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 taken forward a number of initiatives during the period of this review. These include strengthening its market abuse investigation and enforcement capability. An interim report has also been published on its Retail Distribution Review, with firms being warned to take more careful action in future to protect their customers' financial details. The FSA is to adopt a principles-based approach with regard to platforms and is to enhance supervision following Northern Rock. The FSA is also consulting on the sponsor regime as part of the listing review and has launched a campaign to assist homeowners concerned with mortgage repayments. New rules have been issued on telephone recordings. A discussion paper on information transparency in the commercial insurance market has been issued and a separate commentary has been released on systems and controls following the scandal at Société Générale (SocGen) (which is discussed in more detail in Martin Day's article in Part VI of this issue of Financial Services Briefing). A third party administrator has been fined £525,000 for customer document failings and a stockbroker fined £122,500 for poor sales practices. The FSA has recovered £1m from boiler rooms and suspended the registration of Ethnic Mutual Limited (a charity and industrial and provident society). Various other enforcement actions have also taken place.
Market Abuse
The FSA has released its latest Market Division newsletter MarketWatch on market conduct and transactional reporting issues (April 2008 Issue No. 26). This restates the FSA strategy and key objectives concerning market abuse and insider dealing. Clean markets are considered to be vital to the continuing success of London as an international financial centre with the FSA's objectives being to maintain fair, efficient and orderly markets. Insider dealing, market manipulation and other forms of market misconduct distort market operation and reduce investor confidence. UK markets are generally clean although a small but significant minority of counterparties are considered to be potentially abusive especially in terms of informed price movements ahead of merger and acquisition announcements. Market cleanliness is measured through informed price movements. Informed price movements increased between 2005/2006 and 2006/2007 on FTSE 100 merger and acquisition announcements. This does not necessarily confirm market abuse with the price movements possibly relating to abnormal trading ahead of announcements, deliberate strategic information leaks or informed trader activity. The FSA has nevertheless undertaken further review work through its M&A project with advances being made in detection techniques and market intelligence as well as other investigation tools. Specific work has been undertaken in connection with false market rumours especially relating to UK financial institutions in March 2008. The FSA is working on bringing in its Sabre II transaction monitoring system online under MiFID.
The FSA is also reviewing its enforcement work to ensure a capable 'demonstration effect' and is working in close co-operation with other overseas agencies. The FSA had issued an earlier statement confirming that it was investigating trading in certain UK financials' shares during the middle of March 2008. This follows the unfounded rumours that had been circulated within the markets concerning a number of UK financial institutions including banks such as HBOS. It had been uncovered that the rumours had been accompanied by evidence of short selling of relevant stocks. Managing Director of Wholesale and Institutional Markets, Sally Dewar, stated that the FSA would not tolerate market participants taking advantage of volatile market conditions to commit abuse by spreading false rumours and dealing on the anticipated effects on share price. Market participants had to adhere to the market code of conduct at all times. It is perhaps noteworthy that some of HBOS's directors used the "de-ramp" of its share price, largely thought to have resulted from hedge fund activity, to top up their own holdings in the company at bargain basement prices.
The Retail Distribution Review
The FSA has published an interim report on the Retail Distribution Review following its Discussion Paper (DP/07/1) issued in June 2007. The objective is to create a simpler market place with a clear separation between advice and sales. The FSA has been consulting with the industry on possible solutions and significant further challenges. The FSA will assess the economic viability of the structure proposed and consider the impact on consumers and firms. In addition to advice and sales separation, the industry is expected to deliver appropriate market-based solutions in connection with professional standards, remuneration arrangements and provision of simple services to consumers. The FSA has also published its feedback on possible prudential rules changes to reduce the frequency and impact of poor or unsuitable advice by firms in the personal professional investment firm sectors following a discussion paper (DP/07/4) issued in July 2007. Responses suggest that the link between prudential rules and poor or unsuitable advice is too indirect although improved claims handling can be secured through the provision of additional resources. The FSA will consider extending and refining its current capital resources requirements imposed on firms.
Personal Account Details
The FSA has asked financial firms to improve their data security and prevent customers being subjected to identity fraud and other financial crime. The FSA has conducted a review of data security systems and controls of thirty-nine separate regulated firms, including banks, building societies, insurance companies and financial advisers. Whilst some significant good practice was revealed as a result, many firms had underestimated the risk of data loss and fraud to businesses and customers. Inadequate attention was given to internal sources of data loss with firms also being more concerned with adverse media coverage than with dealing with customers in an open and transparent manner. Third party suppliers must also review employee security and maintain adequate security arrangements. Firms must ensure adequate staff awareness in training in addition to IT support. Smaller firms have placed too much reliance on external compliance consultants. Firms should use encrypted laptops and transfer data through secured internet links, limit financial information access where this was not necessary and appoint a senior manager with overall responsibility for data security. (The FSA had earlier fined Nationwide £980,000 for information security lapses in February 2007 and the Norwich Union was fined £1.26m in December 2007.)
Northern Rock
The FSA published a summary of the review conducted by its internal audit division into the supervision of Northern Rock on 26th March 2008. This constitutes the executive summary of a full report and is the subject of separate articles in Part VIII of this issue of Financial Services Briefing.
Information Transparency
The FSA has published a Discussion Paper on intermediary commission disclosure and transparency in the commercial insurance market. The paper considers the conditions that are necessary to create an environment that promotes market efficiency with buyers having access to clear comparable information concerning the role of the intermediary including services and fees. Potential regulatory options are included with further examination on the management of conflicts of interest and with the distinction between intermediaries and insurers becoming less clear. Options include the more strict enforcement of existing provisions with additional guidance and reporting obligations, an enhanced regime to improve commission disclosure and the mandatory automatic disclosure of commission.
Systems and Controls
The FSA has issued a special commentary on systems and controls following the losses suffered by SocGen in MarketWatch Issue 25th March 2008. This highlights measures that firms should consider in reviewing relevant systems and controls to protect them against rogue trader risk such as that suffered by SocGen, with the risk of inappropriate practices leading to significant losses in current market conditions. This topic is discussed further in the article by Martin Day in Part VI of this issue of Financial Services Briefing.
Mortgage Repayments
The FSA has published figures which confirm that one in five mortgage holders are concerned about being unable to meet their repayments over the following twelve-month period. A £2m advertising campaign is to be launched by the FSA to assist consumers to make informed financial decisions and obtain the appropriate mortgage following the end of fixed rate or discount deals. (1.2 million short-term fixed rate mortgages are expected to end during 2008.) The FSA has published a 'Stay in Control of your Mortgage' checklist on its website. The FSA will also launch a two-year pilot project to test delivery of the UK's first national money guidance service following a Treasury announcement on 2nd March 2008. This follows an earlier recommendation that the FSA set up a service to provide free, impartial information and guidance on money matters.
Telephone Recording
The FSA has now issued its new rules requiring firms to record telephone conversations and other electronic communications to assist deter and detect market abuse in the UK. All firms will be required, with effect from March 2009, to maintain records of all telephone conversations and electronic communications relating to client orders and the conclusion of transactions in the equity, bond and derivatives markets. (These new requirements were considered further in an article in Part VIII of the March 2008 issue of Financial Services Briefing.)
Enforcement
The FSA has assisted one hundred and fifty investors recover £1m paid in respect of illegally sold shares through unauthorised overseas investment firms (boiler rooms). The FSA had co-operated with Canadian regulators, the British Columbia Securities Commission and the Ontario Securities Commission to freeze funds and to facilitate repayment. The recovery had been possible due to the quick action undertaken by the Canadian authorities to preserve the relevant funds. (This case will be discussed in more detail by Martin Day in an article on international regulatory co-operation in the July 2008 issue of Financial Services Briefing.)
EU
Introduction
A number of initiatives have also been taken forward at the European Union level. The conclusions of last October's ECOFIN meeting had asked for preliminary policy responses to the recent financial markets situation and the adoption of specific conclusions in light of the completion of the European Financial Committee's ad hoc working group report on financial stability. The Commission was asked to review the separate work streams that were being taken forward following the crisis to ensure consistency including within its own work programme and to develop appropriate policy responses. A road map of actions has been prepared by the European Banking Committee and the Commission in parallel with the work being undertaken by the Financial Stability Forum. This includes specific reviews of transparency, valuation standards, prudential framework, risk management and supervision and market functioning. The Commission has also issued a Communication on the financial turmoil on 27th February 2008 which was discussed at the European Council meeting on 13th-14th March 2008 and a more detailed report was presented to the ECOFIN in April 2008.
European Commission developments
The European Commission has consulted on possible amendments to the European Banking Directive and the Capital Requirements Directives (2006/48/EC and 2006/49/EC) which incorporate the measures adopted to implement the Basel II revised capital requirements within the EU. This includes separate measures with regard to banking book or loan risk and securities and trading book risks which also incorporate interest rate, currency and commodity related exposures. This review is conducted as part of ongoing work in connection with the CRD as well as in response to the recent recommendations of the G7 Financial Stability Forum in the light of recent market events. The most recent announcement concerns large exposures, hybrid capital instruments, supervisory arrangements and network waivers. The work in connection with large exposures, hybrid instruments and technical adjustments follows initiatives taken forward by the Committee of European Banking Supervisors (CEBS). The Commission is also to conduct an impact assessment in connection with the modification of certain provisions.
The Commission has also published a feedback statement on the responses it received to its call for evidence on substitute retail investment products. The Commission was attempting to assess whether material differences in the level of regulatory protection for retail investors arose from differences in transparency and distribution rules on investment products including investment funds, unit-linked life insurance products and structured securities. Opinions differ substantially in connection with whether sectoral differences create investor protection concerns. Industry responses generally considered that adequate protections were already incorporated while investor groups expressed reservations with regard to the adequacy of the protections insured. The Commission will conduct a public hearing on this issue in July 2008 with a formal communication on retail investment products in the autumn of this year.
The Commission has issued an industry report on the EU market for open-ended real estate funds providing access to professionally managed investments in the commercial and various other property sectors. The paper was issued in advance of the Communication to follow on non-harmonised investment funds in Autumn 2008. The report recommends the introduction of EU legislation to allow for cross-border retail distribution of open-ended real estate funds investing primarily in high quality real estate assets including both land and buildings. These are excluded under the current UCITS regime. The opening up of the market through the establishment of common EU-wide rules is therefore recommended.
The Commission has issued a Communication on 'A Common European Approach to Sovereign Wealth Funds' (Com (2008) 115 provisional). This considers the background to the expansion of the Sovereign Wealth Fund (SWF) market since the 1950s. (This Communication is considered further in Martin Day's article on SWFs in Part V of this issue of Financial Services Briefing.)
The Commission has also prepared a separate Communication on 'Europe's financial system: adapting to change' (Com (2008) 122 provisional). This paper highlights issues considered at the Spring European Council following the recent market turmoil and weaknesses identified in the international financial system.
INTERNATIONAL
BIS
The BIS has issued a working paper on 'The financial turmoil of 2000: A preliminary assessment and some policy considerations' (March 2008 - WP No. 251). This considers the background to the recent events in the markets and provides a preliminary interpretation. Relevant policy considerations are examined including accounting, disclosure and risk management as well as prudential architecture and monetary policy.
Capital Adequacy
The BIS has also announced a series of actions to assist making the banking system more resilient to financial shocks. These include strengthening particular aspects of the Basel II capital framework (including the capital treatment of complex structured credit products, liquidity facilities to support asset-backed commercial paper conduits and credit exposures held in the trading book), strengthening global sound practice standards for liquidity risk management and supervision, initiating efforts to strengthen banks' risk management practices and supervisions (including stress testing, off-balance sheet management and valuation practices) and enhancing market discipline through improved disclosure and valuation practices.
FSF
The Financial Stability Forum (FSF) has issued a report for the G7 Finance Ministers and central bank governors which contains a number of recommendations to enhance the resilience of markets and financial institutions. Five specific sets of recommendations are made with regard to strengthening prudential oversight of capital, liquidity and risk management, enhancing transparency and valuation, improving the role and uses of credit ratings, strengthening responsiveness by authorities to risks and adopting stronger arrangements for dealing with stress in the financial system. A number of public and private sector initiatives are already being taken forward which our FSA is to co-ordinate and oversee. This is considered to assist preserve the advantages of integrated global financial markets and level playing fields across countries. (The FSF report follows a request by the G7 in October 2007 to examine the causes and weaknesses that produced the recent turmoil.)
BIS Markets Committee
The Markets Committee of the BIS (formerly the Committee on Gold and Foreign Exchange) has issued an updated paper on 'Monetary policy frameworks and central bank operations' in April 2008 which provides a condensed review of the monetary policy frameworks and market operations of member central banks.
The Joint Forum on Financial Conglomerates
The Joint Forum on Financial Conglomerates (the Joint Forum) has issued a paper on 'Customer suitability in the retail sale of financial products and services' on 30th April 2008. This considers how supervisors and regulated firms across the banking, securities and insurance sectors deal with risks posed by the sale of unsuitable retail financial products.
The Joint Forum has also issued a paper on 'Cross-sectoral review of group-wide identification and management of risk concentrations' on 25th April 2008. This develops work previously conducted by the Joint Forum on risk integration and aggregation and considers the progress made by financial conglomerates in identifying, measuring and managing risk concentrations on a firm-wide basis and across the major risks to which firms are exposed.
Finally, the Joint Forum has also issued a paper on 'Credit risk transfer – Developments from 2005 to 2007' in April 2008, which considers the extent to which its earlier March 2005 paper on credit risk transfer should be updated in light of recent market disruptions. This follows a request by the Financial Stability Forum as part of its work on the recent market turmoil.
IOSCO
The International Organisation of Securities Commissions (IOSCO) has contributed to the papers issued by Joint Forum on Customer Suitability and Risk Concentrations as well as Credit Risk Transfer.
IOSCO also issued a separate paper on 'The role of credit rating agencies in structured finance markets' in March 2008.
The Financial Stability Forum
The Financial Stability Forum (FSF) has issued a report on 'Enhancing Market and Institutional Resilience' on 7th April 2008. This follows the request by the G7 Ministers and Central Bank Governors in October 2007 to examine the causes and weaknesses of the recent market turmoil and to issue recommendations for increasing market and institutional resilience.
ISDA
The International Swaps and Derivatives Association (ISDA) has taken forward a number of initiatives, including commenting on the consultation document issued on UK financial stability and depositor protection issued by the Bank of England, HM Treasury and FSA in January 2008. The response is principally directed at Chapter 4 on wholesale market effects and considers the other comments issued by the Financial Markets Law Committee as well as the City of London Law Society (CLLS), Financial Law Committee and the CLLS's Insolvency Law Committee.
ISDA has also sent a letter to the European Commission proposing the harmonisation of netting arrangements within the EU either by amending the existing Directive on Financial Collateral Arrangements or preparing a new directive based on ISDA's law reform work in both Central and Eastern European countries and across the EU.
The Federal Reserve
The Federal Reserve Bank of New York has taken forward a number of initiatives to improve liquidity within the US financial system.
The Federal Reserve has also opened a Primary Dealer Credit Facility which is an overnight loan facility to provide funding to primary dealers in exchange for specified collateral and is intended to inject funding into the system to support broker dealers especially following the crisis at Bear Stearns.
The Federal Reserve agreed to lend US$29bn to J P Morgan Chase against the portfolio of US$30bn in assets held by Bear Stearns. J P Morgan agreed to provide a separate US$1bn in funding in a note form subordinated to the Federal Reserve providing first loss cover. The loan in note is for 10 years renewable and will be held by a specially formed Delaware limited liability company established for the purpose.
Professor George Walker
Centre for Commercial Studies, London
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