FRSGlobal Proposes Some Arrangements On The Regulatory Front

Andrew Liegel, risk and regulation specialist at FRSGlobal, reviews the Senate Banking, Housing & Urban Affairs Committee discussions on Modernising the US Financial Regulatory System The US Senate Banking Committee has been hard at work the last few days finalising

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Andrew Liegel, risk and regulation specialist at FRSGlobal, reviews the Senate Banking, Housing & Urban Affairs Committee discussions on Modernising the US Financial Regulatory System:

The US Senate Banking Committee has been hard at work the last few days finalising their analysis on the Modernisation of the US Financial Regulatory System. The Special Panel for the Banking Committee identified eight specific areas where they plan on creating reform and corresponding new rules to govern the increasingly complex financial system.

Two of the rules are “Reform the Credit Rating System” and “Creating a Global Financial Regulatory Floor” – clearly two ambiguous and ambitious goals that will take years of proposals, comment periods and financial reviews – which in all likelihood will last well into the next financial crisis.

Only a few of the proposals discussed in the Senate will have any traction over the next couple of years, for precisely the same reasons that no action was taken to reform in 2006-2007, when many people saw the problems beginning to surface.

Between 2003-2007 we saw excellent profitability and investment returns in the US and across the rest of the world. Not since the 1980s when Federal Reserve Chairman Paul Volcker hiked up interest rates, the unemployment rate and GDP declined, has any US politician even thought about initiating regulatory action that will cause small short-term deceleration in economic activity to prevent a long-term economic disaster (what the US has now entered).

In terms of the short term, the following initiatives are likely to take place on the regulatory front:

– Stronger criticism of individual banking practices by leading figures like Federal Reserve Chairman Ben Bernanke and Treasury Secretary Tim Geithner. Regulators at the Bank of England and FSA are far more likely to alert the public of potential problems in their financial institutions. Expect to see the US start to adopt a tougher and more vocal stance.

A clearing house for data around derivatives which are currently unregulated. The clearinghouse will not regulate which derivatives financial institutions can originate and trade, but they will make contract and counterparty data publicly available to investors so that private parties can run risk models to make better investment decisions.

– A lower level of the ‘watch list’ will be created and made public. Currently, when a troubled bank goes on the FDIC’s watch list, its identity is kept private. Expect regulators to let the public know of some of the problems that a bank is having, even if it means a drop in stock prices and customer activity.

This government disclosure will force private (market) risk regulation from investors and Boards that has been noticeably absent in the last 24 months.

What impact will some of the increased transparency have on the actions taken by financial institutions and their investors?

Many financial institutions will have woeful valuations in the next 18-24 months. Expect some large institutions (and any new investment banks that fill the current void) to go back to or start as private partnerships.

In his book, In an Uncertain World, Robert Rubin described many instances where business activities at Goldman Sachs were curtailed because of risk considerations. Why did he not curtail any similar activities at Citigroup? There were no partners banging on his door questioning how he was using their personal (partnership) capital. For the most part, Citigroup was utilising the capital of anonymous and silent shareholders.

– Investors will be demanding access to the transactional level data from which institutions create their traditional Exposure at Default (EAD) and Loss Given Default (LGD) calculations. Large institutional investors will be spending heavily on risk analytics in the next 6-12 months, as they can no longer trust the numbers released by many financial institutions today.

– Far more emphasis will be placed on analytics that link credit and market risk analytics. These are still siloed in many financial institutions, and until the data feeds and internal reporting are linked, financial institutions will not be able to forecast the risks that caused the credit crisis and recession that we have today.

L.D.

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