- The five key objectives
of the US Financial Regulatory Reform
- Interesting
Federal acronyms: "Tier 1 FHC" (Tier 1 Financial Holding Company) and “nonbank”
bank.
- What is going to happen
with Section 404 of the Sarbanes Oxley
Act? -
Basel
ii and Financial Conglomerates
Welcome
to the May 2010 edition of the International Association
of Risk and Compliance Professionals (IARCP) newsletter
The five key objectives of the US
Financial Regulatory Reform
From the paper "Financial Regulatory Reform: A New
Foundation" by the US Department of the Treasury, we read:
(1) Promote robust supervision and
regulation of financial firms.
Financial institutions that are
critical to market functioning should be subject to strong
oversight.
No financial firm that poses a
significant risk to the financial system should be unregulated
or weakly regulated.
We need clear accountability in
financial oversight and supervision.
We propose:
• A new
Financial Services Oversight Council of financial regulators to identify emerging systemic
risks and improve interagency cooperation.
•
New authority for the Federal Reserve to supervise all
firms that could pose a threat to financial stability, even
those that do not own banks.
• Stronger capital and other
prudential standards for all financial firms, and even higher
standards for large, interconnected firms.
• A new
National Bank Supervisor
to supervise all federally chartered banks.
• Elimination of the federal
thrift charter and other loopholes that allowed some depository
institutions to avoid bank holding company regulation by the
Federal Reserve.
• The registration of advisers
of hedge funds and other private pools of capital with the SEC.
(2) Establish comprehensive supervision of
financial markets.
Our major financial markets must
be strong enough to withstand both system-wide stress and the
failure of
one or more large institutions.
We propose:
•
Enhanced regulation of securitization markets, including new requirements for market transparency,
stronger regulation of credit rating agencies, and a requirement
that issuers and originators retain a financial interest in
securitized loans.
• Comprehensive regulation of all
over-the-counter derivatives.
• New authority for the Federal Reserve
to oversee payment, clearing, and settlement systems.
(3) Protect consumers and investors from
financial abuse.
To rebuild trust in our markets,
we need strong and consistent regulation and supervision of
consumer financial
services and investment markets.
We should base this oversight not
on speculation or abstract models, but on actual data about how
people make financial decisions.
We must promote transparency,
simplicity, fairness, accountability, and access.
We propose:
• A new Consumer Financial Protection Agency to protect consumers across the financial sector from
unfair, deceptive, and abusive practices.
• Stronger regulations to improve the
transparency, fairness, and appropriateness of consumer and
investor products and services.
• A level playing field and higher standards for
providers of consumer financial products and services, whether
or not they are part of a bank.
(4)
Provide the government with the tools it needs to manage
financial crises.
We need to be sure that the
government has the tools it needs to manage crises, if and when
they arise, so that we are not left with untenable choices
between bailouts and financial collapse.
We propose:
• A new regime to resolve
nonbank financial institutions whose failure could have serious systemic effects.
• Revisions to the
Federal Reserve’s emergency lending authority to improve accountability.
(5) Raise international regulatory standards
and improve international cooperation.
The challenges we face are
not just American challenges, they are global
challenges.
So, as we work to set high
regulatory standards here in the United States, we must ask the
world to do the same.
We propose:
• International reforms to support our efforts at home, including
strengthening the capital framework; improving oversight of
global financial markets; coordinating supervision of
internationally active firms; and enhancing crisis management
tools.
In addition to substantive reforms of the
authorities and practices of regulation and supervision, the
proposals contained in this report entail a significant
restructuring of our regulatory system.
We propose the creation of a
Financial Services Oversight Council,
chaired by Treasury and including the heads of the
principal federal financial regulators as members.
We also propose the creation of
two new agencies.
We propose the creation of the
Consumer Financial Protection Agency, which will be an independent entity dedicated to
consumer protection in credit, savings, and payments markets.
We also propose the creation of the
National Bank Supervisor,
which will be a single agency with separate status in
Treasury with responsibility for federally chartered depository
institutions.
To promote national coordination in the insurance
sector, we propose the creation of an
Office of National Insurance within Treasury.
Under our proposal,
the Federal Reserve and the Federal Deposit Insurance
Corporation (FDIC) would maintain their respective roles
in the supervision and regulation of statechartered
banks, and the National Credit Union Administration (NCUA) would
maintain its authorities with regard to credit unions.
The Securities and Exchange Commission (SEC) and Commodity
Futures Trading Commission (CFTC) would maintain their current
responsibilities and authorities as market regulators, though we propose to harmonize the statutory and
regulatory frameworks for futures and securities.
B. The new acronym: "Tier 1 FHC"
(Tier 1 Financial Holding Company)
From the paper "Financial Regulatory Reform: A New
Foundation" by the US Department of the Treasury, we read:
We propose the creation of a Financial
Services Oversight Council to facilitate information sharing and
coordination, identify emerging risks, advise the Federal
Reserve on the identification of firms whose failure could pose a
threat to financial stability
due to their combination of size, leverage, and
interconnectedness (hereafter referred to as a
Tier 1 FHC), and provide a forum for resolving jurisdictional
disputes between regulators.
a. The membership of the Council should include
(i) the Secretary of the Treasury, who shall serve as
the Chairman;
(ii) the Chairman of the Board of Governors of the
Federal Reserve System;
(iii) the Director of the National Bank Supervisor;
(iv) the Director of the Consumer Financial Protection
Agency;
(v) the Chairman of the SEC;
(vi) the Chairman of the CFTC;
(vii) the Chairman of the FDIC; and
(viii) the Director of the Federal Housing Finance
Agency (FHFA).
b. The Council should be supported by a permanent,
full-time expert staff at Treasury. The staff should be
responsible for providing the Council with the information and
resources it needs to fulfill its responsibilities.
2. Our legislation will propose to give the
Council the authority to gather information from any financial
firm and the responsibility for referring emerging risks to the
attention of regulators with the authority to respond.
Implement Heightened Consolidated
Supervision and Regulation of All Large, Interconnected
Financial Firms
1. Any financial firm whose combination of size,
leverage, and interconnectedness could pose a threat to
financial stability if it failed (Tier 1 FHC) should be subject
to robust consolidated supervision and regulation, regardless of
whether the firm owns an insured depository institution.
2. The Federal Reserve Board should have the authority and
accountability for consolidated supervision and regulation of
Tier 1 FHCs.
3. Our legislation will propose
criteria that the Federal Reserve must consider in
identifying Tier 1 FHCs.
4. The prudential standards for Tier 1 FHCs – including capital, liquidity and risk management
standards – should be stricter and more conservative
than those applicable to other financial firms to
account for the greater risks that their potential failure would
impose on the financial system.
5. Consolidated supervision of a Tier 1 FHC should extend
to the parent company and to all of its subsidiaries – regulated and
unregulated, U.S. and foreign.
Functionally regulated and depository institution
subsidiaries of a Tier 1 FHC should continue to be supervised
and regulated primarily by their functional or bank regulator,
as the case may be.
The constraints that the Gramm-Leach-Bliley Act
(GLB Act) introduced on the Federal Reserve’s ability to
require reports from, examine, or impose higher prudential
requirements or more stringent activity restrictions on the
functionally regulated or depository institution subsidiaries
of FHCs should be removed.
6. Consolidated supervision of a
Tier 1 FHC should be macroprudential in focus.
That is, it
should consider risk to the system as a whole.
7. The Federal
Reserve, in consultation with Treasury and external experts,
should propose recommendations by October 1, 2009 to better
align its structure and governance with its authorities and
responsibilities.
Strengthen Capital and Other Prudential
Standards For All Banks and BHCs
Capital and management
requirements for FHC status should not be limited to the
subsidiary depository institution. All FHCs should be required
to meet the capital and management requirements on a
consolidated basis as well.
The accounting standard
setters (the FASB, the IASB, and the SEC) should review
accounting standards to determine how financial firms should be
required to employ more forward-looking loan loss provisioning
practices that incorporate a broader range of available
credit information.
Fair value accounting rules also should
be reviewed with the goal of identifying changes that could
provide users of financial reports with both fair value
information and greater transparency regarding the cash flows
management expects to receive by holding investments.
Firewalls between banks and their affiliates should be
strengthened to protect the federal safety net that supports
banks and to better prevent spread of the subsidy inherent in
the federal safety net to bank affiliates.
Close Loopholes
in Bank Regulation
We propose the creation of a new
federal government agency, the National Bank Supervisor
(NBS), to conduct prudential supervision and regulation of
all federally chartered depository institutions, and all federal
branches and
agencies of foreign banks.
We propose
to
eliminate the federal thrift charter, but to preserve its
interstate branching rules and apply them to state and
national banks.
All companies that control an insured
depository institution, however organized, should be subject
to robust consolidated supervision and regulation at the
federal level by the Federal Reserve and should be subject to
the nonbanking activity restrictions of the BHC Act.
The policy
of separating banking from commerce should be re-affirmed and
strengthened.
We must close loopholes in the BHC Act for
thrift holding companies, industrial loan companies, credit
card banks, trust companies, and grandfathered
“nonbank”
banks.
Eliminate the SEC’s Programs for
Consolidated Supervision
The SEC has ended its Consolidated Supervised
Entity Program, under which it had been
the holding company
supervisor for companies such as Lehman Brothers and Bear
Stearns.
We propose also
eliminating the SEC’s Supervised
Investment Bank Holding Company program.
Investment banking
firms that seek consolidated supervision by a U.S. regulator
should be subject to supervision and regulation by the
Federal Reserve.
Require Hedge Funds and Other Private Pools
of Capital to Register
All advisers to hedge funds (and
other private pools of capital, including private equity
funds and venture capital funds)
whose assets under management
exceed some modest threshold should be required to register
with the SEC under the Investment Advisers Act.
The advisers
should be required to report information on the funds they
manage that is sufficient to assess whether any fund poses a
threat to financial stability.
Reduce the Susceptibility
of Money Market Mutual Funds (MMFs) to Runs
The SEC should
move forward with its plans to strengthen the regulatory
framework around MMFs to reduce the credit and liquidity risk
profile of individual MMFs and to make the MMF industry as a
whole less susceptible to runs.
The President’s Working Group
on Financial Markets should prepare a report assessing
whether more fundamental changes are necessary to further
reduce the MMF industry’s susceptibility to runs, such as
eliminating the ability
of a MMF to use a stable net asset
value or requiring MMFs to obtain access to reliable
emergency liquidity facilities from private sources.
Enhance Oversight of the Insurance Sector
Our legislation
will propose the establishment of the
Office of National
Insurance within Treasury to gather information, develop
expertise, negotiate international agreements,
and coordinate
policy in the insurance sector.
Treasury will support
proposals to modernize and improve our system of insurance
regulation in accordance with six principles outlined in the
body of the report.
Sarbanes Oxley News
What is going to happen
with Section 404 of the Sarbanes Oxley
Act?
What is
next for Sarbanes Oxley experts? This is always one of the most
important issues we discuss in the association. Today we will
study a really important opinion:
A report by members of the Office of Economic Analysis, U.S.
Securities and Exchange Commission (SEC). The Commission has
expressed no view regarding the analysis, findings, or
conclusions contained herein.
OFFICE OF ECONOMIC
ANALYSIS
UNITED STATES SECURITIES AND EXCHANGE
COMMISSION (SEC)
Study of the Sarbanes-Oxley Act of 2002
Section 404
Internal Control over Financial Reporting
Requirements
Executive
Summary
The
Public Company Accounting Reform and Investor Protection Act,
otherwise known as the Sarbanes-Oxley Act (the “Act”), was enacted
in July 2002 after a series of high-profile corporate scandals
involving companies such as Enron and Worldcom.
Section
404(a) of the Act requires management to assess and report on the
effectiveness of internal control over financial reporting
(“ICFR”). Section 404(b) requires that
an
independent auditor attest to management’s assessment of the
effectiveness of those internal controls.
Because
the cost of complying with the
requirements of Section 404 of the Act (“Section 404”) has been
generally viewed as being unexpectedly high,
efforts to reduce the costs while retaining the effectiveness of
compliance resulted in a series of reforms in 2007.
This
report presents an analysis of data from publicly traded companies
collected from an SEC-sponsored Web survey of financial executives
of companies with Section 404 experience conducted during December
2008 and January 2009.
The
analysis of the survey data is designed to inform the Commission
and other interested parties as to whether changes occurring since
2007 are having the intended effect of
facilitating more cost-effective internal controls evaluations and
audits, especially as they may apply to smaller reporting
companies.
The
findings of the analysis relating to efficiency include evidence
on the total and component compliance costs, the changes in costs
over time, and the factors that help to explain why costs are
lower or higher for some companies than for others.
These
findings include evidence of direct and indirect effects that
management ascribes to Section 404 compliance, including evidence
on intended benefits.
The
2007 reforms that are the focus of this inquiry include the SEC’s
June 2007 Management Guidance and its order approving the Public
Company Accounting Oversight Board’s (PCAOB)
Accounting Standard No. 5 (AS5)
(collectively referred to as the “2007
reforms”).
We are
primarily interested in whether and how
companies’ experience with Section 404(b) compliance changed
following the reforms, yet this report also presents evidence on
the implementation of both Section 404(a) and Section 404(b).
This
reflects the interrelationship between the two requirements.
The survey
was open to all reporting companies with relevant experience in
complying with Section 404, recognizing that only large
accelerated filers and accelerated filers are currently required
to comply with both Section 404(a) and Section 404(b) and, thus,
have information on the overall cost of compliance with these
sections.
These
experienced filers that responded to the survey tend to have
public float in excess of $75 million,
which is large compared to that of non-accelerated filers that are
not yet required to comply with Section 404(b).
The
evidence on the experiences of larger companies may be useful in
evaluating the extent to which additional improvements to the
implementation of Section 404(b) should be undertaken before it
becomes applicable to non-accelerated filers.
Notwithstanding, it is important to highlight that the analysis in
this report is not designed to provide compliance cost estimates
for companies that have yet to comply with the relevant
requirements of Section 404.
The
general conclusion from the analysis of survey data is that
compliance costs vary with company size
(increasing with size), compliance history (decreasing with
increased compliance experience), and compliance regime (lower
after the 2007 reforms).
Larger
companies tend to incur higher compliance costs in dollar terms
(“absolute cost”), while smaller companies
report higher costs as a fraction of asset value (“scaled cost”).
The
evidence suggests that companies bear some fixed start-up costs of
compliance that are not scalable. Some of these costs are
recurring fixed costs, while others are one-time start-up costs
borne in the first years of compliance that tend to dissipate over
time.
For
companies complying with both parts of Section 404, the cost of
complying with Section 404(b) is reportedly similar to the
incremental cost of complying with Section 404(a) alone.
The
resource requirements of Section 404(a) and Section 404(b)
compliance are quite different, however.
The
Section 404(a) cost is borne through increased internal labor and
outside vendor expenses, while the Section 404(b) cost is
experienced primarily through increased independent-auditor fees,
according to the survey evidence.
The
evidence also indicates that there is an economically and
statistically significant reduction in Section 404 compliance
costs following the 2007 reforms.
This
reduction is most pronounced among larger companies.
More than
half of survey participants (henceforth also referred to as
“respondents”) who answered explicit questions about the effects
of the 2007 reforms report that the reforms
led to a decrease in compliance costs, consistent with the
objectives of the reform and the reported cost reductions.
Nearly all
respondents indicated that they relied on the Management Guidance
and, of those, a majority found it to be useful.
As a
result of the Management Guidance, there has been a shift of
effort among smaller companies toward evaluating the effectiveness
of ICFR and away from the tasks of identifying risks to the
company’s financial reporting and identifying controls that
address identified risks.
These
respondents, however, had a less favorable
response to a question about the SEC’s responsiveness to concerns
about compliance costs.
The Web survey also included
questions about respondents’ perceptions of other potential
effects of Section 404 compliance, including potential beneficial
effects. Respondents ascribe some beneficial effects to Section
404 compliance.
In
particular, respondents were more likely to
report direct benefits of compliance with Section 404 rules (i.e.,
improvements directly related to a company’s financial reporting
process, such as the quality of the company’s ICFR), rather than
indirect benefits of compliance (i.e., improvements indirectly
related to a company’s financial reporting process, such as the
company’s ability to raise capital).
Respondents from larger companies and Section 404(b) companies
tend to regard Section 404 compliance more favorably than those
from their counterparts in almost every respect.
Before
turning to a more detailed outline of findings, it will be useful
to provide some background on the size and compliance categories
of the companies that are the subject of the study.
Throughout
the analysis, respondents are partitioned
based on the size of their company using the size thresholds that
parallel the SEC’s reporting thresholds.
Under SEC
regulations— typically—non-accelerated filers have public float of
less than $75 million; accelerated filers have public float
between $75 million and $700 million; and large accelerated filers
have public float of $700 million or more.
The
evidence on the costs and benefits of
Section 404(b) compliance is almost entirely from the last two
groups, which are termed “large” and “medium/mid-sized” companies
in this report, because “small” companies (with public float less
than $75 million) were typically not yet required to comply with
Section 404(b) at the time of the survey.
Following
previous research, in some instances, the analysis of smaller
companies focuses on those having a public float falling within a
band above and below the $75 million
threshold that distinguishes non-accelerated from accelerated
filers.
In
addition, to separate the effects of Section 404(a) compliance
from those of Section 404(b), when appropriate the analysis
partitions companies that were compliant with both Sections 404(a)
and 404(b) in the relevant fiscal year (henceforth “Section 404(b)
companies”) from those that are compliant with Section 404(a) only
(henceforth “Section 404(a)-only companies”).
A more
detailed presentation of findings as answers to the central
questions of the report follows:
Q1. How
does the cost of complying with Section 404 vary across companies,
and what factors influence a company’s compliance cost?
The
total cost of complying with Section 404 varies across companies
depending on
(1)
the company’s size,
(2)
whether the company is complying with Section 404(a) only or also
with Section 404(b),
(3) the
company’s experience in complying with Section 404(b), and
(4)
whether compliance occurred before or after the 2007 reforms.
Specifically, the absolute compliance cost
in dollar terms tends to increase
with company size (measured by public float), but the cost
scaled by asset value tends to decline as company size increases.
As one
would expect, total compliance costs are typically larger for
companies complying with Section 404(b) in addition to Section
404(a).
Longer
experience with Section 404(b) compliance, however, is associated
with a decrease in the typical reported costs (scaled by company
assets).
The cost
of compliance tends to be lower after the 2007 reforms than before
and this decrease is most pronounced among larger companies.
Q2. What is the observed trend in Section
404 compliance cost before and after the 2007 reforms?
The
Web survey collected response data on audit
fees, outside vendor fees, non-labor costs, and internal labor
hours.
These cost
components were aggregated using conservative assumptions in order
to obtain a dollar estimate of the total cost of compliance (see
Section IV.a).
The
evidence generally indicates that the typical total compliance
costs have decreased from the year prior compared to the one after
the 2007 reform and are expected to decrease further in the fiscal
year in progress at the time of the survey.
Among
Section 404(b) companies, the mean total
Section 404 compliance cost drops significantly from $2.87 million
pre-reform to $2.33 million post-reform, representing a 19 percent
decline in the total compliance cost.
The
compliance cost is expected to be lower still, with a mean cost of
$2.03 million, representing a combined decline of 29 percent.
When
reporting compliance costs by size category, the mean total
compliance cost decreases from $769,000 to $690,000 among filers
with public float lower than $75 million, but this difference is
not statistically significant.
The
reduction in compliance costs is more pronounced among the medium
and large companies that are already required to comply with
Section 404(b).
The
medians reveal similar patterns for the typical company in our
sample.8 The median total Section 404 compliance cost declines
significantly from $1.19 million pre-reform
to $1.04 million post-reform, a 13 percent decline.
The median
expected cost for the fiscal year in progress is lower still,
at $905,000, a combined decline of 24
percent relative to the pre-reform median cost.
For
non-accelerated filers, the median total compliance cost decreased
from $579,000 to $439,000, but, as with the
means, the difference for these companies is not statistically
significant.
When
analyzing first-time compliance costs before and after the 2007
reforms, the results are mixed and the mean decrease in total
costs is not statistically significant.
In
contrast, for companies in their second year of compliance with
Section 404(b), both the mean and median compliance costs are
significantly lower after the 2007 reforms than before.
Meanwhile, among Section 404(a)-only
companies, the mean total cost also decreased from $425,000
pre-reform to $336,000 post-reform, but the difference is not
statistically significant, and the median cost actually increased
from $111,000 to $162,000. Both the mean and the median, however,
are expected to decrease for the fiscal year in progress at the
time of the survey.
Q3. How do
the component costs of complying with Section 404 compare, and how
have they changed since the 2007 reforms?
For
Section 404(b) compliant companies, the largest cost component is
internal labor costs— which can comprise more than 50 percent of
the total compliance cost—followed by the estimated portion of
total audit fees attributed to ICFR (404(b) audit fees), outside
vendor fees, and non-labor cost.
In
general, every component cost declines after the reforms compared
to the year before, and is projected to decline further in the
fiscal year in progress.
The most
notable changes in the cost components between pre-reform and
post-reform are observed in the outside vendor fees and the
percent of the total audit fees attributable to ICFR.
The mean
outside vendor fee decreases by 29 percent from $438,000
pre-reform to $311,000. The median outside vendor fee decreases by
10 percent from $100,000 to $90,000.
Both
differences are statistically significant, and the outside vendor
fees are expected to decrease significantly to a mean cost of
$222,000 and median cost of $55,000 in the fiscal year in progress
at the time of the survey.
The mean
portion of the audit fee that respondents attributed to the ICFR
audit also decreases significantly by 21 percent
from $821,000 to $652,000.
This
decline is expected to continue.
Similarly,
the median audit fee decreases by 13 percent
from $358,000 to $311,000 and is expected to decrease to $275,000.
Q4. What are the benefits of complying
with Section 404, as reported by company executives, and how do
they compare against the costs of compliance?
The
survey asked the respondents to comment on the impact of Section
404 compliance on twelve characteristics relating to internal
governance and investor confidence, of which six were considered
direct effects of compliance and the remaining six indirect
effects of compliance.
The
respondents recognized Section 404 compliance as having a positive
impact on various dimensions of the financial reporting process,
but were less inclined to recognize these improvements as
affecting the companies’ dealings with other capital market
participants.
Furthermore, in an optional section of the
survey, respondents provided their assessment of the cost-benefit
trade-off of Section 404 compliance.
The
majority of respondents to this section perceive the trade-off to
be negative to varying degrees.
This
perceived trade-off is more favorable among larger companies and,
independently of size, improved following the 2007 reforms.
Among
the characteristics that are most widely reported benefiting from
Section 404 compliance is: the quality of
the respondent company’s internal control structure (73 percent),
the audit committee’s confidence in the company’s ICFR (71
percent), the quality of the company’s financial reporting (49
percent), the company’s ability to prevent and detect fraud (48
percent), and the respondent’s confidence in the financial reports
of other companies complying with Section 404 (40 percent).
The
majority of respondents recognize no effect
of Section 404 compliance on: the company’s ability to raise
capital, investor confidence in the company’s financial reports,
the company’s overall firm value, and the liquidity of the
company’s common stock.
Finally,
the perceived effect of Section 404 compliance on the efficiency
of the operating and financial reporting processes and the
timeliness of the company’s financial statement audit varies
widely: while a majority of respondents perceive no effect on
these dimensions, non-trivial portions of respondents recognize a
negative effect—that is, a reduction in the
efficiency of the operating and financial reporting processes
and/or the timeliness of financial statement audit.
In the
cross-section, larger companies were more likely to ascribe
positive direct and indirect effects to Section 404 compliance
than were smaller companies.
Q5. What are the reported benefits of
Section 404 compliance from the perspective of financial statement
users?
In
order to obtain a more complete picture of the effects of Section
404 implementation, staff members from the SEC’s Office of the
Chief Accountant conducted separate in-depth phone interviews of a
sample of 30 users of financial statements—including lenders,
securities analysts, credit rating agencies, and other investors.
Although
the sample is admittedly smaller than that
of issuers participating in the survey, the evidence gathered is
useful because it provides the perspective of financial statement
users on the effects of Section 404 compliance.
In
general, financial statement users regard ICFR disclosures to be
beneficial and indicated that Section 404(a) and Section 404(b)
compliance has had a positive impact on their confidence in the
companies’ financial reports.
The users
generally indicate that Section 404 compliance leads management to
better understand financial reporting risks, put in place
appropriate controls to address financial reporting risks, and
address internal control deficiencies in a more timely fashion
than in the absence of the disclosure requirement.
Although,
users offer divergent opinions regarding the extent to which
disclosures of material weakness affect their decision-making
process, most agree that severe weaknesses
that could take years to remediate are likely to negatively affect
their decision-making.
Users
tend not to perceive the benefits of Section 404 compliance to
vary with the size of the reporting company.
Instead,
many indicate that these benefits depend on a company’s complexity
and industry affiliation. At the same time, the users agree that
variations in compliance requirements based on complexity and/or
industry would likely be impractical.
Finally,
most users indicate that the benefits they
perceive from Section 404 compliance have not changed
substantially over time.
This is an
important finding since it indicates that the 2007 reforms, while
intended to reduce certain duplicative efforts in conducting the
evaluation of ICFR, did not at the same time change financial
statement users’ perception of the effectiveness of Section 404.
Regarding the Section 404(b) requirement, the general
consensus is that the auditor’s report on ICFR required under
Section 404(b) provides an incremental benefit beyond the
management’s report because many respondents perceive the audit
requirement to provide necessary discipline to the reporting
process.
Although
some users express the concern that ICFR evaluation may divert
management’s attention from other important areas of their
businesses, these respondents continued to believe that strong
ICFR is necessary and that financial statements need to be of high
quality and reliable.
Most
users interviewed indicate that the process of compliance with
Section 404 has become more efficient since the initial
implementation in 2004 due to:
(i) reduction in the level of documentation,
(ii)
improved communications between auditors and management,
(iii)
increased use of professional judgment in scoping and testing,
(iv) more
focus on higher risk areas, and
(v)
streamlining of audits subsequent to the first-time effort
required by Section 404 compliance.
Q6. In what ways have the Commission’s
2007 reforms affected the companies’ procedures of complying with
Section 404?
Nearly all respondents who completed an
optional section of the survey requesting feedback on management’s
Section 404(a) experience responded that they used Management
Guidance and found it to be useful.
Those who
responded indicate that both Management Guidance and Auditing
Standard No. 5 have helped reduce the total cost of compliance,
for companies in every size category.
The
respondents also indicate on average that
Auditing Standard No. 5 resulted in a small decrease in the time
it takes to complete the independent audit of ICFR.
The
perceived impact of AS5, however, varies
with the size of the company and its experience with Section
404(b) compliance.
Specifically, the perceived impact of AS5 on the time it takes to
complete the independent audit of ICFR is significantly smaller
among small filers and among companies with no previous experience
with Section 404(b) compliance.
When
asked to compare the changes in activities associated with
management’s evaluation of ICFR, the respondents indicate a slight
decrease on average from pre-reform to post-reform in the number
of risks subject to testing, the number of controls tested, but a
slight increase in the level of documentation, the use of
management’s interaction with controls as evidence, reliance on
evidence gained from self-assessment, and reliance on evidence
from direct testing.
Like much
of the previous results, the responses varied significantly
depending on the respondents’ size. While smaller companies
typically report an increase in every component, the changes
reported by medium and large filers are not homogenous.
Interestingly, however, the evidence
suggests that the compliance process across companies of different
size has become more homogenous following the 2007 reforms.
Finally,
the survey evidence indicates that companies are increasingly
structuring their evaluations of ICFR with the intent of allowing
the independent auditor to rely on their internal work, which is
consistent with one of the goals of the 2007 reforms through
Auditing Standard No. 5.
Some
caveats about the analysis of Web survey data on Section 404
implementation
There
are a number of caveats to consider when interpreting the evidence
presented in this study, some of which are due to the inherent
nature of survey data, while others are the result of the
particular context in which the Section 404 survey takes place.
First,
most, if not all, analyses of survey data are affected to various
degrees by the following potential
difficulties:
• Self-Selection Bias (i.e., Non-response
Bias):
Participation in survey research is generally voluntary.
The
process by which survey participants “select” to participate in a
survey can bias the inference based on survey data, if the
participants’ (self-) selection process is such that particular
segments of the population are systematically over- or
under-represented.
We conduct
extensive analyses to test for the presence and the potential
severity of the problem, particularly by investigating the extent
to which key characteristics of the sample of respondents to the
survey coincide or diverge from those of the list of companies
identified as the target population.
We find
that respondent companies are representative of the initial list
of public companies identified for this study, particularly among
Section 404(b) companies or within company size groups.
We also
find that the typical responses of voluntary
participants in the survey are not significantly different from
those of a randomly selected, stratified sample of companies that
were the target of follow-up efforts to induce their
participation.
Overall,
the evidence is consistent with the notion that the voluntary
nature of the participation introduces no bias in the responses,
at least relative to the separate treatment group where part of
the decision to participate is a result of the follow-up effort.
•
Response Bias:
If there
are no penalties for misrepresentation and
survey participants have systematic incentives to be less than
fully truthful, inference based on survey data (or any other
self-reported information that meets those criteria) may not be
accurate.
A similar
problem arises when survey questions are designed to elicit the
participant’s subjective perceptions on a particular subject and
the participants’ views are systematically biased.
The
portion of survey data that we could independently verify (i.e.,
audit fees) indicates that the participants’ representations do
not deviate substantially from what is reported in official SEC
filings.
Aside from
this exercise, it is virtually impossible to
assess the extent to which the remaining survey data may not be
accurate.
The nature
of the survey questions varies, with some questions focusing on
quantifiable items (e.g., internal labor hours) and others on
directional perceptions (e.g., assessment of the effect of Section
404 on the quality of ICFR) and others still on
directional/ordinal perceptions (e.g., assessment of the effect of
AS5 on the amount of time it takes to complete the independent
audit under Section 404(b)).
The common
element, however, is that these data cannot
be independently verified, either because companies are do not
keep a separate record of the figures provided (e.g., costs) or
because the information provided is based on the respondents’
perceptions which by their very nature are not verifiable.
The analysis in this report provides a
characterization of companies’ experiences with Section 404
compliance that is based on survey participants’ representations
of their experiences.
Other
caveats are specific to the analysis
presented in this report, as they depend on the nature and timing
of the survey.
In
particular:
1.
The number of respondents from Section
404(b) companies that are non-accelerated filers and have usable
data is relatively small—approximately 100 companies versus over
1,600 accelerated filers in the most recently completed
fiscal year (see Table 9)—and there are reasons to believe the
experience of these companies may not extend to other
non-accelerated filers that are yet to comply with Section 404(b).
Specifically, non-accelerated Section 404(b) companies that
participated in the survey are either voluntary compliers or have
been required to comply in the past as accelerated filers and must
continue to do so because their float has not dropped below $50
million since.
To the
extent that these factors affect companies’ experience with
Section 404(b) compliance, one should be careful when
extrapolating the results to non-accelerated filers that are yet
to comply.
2.
Non-accelerated filers were required to
start complying with Section 404(a) at the end of 2007—after the
reforms.
Yet, a
number of non-accelerated filers responding to the survey reported
bearing Section 404 compliance costs prior to the reform.
These
respondents were contacted after the survey was closed to inquire
about the nature of the information provided.
These
respondents indicated that their company began complying with
Section 404 requirements prior to the Commission’s public
announcement that the compliance deadline had been extended and,
thus, they viewed the resulting pre-reform costs reported in the
survey as appropriately ascribed to Section 404(a) compliance.
The
analysis of non-accelerated filers’ experience prior to the
reforms should be interpreted with the caveat in mind that it may
not be representative of what the typical non-accelerated filer
would have experienced.
3.
The characteristics of the internal
governance structure and financial reporting process are likely to
be important determinants of the companies’ compliance
experiences, including costs and benefits and the nature of the
audit services they obtain under Section 404(b).
To the
extent that accelerated and non-accelerated filers display
significant differences in these dimensions, it may not be
appropriate to extrapolate the analysis of accelerated filers to
non-accelerated filers.
4.
All the cost figures presented in this
analysis are based on survey respondents’ characterization of the
resources devoted to Section 404 compliance. As such, the general
caveats above apply. Moreover, there are some aspects specific to
our analysis:
a. All
estimates presented in this report are based on non-audited
numbers based on the respondents’ perception provided in the
survey.
Moreover,
the nature of the estimates is limited by the scope of the survey.
b.
There are reasons to question the ability of respondents to
provide an accurate breakdown of audit fees into Section 404(b)
fees versus financial statement audit fees.
Auditors
interviewed by the SEC’s OCA staff highlight this difficulty on
the basis that, for Section 404(b) companies, the two audits are
integrated and audit firms do not typically provide a breakdown of
the fees.
Based on
conversations with issuers, however, it seems routine for them to
request and obtain audit fee quotes that account for the
incremental auditor’s work under Section 404(b) requirements
before the company begins complying with this section of the Act.
Thus, it
is possible that respondents’ attribution of audit fees to Section
404(b) may be inaccurate, to the extent that they are based on
quotes provided by auditors upon first-time compliance with this
section and that such a breakdown does not apply in subsequent
years of compliance
c. It is important to note that the
estimates of internal labor costs presented in this report are
based on an assumption about a reasonable hourly rate.
The rate
adopted for internal labor is $121 per hour, consistent with the
rate quoted as of September, 2008 for a junior accountant cited in
a report on salaries prepared by the
Securities Industry and Financial Markets Association (SIFMA),
to which the Commission frequently refers in its
rulemakings.
This is at
the low end of cost estimates that are provided in the SIFMA
report for accounting and related services,
and above the rate of $50/hour (or $100,000 for 2000 hours) that
is assumed in a series of Financial Executives International
(“FEI”) reports of survey findings relating to the costs of
compliance with Section 404 that date back to 2005.
Although
our assumed rate is within the range of reasonable estimates for
evaluating the overall costs of compliance, it is not intended for
use in estimating the cost to an individual company.
We have
provided information sufficient for determining how the internal
labor costs are affected by changes in the hourly rate—e.g.,
doubling (halving) the rate to $242 ($60.5) per hour doubles
(halves) the associated labor costs— and by changes in internal
labor hours, each of which may vary across companies.
d.
Coates (2007), among others, highlights that implementation of the
Sarbanes-Oxley Act “created new incentives
for firms to spend money on internal controls” even where
companies were required to invest such resources under the
previous regulatory regime.
This
observation is particularly relevant in the context of Section 404
implementation. In particular, Section 13(b)(2) of the Exchange
Act requires companies to maintain effective ICFR, while Section
404 requires management to report on the effectiveness of ICFR.
By this
reasoning, it is conceivable that Section 404 may have given
issuers incentives to spend more resources to meet the
requirements of the Exchange Act, causing companies to bear
“deferred maintenance” expenses to bring ICFR into compliance with
those requirements.
It is
possible that survey participants include these costs in their
assessment of the incremental costs due to Section 404 compliance.
Whether
this is the correct measure of the incremental costs of Section
404 compliance depends on the objective of the analysis.
For
example, issuers were required to be in compliance with Section
13(b)(2) of the Exchange Act prior to SOX, so the ICFR maintenance
costs might not seem pertinent.
From this
perspective, Section 404 cost estimates that include the ICFR
maintenance expenses overestimate the cost of compliance with
Section 404—by including more than just the cost of reviewing ICFR
and preparing the mandated disclosures.
Alternatively, if the argument above is correct, in the sense that
companies systematically shirk in complying with the Exchange Act
requirements absent SOX, then the incremental economic cost of
Section 404 compliance should include the aforementioned
maintenance expenses that would not be borne absent Section 404.
Similarly,
it is worth noting that a parallel logic applies to the benefits
of Section 404 compliance.
That is,
from an economic perspective, the incremental benefits of Section
404 include the improvements in ICFR resulting from the deferred
maintenance that would not have occurred absent the new disclosure
requirements of Section 404.
5.
Participants in the survey provided their
perceptions of the effects of Section 404 compliance, both on the
financial reporting process and their company’s interaction with
capital market participants. The following caveats should be kept
in mind for this part of the analysis:
a. The
assessment of the benefits is qualitative in nature, given the
intrinsic difficulty of quantifying the benefits of Section 404
compliance in monetary terms, and not directly comparable to the
cost estimates provided by the same respondents.
b. In
addition to lack of comparability with cost estimates, the
analysis of the survey responses about the benefits of compliance
may be subject to response bias.
In
particular, the response bias would seem to be especially relevant
when participants provide their assessment of how Section 404
compliance affects subjects outside the corporation (e.g.,
investors’ confidence in the company’s reports).
The
resulting analysis may be biased if the respondents’ perception or
their representation of those perceptions is biased.
With this
caveat in mind, the staff of the SEC’s
Office of the Chief Accountant (OCA) conducted in-depth interviews
with individuals representing a variety of external users of
financial statements to gather their views on the effects of
Section 404.
This
effort complements the analysis of the views expressed by the
companies participating in the survey, in combination providing a
broader and more complete assessment of the effects of Section 404
on capital market participants.
6. In
various parts of the survey, the
participants provided information about their experience with
Section 404 compliance over several years: the most recently
completed fiscal year; the fiscal year prior to that, and the
fiscal year in progress at the time of the survey.
While
responses referring to the participants’ past experience reflect
events that are certain, responses for the fiscal year in progress
at the time of the survey result in estimates and perceptions that
are intrinsically less precise, due to the inherent uncertainty
about future events.
To study
all 139 pages of the report:
www.sec.gov/news/studies/2009/sox-404_study.pdf
Basel
ii and Financial Conglomerates
There
is a major problem with the
differentiated nature of financial regulation in the
international banking, insurance, and securities
sectors.
There are important
gaps
arising from the scope of financial regulation as it relates to
different financial activities, with a particular
focus on certain unregulated or lightly regulated
entities or activities.
Some conglomerates are very large
and global in their operations, and are undoubtedly of
systemic importance. Their failure would clearly pose
considerable challenges.
These groups should be subjected
to an acceptable level of global consolidated
supervision. Are they?
Today we
will study a very interesting paper:
Basel Committee on Banking Supervision, The
Joint Forum: Review of the Differentiated Nature and Scope of
Financial Regulation, Key Issues and Recommendations (January
2010)
Review of the Differentiated Nature and Scope of
Financial Regulation
Executive Summary
I.
Introduction
This report
analyses key issues arising from the differentiated nature of
financial regulation in the international banking, insurance,
and securities sectors.
It also addresses gaps arising
from the scope of financial regulation as it relates to
different financial activities, with a particular focus on
certain unregulated or lightly regulated entities or activities.
The Joint Forum prepared this report at the request of
the G-20 to help identify potential areas where systemic risks
may not be fully captured in the current regulatory framework
and to make recommendations on needed improvements to strengthen
regulation of the financial system.
The Joint Forum
presents its findings in five key issue areas:
•
Key regulatory differences across the banking, insurance, and
securities sectors;
• Supervision and regulation of
financial groups;
• Mortgage origination;
• Hedge
funds;
• Credit risk transfer products (focusing on
credit default swaps and financial guarantee insurance).
The Joint Forum focused on these areas because they help
shed light on some of the major sources of systemic risk that
emerged from the current financial crisis.
Unless action
is taken, these issues may continue to pose systemic risk to the
financial system and the global economy.
The Joint Forum
analysed problems that sometimes extend beyond or cut across the
scope of existing regulation of the banking, insurance, and
securities sectors.
The Joint Forum’s goal was to
analyse the key issue areas, identify gaps, and produce
recommendations to address these gaps and bolster regulatory
frameworks over the long term.
The recommendations are
supplemented with policy options when consensus could not be
reached.
This report is part of a global effort to reform
and strengthen financial regulation by the G-20 Leaders and
co-ordinated by the Financial Stability Board (FSB).
The
Joint Forum’s parent committees - the
Basel Committee on Banking Supervision (BCBS), the International
Organization of Securities Commissions (IOSCO), and the
International Association of Insurance Supervisors (IAIS) -
have initiated and conducted several other projects aimed at
strengthening financial regulation and notably at redefining its
scope.
Given the Joint Forum’s cross-sectoral
perspective, this report has taken into account all of the
analyses and recommendations from these initiatives, as well as
other authoritative research.
Additionally, the Joint
Forum notes that global policy initiatives aimed at reducing the
impact of future crises are resulting in increased prudential
requirements on regulated entities.
Paradoxically, these
concerted efforts could result in an undesired effect, that is,
providing incentives to operate outside the traditional
boundaries of supervision and regulation for the three sectors.
II. Mandate
At their 15 November 2008 meeting,
the G-20 Leaders called for a review of the
differentiated nature and scope of regulation in the banking,
securities, and insurance sectors.
This report responds to the following declaration:
“The appropriate bodies should review the differentiated
nature of regulation in the banking, securities, and insurance
sectors and provide a report outlining the issue and making
recommendations on needed improvements.
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.”
In its 25 March 2009 report on Enhancing
Sound Regulation and Strengthening Transparency, the G-20 stated
the following:
“The Joint Forum, a Working Group of the
BCBS, IOSCO and the IAIS, is undertaking a project that
addresses the differentiated nature and scope of financial
regulation.
The main objective of this project is to
identify areas where systemic risks may not be fully captured in
the current regulatory framework.
Special emphasis will
be placed on institutions, instruments, and markets that are
currently unregulated or lightly regulated.
As
appropriate, the Joint Forum will leverage off current work from
other international bodies in its assessment.”
III. Focus and guiding principles of this
study
In light of the breadth
and short time frame of this mandate, the Joint Forum took a
focused approach for identifying and analysing key issue areas
and gaps.
Drawing primarily on previous Joint Forum
analyses, the Joint Forum first analysed the differentiated
nature of financial regulation by comparing key differences in
existing international regulation across the banking, insurance,
and securities sectors.
The Joint Forum also focused on
areas that correspond to immediate and well known gaps in
supervision and regulation, have a strong cross-sectoral
dimension, have been addressed by Joint Forum analyses of
similar issue areas, and would benefit from a mix of different
regulatory perspectives.
While the areas the Joint Forum
focused on obviously do not represent all of the existing gaps
and differences in financial supervision and regulation, the
either contributed to the crisis in varying degrees or pose
significant systemic risk.
A. Focus of this study
This report focuses on five key issue areas for the
following reasons.
1. Key
regulatory differences across the banking, insurance, and
securities sectors
International financial regulation is sector specific as
evidenced by the independent development of core principles or
standards in each financial sector.
A sector-specific
approach to supervision comes with the potential for increasing
regulatory gaps, which causes supervisory challenges and
presents opportunities for regulatory arbitrage.
Differences exist in the nature of financial regulation among
the banking, insurance, and securities sectors.
These
differences are warranted in some cases due to specific
attributes of each financial sector, but, in others, these
differences may contribute to gaps in the regulation of the
financial system as a whole.
One way to understand the
differences and identify the gaps is to compare the core
principles for financial supervision across each sector.
The core principles reflect characteristics of the
respective sector and the nature of the supervised financial
institutions.
They represent the key components and
features of the supervisory and regulatory framework of each
financial sector.
These principles, issued independently
by the BCBS, IAIS, and IOSCO, correspond to the minimum
requirements for sound supervision.
This analysis
provides insights into the differentiated nature of regulation
across sectors from an international perspective2 but not into
the unregulated sector.
2. Supervision and regulation of financial
groups
Financial groups,
through networks of legal entities and structures, offer a wide
range of financial services and are often active across multiple
jurisdictions and with multiple interdependencies.
The
financial crisis has shown the significant roles these financial
groups play in the stability of global and local economies.
Because of their economic reach and the mix of regulated and
unregulated entities (such as special purpose entities and
unregulated holding companies), financial groups blur the
boundaries among the sectors and present challenges for the
application of sector-specific financial regulation and also for
their review and assessment by supervisors.
3. Mortgage origination
The focus of the role of mortgage products in the financial
crisis has been on the securitisation of mortgage loans or the
sale of securitisations.
This has been addressed in
several international fora, including the Joint Forum and its
parent committees.
Receiving far less attention,
however, is the fundamental building block of sound
securitisation: the quality of underwriting of the component
mortgages.
The G-20 noted that the credit quality of
loans granted with the intention of transferring them to other
entities through the securitization process was not adequately
assessed.
Therefore, this report focuses on standards
for the origination of mortgage loans that contribute to sound
securitisations and global market stability.
4. Hedge funds
Hedge funds, especially the largest of them, could have a
systemic impact on financial stability.
Failure in
particular of a large, highly leveraged hedge fund might not
only impact its investors, but also financial institutions and
markets.
Yet hedge funds are perceived as largely
unregulated because they, like individual investors, typically
do not have legal or regulatory investment restrictions,
although their operators are regulated in many countries.
While the possible contribution of hedge funds to the
financial crisis is still a subject of debate, the Joint Forum
agreed that the lack of a consistent prudential regime for
monitoring and assessing hedge funds is a critical gap in the
regulatory framework.
5. Credit risk transfer products
Credit default swaps and financial guarantee insurance
products transfer risks within but also outside the regulated
sectors.
There is broad agreement that these products
should be subject to sound counterparty credit risk management
and that more transparency is needed.
This report focuses
on areas not already specifically addressed by other fora and on
areas where additional input on previous recommendations would
be beneficial.
This report also consolidates and
emphasises recommendations that have been made in other fora.
B. Guiding principles of this study
The broad mandate led to analysis of a diverse and large
range of issues.
Consequently, some recommendations and
policy options are aimed at supervisors while others target more
generally policymakers.
In developing these
recommendations and policy options, the Joint Forum applied
certain guiding principles that reflect general views about the
nature of financial regulation and, to a great extent, echo
general recommendations made by the G-20.
Articulating
these principles helps ensure that these recommendations are
designed for the long term.
• Similar activities,
products, and markets should be subject to similar minimum
supervision and regulation.
• Consistency in regulation
across sectors is necessary; however, legitimate differences can
exist across the three sectors.
• Supervision and
regulation should consider the risks posed, particularly any
systemic risk, which may arise not only in large financial
institutions but also through interactions and
interconnectedness among institutions of all sizes.
•
Consistent implementation of international standards is critical
to avoid competitive issues and regulatory arbitrage.
Because of the dynamic, changing nature of the global financial
system, the scope of financial regulation must be continuously
monitored and reviewed.
IV. Key issues and gaps
The following summarises the findings and observations in
the five areas reviewed.
A.
Key regulatory differences across the banking, insurance, and
securities sectors
To
undertake the review of the differentiated nature of existing
regulation in the banking, securities, and insurance sectors,
the Joint Forum focused on updating a review of the respective
core principles of supervision in the banking, insurance, and
securities sectors conducted in 2001.
The core
principles reflect the main characteristics of the respective
sector and the nature of the financial institutions supervised
under each framework.
The purpose of such comparsion was
to identify common principles and understanding differences when
they arise.
Despite different formats, content and
language used, the core principles review revealed substantial
commonalities across sectors.
Indeed, differences among
each sector’s core principles have been decreasing slightly over
time, reflecting the converging nature of the business in the
three sectors.
Furthermore, some of the existing
differences among the core principles are warranted as they
reflect - at least in part - intrinsic characteristics of the
banking, insurance, and securities
sectors.
Examples
of these intrinsic differences include the following ones:
• There are many unique aspects in securities regulation
reflecting the broader scope of securities supervisors.
The IOSCO core principles therefore encompass not only the
regulation and supervision of securities firms, but also that of
markets, exchanges, collective investment schemes, and
disclosure by issuers.
This broader scope of the IOSCO
core principles reflects unique and intrinsic aspects of
securities regulation and supervision. Core principles in the
banking and insurance sectors describe only the framework needed
to supervise financial institutions, not markets.
•
Differences in the nature of the businesses being conducted by
firms within each sector also explain and justify some
fundamental differences in the nature of their regulation.
An example of this differentiated nature of businesses of
firms across sectors is the key role assigned to technical
provisions by insurance regulation, but not by banking and
securities regulation.
Insurance companies offer
protection against uncertain future events.
As a
consequence, much regulatory and supervisory effort in the
insurance sector is directed towards the valuation of technical
provisions as they are estimations of the cost of future
liabilities.
However, as already noted by the Joint Forum
in 20018, key differences remain among the regulatory frameworks
of the banking, securities, and insurance sectors that have no
objective justification.
Furthermore, the relevance of
some of these differences has been emphasised by the financial
crisis, as noted by the G-20 in its report on Enhancing Sound
Regulation and Strengthening Transparency.
As a general
and overarching matter, the Joint Forum believes that there is
room for greater consistency among each sector’s core
principles, as well as the standards and rules applied to
similar activities conducted in different sectors.
Such
improvements would reduce opportunities for regulatory arbitrage
and contribute to greater efficiency and stability in the global
financial system.
Also, the financial crisis evidenced
the lack of a coordinated approach to assess the implications of
systemic risks and of the necessary policy options to address
them.
The core principles for each sector should
appropriately reflect the extent to which systemic risk and
financial stability play a role in the development of
supervisory policies and approaches.
More specifically,
despite exposures to common risk factors and growing
interactions and risk transfer across the three sectors, there
are areas treated differently for the purposes of prudential
regulation of financial firms under each sector’s supervisory
system:
• This is notably the case with regard to the
supervision and regulation of financial groups.
The
emphasis placed on supervision on a group-wide basis varies
dramatically and the principle is applied in very different ways
in the three sectors.
While the Basel framework has
always placed much focus on consolidated supervision, the IAIS
only started requiring group-wide supervision (in addition to
supervision of individual entities) in 2003.
IOSCO’s
core principles do not require securities firms to be supervised
on a group-wide basis.
• Differences exist regarding a
global uniform capital framework within each sector.
A
uniform framework exists only in the banking sector, whereas
different frameworks still coexist within securities and the
insurance sectors at the international level.
•
Prudential regulations across sectors also remain largely
different from both a conceptual and a technical point of view.
Although these largely reflect significant differences in
underlying business activities, some of these differences create
supervisory challenges as well as opportunities for regulatory
arbitrage.
• The extent to which regulation of the
different sectors deal with business conduct and consumer or
investor protection also vary.
The Joint Forum believes
that addressing these inconsistencies in supervisory frameworks
across the banking, securities, and insurance sectors is
necessary in order to ensure a sounder financial system in the
future.
In addition to considering the legal or
regulatory framework for evaluating differences in prudential
regulation across sectors, it is also important to consider how
supervisors implement these regulations.
Differences at
the implementation level are important as they may impede fair
and effective supervision and assessment of the financial sector
in general.
Although how supervisors implement
regulations was beyond the scope of this work, the Joint Forum
wishes to emphasise that partial or inconsistent implementation
of even nearidentical prudential regulation can result in
significant differences in practice.
B. Supervision and regulation of financial
groups
Financial groups play a
significant economic role but can threaten financial stability
at local and global levels.
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.
Financial groups offer services in banking,
securities, insurance, or a combination of these services.
This mix blurs the traditional supervisory and regulatory
boundaries among the sectors.
Moreover, these groups
rely on a network of legal entities and structures (some of them
unregulated) to derive synergies and cost savings and to take
advantage of differences in taxation, supervision, and
regulation.
This report focuses on differences in the
treatment of:
• Unregulated entities when calculating
group capital adequacy.
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.
These differences create gaps when unregulated entities are used
to lower capital requirements of individual regulated entities,
to reduce group capital adequacy requirements, and to blur the
distinction among sectors.
This can encourage the
creation of group structures that are complex, opaque, and
interdependent.
• Intra-group transactions and exposures
(ITEs), including those involving unregulated entities.
ITEs allow a financial group to coordinate its businesses across
its legal structure.
ITEs can create contagion and
unintended risks across the group and/or individual legal
entities within the group, as shown by the failure of Lehman
Brothers.
The differences in approaches to supervision
and regulation of ITEs can make it difficult for supervisors to
assess the risks to the sustainability of the business models of
the group and its legal entities.
• Unregulated entities,
particularly unregulated parent companies of regulated entities.
Differences can create loopholes for financial groups to
establish unregulated parent holding companies that end up
controlling regulated entities from a completely separate
jurisdiction.
The unregulated parent holding company’s
jurisdiction may not have related regulated entities or not have
legal authority to exercise power or oversight over unregulated
entities.
This hinders supervision.
The
unregulated parent holding company is under no obligation to
provide information to unrelated third parties, such as foreign
supervisors, and is not required to produce the information in a
meaningful way.
Existing protocols for obtaining and
sharing critical information do not address unregulated entities
that are higher in the organisational hierarchy of ownership.
These differences help create situations in which regulatory
requirements and oversight do not fully capture all the
activities of financial groups or the impact and cost that these
activities may impose on the financial system.
Thus,
there is a need to consider regulatory reforms to address, where
appropriate, these differences.
Meanwhile, supervisors
need to monitor the risks that these differences can create and
ensure that they are managed by regulated entities.
C. Mortgage origination
Until 2007, this decade was characterised by relatively
strong economic growth, low interest rates in many
jurisdictions, an abundance of liquidity, and increased lending
to consumers.
In a number of countries, housing and
mortgage markets expanded dramatically, and there was rapid
expansion in the variety and number of mortgage products and in
related securitisation.
Lack of discipline by market
participants in several jurisdictions was notable during this
boom period.
When housing price bubbles were suspected,
it was not clear at what point a systemwide response would be
needed, especially given the positive macroeconomic effect of
increasing home values and homeownership.
This
evaluation was further complicated by rising home values masking
a number of poor underwriting practices, particularly those
designed to lower initial monthly payments.
In several
countries that experienced a surge in mortgage lending and
housing growth, most notably the United States and the United
Kingdom, lenders developed new, riskier products that made use
of relaxed product terms, liberal underwriting, and increased
lending to highrisk populations.
These developments
eventually resulted in significant losses for consumers and
financial institutions alike.
However, many other
countries with sophisticated mortgage markets have not
experienced a significant degree of distress and some countries
did not experience such growth, for example, Germany and Canada.
This report focuses on two fundamental areas of concern:
• Poor mortgage underwriting practices.
Problems
arising from poorly underwritten residential mortgages in
certain countries contributed significantly to the global
financial crisis; indeed, the securitisation and other
structured financing of these mortgage loans
- which
were purchased by a number of international financial firms
- spread the problems of their poor underwriting to the
banking, securities, and insurance sectors globally.
In
contrast, prudent practices and sound and comprehensive policies
may have prevented market participants in those countries that
have not experienced a significant degree of distress from
engaging in the less disciplined underwriting behaviour that was
endemic in other, more troubled mortgage markets.
•
Mortgage originators subject to differing supervision,
regulation, and enforcement regimes for similar
activities/products.
Like most aspects of the mortgage
industry, the prevalence, role, and supervision of nonbank
credit intermediaries varies greatly across the various mortgage
markets.
Mortgage originators range from the smallest
individual mortgage brokers to large international lenders.
They include lenders that provide warehousing lines to fund
loans on an interim basis, those that structure securitisations
and market securities, and central banks and
government-sponsored enterprises that essentially make markets
in mortgage loans.
In some cases, the government closely
controls the mortgage market through explicit guarantees for the
full balance of the loan, while in others involvement is
limited.
The number of participants, the variety of
roles they play, and the differences among countries are
substantial, particularly given the patchwork approach to the
regulatory framework in many countries.
Such differences
created regulatory gaps that helped erode prudent mortgage
underwriting practices.
D. Hedge funds
Debates continue over whether and to what extent hedge funds
may have contributed to - or mitigated - the expansion of the
financial crisis.
Some argue that hedge funds increased
stress on liquidity in the financial markets in fall 2008, while
others argue that hedge funds generally reduce the likelihood
and prevalence of asset bubbles given the strategies hedge funds
use.
There is, however, general consensus that hedge
funds, given their role in the economy, may have a systemic
impact.
The analysis for this report focuses on four
areas of concern.
• Internal organisation, risk
management, and measurement.
Failures in risk management
by hedge fund managers can cause problems for markets and are a
matter of cross-border and cross-sectoral concern.
Yet
there is no common or cross-border understanding of or
requirements for how funds are organised or how fund risks are
managed and measured.
• Reporting requirements and
international supervisory cooperation.
The risks posed
by hedge funds cannot be easily measured by supervisors or
investors because funds are not required to fully disclose their
activities.
The limited disclosure rules that funds do
face vary by jurisdiction and information collected is not
shared by supervisors for hedge funds operating across borders.
• Minimum initial and ongoing capital requirements for
systemically relevant fund operators.
Adequate financial
reserves are needed to help fund operators withstand the
operational risks they incur, ensure their orderly dissolution,
and minimize potential harm to the financial system.
Not
all supervisors require such fund operators to meet even minimum
capital requirements.
• Procyclicality and
leverage-related risks posed by the pool of assets.
The
use of leverage allows funds to magnify potential returns but
also the exposures, and, consequently, the risks for not only
fund investors, but also the financial system itself.
Supervisors do not constrain the use of leverage by funds.
E. Credit
risk transfer products
One of
the factors contributing to the crisis was the inadequate
management of risks associated with various types of products
designed to transfer credit risk.
This resulted in
severe losses for some institutions.
These products
transfer risks within and outside the regulated sectors.
This report focuses on two credit risk transfer products that
were evidenced to contribute to major gaps in market practices
or effective regulation: credit default swaps and financial
guarantee insurance.
Credit default swaps (CDS) and
financial guarantee (FG) insurance are products that provide
protection against identified credit exposures.
Because
the provider of that protection may have to make payments based
on the performance of the underlying credit, these products
create new sources of credit exposure.
Buyers of credit
protection, therefore, need to maintain and enforce sound
counterparty credit risk management practices with respect to
credit protection providers.
While CDS and FG insurance
products have quite different legal structures, they perform
similar economic functions.
The analysis identified the
following issues as common to both the CDS and FG insurance
markets. Each contributed to the recent crisis or poses
crosssectoral systemic risk.
• Inadequate risk
governance:
Sellers of credit protection did not, and
often could not (given their existing risk management
infrastructure) adequately measure the potential losses on their
credit risk transfer activities.
This was generally true
in the CDS market and to a lesser extent in the regulated FG
insurance market (where there is at least some financial
reporting required by statute).
Buyers of protection did
not properly assess sellers’ ability to perform under the
contracts, and they permitted imprudent concentrations of credit
exposures to uncollateralised counterparties.
•
Inadequate risk management practices:
Poor management
of large counterparty credit risk exposures with CDS and FG
insurance transactions contributed to financial instability and
eroded market confidence.
CDS dealers ramped up their
portfolios beyond the capacity of their operational
infrastructures.
• Insufficient use of collateral:
The absence of collateral posting requirements for highly rated
protection sellers (eg AAA-rated monoline firms) allowed those
firms to amass portfolios of over-the-counter derivatives, and
FG insurance contracts - and thus create for their
counterparties excessive credit exposures - far larger and with
more risk than would have been the case had they been subject to
normal market standards that required collateral posting.
• Lack of transparency:
The lack of transparency in
the CDS and to a lesser extent in the FG insurance markets made
it difficult for supervisors and other market participants to
understand the extent to which credit risk was concentrated at
individual firms and across the financial system.
Market
participants could not gauge the level of credit risk assumed by
both buyers and sellers of credit protection.
•
Vulnerable market infrastructure:
The concentration of
credit risk transfer products in a small number of market
participants created a situation in which the failure of one
systemically important firm raised the probability of the
failure of others.
Separately, this report addresses key
issues and gaps specific to CDS products.
They are
largely unregulated although their use is subject to supervision
and regulation when protection buyers and sellers are regulated
institutions.
To the extent that unregulated entities,
such as special purpose entities, are major participants in CDS
markets, this may be perceived as a gap in existing supervision
and regulation.
For example, even if regulated firms are
subject to capital requirements for risks arising from their CDS
exposures, systemically important unregulated firms are not
subject to comparable requirements, and this may pose a systemic
risk.
There also are concerns about potential weaknesses
in the market infrastructure for CDS products because they are
typically traded over-the-counter.
Operational risks can
be exacerbated by weaknesses in market infrastructure.
Finally, there are key issues and gaps specific to FG insurance
products.
The number of FG insurers worldwide is small,
but they operate across international boundaries and the
regulation of these insurers varies considerably across
jurisdictions.
In recent years, FG insurers increased
their risk appetites and expanded into asset-backed securities,
including collateralised debt obligations, as well as subprime
mortgage-backed securities.
Insurers also established
minimally capitalised special purpose entities, which sold CDS
products that were not legally permitted within the main FG
insurance business.
Accounting practices, capital and
liquidity, the role of credit rating agencies, use of special
purpose entities, and knock-on effects pose cross-sectoral
and/or systemic impact as the economic validity of the business
model and design of these products remains in question.
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