Laocoon, the Trojan priest, didn't trust the Greeks and their wooden horse. But before he could warn his fellow Trojans, the hostile gods sent two snakes to throttle him and his sons. The sculptor's treatment of this event seems to epitomize the struggle between the regulators and the regulated in today's financial markets. But who is being strangled and who's doing the strangling?
A score of diverse institutions, operating globally in the major money centres and emerging markets, present supervisors with an increasingly tortuous task. "The concept 'small is beautiful' doesn't exist in the financial services industry," laments Tom de Swaan, executive director at Holland's central bank.
No single lead supervisor can hope to get the full picture - encompassing all subsidiaries and financial affiliates - of one of these sprawling entities which might include banking, fund management, securities and commodities trading, and insurance. Indeed, it might be dangerous to try.
"Over-supervision can disrupt the markets," warns Clifford Smout, head of supervisory policy at the Bank of England. There may be legitimate worries about systemic risk but "you don't want to extend the regulatory net to give the impression that dealing with subsidiaries is as safe as dealing with the [regulated] bank".
The solution lies not in developing perfect insight into what these institutions are doing, nor in tearing up the rule-book and starting again, most practitioners conclude. The answer is less dramatic: more coordination between regulators, better information gathering and sharing, and swifter procedures for dealing with anything that threatens to jolt the financial system.
Baring gifts
The world's banking, securities and insurance supervisors and the authorized exchanges were moving towards this anyway, so they say. But the collapse of Barings in February 1995 and the unmasking of Daiwa Bank's 11-year deception in New York last September gave them a big shove: financial supervisors and the supervised were driven closer together in the common pursuit of standards that might minimize shocks without distorting markets.
At a meeting in May 1995, securities regulators from 16 countries signed the so-called Windsor Declaration, calling for closer cooperation and better information-flow between futures exchanges, and better procedures in cases of insolvency. The Futures Industry Association (FIA) launched a "global task force" in March 1995 which, by June, had produced recommendations on financial integrity for futures and options markets, and their participants. Within a year, some 55 exchanges had signed a cooperation agreement on information-sharing.
In July 1995 the so-called Tripartite Group of bank, securities and insurance regulators published a report on the supervision of financial conglomerates. It recommended setting up a nine-person joint forum representing the Basle Committee on Banking Supervision, the International Organization of Securities Commissions (Iosco), and the International Association of Insurance Supervisors (IAIS). The forum is now up and running.
UK and US financial regulators have also organized joint visits to some of the major global financial firms, primarily to examine management controls - the weak link in the Barings and Daiwa fiascos. They have typically visited firms for three-and-a-half days and "asked intelligent questions about management and reports", says a Goldman Sachs source. The UK Securities & Investments Board (SIB) and US Securities & Exchange Commission (SEC) selected two guinea-pig firms for a thorough study of how such global investment and wholesale banking operations are run. "We've done the first two, and we're on to the next pair," says Tim Shepheard-Walwyn, special adviser to the SIB.
The practitioners too have sought to make their industry more transparent to regulators and end-users - and to each other - by issuing their own guidelines. The G30 report on derivatives practices and principles, produced in July 1993, was the first attempt to fight fire with fire, anticipating a crackdown by regulators. It offered a set of principles for the management of a derivatives trading operation. In March 1995 the Derivatives Policy Group (DPG), drawn from six US securities firms, produced Framework for Voluntary Oversight, a code for better disclosure of their over-the-counter (OTC) derivatives activities which they mostly book in unregulated affiliates. Quarterly reports by these firms give more information on total marked-to-market exposure to derivatives counterparties and their credit ratings, but there is still little on daily market risk profit-and-loss. Such disclosure doesn't make scrutiny by supervisors a redundant exercise. In the UK a "major task of the SFA", says chief executive Richard Farrant, "has been reminding firms that they're not doing what they say they're doing."
Group psychology
The consulting arms of accounting firms have also attempted to fill a gap by developing principles and checklists. In January, Coopers & Lybrand published a checklist of 89 risk principles designed to guard against weaknesses in management controls. "The DPG and the G30 publications were good for advice, but not on control," says Patrick Fell, a principal at Cooper's & Lybrand.
Since Barings, the focus has shifted somewhat from number-crunching exercises and the bugbear of derivatives to a broader view of market and credit risk management, operational risk and control, standards of business conduct, and even the culture of an institution and the character of the people who run it.
Unfortunately, management control is harder to codify than buckets of market risk and counterparty exposures. Measuring how a firm manages itself is as much a job for the company psychologist as for the auditor.
But the numbers cannot be ignored. The supervision and the good internal control of these firms is a complex combination of disciplines: understanding and quantifying market risk, including low-probability but highly damaging price movements, the so-called "fat tails"; factoring in credit exposures and their sensitivity to the above market risk; mastering information-flow, systems, command structure, independent oversight and risk control; and monitoring the culture fostered by the people at the top. Just as an exceptional gymnast performing a triple somersault knows at every instant exactly what his position is, relative to the earth and the flying trapeze, so a complex financial institution needs up-to-the-minute - and, if possible, real-time - information, to assure its performance and to avoid a crash. Supervisors shouldn't aspire to handling so much information. That would be equivalent to getting onto the trapeze themselves. Nor should they micro-manage their charges. Moreover, there are obstacles to a single supervisor attempting to gather solo all the relevant information about a global firm.
It is expedient for supervisors to rely on outside agents and their supervisors to gather much of the information. But they can't rely on them to do their job as policemen. Auditors may not see the wood for the trees; rating agencies don't have access to some sensitive information; nor do auditors or rating agencies review firms frequently enough; and internal risk controllers, theoretically independent, are paid employees of the firm and might have difficulty blowing the whistle. As one UK compliance officer told Euromoney: "I'm paid by my firm to help it develop its business successfully and effectively within a regulatory framework. If senior management overrules me I have a choice: either I can whistle-blow or move somewhere else."
Some experts would like to see market forces applied to the regulation of major financial institutions. Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, suggests severely reducing the regulation and oversight of large, globally-active institutions, to save costs and reduce moral hazard (the assumption that because they're regulated, the regulator won't allow them to fail). New Zealand has already lifted supervision from its banks, relying on quarterly disclosure, comment from rating agencies and the press, and placing greater responsibility with bank directors. New Zealand is not a great pilot project for other jurisdictions, since all but one New Zealand bank has a foreign-regulated parent. But the experiment may show how disclosure and making directors de facto supervisors can shift the supervisory burden closer to the market.
Risk management ratings
These concepts don't cut much ice in the US or the UK. But some risk controllers like the idea of supervisors rating firms publicly for their management controls. In the US, the Office of the Comptroller of the Currency (OCC) and the New York Federal Reserve have gone some way towards this by ranking banks on the basis of "supervision by risk". Central banking expert Bert Ely has suggested that instead of a regulatory umbrella, banks should form syndicates which sell individual members a cross-guarantee. The premium for this guarantee, paid by each bank, varies according to its relative capital strength and risk control. Supervisors, however, have a role that would be difficult to replace, as a check on monopolistic tendencies. They are also best-placed to warn on distortions in the sector, such as over-zealous property lending or a skewing of the bonus system in favour of employees. Whether their warnings are heeded is another matter.
Financial institutions are not good at acknowledging their mistakes. Disclosing bad loan provisions or outstanding litigation is one thing. Revealing quarterly how accurate their value-at-risk (VAR) calculations have been would jar with most institutions. Yet that is the basis of a proposal last year by two New York Fed researchers: that financial institutions should themselves decide what capital to hold against their risk positions, quarter by quarter. If losses during that quarter exceed the pre-committed capital then the firm is penalized by having to disclose the fact publicly and, possibly, by suffering a financial penalty. JP Morgan, Chase/Chemical and Bankers Trust helped with the research and appear to support the idea. So does Michael Moskow, president of the Federal Reserve Bank of Chicago, who endorsed it in a speech on June 6. Moskow and others are attracted by the idea of market forces providing the discipline for market participants. But the pre-commitment approach has its critics. Robert Gumerlock, managing director for risk control at Swiss Bank Corporation, fears the encouragement to commit just enough capital to avoid penalties would lead to brinkmanship and possibly increased systemic risk. "Pre-commitment aims to construct a scheme of speed limits and fines for speeding," he wrote recently, "while the [Basle] committee [proposal for a minimum of three times a bank's own VAR calculation] seeks to guarantee that vehicles are roadworthy at all speeds."
There is a danger of risk management theories, techniques and numbers getting too specific. Mark Brickell, managing director at JP Morgan, and former chairman of the International Swaps & Derivatives Association (Isda), argues for regulatory diversity which allows "each regulator to specialize in a particular part of the market, instead of forcing one agency to attempt to cover all". The towering authority of one monolithic [US] regulator "could translate into less certainty in markets", Brickell says. Instead, he favours the existing diversity and market discipline - "a uniform force for good behaviour, which works through the competitive process and the value of reputation". But regulators, who are paid to be cynical, might not agree with Brickell's Panglossian view of markets and market participants.
Perhaps the ideal micro-model for audit and supervision of complex financial activity is the triple-A derivative products company (DPC) as set up by a dozen or so banks and investment banks (see Euromoney, June 1996, page 120). These creations are subjected to frequent and intensive scrutiny by auditors and rating agencies, whose reputation is on the line if the DPC ever failed to perform in extreme conditions. However, the cost of the surveillance is considerable, and DPCs are only simple structures with a limited range of products and limited exposure to market and operational risks.
Financial supervisors are faced with a diversity of complex institutions. None of the top 20 institutions is constructed alike or has exactly the same range of businesses. The global name SBC Warburg "is just a logo", complains one supervisor. ING is an unregulated holding company which owns a banking group and an insurance group. Although the Dutch central bank says it has a satisfactory dialogue with the holding company, it has limited legal rights there. The boundaries of a group may become increasingly blurred as more services, such as information processing, payments and settlement are outsourced. "Instead of processing transactions, you have to manage the interface," says Stephen Kingsley partner at Arthur Andersen. "The regulatory responsibility stays with the institution."
The regulator's ultimate sanction, if it finds the structure of a group not sufficiently transparent, is to withhold authorization from the regulated affiliate. This is a very blunt instrument: supervisors establishing a recognized rating system might be part of the answer.
But with a diverse group, deciding which of its many regulators should be the lead supervisor and should take responsibility for overseeing the group is an increasingly difficult problem.
The European Union's investment services directive (ISD), which officially took effect from January 1, has brought matters to a head. Although the ISD was drawn up in 1993 and there were nearly three years to work out its implications, some fundamental details are still unsettled. Euro-lawyers are still wrangling about where a cross-border deal is deemed to have taken place. Is it where the customer is, where the dealer is or where an exchange-traded transaction has occurred? For example, if the Italian branch of a British securities firm uses a remote terminal to trade a German Bund future for a customer in Paris, where did the transaction take place, which supervisor has oversight of the trader's conduct and which supervisor monitors the integrity of the deal? Does an exchange have supervisory powers over a dealer in another jurisdiction? Such questions were still being raised between EU regulators last month. "Oversight and enforcement tend to be territorial," opines a UK regulator. But the wrangling is likely to continue for months if not years.
Perhaps the Europeans will reach sensible solutions. But if harmonizing local rules on a European scale is a headache, attempting it on a global scale, including less developed markets, would be a nightmare. It is one that may be forced on regulators by the spread of Internet dealing, which arguably has no geographical location. Germany is already attempting to restrict money transfers on the Internet to licensed banks.
Cooperation between regulators is simply a matter of more coordination and communication, says de Swaan, of de Nederlandsche Bank, who is chairman of the joint forum on international regulation. "If, in the process of mapping that out, you discuss how you can fill in gaps and cut out overlaps, so much the better," he says. All participants now "recognize the need for coordination and sharing information, but the big issue is how do you translate it into practical terms". The Basle committee has been able to wield influence because it is 20 years old and has only 11 members - the G10 countries plus Switzerland. Iosco and the IAIS are younger groups with wider membership and have more trouble reaching a consensus. Recently, Iosco's technical committee, comprising only 16 major countries, has done better in this respect. Last year's Tripartite Group report concluded that coordination must be formalized to work better. Since then, global supervisory coordination has proceeded by memorandum of understanding (MOU).
The most important aspect is to develop crisis management procedures. The quicker and better the cooperation between supervisors, the less likely it is that a problem will disrupt the markets.
But de Swaan warns: "You can't make a scenario [beforehand] on whether you'd intervene or wind up." Each situation is different and to have a lifeboat on standby increases the moral hazard and the temptation to launch it.
When the Ariane 5 space rocket veered off course last month, with its $500 million payload in jeopardy, the mission controllers blew it up before it could do more damage on the ground. It was a costly decision but it was taken promptly. In the financial markets the decision to intervene is seldom as clear-cut. But hesitation by risk controllers or regulators faced with a nasty choice is often expensive. BCCI was allowed to operate long after the first suspicions of nefarious dealing were raised. Barings' risk controllers dithered when faced with some puzzling unreconciled trades. Daiwa Bank's top management, and then the Bank of Japan, tried to tidy up their problem internally, inviting US regulatory wrath and heavier penalties. Losses taken early, as every trader will tell you, can forestall a lot of subsequent grief. But these decisions need to be taken with the help of good information. The agony of the global regulator continues.
Landmarks on the route to global regulation:
* Derivatives: practices and principles, G30 global derivatives study group, July 1993
* Financial derivatives, actions needed to protect the financial system, US General Accounting Office, May 1994
* Risk management guidelines for derivatives, Basle committee, July 1994
* Operation and financial risk management control mechanisms for otc derivative activities of regulated securities firms, Iosco technical committee, July 1994
* A preliminary framework for public disclosure of derivatives activities and related credit exposures, Institute of International Finance, August 1994
* Discussion paper on public disclosure of market and credit risks by financial intermediaries (Fisher report - Euro-currency committee of the G10 central banks), September 1994
* Futures Industry Association sets up global task force on financial integrity, March 1995
* Framework for voluntary oversight - Derivative Policy Group (CS First Boston, Goldman Sachs, Morgan Stanley, Merrill Lynch, Salomon Brothers, Lehman Brothers), March 1995
* An internal model-based approach to market risk capital requirements - use your own models, Basle committee on banking supervision, April 1995
* Framework for supervisory information about derivatives activities of banks and securities firms, Iosco technical committee and Basle Committee, May 1995
* Windsor declaration - a resolution by 16 countries to strengthen supervision of futures exchanges, May 17 1995
* Financial integrity recommendations - Futures Industry Association, global task force, June 1995
* The supervision of financial conglomerates - a report by the tripartite group of bank, securities and insurance regulators, July 1995
* Report on the board of banking supervision inquiry into the circumstances of the collapse of Barings, July 1995
* Bringing market-driven regulation to European banking - a proposal for 100% cross-guarantees, Bert Ely, July 1995
* SEC/SIB joint initiative to improve oversight of global securities firms, July 17 1995
* A pre-commitment approach to capital requirements for market risk, Paul Kupiec and James O'Brien, senior economists, US Federal Reserve, July 1995
* Singapore minister of finance report on the collapse of Barings, September 1995
* Public disclosure of the trading activities of banks and securities firms, Iosco technical committee, Basle committee, November 1995
* The Investment Services Directive - who should be the principal regulator of cross-border services? Charles Abrams, SJ Berwin, December 1995
* Twin peaks: a regulatory structure for the new century, Michael Taylor, Centre for the Study of Financial Innovation, December 1995
* Managing derivatives risk - guidelines for end-users of derivatives, the Futures & Options Association, December 1995
* Supervisory framework for the use of "back-testing" in conjunction with the internal models approach to market risk capital requirements - a proposed add-on to VAR times three, Basle committee on banking supervision, January 1996
* Generally accepted risk principles - a checklist of 89 risk management principles, Coopers & Lybrand, January 1996
* Declaration on cooperation and supervision of international futures markets and clearing organizations, agreement by 49 futures exchanges and clearing houses, March 15 1996
* The regulation of derivatives - a plea for pre-commitment capital, Michael Moskow, president, Federal Reserve Bank of Chicago, June 6 1996
* Lacking commitment - a critique of the pre-commitment approach to market risk, Robert Gumerlock, SBC Warburg, June 1996
Regulation writ Large Andrew Large, chairman of the uk's Securities & Investments Board, explains his approach to regulating diverse financial groups.
What's your biggest problem?
We have a mismatch. We have an international capital market which we all value. It's been a benign factor in the last 20 or 30 years, and its continuance depends on confidence in it and its processes and the players within it. But who plays referee? The answer is: a number of bodies regulate different parts of the market, but there's no one regulator in particular. We're all seeking the most satisfactory way to underpin the international capital market without tying it up in red tape. Big financial services groups operate across sectors and across frontiers. The regulators on the whole are national, and often sectoral.
Do you have a solution?
The regulator can't very easily lay down a blueprint. There's an interplay between the supervisor of global conglomerates and the supervised, and they're mutually reliant. The supervisor will never have the same understanding of all the risk control models, so it has to be a collaborative endeavour. But what happens if the supervisor comes to the view that the party being supervised isn't doing it right? How do you move from 'we're all in this together'-mode to 'sorry I'm putting my policeman's hat on'. It's not easy, particularly if the same people are adopting both roles. We've got to develop and understand the human aspects of how and at what juncture the supervisor can take off the hat that says we're working together to get an understanding, and, on the basis of that understanding say "We're now going to require you to do x". On the other hand, if you have different people handling the collegiate and the policeman's role, how many regulators do you need? As supervisors we can't do it on our own; we need to work with the industry, and that does happen.
Are you working without a blueprint in mind?
Do we build up a great academic model? I say no, because you've got to be thoroughly practical. For example, right now we're working with our colleagues in the States looking at the activities of a number of significant groups and asking them to show us how their control procedures work. We're learning a lot. It becomes a step by step, practical process, which we hope other countries will find useful too.
It's very cosy though isn't it, if you're cynical. These global investment banks are driving the regulatory process: you're fitting in with what they're doing and saying 'you show us'.
No, that is far from being the whole truth. Being mutually reliant is not the same as being cosy. You have to remember the speed with which the world is moving, the sheer capabilities of information technology advances and the technical advances in financial instruments and risk management. If you then say the regulator ought to be ahead of all this and have resources and people there, and then lay down a blueprint, I don't think it's realistic.
Should markets set their own pace of development?
You could say it's better to slow things down and put a bit of red tape into it because then the system will be safer. Others would say that it's not the regulator's job to stop anything going wrong because then you would reduce the incentive for responsible behaviour. You might possibly even hasten some of the accidents you're seeking to avoid. If your philosophy was a dirigiste one, slowing down the international capital market, or indeed stopping it, might be the price you would have to pay. I don't take that view. I think we can find a middle way between total freedom and over-regulation.
You could say that Glass-Steagall slowed down what was happening in the States, and that the freer capital markets have been exported to London and to the ether. They've exported their problem, and now we're having to cope with it.
Hang on, that's a bit far-fetched. You're suggesting the international capital market is a problem without a solution. I disagree. It's been an extremely valuable source of capital and lubricant to the world economic process.
Let's call it a challenge, rather than a problem.
It is a challenge. I acknowledge that having such a market poses a number of questions and dangers. I'm not saying we should avoid them altogether. We ought to try to facilitate the future of the overall marketplace. This means mitigating systemic risk. The most important element here is for firms to have effective controls in place and to operate in a prudent manner. But it goes beyond investment firms and groups. We've also got to look at the supervision of markets, at issues such as transparency, at the clearing and settlement arrangements, the legal infrastructure, and ensure, mostly through better transparency, that warning signals appear more quickly and that information is transferred from one party to another before something goes wrong. If you take the Barings case. Okay, so the exchanges in the Far East were aware of the positions that existed and the question that everyone's been asking is "How is it that the information was not made available to the lead regulator?" Now regulators have very elaborate and good ways of passing information from one to another but it's often on a reactive basis. The challenge is that you want to make sure that, when something is important is happening, you get to know it. So we've got to speed up the move from a reactive to a proactive volunteering of information. That's a bit of a cultural change, which events like Barings have encouraged. It's why last March over 50 exchanges and regulatory bodies signed a memorandum of understanding at Boca Raton, so that information about a firm's large exposure on one market would automatically be shared with the right supervisor and lead regulator.
Do you think it would be possible to have global monitoring of positions?
No. And I'm not suggesting it. If you have global monitoring then you're saying we need a sort of global surveillance machinery; but real life's not like that. And even if the political will and financial resources were there, it might not work organizationally. So we have to do the best we can as a proxy for that, but it needn't be flabby at all. If there's a better understanding of what sorts of information in possession of an exchange could be important to a lead regulator, and the exchange felt an obligation to transmit that information to a party that had power to do something with it, that's not global surveillance but it's a great deal better than the situation you have up to now, domestic and sectoral. It isn't going to cost much, just the cost of a phone call, and the time it takes to get people to think about who needs to know what. One doesn't need big bureaucracies and superstructures.
Hasn't that happened already?
It's an evolutionary process. It's in place, but the proof of the pudding is in the eating.
Does it concern you that an unregulated entity, such as Sumitomo, can cause such disruption?
Yes it concerns me, because this is one case and there have been others where end-users have been involved. But I don't necessarily conclude that therefore end-users should be regulated. One's got to rely on the market to ensure that the users of markets are themselves people who have satisfactory controls. We have responsibilities for, and feel able to exercise some influence and control over, the fitness and properness of firms that are authorized to do investment business. But if you said you've got to put controls on people who use investment business I would say you really are going down a slippery slope.
Is the SEC in a better position, regulating listed corporations?
If you look at the history of regulation in the US, it was always based on markets and exchanges and manipulation of markets. Our regulatory system has been going less than 10 years. The initial emphasis was very much on conduct of business. Integrity of markets is a pretty serious matter. We're definitely going to have to find a way forward here, so that market integrity is taken seriously but in a way which enables markets to operate.
End-user nightmare Sumitomo Corporation's copper adventures have shown once again that the stability of financial markets is at the mercy of big, unregulated players. Metallgesellschaft, which came unstuck in oil futures at the end of 1993, was an earlier example.
There are many points on the interface between markets - particularly derivatives markets - and end-users, where lack of transparency or ignorance can cause big losses, misunderstanding and disruption.
A bank or broker dealing with a fund manager often doesn't know whether its true exposure is with the fund manager or with one of the fund manager's clients. Unless accounts are segregated and referred to individually, the dealer cannot build up a detailed picture of his value-at-risk. "Blind counterparties are an issue that concerns us," says Douglas Harris, until recently senior deputy comptroller at the US Office of the Comptroller of the Currency (OCC).
End-users of futures contracts are frequently exposed unwittingly to an additional risk - exposure to a third-party broker through which their own broker has dealt as agent. The end-user may think that because it owns a position on an exchange it has only the credit risk of the exchange. But if the third-party broker defaults, clearing members of the exchange don't guarantee the trades of a defaulting member's customers. If the end-user's broker hasn't taken collateral to cover the position then the end-user faces a loss. "There's an unspoken conspiracy to keep end-users in the dark about this," warned Verne Sedlacek, CFO of Harvard Management, at a futures industry conference last month. "Customer ignorance is a risk to the system." Andrea Corcoran, division director at the US Commodity Futures Trading Commission (CFTC), says it is unlikely that a reputable broker acting as agent would fail make good the client's loss if it had put a trade through a third-party broker which had defaulted. But that would be a business decision not a legal requirement. A UK lawyer says that a UK broker is obliged to warn a client if it is putting funds with, say, a Tokyo broker in a non-segregated account. The UK Securities & Futures Authority (SFA) has imposed new requirements on firms if their clients object to them passing their money to a third-party broker in an overseas jurisdiction: firms must either pass their own money - instead of the client's money - to the third-party broker or return the money to the client. |