Better Late Than Never? FSB Reports Regulatory Reform Is Advancing, But Slowly

Co-authored by Heath Tarbert and Sylvia Mayer
On June 19, 2012, the Financial Stability Board (“ FSB ”) issued a progress report to the G20 Leaders on the steps FSB member nations have taken to implement financial reforms designed to improve the stability of the global financial system.  The FSB reviewed, among other things, its members’ Basel implementation, adoption of resolution-planning regimes, oversight of the so-called “shadow banking system,” reform of the OTC derivatives market, and the effectiveness of the FSB itself.  The FSB concluded that its member nations have made significant progress in implementing globally agreed financial reforms, but large strides are still necessary—particularly regarding recovery and resolution planning—to protect the global economy against future financial crises.
What is the FSB?
The FSB is an informal body of financial regulatory authorities from the G20 nations and the former members of the Financial Stability Forum.  It was established in 2009—in the wake of the 2008 financial crisis—with the intent of improving global financial stability by coordinating the way in which the world’s major economies implement their own financial reforms.  At present, the FSB is not an independent legal entity but acts under the auspices of the Bank for International Settlements (“ BIS ”), an international organization that assists central banks in promoting financial stability and serves as an international central bank itself.  The FSB has no enforcement authority; it derives its legitimacy from the cooperative participation of its member nations.  As described below, however, the FSB’s institutional power may be growing: the G20 Leaders recently granted the FSB authority to organize itself as an independent legal entity.
Summary of the Progress Report
The FSB’s report assesses its members’ progress in implementing measures intended to improve the stability of the global financial system.  Those reforms, together with the FSB’s review of their progress, are described below:
1. Basel implementation and risk management .  All 27 member nations of the Basel Committee on Banking Supervision (“ BCBS ”) are implementing the Basel II/II.5/III frameworks, but the process—most notably for the U.S.—is taking longer than expected.  The U.S. is the largest economy that has not yet implemented Basel II or II.5 (in part because they have been criticized by some U.S. regulators and policymakers).  Though the U.S. has published draft Basel III rules, preliminary BCBS peer review suggests those rules—as well as the rules published by the E.U. and Japan—may have less force than the BCBS had intended.  The BCBS expects to publish updated findings on member nations’ Basel compliance in November 2012.
For systemically important financial institutions (“ SIFIs ”), some of Basel III’s most dramatic aspects include increased capital and liquidity requirements.  As the FSB notes, the BCBS found that (i) most global SIFIs likely will be able to comply with the capital requirements “through earnings retention and reduced distributions over the [six-year] transition period” but that most global SIFIs need to improve their liquidity profiles by extending the terms of their funding or restructuring certain business models.
Finally, the FSB highlighted its efforts aimed at promoting better risk-management practices through stronger regulation and enhanced disclosure requirements.  The FSB is currently reviewing G20 nations’ regulatory requirements for risk-management practices.  It has also assisted in forming the Enhanced Disclosure Task Force, a body whose mission is to report to the FSB on principles and best practices for risk disclosure, with a view to increasing market discipline of financial institutions.
2.  Recovery and resolution planning .  FSB member nations have been implementing resolution-planning regimes and other measures to increase SIFIs’ ability to be resolved in a crisis without government support and with limited disruption to the financial system.  These measures are guided at a high level by the FSB’s 2011 publication Key Attributes of Effective Resolution Regimes for Financial Institutions (“ Key Attributes ”) and, in the U.S., have been implemented by the FRB and FDIC’s joint regulations under the Dodd-Frank Act.  The FSB has recommended that its member nations prioritize SIFIs’ development of recovery and resolution plans (colloquially known in the U.S. as “Living Wills”), which the FSB views as a critical and, at present, delayed component of global financial reform.
The FSB did, however, identify certain examples of progress in resolution planning.  It specifically named the U.S.’s regime under Dodd-Frank as an example of progress in implementing the Key Attributes.  (The FSB did not specifically mention the U.K.’s regime, though the Financial Services Authority’s resolution-planning requirements have much in common with those under Dodd-Frank.)  It also noted that the E.U.’s eventual adoption of recently proposed resolution-planning legislation would be an important step toward consistent implementation of reforms throughout the E.U.
In addition, the FSB recommends implementing several other components of the Key Attributes, all of which are dependent on the preparation of effective resolution plans by SIFIs.  These include the following:

      • Establishment of an appropriate crisis management group (“ CMG ”) for each global SIFI, including prudential supervisors, central banks, and other resolution-planning authorities;
      • Implementation of resolvability assessments to test SIFIs’ resolution plans;
      • Implementation of institution-specific cooperation agreements to facilitate cooperation among the home- and host-country authorities in that SIFI’s CMG; and
      • Cross-border cooperation protocols among the members of each SIFI’s CMG and host-country authorities that are not members of the CMG.

As all four of these measures depend in part on SIFIs having already adopted effective resolution and recovery plans, the FSB views the adoption of such plans as the most serious delay in improving global financial stability.  It expects each SIFI’s home-country regulators and resolution authorities to lead the development of high-level resolution planning for that SIFI by September 2012.  In addition, the FSB and BCBS are currently working to develop heightened standards for domestic regulators to follow in supervising SIFIs.  They are also working to extend the resolution-planning framework to each G20 nation’s domestic SIFIs, systemically important insurers, and nonbank SIFIs.
3.   Oversight of the “shadow banking system .”  The FSB is working to develop ways in which its members can improve oversight of the “shadow banking system,” the sector of the global financial industry that is not currently subject to heightened prudential regulation.  The FSB’s definition of “shadow banking” is quite broad: “credit intermediation involving entities and activities outside the regular banking system.”  Several specific workstreams are now studying the potential risk the “shadow banking system” poses to the stability of the global financial system:

      • In July 2012, the BCBS will propose the regulation of banks’ interactions with the “shadow banking system”;
      • In Fall 2012, the International Organization of Securities Commissions (“ IOSCO ”) will publish policy recommendations to make money market funds less prone to runs;
      • In September 2012, the FSB will publish policy recommendations on mitigating the systemic risk of “shadow banking” entities’ failure, including a list of entities that it believes warrant heightened regulation and an analysis of factors that may increase systemic risk;
      • In late 2012, the IOSCO and the BCBS will publish a report on decreasing the systemic risk of securitization practices, including an analysis of retention requirements and measures to increase transparency and standardization; and
      • By the end of 2012, the FSB will publish a report on the implications of the securities lending and repo markets on financial stability, including the following issues:

(i) lack of transparency, (ii) pro-cyclicality of system leverage and interconnectedness through valuation, haircuts and collateral re-use, (iii) other issues associated with re-use of collaterals, (iv) potential risks arising from fire-sale of collateral assets, (v) potential risks arising from securities lending activities, (vi) shadow banking through cash collateral reinvestment, and (vii) insufficient rigour in collateral management and valuation.

The FSB cites as recent progress (i) the U.S. Financial Stability Oversight Council’s (“ FSOC’s ”) authority to designate nonbank SIFIs for prudential supervision, (ii) the U.S. Securities and Exchange Commission’s (“ SEC’s ”) recent imposition of liquidity, maturity, and credit quality requirements for money market funds, and (iii) the European Commission’s publication of its March 19, 2012 Green Paper on Shadow Banking.
4.   Reform of the OTC derivatives market .  The FSB’s review of OTC derivatives reform is based on the G20 nations’ 2009 commitment to implement three major reforms by the end of 2012:

(i)                 Trading all standardized OTC derivatives electronically or through exchanges and clearing them through central clearing parties (“ CCPs ”);

(ii)               Reporting OTC derivative trades to trade repositories; and

(iii)             Subjecting non-centrally cleared OTC derivatives to higher capital requirements.

Of the G20 members, the U.S., the E.U., and Japan have made the most progress in implementing these three principles through regulation and expect to have fully implemented the reforms by the end of 2012.  Other G20 members, however, are waiting on the U.S., the E.U., and Japan to finalize their frameworks so as to maximize consistency and safeguard financial market infrastructure when they reform their own such frameworks.
The FSB also determined that G20 nations have made progress in implementing four safeguards to the market for centrally cleared derivatives.  In its view, these safeguards allow all other G20 nations to begin implementing their own OTC derivatives market reforms.  The four safeguards include the following:

(i)                 “fair and open access by market participants to CCPs, based on transparent and objective criteria . . .”;

(ii)               “cooperative oversight arrangements between all relevant authorities . . . that result in robust and consistently applied regulation and oversight of global CCPs . . .”;

(iii)             “resolution and recovery regimes that ensure the core functions of CCPs are maintained during times of crisis and that consider the interests of all jurisdictions where the CCP is systemically important . . .”; and

(iv)             “appropriate liquidity arrangements for CCPs . . . .”

The FSB’s next progress report will review how well G20 members and the participants in the global financial industry have implemented all of the above-mentioned reforms to the OTC derivatives market.
5.   Uniform global accounting standards .  Part of the FSB’s review examined the progress of the International Accounting Standards Board (“ IASB ”) and the Financial Accounting Standards Board (“ FASB ”) in converging their accounting standards to create a uniform global accounting system.  Convergence has been slow for several reasons.  First, the SEC has not yet developed plans to implement IFRS accounting for U.S.-based public companies.  Second, the IASB and FASB have been unable to agree on accounting standards for many financial instruments and, further, have been trying to address hedging separately from each other.  Third, many financial institutions are disinclined to change the way they account for the netting of their derivatives contracts because it may result in significant changes to their balance sheets.1  The FSB encouraged the IASB and FASB expeditiously to pursue converged global accounting standards on these and other issues.
6.  Other reforms .  The FSB’s review also addressed the following additional reforms:

    • Legal entity identifiers (“ LEIs ”).  The FSB expects to prepare a global LEI framework by March 2013 that “uniquely identifies parties to financial transactions.”  The FSB envisions a three-tiered approach for management of the LEI system: a Regulatory Oversight Committee to govern the system, a Central Operating Unit to ensure global consistency of implementation, and Local Operating Units in participating nations to assign unique LEIs to legal entities.
    • Reduced reliance on credit rating agencies (“ CRAs ”).  The FSB continues to encourage its members to find ways their companies can become less dependent on credit ratings supplied by credit rating agencies.  In the FSB’s view, companies’ blind adherence to CRAs’ credit ratings increases systemic risk because such ratings are pro-cyclical and because adherence to those ratings largely substitutes for companies’ own robust risk-management frameworks.
    • Enhanced market disclosures and consumer protection .  The IOSCO continues to promote the adoption of enhanced market-disclosure requirements, especially regarding asset-backed securities, ETFs, and other complex financial products.  In addition, the FSB encourages continued development of consumer-protection frameworks, particularly with respect to residential mortgage underwriting practices.
    • Reform of compensation practices .  The FSB has found that most of its member nations have largely adopted the 2009 Principles for Sound Compensation Practices and their corresponding Implementation Standards (collectively, the “Principles and Standards“).  Those nations generally attribute compliance with the FSB’s Principles and Standards to heightened supervisory review of compensation practices, though many nations continue to have difficulty “align[ing] compensation with ex-ante risk taking and with ex-post performance,” as well as with “identif[ying] material risk takers.”
    • Establishment of macroprudential regulatory frameworks .  The FSB continues to encourage G20 nations to develop frameworks for macroprudential regulation of the financial system— i.e. , frameworks to guide prudential regulators in supervising the financial system.  Examples of macroprudential frameworks include the establishment of the FSOC in the U.S., the European Systemic Risk Board in the E.U., and the Financial Stability Working Group in Switzerland.  Many G20 nations are either establishing similar institutional structures or expanding the authority of institutional structures that are already in place.
    • Cooperation with international standards .  Recognizing that international standards cannot be legally binding on any particular nation unless adopted by that nation, the FSB has made efforts to promote compliance with its standards among both its member nations and the rest of the international community.  Among other initiatives, the FSB has recently reviewed the financial reforms implemented by Canada and Switzerland, is currently reviewing South Africa’s reforms, and will review all of its member nations’ progress in establishing effective risk-governance and resolution-planning regimes.
    • Unintended effects on developing economies .  In February 2012, the FSB began to study whether G20 financial regulatory reforms were having unintended consequences on developing economies.  It reached three main conclusions.  First, developing economies largely support the G20’s reforms.  Second, some of those economies are concerned about the potential for home-country bias in G20 reforms that may adversely affect developing economies.  Finally, the FSB concluded that it should continue to study potential unintended consequences because the G20’s financial regulatory reforms have not yet been fully implemented.  The complete results of the FSB’s study are set forth in a separate report that was also issued on June 19, 2012.

Enhancement of the FSB’s Institutional Role
Finally, the FSB’s progress report contained one additional recommendation: that the G20 Leaders grant the FSB greater authority as an international institution so that it can more effectively monitor its member nations and better coordinate regulatory reforms among them.  To that end, the FSB proposed its organization as an independent legal entity under Swiss law, its establishment of a committee to govern its finances, the adoption of internal procedural rules, and modifications to its charter to facilitate its independence.  The G20 Leaders immediately endorsed the FSB’s recommendation, strengthening both the FSB’s international legitimacy and its macroprudential regulatory influence.  Although the FSB will remain for the present as an affiliate of the BIS, it will undertake a review in five years to determine whether it should sever that affiliation and operate independently.
What to Expect
The FSB’s report, backed by the G20’s grant of additional authority to the FSB, suggests that certain areas of the financial industry are likely to see increased regulatory efforts over the coming years:

Reform Area What to Expect
Basel Implementation and Risk-Management Practices
  • Over time, potential strengthening of draft Basel III rules in U.S. to conform to globally agreed standards
  • International-level review of Basel III compliance in all major economies
  • Efforts to increase separation between banking operations and trading operations
  • Increased regulatory expectations to base risk calculations on expected shortfall rather than value at risk
Recovery and Resolution Planning
  • Implementation across the E.U. and other major economies of resolution-planning requirements similar to those in the U.S. and U.K.
  • Implementation of resolution-planning requirements for insurers and smaller financial institutions
  • Use of U.S. and U.K. resolution plans to establish crisis-management groups
  • Use of resolution plans to facilitate cross-border coordination among regulatory authorities
  • Over time, establishment of cross-border resolution protocols among home- and host-country authorities
“Shadow Banking”
  • Enhanced disclosure requirements for financial institutions’ repo, securities-lending, and securitization business lines
  • Enhanced regulation of money market funds
  • Over time, identification and prudential regulation of a wider array of business practices
OTC Derivatives
  • In the U.S., E.U., and Japan, final implementation of OTC derivative reforms that are currently in progress
  • Across other major economies, development of OTC derivatives regulation consistent with practices in U.S., E.U., and Japan
Accounting Standards
  • Over time, continued efforts toward convergence of IASB and FASB accounting standards
Legal Entity Identifiers
  • Beginning mid-to-late 2013, beginning of efforts to implement global LEI system at national level
Credit Rating Agencies
  • Continued discussion of ways to reduce companies’ reliance on credit rating agencies in determining creditworthiness
  • Over time, potential increased diligence and monitoring costs for lenders
Compensation Practices
  • Continued regulatory scrutiny of compensation at financial institutions
International Regulatory Coordination
  • Increased coordination among regulators and greater uniformity of regulation across major economies
  • Increased presence and influence of the FSB as a driver and coordinator of national regulatory authorities