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Basel Committee on Banking
Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
B. Supervision and regulation of financial groups
Financial groups play a significant economic role but can
threaten financial stability at local and global levels.
Governments, supervisors, and central banks have
struggled to evaluate the risks of
financial groups and have incurred significant costs in
mitigating the potential impact of financial groups on financial
stability.
Financial groups offer
services in banking, securities, insurance, or a combination of
these services.
This mix blurs the traditional
supervisory and regulatory boundaries among the sectors.
Moreover, these groups rely on a network of legal entities
and structures (some of them unregulated) to derive synergies
and cost savings and to take advantage of differences in
taxation, supervision, and regulation.
This report
focuses on differences in the treatment of:
•
Unregulated entities when calculating group capital adequacy.
The differences in how a financial group is defined, in
how entities are included for calculations, and in the methods
for calculating group capital adequacy create problems for
supervisors in assessing the risks of a financial group, the
capital adequacy of the group, and implications for regulated
entities within the group.
These differences create gaps
when unregulated entities are used to lower capital requirements
of individual regulated entities, to reduce group capital
adequacy requirements, and to blur the distinction among
sectors.
This can encourage the creation of group
structures that are complex, opaque, and interdependent.
•
Intra-group transactions and exposures (ITEs), including those
involving unregulated entities.
ITEs allow a financial group to coordinate its
businesses across its legal structure.
ITEs can create
contagion and unintended risks across the group and/or
individual legal entities within the group, as shown by the
failure of Lehman Brothers.
The differences in
approaches to supervision and regulation of ITEs can make it
difficult for supervisors to assess the risks to the
sustainability of the business models of the group and its legal
entities.
•
Unregulated entities, particularly unregulated parent companies
of regulated entities.
Differences can create loopholes for financial groups to
establish unregulated parent holding companies that end up
controlling regulated entities from a completely separate
jurisdiction.
The unregulated parent holding company’s
jurisdiction may not have related regulated entities or not have
legal authority to exercise power or oversight over unregulated
entities.
This hinders
supervision.
The unregulated parent holding
company is under no obligation to provide information to
unrelated third parties, such as foreign supervisors, and is not
required to produce the information in a meaningful way.
Existing protocols for obtaining and sharing critical
information do not address unregulated entities that are higher
in the organisational hierarchy of ownership.
These
differences help create situations in which regulatory
requirements and oversight do not fully capture all the
activities of financial groups or the impact and cost that these
activities may impose on the financial system.
Thus,
there is a need to consider regulatory reforms to address, where
appropriate, these differences.
Meanwhile, supervisors
need to monitor the risks that these differences can create and
ensure that they are managed by regulated entities.
C. Mortgage origination
Until 2007, this decade was characterised by relatively
strong economic growth, low interest rates in many
jurisdictions, an abundance of liquidity, and increased lending
to consumers.
In a number of countries, housing and
mortgage markets expanded dramatically, and there was rapid
expansion in the variety and number of mortgage products and in
related securitisation.
Lack of
discipline by market participants in several jurisdictions was
notable during this boom period.
When housing
price bubbles were suspected, it was not clear at what point a
systemwide response would be needed, especially given the
positive macroeconomic effect of increasing home values and
homeownership.
This evaluation was further complicated
by rising home values masking a number of poor underwriting
practices, particularly those designed to lower initial monthly
payments.
In several countries that experienced a surge
in mortgage lending and housing growth, most notably the United
States and the United Kingdom, lenders developed new, riskier
products that made use of relaxed product terms, liberal
underwriting, and increased lending to highrisk populations.
These developments eventually resulted in significant losses
for consumers and financial institutions alike.
However,
many other countries with sophisticated mortgage markets have
not experienced a significant degree of distress and some
countries did not experience such growth, for example, Germany
and Canada.
This report focuses on two fundamental areas
of concern:
•
Poor mortgage underwriting practices.
Problems arising from poorly underwritten residential mortgages
in certain countries contributed significantly to the global
financial crisis; indeed, the securitisation and other
structured financing of these mortgage loans
- which
were purchased by a number of international financial firms
- spread the problems of their poor underwriting to the
banking, securities, and insurance sectors globally.
In
contrast, prudent practices and sound and comprehensive policies
may have prevented market participants in those countries that
have not experienced a significant degree of distress from
engaging in the less disciplined underwriting behaviour that was
endemic in other, more troubled mortgage markets.
•
Mortgage originators subject to differing supervision,
regulation, and enforcement regimes for similar
activities/products.
Like most aspects of the mortgage industry, the
prevalence, role, and supervision of nonbank credit
intermediaries varies greatly across the various mortgage
markets.
Mortgage originators range from the smallest
individual mortgage brokers to large international lenders.
They include lenders that provide warehousing lines to fund
loans on an interim basis, those that structure securitisations
and market securities, and central banks and
government-sponsored enterprises that essentially make markets
in mortgage loans.
In some cases, the government closely
controls the mortgage market through explicit guarantees for the
full balance of the loan, while in others involvement is
limited. The number of participants, the variety of roles they
play, and the differences among countries are substantial,
particularly given the patchwork approach to the regulatory
framework in many countries.
Such differences created
regulatory gaps that helped erode prudent mortgage underwriting
practices.
D. Hedge funds
Debates continue over whether and to what extent hedge funds
may have contributed to - or mitigated - the expansion of the
financial crisis.
Some argue that hedge funds increased
stress on liquidity in the financial markets in fall 2008, while
others argue that hedge funds generally reduce the likelihood
and prevalence of asset bubbles given the strategies hedge funds
use.
There is, however, general consensus that hedge
funds, given their role in the economy,
may have a systemic impact.
The analysis for this
report focuses on four areas of concern.
•
Internal organisation, risk management, and measurement.
Failures in risk management by hedge fund managers can
cause problems for markets and are a matter of cross-border and
cross-sectoral concern.
Yet there is no common or
cross-border understanding of or requirements for how funds are
organised or how fund risks are managed and measured.
•
Reporting requirements and international supervisory
cooperation.
The risks posed by hedge funds cannot be easily measured
by supervisors or investors because funds are not required to
fully disclose their activities.
The limited disclosure
rules that funds do face vary by jurisdiction and information
collected is not shared by supervisors for hedge funds operating
across borders.
•
Minimum initial and ongoing capital requirements for
systemically relevant fund operators.
Adequate financial reserves are needed to help fund
operators withstand the operational risks they incur, ensure
their orderly dissolution, and minimize potential harm to the
financial system.
Not all supervisors require such fund
operators to meet even minimum capital requirements.
•
Procyclicality and leverage-related risks posed by the pool of
assets.
The use of leverage allows funds to magnify potential
returns but also the exposures, and, consequently, the risks for
not only fund investors, but also the financial system itself.
Supervisors do not constrain the use of leverage by
funds.
E. Credit risk transfer products
One of the factors contributing to the crisis was the
inadequate management of risks associated with various types of
products designed to transfer credit risk.
This resulted
in severe losses for some institutions.
These products transfer risks within and outside
the regulated sectors.
This report focuses on two credit
risk transfer products that were evidenced to contribute to
major gaps in market practices or effective regulation: credit
default swaps and financial guarantee insurance.
Credit default swaps (CDS) and financial
guarantee (FG) insurance are products that provide protection
against identified credit exposures.
Because the
provider of that protection may have to make payments based on
the performance of the underlying credit, these products create
new sources of credit exposure.
Buyers of credit
protection, therefore, need to maintain and enforce sound
counterparty credit risk management practices with respect to
credit protection providers.
While CDS and FG insurance
products have quite different legal structures, they perform
similar economic functions.
The analysis identified the
following issues as common to both the CDS and FG insurance
markets. Each contributed to the recent
crisis or poses crosssectoral systemic risk.
•
Inadequate risk governance:
Sellers of credit protection did not, and often could not (given
their existing risk management infrastructure) adequately
measure the potential losses on their credit risk transfer
activities.
This was generally true in the CDS market
and to a lesser extent in the regulated FG insurance market
(where there is at least some financial reporting required by
statute).
Buyers of protection did not properly assess
sellers’ ability to perform under the contracts, and they
permitted imprudent concentrations of credit exposures to
uncollateralised counterparties.
•
Inadequate risk management practices:
Poor management of large counterparty credit risk exposures with
CDS and FG insurance transactions contributed to financial
instability and eroded market confidence.
CDS dealers
ramped up their portfolios beyond the capacity of their
operational infrastructures.
•
Insufficient use of collateral:
The absence of collateral posting requirements for highly rated
protection sellers (eg AAA-rated monoline firms) allowed those
firms to amass portfolios of over-the-counter derivatives, and
FG insurance contracts - and thus create for their
counterparties excessive credit exposures - far larger and with
more risk than would have been the case had they been subject to
normal market standards that required collateral posting.
•
Lack of transparency:
The lack of transparency in the CDS and to a lesser extent in
the FG insurance markets made it difficult for supervisors and
other market participants to understand the extent to which
credit risk was concentrated at individual firms and across the
financial system.
Market participants could not gauge
the level of credit risk assumed by both buyers and sellers of
credit protection.
•
Vulnerable market infrastructure:
The concentration of credit risk transfer products in a small
number of market participants created a situation in which the
failure of one systemically important firm raised the
probability of the failure of others.
Separately, this
report addresses key issues and gaps specific to CDS products.
They are largely unregulated
although their use is subject to supervision and regulation when
protection buyers and sellers are regulated institutions.
To the extent that unregulated entities, such as special
purpose entities, are major participants in CDS markets, this
may be perceived as a gap in existing supervision and
regulation.
For example, even if regulated firms are
subject to capital requirements for risks arising from their CDS
exposures, systemically important unregulated firms are not
subject to comparable requirements, and this may pose a systemic
risk.
There also are concerns about potential weaknesses
in the market infrastructure for CDS products because they are
typically traded over-the-counter.
Operational risks can
be exacerbated by weaknesses in market infrastructure.
Finally, there are key issues and gaps specific to FG insurance
products.
The number of FG insurers worldwide is small,
but they operate across international boundaries and the
regulation of these insurers varies considerably across
jurisdictions.
In recent years, FG insurers increased
their risk appetites and expanded into asset-backed securities,
including collateralised debt obligations, as well as subprime
mortgage-backed securities.
Insurers also established
minimally capitalised special purpose entities, which sold CDS
products that were not legally permitted within the main FG
insurance business.
Accounting practices, capital and
liquidity, the role of credit rating agencies, use of special
purpose entities, and knock-on effects pose cross-sectoral
and/or systemic impact as the economic validity of the business
model and design of these products remains in question.
Basel Committee on
Banking Supervision, The Joint Forum
Review of the Differentiated
Nature and Scope of Financial Regulation
Key Issues and
Recommendations (January 2010)
Conglomerates
- Part 1:
Introduction, Mandate, Focus and guiding principles of this study,
Key issues and gaps
Conglomerates - Part 2:
Supervision and regulation of financial groups. Mortgage
origination. Hedge funds
Conglomerates - Part 3:
Recommendations and options for effective and consistent
financial regulation across sectors. Reducing key regulatory
differences across the banking, securities, and insurance sectors.
Strengthening supervision and regulation of financial groups.
Promoting consistent and effective underwriting standards for
mortgage origination. Broadening the scope of regulation to hedge
fund activities
Conglomerates - Part 4:
Strengthening regulatory oversight of credit risk transfer
products. Key differences in regulation across the banking,
securities, and insurance sectors.
Background and approach adopted by the Joint Forum. Key issues
and gaps
Conglomerates - Part 5:
Recommendations to reduce key differences in regulation across
the banking, securities, and insurance sectors. Supervision and
Regulation of Financial Groups. SPEs. Key issues and gaps.
Recommendations to strengthen supervision and regulation of
financial groups
Conglomerates - Part 6:
Mortgage Origination. United Kingdom, United States, Spain,
Canada, Germany. Key issues and gaps. Recommendations to promote
consistent and effective underwriting standards for mortgage
origination
Conglomerates - Part 7:
Hedge Funds. Key issues and gaps
Conglomerates - Part 8:
Recommendations and policy options to broaden the scope
of regulation to hedge fund activities.
Credit Risk Transfer Products.
Key issues and gaps common to both CDS and FG insurance (CDS -
Credit default swaps, FG - Financial guarantee)
Conglomerates - Part 9:
Key issues and gaps specific either to CDS or FG insurance.
Recommendations and policy options to strengthen regulatory
oversight of credit risk transfer products
Conglomerates - Part 10:
Annex 1-9
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