The IIF is preparing a report recommending that the financial industry increases transparency and improves risk and liquidity management to ride out the credit crunch, writes Rick Waugh.
A number of critical issues have converged on global financial markets to create the current crisis. Significant among the industry’s woes are: compressed spreads; lax lending and underwriting standards; aggressive mortgage terms; unregulated mortgage originators; increasing fraud; declining due diligence; consumer indifference about mortgage debt; and structural incongruities.
Leaders of the world’s financial services institutions, however, recognise the industry’s responsibility to restore confidence in the financial markets. The Institute of International Finance (IIF) is drawing on very senior executives from many of its 375 or so financial services member firms to formulate recommendations for the industry designed to raise standards and improve best practices.
In an interim report released in Frankfurt, Germany, on April 9, the IIF’s Committee on Market Best Practices initiated considerable momentum towards solving the problems that have arisen and preventing them from recurring in the future. The 38-page interim report demonstrates an unprecedented effort by the industry to develop practical solutions, and sustain an informal dialogue and regulatory authorities. The Committee plans to produce a final report in the summer.
As the interim report emphasises, the financial service industry needs to increase transparency in several aspects of its work. Many firms need to improve on risk management, liquidity management and conduit underwriting approaches significantly. Firms should also reconsider incentives and compensation structures. Furthermore, the IIF recommends improvements in the work of ratings agencies and proposes initiatives to deal with the valuation problems faced in a mark-to-market world at times of low liquidity. Public confidence can be rebuilt only if the industry is seen to be directly addressing key weaknesses and seeking to provide more comprehensive information on its activities. Improving transparency is of central importance.
Structured products
For example, with structured products, the Committee is considering standardised market definitions and structures, clarification of the roles of agents, and more reader-friendly issue documentation. It is also looking at ways to make valuation processes and methodologies more understandable to investors and the public and to enhance underwriting practices so that clearer information is provided. Incentives and compensation are also being reviewed, with a view towards improved transparency. The Committee recommends that incentive compensation models are closely aligned to shareholders’ interests and long-term, firm-wide profitability. The same principles should apply to severance packages.
Another key consideration is risk management, which is much more than just a monitoring function. It is a core responsibility of the CEO and the entire executive management team.
It is essential that firms introduce processes, if they do not already have them, to ensure that senior management adopts and periodically affirms their firm’s risk appetite. This should be understood and communicated at all levels of the organisation.
The interim IIF report also emphasises the need for effective governance frameworks relating to valuation processes that incorporate risk, finance and accounting policy inputs, to ensure proper product and risk controls. Procedures need to be in place for times of market stress to better enable management to act when changes in market liquidity, or volatility, require changes in valuation approaches for individual assets.
During the past decade, fair-value or mark-to-market accounting has proved valuable in promoting sound risk management, transparency and market discipline. And it continues to be an effective approach for securities in liquid markets. Our challenge is to apply this approach at times when liquidity dries up in secondary markets.
Banks alone can not resolve the issues. The IIF proposes that a top-level technical dialogue is initiated among firms with international and national accounting standard-setters, auditors, supervisors and market participants, to address many of the limitations in the mark-to-market system. Combined with improved disclosure, this new dialogue can garner greater agreement on approaches to valuation.
Rick Waugh is president and CEO at Scotiabank, and co-chairman of the IIF’s Committee on Market Best Practices.
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