This article reviews the main regulatory developments that have taken place at the UK, EU and international levels over the past two months in the financial services sector.
UK
Introduction
The FSA has begun the year by issuing its Financial Risk Outlook for 2008 and its Business Plan 2008/9. The FSA has also published a review of the structure of the Listing Regime and reported on progress on increased access for retail customers to alternative investment vehicles. It has proposed a further simplification of the investment advice disclosure regime and taken forward initiatives to assist small businesses.
Financial Risk Outlook
The FSA published its latest Financial Risk Outlook ("FRO") on 29th January 2008. This sets out the issues that the FSA pose current risks to its ability to continue to meet its statutory objectives and strategic aims. Key risks are referred to as ‘priority risks’ which are considered to be of particular importance over the following eighteen months. The FRO has been restructured to provide more detailed discussion on each of the priority risks identified with an overview of the present economic and financial conditions and a separate section on industry focus which examines non-specific exposures.
The FRO focuses on the events of the second half of 2007 and the subsequent, less benign, economic conditions. This is referred to as the ‘central economic scenario’ for the UK and global economy. Relevant risks have increased significantly following the last FRO with financial markets being vulnerable to external shocks with firm impact being more severe. The operating environment for firms remains difficult and is expected to continue which investor confidence remains low. Firms’ business models have been shown to be unsuitable in the new stressed financial conditions especially where liquidity is restricted. This puts pressure on measures of prudential risk including capital and liquidity with many lenders being forced to shrink their mortgage businesses with further direct consequences on the real economy and consumers. This will also place further pressure on highly indebted consumers with debt repayment problems expected to increase during the year. The FSA expects firms to continue to focus on conduct of business compliance and to respect its high level principles. Firms must ensure that they treat customers fairly and deal with market abuse and other areas of financial crime. The FSA will also consider other issues not covered in the FRO in detail including increased longevity, retail distribution and climate change.
The five priority risks identified in the FRO can be summarised as follows:
(a) existing business models of some financial institutions are under strain as a result of adverse market conditions;
(b) increased financial pressures may lead to financial firms shifting attention from focusing on conduct of business requirements and from maintaining and strengthening business as usual processes;
(c) market participants and consumers may lose confidence in financial institutions and in the FSA's ability to safeguard the financial system;
(d) a significant minority of consumers could experience financial problems due to high levels of borrowing; and
(e) tighter economic conditions could increase the incidence or discovery of financial crime or lead to firms’ resources being diverted from dealing with financial crime problems.
As part of its central economic scenario analysis, the FRO highlights a number of ‘alternative scenarios’ to identify further shocks that could have further consequential effects on financial stability. The three main alternative scenarios considered relate to a further reduction in the availability of credit, falls in property prices and rising inflationary pressures. All of these are considered to be interlinked and to reinforce each other. The FRO identifies a number of specific risks that could arise for firms and markets as well as consumers under each alternative scenario. In its industry focus, the FRO identifies a number of key messages for banks and building societies. Banks should assume that the operating environment will remain difficult for a sustained period and therefore plan accordingly. Banks need to have funding plans in place for both the short and medium term which have been stress test against the risk that the availability of funding remains restricted and more costly than before the onset of the market dislocation. A more careful approach to risk assessment and management is a necessary condition for an improvement in the quality of balance sheets and the restoration of confidence in the banking sector more generally. Firms need to maintain the momentum in improving their stress and scenario testing. Treating customers fairly should continue to be a key priority. Investment banks and commercial banks should work on the assumption that their business environment will remain difficult for a sustained period. Investment banking businesses should look at their remuneration policies to consider whether they provide the right incentives for risk assessment and to reflect the need for their cost base to adapt to earnings volatility. Banks should continue to seek fair and independent valuations for structured finance and other illiquid products and ensure that controls are in place to provide clients with valuations that are fair, clear and not misleading. Banks need to ensure that they continue to focus on improving anti-market abuse systems and control inside information.
Business Plan
The FSA released its Business Plan 2008/9 on 6 February 2008. This sets out its programme of work for the regulatory year ahead and explains how it will address the risks highlighted in the FRO. The Business Plan is structured according to the FSA’s key objectives of promoting efficient, orderly and fair markets, helping retail customers achieve a fair deal and improving its business capability and effectiveness. Its budget for 2008/9 is also attached.
FSA Chairman Callum McCarthy notes in his foreword that 2008 is expected to continue to place heavy demands on all those involved in financial markets as pressure persist although they have changed in character. There has been a fundamental re-pricing of risk with adjusted priorities and practices being required. The FSA will assist the Government in preparing legislation to improve the treatment of failing banks and the UK deposit insurance scheme. Despite the new economic circumstances and enhanced risks, much of the FSA’s work has not been affected by the recent difficulties. These include financial capability, effective retail distribution, treating customers fairly, exerting UK influence in EU policy and continuing to make the FSA more efficient. The FSA also remains committed to its risk based approach to regulation, a determination to make markets work more effectively and a recognition that regulation cannot prevent all market failure. It will also use its enforcement powers to reinforce its policy objectives as an effective deterrent to irresponsible behaviour and rely insofar as practicable on more general principles rather than detailed rules.
In commenting on the lessons from Northern Rock, Chief Executive Hector Sants refers to four specific initiatives. The FSA has commissioned a ‘lessons learned’ review by its Director of Internal Audit on its supervisory approach to Northern Rock which will be presented to the FSA Board at the end of February. The FSA will review the regulatory framework for liquidity in co-operation with the Bank of England having regard both to domestic rules and relevant international development. The FSA will work with the Treasury and Bank of England to improve the depositor protection regime and reform insolvency law for financial institutions. The FSA has also contributed to the Chancellor’s review of the operational efficiency of the Tripartite arrangements. Separate work will be carried out in connection with rating agencies and the difficulties of dealing with non-transparent and complex markets.
The FSA budget is to increase by 7.1% to £323m. This is considered necessary due to underlying cost increases of £11.5m, an investment of £5.9m in enhancing supervisory strategy for small firms, a £3.5m in the European Alternative Instrument Identifier (AII) and £400,000 from other new initiatives. The FSA has been able to generate 5.5% in efficiency savings with fee income to increase by 6.9% or £20.6m.
In promoting efficient, orderly and fair markets, FSA priorities will focus on liquidity and capital revision and sound management. The FSA published a discussion paper on liquidity requirements for banks and building societies in December 2007 (DP07/7) which builds on work started earlier in the year in co-operation with other regulators including the Basel Committee. The FSA proposes to adopt a qualitative and quantitative approach to liquidity with qualitative requirements allowing for stress tests that best suit each firm’s business. Firms will specify the stress test periods, assumptions, mitigating actions and contingency funding plans most suitable to them subject to high-level principles and supervisory review. Quantitative measures corresponding to standardised stress factors will reduce the risk tests not being implemented properly. Attention will focus specifically on strengthening banks’ resilience to short-term liquidity shocks. In promoting efficient, resilient and internationally attractive financial markets, work continues on the UK listing regime, multilateral trading facilities, contracts for differences, covered bonds, commission disclosure on insurance sold to commercial customers, private equity, the carbon emissions market and Islamic finance. Resilience initiatives include a Tripartite conference for CEOs on strategic and policy issues including pandemics, the extended use of Fact books, improved EU crisis co-ordination and resilience benchmarking exercises. In connection with financial crime, resources for the Financial Crime and Intelligence Division will be increased with reviews having been conducted of the security issues arising with regard to consumers’ personal data and anti-money laundering and terrorist financing under a principles based approach. Anti-financial crime systems are to be reviewed in response to the Financial Action Task Force (FATF), Mutual Evaluation of the UK and National Audit Office recommendations. The FSA has continued to develop its SABRE II market monitoring system in connection with market abuse and the use of transactional reports with the Alternative Instrument Identifier code. (At the same time EU and international work continues on the Solvency II Directive, capital definitions, international accounting standards, UCITS, mortgage credit and a code of conduct for rating agencies - see below).
Retail initiatives continue to focus on the treating customers fairly (TCF) initiative to come into effect during 2008 with industry progress being monitored through ARROW or enhanced supervision. Work will be specifically undertaken in connection with unfair contract terms, the quality of firms’ communications with consumers, product disclosure, suitability of recommendations, self-invested personal pensions, payment protection insurance, unauthorised overdraft charges and with-profits funds as well as arrears management practices. Work will also continue on the financial capability agenda as well as conduct of business regulation of retail banking and improvements in the Financial Services Compensation Scheme and a possible merger of the Financial Ombudsmen Service with the Pensions Ombudsman following the Thornton Review of Pensions Institutions.
In improving business capability and effectiveness, a number of initiatives are highlighted with regard to staff recruitment, additional office space and technical infrastructure including knowledge management and Integrated Regulatory Reporting using the new strategic reporting system GAthering Better Regulatory Information ELectronically (GABRIEL) which will come into effect during the second half of 2008. This will provide firms greater choice in submitting information to the FSA with improved functionality in comparison with the current Firms online system and other legacy systems in place.
Listing Regime
The FSA has published a discussion paper on the structure of the UK listing regime (DP08/1). This considers the re-labelling of the Primary and Secondary listing segments of the market to assist participants understand the obligations on issuers of the various types of securities covered. A new structure for listing is considered in which securities subject to higher standards will be more clearly separated from EU directive minimum standards. Primary Listing will be re-labelled ‘Tier One Listing’ and Secondary Listing and Global Depository Receipts (GDRs) ‘Tier Two Listing’. The alternative is to admit Secondary Listed securities and GDRs to trading but not to be ‘officially listed’ by the FSA. UK companies are only eligible for a ‘super-equivalent’ Primary Listing and not Secondary Listing while overseas issuers can chose between the two separate regimes. The paper attempts to try to create a form of level playing field for overseas and UK issuers. The distinct treatment of corporate governance requirements is also considered with only UK companies being subject to the Combined Code. One suggestion is to require overseas companies to ‘comply or explain’ against the Combined Code in place of their existing sole compliance with their local governance requirements. (Separate consideration is also given with regard to the FSA’s regulatory resources in overseeing the GDR market.)
Alternative Investments
The FSA has issued a further consultation paper on extending the availability of funds of hedge funds for retail investors (CP08/4 following CP07/6) last year. Retail oriented funds of alternative investment funds (FAIFs) are to be introduced although further consultation is with regard to managers’ duties and taxation. The Treasury has issued a separate paper on taxation. FAIFs are to be introduced into the Non-UCITS Retail Schemes (NURS) regime. Existing rules are to be relaxed restricting investment in unregulated collective investment schemes from 20 to 100 per cent. the prohibition of circulatory of investment within a NURS is to be removed and extended to apply to the Qualified Investor Scheme (QIS) regime with due diligence criteria being applied to investment managers where they invest more than 20 per cent. in unregulated schemes. Additional consultation is sought on whether existing repayment standards should be altered to allow for the time required for funds of funds to obtain asset valuations held in underlying funds, allowing FAIFs to act as feeder funds into master funds and strengthening due diligence rules and guidance for fund managers operating FAIFs.
Investment Advice Disclosure
The FSA has issued a consultation paper on simplifying disclosure on services and costs (CP08/3). Its objective is to ensure that investment advisors provide consumers with clear and simple information concerning services and costs. A principles-based approach to disclosure came into effect with the Conduct of Business Sourcebook (COBS) on 1st November 2007. The FSA is now proposing to introduce a single disclosure document to combine the information contained in the ‘Menu’ and ‘Initial Disclosure Document’ (IDD) following consumer research. The purpose is to simplify investment disclosure but continue to provide firms with discretion over how the information is presented at the same time as maintain their responsibility to consumers. This is also considered to comply with various EU disclosure requirements.
EUROPEAN UNION
Introduction
The European Commission has issued a Communication on 'Europe's financial system: adapting to change' (Com (2008) Provisional). A summary has been provided of the administrative measures and sanctions including criminal penalties maintained by each Member State under the Market Abuse Directive. The Commission has adopted an ‘equivalence mechanism’ in relation to third country Generally Accepted Accounting Principles (GAAPs) and published new research on UCITS' investment policies. The Commission has called for an extension of cross‑border euro‑payments with the Commission and the European Central Bank welcoming the launch of the Single Euro Payments Area.
Europe’s Financial System
The Commission has issued a Communication to the European Parliament and the Council in connection with ‘Europe’s financial system: adapting to change’. The report accepts the changes that have taken place in international financial markets and the connections in the global marketplace. The global economic situation and outlook remain unusually uncertain at the beginning of 2008 following financial turmoil, the US slowdown and soaring commodity prices. The European economy has responded relatively well although GDP growth had slowed during the last quarter. Forecasts have been downgraded to 2 per cent. GDP for the EU and 1.8 per cent. for the Euro area. The Commission considers that the most effective way to deal with the shocks facing the global economy is to maintain sound and stable macroeconomic policies supporting a balanced policy mix and to continue with existing structural reforms. The right policies instruments are already in place under the Lisbon strategy for growth and jobs, while improvements have been secured in budgetary balance under the Stability and Growth Pact. Member States have agreed country specific recommendations although further work is required on implementation with national reform programmes also be subject to peer review at the EU level. The Commission has identified four priority areas and listed the action required to be taken at the EU level under the Community Lisbon Programme. These consist of investing in people and modernising labour markets, unlocking business potential, investing in knowledge and innovation and helping the EU become a low carbon economy. The report contains further discussion of regulatory developments within Europe, Europe’s response to recent market events, new principles to be applied to sovereign wealth funds and state aid controls. An ECOFIN action plan has been produced to assist the Spring 2008 European Council based on three core principles of primary responsibility for managing risks remaining with individual financial institutions and investors, national regulatory and supervisory frameworks must be adequate to deal with increasingly complex and innovative financial systems and co-operation between regulatory authorities in the EU and internationally must be promoted to prevent and manage risks within a progressively globalised financial system. The EU will work with other countries to improve information provided by credit rating agencies, update accounting and valuation rules, encourage prompt and full disclosure of losses by financial institutions, improve EU early warning systems on financial stability through regular reporting from the Level 3 Committees, promote the effectiveness of EU networks of financial supervisors and ensure strong and effective supervision across border groups, work on a common practical framework for the assessment of the systemic implications of potential crises (including guidelines for crisis management and improved information exchange) and seek political agreement between the Commission, the Council and the Parliament to deliver necessary legislative changes before April 2009.
Market Abuse Directive
The Committee of European Securities Regulators (CESR) has produced a Report on ‘Administrative Measures and Sanctions as well Criminal Sanctions available in Member States under the Market Abuse Directive’ ("MAD") (November 2007) (CESR/07-693). This contains a summary of all of the relevant national measures adopted to implement MAD across twenty‑nine countries including the twenty‑seven EU Member States and Norway and Iceland. MAD gave Member States discretion in imposing sanctions with administrative measures and sanctions only having to be effective, proportionate and dissuasive (MAD Article 14). The objective of the report is to provide market participants with information concerning MAD implementation measures across all Member States. The report is issued as part of CESR’s efforts to monitor the extent of equivalence of supervisory powers across Europe under the MAD with a view to promoting convergence. The report includes attribution powers as well as general and co-operation authority and an assessment of supervisory practice.
GAAP Equivalence
The Commission has adopted a Regulation on which third country GAAPs are to be considered equivalent to International Financial Reporting Standards ("IFRS") adopted by the EU. Charlie McCreevy, Internal Market and Services Commissioner, has welcomed the regulation as milestone in securing the objective of promoting the efficiency of capital markets through the establishment of a common worldwide accounting language. This will assist establish a common set of worldwide accounting standards for listed companies with costly and burdensome reconciliation requirements being eliminated in the short term. The Commission will prepare concrete proposals on which third country GAAPs should be accepted as equivalent on the basis of the definition of equivalence and mechanisms established under the Regulation. This will begin in 2009 with third countries being able to use their GAAPs for a transitional period until 2011. The US's SEC has already adopted a proposal to remove the reconciliation requirement for US GAAP for foreign issuers using IFRS which includes EU companies. The EU was the first to make IFRS mandatory for listed companies since 2005 and is the largest mixed jurisdiction within which IFRS is applied.
UCITS Investment Policies
The Commission has published research on 'Investment Funds in the European Union: Comparative analysis of use of investment powers, investment outcomes and related risk features in both UCITS and non-harmonised markets' in February 2008. The study will be considered at an open hearing on non-harmonised retail funds and real estate funds in April and will form the basis for a communication on non-harmonised investment funds in the autumn of 2008. The study considers the investment outcomes (including performance and related risks) of UCITS and non-UCITS funds over the last five years.
The UCITS III Directive which came into effect in 2004 allowed UCITS fund managers to invest in a wider range of eligible assets, to invest in derivatives for hedging and leveraging purposes and to adopt new investment strategies including index-based investing and fund-of-fund strategies. The report considers how managers used these opportunities. Substantial use of derivatives has been limited to a small subset of UCITS funds with non-harmonised funds not using leverage or using other methods to leverage performance including borrowing or short selling. High levels of market risk have not arisen and managers consider that the new rules provide an important degree of flexibility. The survey specifically considers the effects of changes on leverage, valuation risk, liquidity risk and counter party risk. Managers developed strong risk management procedures before launching new more complex products and considered the suitability of their funds for retail investors and supporting risk management processes required.
The Single Euro Payments Area
The Single Euro Payments Area ("SEPA") came into operation on 21st January 2008. SEPA allows payments to be made throughout the Euro area in a quick, safe and as easy manner as under national payment systems. All euro payments are treated as national under SEPA with one set of payment instruments. This is considered to provide a natural progression and extension from the earlier introduction of the euro. The original launch covers payment instruments for credit transfers with direct debits to follow before November 2009. The SEPA Cards Framework for card payments has been in place since January 2008. It is expected that the SEPA payment market could exceed Є123bn over six years and a further Є238bn if SEPA is used as a platform for electronic invoicing. This represents the beginning of a process of migration from national electronic payment instruments to SEPA instruments.
INTERNATIONAL
Introduction
The Bank for International Settlements (BIS) has issued a paper on Latin American financing and a policy paper on transmission mechanisms for monetary policy in emerging market economies. It has issued a separate paper on central bank policy rate guidance. It has also issued a number of working papers on such matters as Asian equity flows, asset prices and monetary policy, central bank statistical co-operation, macro prudential policy and housing finance agencies in Asia. The Basel Committee has issued an updated paper on liquidity risk management and supervisory challenges.
BIS
The BIS paper 'New financing trends in Latin America: A bumpy road towards stability' (February 2008) considers issues and challenges arising from the most recent financing developments in the Latin America regions.
The BIS policy paper on ‘Transmission Mechanisms for Monetary Policy in Emerging Market Economies’ (January 2008) No. 35. This examines the major changes in monetary policy transmission in emerging market economies over the last decade with policy implications being highlighted.
BIS has also issued a working paper on 'Co-operation between Central Banks and National Statistical Institutes: The cases of Australia, Canada and the Netherlands' (December 2007).
BIS has also released separate working papers on Central Bank Policy Rate Guidance and Financial Market Functioning, Asian Equity Flows, Market Returns and Exchange Rates, Global Monitoring Statistics, Prudential Policy and Monetary Policy, Housing Finance Agencies in ASIA. (All of these are available on the BIS website.)
IOSCO
The Technical Committee of the International Organisation for Securities Commissions (IOSCO) has reviewed progress by the Task Force on the Sub-Prime Crisis which was set up in Tokyo in November 2007. The Task Force was to consider enhanced transparency by issuers of structured products and appropriate due diligence from investors, risk management process for intermediaries, valuation and accounting issues and the roles and duties of credit rating agencies. Final conclusions will follow in May 2008. The Technical Committee has also considered possible advancements in the model IOSCO Code of Conduct Fundamentals for Credit Rating Agencies including disclosure of the assumptions underlying the individual ratings for structured finance transactions, prohibition of advice on the design of structured products which an agency rates and reasonable steps to use information of sufficient quality to support credit ratings. A consultation paper would be produced in March on proposed changes to the model Code. The Technical Committee has also identified other steps that can be taken by market participants to assist restore confidence in the operation of markets. Financial Institutions are encouraged to enhance the information available in the primary market for structured finance instruments. Market participants should co-operate to identify information that will relevant and useful in achieving an appropriate level of transparency in the secondary market. Financial Institutions should make accurate and complete disclosure of the size and level of exposures related to structured finance to the markets and institutional investors and asset managers should develop and undertake strict due diligence processes in their assessment prior to any investment into complex structured products.
IOSCO had separately asked that publicly traded companies provide investors with clear and accurate information on the accounting standards used in the preparation of their accounts.
Financial Stability Forum
The Financial Stability Forum’s (FSF) Working Group on Market and Institutional Resilience has produced an interim report for the G7 Finance Ministers and Central Bank Governors on adjustments and near term challenges to the financial system. The causes of and weaknesses revealed by market turbulence are identified with general policy directions for strengthening the resilience of key elements of the financial system.
The FSF has separately welcomed the final report produced by its Hedge Fund Working Group on ‘Hedge Fund Standards’ (January 2008). The best practice standards are considered to represent an important improvement in the establishment of improved disclosure practices and market discipline in the hedge fund sector. They were expected to enhance resilience and mitigate systemic risk. This implements one of the recommendations issued by the FSF in its earlier ‘Update on Highly Leveraged Institutions’ paper in May 2007 which parallels the work being carried out by the US President’s Working Group on Financial Markets Committee. The FSF had called on the global hedge fund industry to review and enhance existing sound practice benchmarks for managers in light of expectations for improved practices within the official and private sector. The setting of standards is also stated to be the beginning rather than the end of the reform process. A ‘comply or explain’ expectation is applied to hedge fund managers with a Hedge Fund Standards Board to be established subsequently to maintain the standards and report on compliance. The Board will also co-ordinate convergence with the parallel initiative being undertaken by the US President’s Working Group.
Professor George Walker
Centre for Commercial Law Studies,
London
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