If the market meets standards of best practice, there is less need for the authorities to impose draconian new regulations.

Since August 2007 global markets have been in a period of what many would consider a long overdue reassessment and repricing of risk, after immediate and intensive corrective action to preserve liquidity in financial markets. The market turbulence also illustrates the consequences of a period of over-consumption and over-production of complex financial products, combined with serious difficulties in monitoring the associated risks.

In fact the benefits that should normally have been derived from financial innovation, such as complex securitised products, became associated with entirely new risk configurations.

Over the years, certain financial intermediaries have been eager to shift to the originate-to-distribute model, while weakening their due diligence process, accompanied by an immense investor appetite to increase returns by assuming complex risks that were not always fully understood. The situation was compounded by the outsourcing of important internal due diligence responsibilities to credit rating agencies and other third parties. At the same time the use of such new complex instruments was not supported by sufficiently adequate and comprehensive risk monitoring functions; it also involved a global distribution which included investors located in jurisdictions lacking sophisticated oversight.

Such market crisis has highlighted, I believe, the need to review and enhance, when justified, best practices in three main areas: risk management, transparency and due diligence processes for structured products; the role and methodology of rating agencies; and valuation of complex instruments.

On risk management, the regulatory authorities consider that larger and more robust liquidity buffers are necessary. They are also proposing to take specific measures, to be implemented over a period of time, in order to: raise Basel II capital requirements for certain complex structured credit products; introduce additional capital charges for default and event risk in the trading books of banks and securities firms; and strengthen the capital treatment of liquidity facilities to off-balance sheet conduits.

During this period of turbulence, there has been an intense focus on the need for transparency and due diligence for structured products. Work is being done in several areas to enhance transparency. Transparency is, of course, important in the case of the originate-to-distribute model as the risk is widely spread – and sometimes blended and disguised – and it is difficult to know where the losses lie. But, for its own part, the market believes that lack of transparency is not one of the main causes of recent market turbulence, and that there is a high level of transparency available to investors in securitisation markets already. But the industry also recognises that improvements should be made, where this is practicable.

Risk comeuppance

With regard to due diligence processes, two main issues have arisen. One is the suspicion that originators may not have been as active in due diligence about the risk of default as they should have been, as they have immediately passed the risk on. The other is that investors, seeking to increase their return, assumed complex risks that they did not always fully understand.

The due diligence process in practice was mainly outsourced to credit rating agencies. Consequently, the role and methodology of rating agencies have been under intense scrutiny lately, both at the European and global level. The focus has been on: the quality and integrity of the ratings process; independence and avoidance of conflict of interest within credit rating agencies; and ensuring that credit rating agencies meet their responsibilities both to the investing public and to issuers. The European Commission has put forward proposals for the regulation of rating agencies in Europe, and at the time of writing further action is expected soon.

One of the most difficult issues arising during the period of market turbulence was how to value structured securities, which are normally valued by marking them to market, when there is no longer a market. Valuation is usually a matter for individual market firms and their auditors, however an industry working group has been examining the issue more generally. In normal markets, mark-to-market accounting has proved very useful in promoting transparency and market discipline. Although some market participants consider that in conditions where liquidity is severely restricted, marking to market has the potential to complicate valuation.

Therefore, the originate-to-distribute model was expected to produce important benefits in financial innovation while diversifying risks and revenue streams and contributing to cost efficiencies. It was assumed that it would help avoid banking crises in which huge risks are concentrated on banks’ own books. And indeed it is fair to say that the distribution of credit risk from banks to investors has generated benefits for the financial system and the global economy.

However, such models only work effectively if all market participants maintain high standards of risk management and disclosure, particularly for complex structured products. Much is being done to address the shortcomings in market practices that occurred in the run-up to recent market turbulence.

Considered responses

In these turbulent times, self-regulatory organisations have an important role to play in bringing the market together, through committees and working groups, to discuss the appropriate responses. The search for ways of restoring market confidence has been at the heart of the work of the International Capital Market Association (ICMA) Regulatory Policy Department over the past year. ICMA’s work on regulatory policy and good market practice is one of the main functions of ICMA as a self-regulatory organisation and international trade association, and one of the main potential benefits for our members.

ICMA’s role in helping to make the market function involves taking practical steps to restore market confidence by seeking a consensus among our members on setting standards of good market practice to make sure that the market functions well.

The latest turbulence in capital markets has served as a reminder that ICMA and its members have a responsibility to continue their activities in support of an efficient functioning of truly integrated global financial markets and to ensure that an efficient and robust regulatory infrastructure, which respects free market principles, is in place to support them. If the market meets standards of best practice, there is less need for the authorities to impose new regulations.

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