Alert April 15, 2008

Financial Stability Forum Recommends Capital/Liquidity/Risk/Disclosure Changes to Respond to Market Turmoil

In October 2007, the G-7 Finance Ministers and Central Bank Governors asked the Financial Stability Forum (“FSF”) (which consists of regulatory agencies from the G-7 countries and other prominent regulators) to evaluate the market turmoil and make recommendations for change.  The FSF published its report (the “Report”) in response to this request and recommends coordinated changes affecting banking institutions, securities firms and credit rating agencies (“CRAs”).  The Report also includes an appendix with a detailed list of recommendations for implementation (regulatory and otherwise) and accompanying time frames, and another appendix providing leading practice disclosure for selected disclosures, which a separate article in this Alert discusses in greater detail.

A significant focus of the Report is perceived weaknesses relating to structured products.  The Report first discusses the underlying causes and weaknesses underlying the market turmoil, which include poor underwriting standards for loans; weak control by banks over balance sheet growth and off-balance sheet risks; insufficient investor due diligence, and overreliance on CRA ratings; poor performance by CRAs concerning diligence, rating methodologies, and disclosure about assumptions; incentive distortions, including insufficient incentives for originators, distributors and managers to provide ongoing meaningful disclosures, incentives for banks to securitize assets with low capital charges (i.e., 364-day liquidity facilities, and compensation systems that did not have sufficient focus on longer term risks; and inadequate disclosures and regulatory frameworks.  In response to this turmoil and the perceived weaknesses, the FSF made the following recommendations: 

I.  Strengthen Prudential Oversight of Capital, Liquidity and Risk Management

While making general recommendations in this area, the Report states that it “is especially important to strengthen the prudential framework for securitization and off-balance sheet activities.” 

Capital.  As to capital, the Report provides that the Basel II capital framework needs timely implementation, that the Basel Committee on Banking Supervision (“BCBS”) will issue proposals in 2008 to raise capital requirements for collateralized debt obligations (“CDOs”) and other complex structured products, that the BCBS and the International Organization of Securities Commissions (“IOSCO”) will issue proposals in 2008 to raise capital requirements for exposures located in the trading book to more expressly capture credit risk, and that the BCBS will issue proposals in 2008 to increase the capital requirements for banks’ liquidity facilities to off-balance sheet asset-backed commercial paper conduits (“ABCPs”).  In addition, banking supervisors will assess the correlation between capital levels and cyclicality of markets, and insurance supervisors will consider strengthening the regulatory and capital framework for monoline insurers.

Liquidity.  The Report states that by July 2008 the BCBS will issue for consultation sound practices on liquidity management.  The guidance will cover, among other things, the identification and measurement of the full range of liquidity risks (including contingent risks with off-balance sheet vehicles), stress testing, management of intra-day risks, and the role of disclosure and market discipline.

Risk Management.  The Report also provides that, using Pillar 2 of Basel II, regulators will seek to strengthen banks’ risk management practices.  As to off-balance sheet exposures, supervisors will require that banks develop prudential reports adequately covering risks, capture these risks as part of capital and liquidity management, and use stress testing with respect to exposures.  Supervisors also are expected to issue risk management guidance concerning securitizations.

OTC Derivatives.  The Report also addresses over-the-counter (“OTC”) derivatives exposures.  Among other things, the Report provides that market participants should amend standard documentation to address new cash settlement protocols (which address market disruption); and more generally that financial institutions should develop a longer-term plan for reliable OTC derivatives infrastructure.

II.  Enhancing Transparency and Valuation

Disclosures.  The Report also focuses on how financial institutions should enhance their disclosures under Pillar 3 of Basel II.  In the short term, the Report encourages institutions to make robust disclosure using the leading practices described in a chart in the Report with respect to special purpose entities, CDOs, commercial mortgage-backed securities, leveraged finance, and other subprime and Alt- A exposures. 

Over the longer term, the Report encourages institutions, investors and auditors to collaborate to create relevant disclosure frameworks (with regulators using more prescriptive approaches if voluntary progress does not occur).  Moreover, the BCBS is expected in 2009 to publish guidance to strengthen disclosures around securitization exposures, sponsorship of off-balance sheet vehicles, liquidity commitments to ABCPs, and valuations.  The Report also suggests that international standards be developed for the accounting and disclosure standards for off-balance sheet vehicles.

Valuation.  The Report also discusses valuation methodologies.  In this regard, the International Accounting Standards Board (“IASB”) is expected to strengthen its standards regarding valuations generally, and particularly toward valuing financial instruments in markets that are no longer active.  Financial institutions should establish rigorous valuation processes and disclosures, including using expert judgment of the institution to value illiquid securities and enhancing disclosures about valuation methods.  The BCBS is expected to issue guidance on these practices in 2008.

Securitization Transparency.  The Report also provides that securities market regulators should work with market participants to expand information on securitized products and underlying assets.  In this regard, templates should be created for more standardized disclosures, and originators and issuers should be transparent about underwriting standards and make their own due diligence available.  Securities regulators also should establish a comprehensive system for post-trade transparency of the prices and volumes in secondary markets.

III.  Credit Ratings

The Report also suggests several initiatives to improve the use of credit ratings in structured investments.

Ratings Quality, Disclosures and Conflicts of Interest.  To improve the quality of ratings the Report states that CRAs should improve the rating process and manage conflicts of interest.  To further this effort, by mid-2008 IOSCO is anticipated to revise its Code of Conduct Fundamentals for CRAs to improve the ratings process, better disclose conflicts, and provide better disclosure to investors.  The Report also provides that CRAs should clearly differentiate ratings on structured products from those on bonds (to show different risk properties to investors), and CRAs should expand the initial and ongoing information they provide on structured products to include such items as rating stability, assumptions underlying ratings, and any limitations on ratings due to insufficient data.  CRAs also should enhance their review of incoming data and test the due diligence performed on underlying assets by, among other things, requiring representations from underwriters as to the level of due diligence, establishing an independent function to determine when a credit rating for a new product is necessary, and refraining from providing ratings when insufficient data is available.

Appropriate Use of Ratings.  The Report also suggests that investors address possible over-reliance on ratings, with investor associations perhaps developing standards of due diligence and credit analysis for structured products.  The Report also suggests that authorities re-evaluate the significant roles they have provided ratings in regulations and supervisory rules.

IV.  Regulators and Central Banks

The Report also discusses how regulators themselves should respond to the market turmoil.  Among other things, regulators should focus more on international coordination in developing rules and overseeing global institutions.  They also should enhance the sharing of information during periods of market strain, and develop timetables to implement more important policy initiatives.

Finally, the Report discusses the roles central banks can play in alleviating market crises.  Among other things, they should have the flexibility to inject substantial reserves into the market, to conduct operations with a wide range of collateral (including illiquid instruments), and to develop sources of funding that are less subject to stigma.  Central banks also should develop a coordinated policy to quickly and efficiently deal with weak and failing banks, and to strengthen deposit insurance arrangements.