervise systemically important institutions, they have created an overlapping duplicate of regulation so that many firms will now be supervised by more than one authority," says Hal Scott, professor of international financial systems at Harvard Law School and director of the Committee on Capital Markets Regulation, an independent research organisation.

There is clearly much that still needs to be worked out by the European and US authorities in designing systemic risk boards. In its first meetings, the FSB will need to address how it can co-ordinate its activities with the European and US agencies. Indeed the greatest priority for all three might be to collaborate carefully and ensure the emerging boards are set up to properly exchange information and monitor the financial system in concert.

"The market needs to be comforted that regulatory policy-makers are co-ordinating better than the impression that is currently being given," says David Clark, chairman of the London-based Wholesale Market Brokers' Association and formerly a senior adviser to the FSA. "When two regions introduce legislation partly as a means of dealing with political issues, harmonisation tends to happen more by luck than judgement. There is a danger of having too many boards, and it is important the terms of reference of the boards are made clear and do not conflict."

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