Regulator interview: Consob in the spotlight

Continuing our series of interviews with national regulators, Structured Products offers the responses of Marcello Minenna, head of quantitative analysis at Commissione Nazionale per le Società e la Borsa, at conferences and in interview explaining how the Italian securities and exchange commission operates and fits in with the other Italian regulators relevant to structured products. By Richard Jory

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Which government departments are responsible for the regulation of retail and institutional structured products in your country?

In Italy, the government departments responsible for retail and institutional structured products are Commissione Nazionale per le Società e la Borsa (Consob), the Bank of Italy and the Institute for the Surveillance on Private Insurance Companies (Isvap).

Explain the legislative responsibilities for the governance of retail and/or institutional structured products in Italy.

Consob is charged with the surveillance of transparency and correctness of conduct regarding issuers and distributors of structured products, with a focus on retail investors.

Bank of Italy monitors the transparency of deposits and liabilities products (such as mortgages) and regulates asset management companies (specifically the investment policies of the Undertakings for Collective Investment in Transferable Securities Directive (Ucits), while Ucits disclosure is under Consob’s surveillance).

Isvap covers the stability of private insurance companies and the financial engineering of financial insurance policies (although disclosures are regulated by Consob).

The high fragmentation of this framework reveals a partition of competencies that hampers the definition of common standards of disclosure for structured products and, despite the various communication protocols between the three authorities, creates inconsistencies in the overall Italian regulation of structured products.

What has been the effect of the collapse of Lehman Brothers on the governance of structured products and how have you responded to this?

The Lehman Brothers collapse revealed the need for better disclosure standards to safeguard Italian retail investors, which led Consob to enhance transparency on structured products.

 In April 2009 Consob published the new Issuers Regulations, which simplify the prospectus requirements for Ucits and financial insurance products. Under the new provisions, investors must be given a document (which is part of the prospectus) consisting of a few pages (that is, one or two) that summarises all the key information about risks, costs and potential returns of the investment over its optimal time horizon.

Where has your intervention – either by adjudication or legislation – been most required in the field of structured products?

The main intervention recently was to ensure information for retail investors was promptly updated to reflect the spike in the riskiness of products exposed to Lehman Brothers and, later, to Icelandic banks.

By monitoring a watchlist of national and international issuers, Consob observed the boost in the credit spreads of Lehman Brothers, and in April 2008 (several months before Lehman defaulted) required updates to the prospectuses of products exposed to the bank (mainly index-linked policies embedding bonds issued by Lehman), to reflect the higher probability of negative returns at the end of the investment horizon.

Similar actions were undertaken several months before the bankruptcy of Iceland’s banks, pursuing Consob’s objective of safeguarding investors and eliminating any room for any litigation.

What regulations on structured products had you introduced before the bankruptcy of Lehman Brothers?

Before the bankruptcy of Lehman Brothers, investor disclosure on many structured products was essentially monitored through prior authorisation of prospectuses before their publication. Prospectuses mainly took a mixed approach, where the narrative description of all risks of the investment appeared together with specific information on the characteristics of the product and the exemplification of its returns through standard indicators, such as the internal rate of return.

What regulation do you plan to impose, or have you imposed, as a result of the bankruptcy of Lehman Brothers?

After the collapse of Lehman Brothers, Consob adopted an innovative and ambitious approach regarding the offering documentation of many structured products by publishing the revised version of the Issuers Regulations on April 2009.

The length of prospectuses was reduced. Inside the prospectus, the key role was assigned to a one- to two-page document, the so-called ‘product information sheet’, which illustrates: an ‘unbundling’ table that breaks the product down to its elementary components and cost items, and a table of probability scenarios; the degree of risk of the product (in a qualitative scale of six classes variable from low to very high), measured in terms of volatility metrics; and the recommended investment time horizon of the product.

These indicators are the three pillars of a risk-based approach developed by the Consob Quantitative Analysis Unit and whose methodological and technical details are explained in the Quaderno di Finanza Consob 63 titled A quantitative risk-based approach to the transparency on non-equity investment products published in April 20091.

The introduction of the risk-based approach in the regulation of prospectuses for Ucits and financial insurance products prompted Consob to move from ex ante to ex post surveillance of many structured products, and to develop simplified systems to process the information conveyed by the synthetic indicators and promptly detect anomalies.

The three indicators provide a self-contained and internally consistent informative set where all significant risks of the product are considered and represented in a clear form, which helps investors to make informed investment decisions.

In the case of structured products, the unbundling table offers a breakdown of the different components of the total price of the product, giving evidence of the relative weight of its the fair value and of the various cost items.

The table of probability scenarios shows the prospective returns of the investment by indicating the probability of achieving negative or positive returns. In the second case, further focus is provided on the likelihood of getting payoffs lower, higher or in line with those of a risk-free asset, such as a risk-free floating-rate bond, over the same time horizon.

The strength of this table lies in the way it captures the exposure of the investment to any material risk source and translates it into a piece of information that any investor will be familiar with.

Moreover, the probability scenarios are strictly linked to the other indicators of the risk-based approach defined by Consob.

First, by definition, they are consistent with the fair evaluation of the product exhibited in the unbundling table, because – as well known in finance – the fair price of any product is nothing more than the discounted expectation of the probability distribution of its payoffs at maturity under a risk-neutral measure.

The probability scenarios complete the information to investors. The fair value at inception is a good indicator of the cheapness or expensiveness of a structured product, that is, its ability to compensate investors for the risks taken. But it is only a mean value, which does not give proper disclosure of how market and credit risks can affect the performances at maturity. Probability scenarios highlight the shape of the distribution of the final returns of the investment, signalling how the various risk sources achieve more or less appealing results from a product.

Secondly, the figures in the table of probability scenarios are determined according to a simulative methodology developed considering the volatility both of the yield curve and of the assets underlying the product (as in the case of a structured bond). In this way, consistency with the information conveyed by the degree of risk is ensured, as both indicators rely on the volatility of potential return.

This point deserves particular attention as the connection with the synthetic indicator of the overall riskiness of the investment suitably supplements the information offered by the degree of risk. This integrated representation rules out oversimplification, which characterises the Key Information Documents (Kid) of Ucits.

At the same time, the forward-looking logic behind the simulative methodology ensures the probability scenarios inherit the volatility due to the various risk factors. This has been completely disregarded by the old-fashioned approach based on the statistics of past performance, which – as everybody knows – cannot be assumed as valid or even meaningful information about the future.

Third, for structured products, which are typically aimed at achieving a given payout on a given horizon, probability scenarios offer a snapshot of what could happen at the end of the recommended investment horizon, which allows the investor to disregard what happened before and so removes liquidity risk from the analysis.

The flexibility of the risk-based approach allows it to be extended in a straightforward manner to highlight the risks and implicit costs of liabilities products, such as mortgages, especially when derivatives-like contracts are attached to them.

What is your usual consultation process for the implementation of new regulations on structured products?

New regulations on structured products are subject to a public consultation process including all market participants according to Law 262 of December 28, 2005.

The last consultation process started in July 2009 and concerned the adoption of a risk-based approach for structured products issued by banks and corporates. The comments received by the various participants in this consultation were conflicting.

The financial industry was mostly against introducing synthetic indicators in the summary of the prospectus, preferring to continue with the narrative description of the risks of the products offered to retail.

Consumer associations and several academics favoured the risk-based approach, and recognised its ability to disclose all the information needed to make an informed investment decision and to overcome the opacity regarding the risk-reward profile of structured products.

In what ways have you dealt with the mis-selling cases that structured products tend to throw up?

The transparency realised with the risk-based approach proved to be an important tool in enforcing initiatives regarding the correctness of conduct at the point of sale of structured products.

It is evident that, when a product has a high degree of risk, as confirmed by a high probability of achieving negative returns at the end of the recommended investment horizon, intermediaries have to pay attention when distributing it, as such a product could be suitable only for investors with a high risk appetite.

When the behaviour of distributors proved these aspects were disregarded, leading to the sale of risky structured products to retail investors, Consob intervened to stop mis-selling. This was the case when the bond convertendo was issued in September 2009 by Banca Popolare di Milano.

In this case, the one-page product information sheet showed:

• Risk degree: very high.

• Time horizon: four years.

• Probability of having negative return: 68.5%.

• Probability of having positive return below risk-free asset: 2.8%.

• Probability of having positive return in line with risk-free asset: 4.4%.

• Probability of having positive return above risk-free asset: 24.3%.

Are there any other areas of the government that have responsibility for or influence over the regulation of structured products?

The Italian Treasury Department oversees the work of the Italian delegation that participates in the legislative process at the European Community level.

The output of this process are provisions (such as directives and regulations) that are eventually applied in the regulation of Italian financial markets and operators.

In particular, structured products issued by banks or corporates are offered to retail investors through prospectuses whose format and contents are defined by Prospectus Directive, while the prospectuses of index-linked and unit-linked policies must comply with templates defined by Consob in its Issuers Regulations. The same holds for Italian Ucits, even if with the new Kid Ucits prospectuses will also be regulated by European provisions.

The Italian delegation is participating in the review of the Prospectus Directive. The amendments discussed by the European working group include the introduction of specific provisions aimed at ensuring comparability across different non-equity investment products. In this regard, some European countries are oriented to take the Kid of Ucits as a baseline and to focus only on the comparability of the format of the prospectus summary. On the other side, there are other countries (including Italy) that strongly support the idea that more substantial comparability must be achieved in terms of the contents of the summary.

Given that the summary is the key document to help investors in making their investment decisions, it should contain synthetic risk-reward indicators similar to the three pillars of the risk-based approach developed by Consob, whose guidelines are shared by the ongoing work of the European Community on the disclosure on packaged retail investment products”.

Are structured products suitable investments for the retail investor market?

Structured products allow retail investors to pursue specific objectives in terms of risk taking or of target return over a given investment horizon. In this sense they should be regarded as powerful instruments to create added value in the financial markets, and to achieve results that more standard products cannot offer.

The key point is how to ensure investors really understand structured products. Nobody can pretend retail investors are familiar with financial concepts and terminology, such as barrier options, payoff structure, subordination level and so on. But good disclosure doesn’t need such a high level of detail and technicalities.

It is enough to provide retail investors with a few synthetic indicators of the risk-return profile of the products to give them the tools they need to comprehend the various investment alternatives and to select the product most suitable to their needs.

No matter how sophisticated or complex structured products can be, if  they are represented to retail investors using the same simple informative set containing the degree of risk and the probability scenarios of return at the end of the recommended investment horizon.

This would answer the key question about the possibility of defining a unique regulatory framework able to fit all products, despite the differences in their underlying financial engineering, overcoming such secondary distinctions as the presence of wrappers rather than asset managers, or the different distribution channels being used.

As underlined at the Structured Products Kid roundtable last April by Richard Metcalfe, senior policy director at the International Swaps and Derivatives Association, the perceived correlation  between complexity of product design and risk exposure is an enemy of risk disclosure, as it doesn’t allow people to make decisions – instead, you are making decisions for them.

What mechanisms have you adopted to ensure you hear the views of investors, product providers and distributors?

As confirmed by Italian consumer associations, the three synthetic indicators of the risk-based approach adopted by Consob convey all the relevant information investors are interested in, and the way the indicators are represented in the product-information sheet of the prospectus is simple and easy to understand.

In particular, the table of probability scenarios was appreciated, as it shows the chances to lose or gain in exactly the same way as when playing the lottery, and for any scenario provides a figure representative of the size of the losses or gains incurred, in relative terms (that is, with respect to the alternative given by the risk-free asset).

From the point of view of product providers, the transition to a ‘quantitative transparency’ reduces regulatory burdens. They will publish prospectuses that are much shorter than before and the synthetic indicators to compute can be easily obtained using their proprietary models of pricing and risk measurement, without the need to create new departments charged with producing compliance information.

Distributors can benefit from the product information sheet prepared by product providers to become quickly familiar with the key features of the products and to select the investment alternatives that are more in line with their clients’ needs.

Are the rules governing structured products the same as for other retail investments?

The definition of quantitative risk-based indicators to offer an integrated and consistent representation of all risks, costs and potential performances of non-equity products over the recommended investment time horizon allows uniform regulatory measures to be adopted to set out the pre-contractual transparency for any kind of product, structured or not.

For more elementary products, however, a simplified disclosure regime can be envisaged.

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