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Radical Reform Recommended for Both EU and U.S. Financial Sector

Financial Reform Watch

In spite of the holidays and new year celebrations, financial sector events have continued to unfold unremittingly, forcing EU policy makers to consider policy readjustments, yet again.

The scandal surrounding Bernard L. Madoff Investment Securities LLC, the financial implications of which are global and yet to be fully discovered, is one of the most recent examples. No doubt, Madoff will give those supporting new financial regulation and oversight the upper hand in reform discussions just as Enron provided carte blanche for those promoting the Sarbanes-Oxley legislation, and its EU siblings, a few years ago.

One of the calls for new, drastic, financial reform—more difficult to argue against in a post-Madoff environment—comes from the distinguished Financial Times columnist Willem Buiter. In a recent speech, Buiter provided a damning analysis of the shortcomings of the financial system and also provided his recommendations for the appropriate policy responses. It would have been less surprising if these radical proposals had emanated from outraged elected officials, rather than from a professor of political economy at the London School of Economics.

The EU bureaucracy will very soon be back in full gear to prepare for the G20 meeting in London scheduled for early April. Before then, it will put forward a set of proposals for a new EU financial infrastructure. It is still far too early to forecast what the EU will propose in terms of regulation, but if Buiter’s recommendations are used as a template, then generations to come will look back at 2009 as the year of incredible financial reform.

Here are some of Buiter’s top recommendations:

  • Require the originator of any securitised assets or cash flows to retain a sizeable fraction of the equity tranche or first-loss tranche of the securitised instrument.
  • Take the rating agencies out of the regulatory process by eliminating the role of external ratings in the Basel II capital risk-weightings (for bank assets); restrict rating firms from engaging in any other commercial activities; and establish a global regulator or a uniform standard for regulating eligible rating agencies.
  • The introduction and marketing of new financial products and instruments should be regulated and be subject to testing in ways similar to those used for the regulation and testing of new medical and pharmacological drugs.
  • Any incorporated entity above a certain threshold size and with narrow leverage will be subject to the same capital requirements regime, liquidity requirements regime, reporting regime, and governance regime.
  • Establish a single EU-wide regulator for border-crossing banks and for other systemically important border-crossing financial activities or institutions.
  • Stick to (or return to) strict fair value accounting, including mark-to-market whenever possible. Do not permit reclassification of assets between liquidity categories. Use regulatory forbearance regarding the actions required to restore regulatory capital ratios, leverage ratios, or liquidity ratios that may be distorted by distressed asset fire sales in illiquid markets.
  • Subject the members of financial institutions’ boards of directors to bi-annual written examinations (developed by regulators) to test their knowledge of the products and services their institutions trade and manage.
  • Mitigate the pro-cyclical effect of constant regulatory capital ratios by having countercyclical regulatory capital requirements.
  • Don't regulate on the basis of information that is private to the regulated entity. Only use independently verifiable information.

In the coming weeks, the U.S. Congress will begin hearings on financial regulatory reform. The House Financial Services Committee had scheduled a hearing for this week, but has postponed it presumably until the new Obama Administration is in place later this month. That said, the Securities and Exchange Commission (SEC) adopted some new rules governing credit rating agencies in December, including:

  • Rating agencies may not rate securities they helped structure.
  • Employees of rating agencies may not accept gifts from companies issuing securities, except “in the context of normal business activities, such as meetings, that have an aggregate value of no more than $25.”
  • Rating agencies must maintain detailed records and provide more comprehensive information to the SEC about how they conduct ratings and the historical accuracy of their ratings.

Despite these new rules, the $50 billion Madoff scandal has incited widespread criticism of the SEC’s failures and calls for widespread reform. Some of the suggestions include:

  • End the “oligopoly” of the three major credit rating agencies—Moody’s Investor’s Service, Standard and Poor’s, and Fitch Ratings—and encourage competition.
  • Prohibit issuers of securities from paying for credit ratings and have investors or possibly the public sector finance credit ratings.
  • Alter the rules requiring credit ratings.
  • Impose on SEC officials a multi-year moratorium against working on Wall Street following their departures from the commission.

In a televised interview on 7 January, President-elect Obama said, “"Wall Street has not worked, so it's going to be a substantial overhaul. We're going to have better enforcement, better oversight, better disclosure, increased transparency. We're going to have to look at this alphabet soup of agencies and figure out how do we get them to work together more effectively. We've got to update the whole system to meet the needs of the 21st century."

Obama also indicated he would like to have some regulatory reforms on the table prior to the April meeting of the G20. More details will likely emerge on 15 January when Obama’s nominee to head the SEC, Mary L. Schapiro, is scheduled to appear before the Senate Banking Committee.

 

Notice: The purpose of this newsletter is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This alert should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.