The Mounting Pressure on Compliance and Internal Governance
(The following post was contributed to Corporate Compliance Insights by Mr. Sinan Baskan, the Director of Business Development for Financial Markets at Sybase. Mr. Basan can be contacted through the official Sybase website.)
The Mounting Pressure on Compliance and Internal Governance
Uncertain obligations under certain change
Fifteen years ago, if someone had surveyed the nation’s top management across industry sectors about which sectors are the most regulated, financial services would have ranked right at the top along with utilities and healthcare. A casual look at today’s headlines would convince anyone that the financial markets are more reminiscent of the Wild West rather than a carefully supervised industry in spite of the myriad of federal and state institutions that are set up to provide governance.
While regulatory compliance and internal governance functions have been adapting to meet the deregulated business environment, the long-range challenge is the far more fundamental structural changes that have yet to be clearly defined.
Understandably, the current crisis has drawn attention to the quality of regulatory governance of the markets; the impulse to call for more government action in time of uncertainty is nothing new. Some observers attribute causality to lax regulatory supervision and some to lack of adequate regulation. In fact, since the days of the Glass-Steagall Act we have been moving steadily toward less-regulated financial markets and have been doing so at a faster pace in the last two decades and on a global scale. Though even the most credible arguments for increased regulation are not proposing a return to the regulatory regime of decades ago, the prevailing sentiment, especially from former advocates of deregulation, is that we have gone too far in reducing oversight of markets. Therefore, before blame is placed squarely and easily at the door of regulators and public officials, it behooves the entire community to remember that a series of decisions by industry leaders, legislators, policy makers, academics and media pundits, considerable amount of lobbying and wishful thinking set the stage for what we have experienced in recent years.
Even though free market advocates continue to stress that the markets can be self-governing, most experts dismiss these as theoretical arguments that cannot be substantiated by evidence and that markets, rather than being frictionless, are rife with information asymmetries. Transparency and access to efficient pricing is not available to every participant. They require considerable investment. Larger institutions have a clear interest in opaque, inefficient markets that are unregulated and have high barriers to entry. At any rate, the global economy cannot wait for the intrinsic dynamics to play out over time, it is politically unacceptable.
Hence, the consensus opinion is that we need and will have a new regulatory regime. The U.S. Administration’s efforts on regulatory reform have already been criticized even though the total program has not yet been explained. The criticism centers on any attempt to reduce the fragmentation of the regulatory responsibility. There is one regulatory agency for each of securities, derivatives and mortgage-backed assets and five agencies for banks at the federal level, in addition to the fifty state level agencies and a number of consumer protection organizations. The centralization of regulatory authority does not necessarily lead to improved outcomes; FSA in UK was not effective in picking up signs of trouble early on and avert trouble. However, a more holistic approach is critical to enhancing enforcement quality and visibility to market activity. There is also ambivalence about burdening the Federal Reserve with additional responsibilities, which may lead to conflicts of interest or mixed priorities.
The more fundamental issues on reform center on what the policy objectives are and what should be regulated, how to enforce compliance and who should be accountable. The reforms may address developing a particular market structure (electronic trading, central clearing and settlements for all or only some asset classes, accommodation of private liquidity pools). They may accommodate different models and be focused on compliance with certain rules. Alternatively, regulatory policy may focus on monitoring behavior (a principles based approach similar to Basel II).
Recently, we have witnessed bans on flash orders and naked shorting, clear attempts to eliminate extreme behavior. But these do not constitute a more comprehensive approach. The model would determine the compliance requirements. Regulations based on trading transactions, exchange operations and how information is made available to participants will lead to specific sets of rules for everyone to follow, with officials monitoring at the transactional level. A model that relies on certain principles that ensure liquidity and transparency on the balance sheet and asset liability of financial institutions will lead to a different compliance model. The policy objective may be to guard against systemic risks (the risks that individual firms may assume that may lead to system-wide failure) in which case tracking financial performance of institutions closely with reference to macroeconomic factors will be the overriding concern.
So far, the response from governments qualifies more as triage than a purposeful and deliberate re-design of the regulatory models. The measures are addressing the consequences of disproportionate and misguided risk taking across the entire economy, which typically results in further incentives for risk taking and modification of risky behavior. For instance, risk insurance led to the creation of credit default swaps (CDS), leading to far more extreme risk taking. It has been the hope that changes in regulations reduce systemic risk by either preventing certain behavior or building mechanisms for early alerts. But that does not seem to be happening.
Both sides of the Atlantic have seen a plethora of proposals for tightening regulations and closing loop holes. All of these will have different impacts on how a compliance officer discharges the responsibilities of his or her position.
A cursory assessment of some key considerations gives some sense of the work that remains to be done:
- Policy action to unwind failing institutions through public ownership to some degree will generate additional guidelines and mandates by governments to re-distribute risky assets without an objective market-driven pricing mechanism. The CFO and the compliance officer may still have value and carry these assets on the balance sheet and follow transacting rules that may be too complicated and as of yet unspecified.
- Designating a systemic risk regulator at the federal level with responsibility for aggregate economy-wide risks, and tracking these to the source transactions, will generate different sets of financial reporting at individual firms
- Elimination of securitization for certain instruments such as consumer debt and residential mortgages may actually simplify compliance and governance for firms that have in the past held traded securities and used hedging extensively
- Requirements that the firms engaged in securitization should carry some of these assets on their balance sheets for a time before trading out of them may actually give the compliance officer a vote in the securitization process
- Stricter lending practices and requirements, especially for consumer credit, will help streamline and simplify governance over lending. However accountability for effective enforcement will also increase.
- Tighter requirements for economic capital along with stress testing requirements will shift compliance practices to a more principles-driven paradigm. More quantitative skill sets and macroeconomic analyses will be essential
- Mark-to-Market accounting in some form will still be required and compliance officers will need to develop valuation methodologies when markets are not delivering updated prices continuously.
- The issues raised regarding the credibility of credit ratings agencies are already forcing most institutions to develop internal ratings engines of their own. This is a relatively new area for the CFOs and compliance officers.
The uncertainty regarding the final form regulatory reform may take will continue for a while but compliance enforcement is certain to evolve in several specific directions. First, there will be more reliance on quantitative methodologies to anticipate the impact on the balance sheet of asset pricing fluctuations and transactions. The second evolution is in the assimilation of certain principles that define the limits on traded capital risk into operational procedures, the full implications of which remain to be seen.
**********
About the Author
Sinan Baskan is Director of Business Development for Financial Markets at Sybase and is responsible for developing solutions for lines of business in the Financial Services sector.
He has held various positions in the Product Engineering, Professional Services and Marketing organizations at Sybase.
Tags: Compliance, corporate compliance, corporate governance, internal governance, sinan baskan, sybase
