FT.com / Special Reports - Long road to regulation: Not since the Great Depression of the 1930s has there been so much ferment about regulation. With belief in a self-correcting market shattered by the financial collapse, taxpayers and politicians are angry about the enormous cost of propping up the banking system. Regulators, meanwhile, are under fire for allowing such a catastrophe to occur on their watch.
At global gatherings such as the recent Group of 20 summit in Pittsburgh, world leaders have promised to work towards a harmonisation of global rules to keep banks in line, and regulators have promised to be tougher on the industries they oversee. Proposals for regulatory restructuring and robust guidelines for everyone from banks and hedge funds to credit rating agencies are being floated in Washington, London and Brussels.
But with the immediate economic crisis easing amid a return of confidence in the financial system, cracks are beginning to emerge – and the financial services industry is fighting back.
European Union proposals to regulate hedge funds and US plans for a consumer finance agency have each run into strong opposition. And in spite of pledges to act together, it is clear that on important issues such as remuneration, many countries are taking their own approach.
Most agree that tighter rules on bank capital and liquidity are necessary, and the majority of countries would like a better system in place in case of another cross-border bank collapse. There is also widespread agreement that regulators need to act to prevent systemic risk.
It is hedge funds, perhaps more than any other part of the financial services sector, that are likely to see the biggest change in the way they are regulated.
Though most agree that the role played by hedge funds in the financial crisis was secondary at most, the troubles have created an opening for those who have long wanted to know more about a sector often regarded as secretive. The revelation that several hedge funds and funds of funds lost investor money in the Ponzi scheme run by disgraced financier Bernard Madoff has also spurred government interest.
Regulators and lawmakers around the globe are now seeking to collect more information on what hedge funds are doing, and in some cases are demanding that they do more to protect investors.
The proposed European Union Alternative Investment Fund Manager directive has drawn the most attention because it has the most detailed requirements. As drafted, it permits regulators to set limits on leverage, and mandates the use of onshore custodians. It also proposes such tight requirements for non-EU funds that many of them would effectively be excluded from the 27-nation bloc. However, a tough fight is expected before the directive can become law, with the UK, for one, promising to seek amendments to a proposal that would have a significant impact on the City of London. Backers of the draft say they want even tougher rules, and perhaps limits on fees. “This is a relatively mild directive,” says Poul Nyrup Rasmussen, the Danish socialist who helped lead the European Parliament’s efforts to regulate hedge funds. “It is not a question of whether we are going to have regulation or not. It is how we regulate best.”
Meanwhile, the US is working on legislation that would force hedge funds to register with the Securities and Exchange Commission. The industry sued to stop a similar effort in 2005, but is unlikely to prevent Congress from taking action this time around. In Asia, Singapore is looking at beefing up its regime for so-called “exempt funds” for fear it could become a haven for funds seeking regulatory arbitrage.
But hammering out the details takes time. The Pittsburgh summit produced relatively little on the regulation front, other than pledges to implement promises that had already been made.
The Basel Committee, which sets international banking standards, is busy working out the details of new tougher bank capital rules, although it is not clear when exactly institutions will be required to meet them. Similarly, widely expected rules on leverage ratios and liquidity have not yet been announced.
So far, most countries are avoiding a regulatory race to the bottom – if anything, they are going the other way. The UK, for example, is pressing ahead with its own liquidity rules, while the Netherlands has pushed through curbs on bankers’ bonuses. Even Singapore, which has long been favoured by financiers for its “light-touch” regulatory regime, considering tightening up its rules.
“Policymakers recognise the need for convergence to avoid encouraging regulatory arbitrage and a ‘lowest common denominator’ approach,” says Barbara Ridpath, chief executive of the International Centre for Financial Regulation, the think-tank. However, she notes that reaching international agreement is likely to be difficult. “Political constituencies are domestic and tend to dislike the imposition of solutions perceived to be invented elsewhere. So the most likely resolution is a long, slow process toward convergence with many domestic missteps and hazards along the way,” she cautions.
Marcus Sephton of KPMG agrees. “We are all working in our own national jurisdictions with national rules and regulations and national regulatory and supervisory operating procedures. Is that going to change in the next five years? I do not think so.”
And while proposals for regulatory restructuring are in the pipeline in the US, EU and UK, each is likely to meet rather different fates.
President Barack Obama’s proposals to give the US Federal Reserve more power to act as a systemic regulator has run into trouble with some in Congress who distrust the Fed, while his proposed consumer finance agency is coming under heavy fire from the industry. The barriers to reorganisation are, furthermore, enormous. Much of Obama’s political energy is focused elsewhere and members of his own Democratic party are also pushing rival plans – not to mention the fact that the US has a longstanding history of rejecting major change.
“It is not like this hasn’t happened before,” says Carol Beaumier, a former banking regulator, now at the Protiviti consultancy. “Our pattern after a crisis is to add rules. We also add agencies. But we do not engage in fundamental reform.”
The EU plans for creating three pan-European regulators to oversee banking, insurance and the securities industry have so far proved less controversial, in part because national regulators will retain day-to-day responsibility and governments can refuse to do anything that would negatively impact their finances.
The proposals for regulatory overhauls, however, have done little to resolve the problem of those institutions that are seen as “too big to fail”. Germany has been pushing for a resolution regime and the UK is demanding banks produce so-called “living wills” that would make it easier to break them up in the event of a collapse. But there appears to be little consensus beyond having a “college” of national regulators to share responsibility for the supervision of multinational banks, and that would do little to prevent the cross-border squabbling over assets that occurred when Lehman Brothers and the Icelandic banks collapsed last year.
“The core problem with a college of regulators [approach] is that it is composed of national regulators whose core mission is protecting consumers in their jurisdiction,” says Simon Gleeson, a partner at law firm Clifford Chance. “We need legislation that allows them to act collegially when things are going badly.”
The lack of clarity on new structures has not stopped existing regulators from flexing their muscles. Roundly criticised for their failure to prevent the financial crisis, regulators have become more proactive and intrusive. In the case of the Securities and Exchange Commission, this has meant bringing more enforcement cases and new rules on everything from short-selling to giving investors more ability to nominate directors. The SEC is also working to harmonise rules with the Commodity Futures Trading Commission to prevent traders from exploiting any grey areas between jurisdictions.
In the UK, the Financial Services Authority is forging ahead with new rules on liquidity and pay, in spite of complaints from London’s financial community that this will make it harder to compete with other, slower-moving, jurisdictions. “The UK is never going to stop ‘gold plating’ and they argue that this is because they are the top financial services centre,” says Selina Sagayam, a partner at Gibson, Dunn & Crutcher. “If you want to come here [to the UK], you have to have higher standards,” she says.
The FSA is also talking about regulating – or banning – specific products, such as mortgages for more than the underlying value of a property, in what would be a departure for its old “principles-based” regulation approach.
Something similar may happen in the US, where the Obama administration is talking about requiring financial services providers to make a standard “plain vanilla” option available to most consumers. “We are going to see a lot more regulation of products where they will say ‘no, you cannot do that’,” says Peter Bevan, a partner at law firm Linklaters.
Regulators around the world are also becoming more active in other ways. Many of the proposed reforms, including the creation of systemic risk regulators, are “aimed at preventing problems, and so there will be more attempts at intervention before problems arise”, says Peter Green, a partner at Morrison & Foerster.
This new, tougher attitude is starting to have an effect. Risk and compliance departments have been beefed up at many banks, while large financial institutions in the UK, Switzerland and France have pledged to defer bonuses and link them to long-term performance.
“Even if an individual wants to get carried away, he will not be able to because new limits will be in place,” according to Andrew White, global head of risk management at Thomson Reuters, the information group. In addition, many banks are reconsidering the role of their proprietary trading and structured products operations in anticipation of an expected increase in capital requirements. “Although there will be lip-service paid to maintaining financial innovation, there will be pressure on firms to keep to simpler products,” says Michael McKee, a partner at DLA Piper.
One place where the constraints could be felt early is in the derivatives world. Regulators and lawmakers are pushing for more over-the-counter derivatives to be standardised and sold on exchanges. This is likely to increase competition and cut costs for ordinary products, but will also make the area less profitable. In turn, that could make it harder for companies to find providers for more customised products.
Structured product deals have also been affected, because many participants are unwilling to enter into long-term deals before they know how exactly the market will be regulated.
Industry participants say the recent deal by Barclays to de-risk its balance sheet by selling $12bn worth of assets to a new company headed by a group of former executives of Barclays Capital, its investment banking division, could be a harbinger of spin-outs to come.
Some banks may also look to slim down their proprietary trading desks to avoid the expected rises in capital requirements, which some fear could send traders into the arm of less well-regulated private entities. “One of the consequences of more regulation will be that many activities will become less regulated because they will move beyond the perimeter,” says Benedict James, a partner at Linklaters.
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