Financial services firms have been roundly slated for their part in the credit crunch, and the knock-on recession that it is inflicting across industry sectors around the globe. The likelihood is that they will face much tougher regulation as a consequence, although they have put forward their own proposals for reform, in the hope that a willingness to change will temper the anger of politicians and regulators.

A report from the Institute of International Finance, which represents leading financial firms, sets out how the industry plans to reform itself. It proposes a new set of Principles of Conduct and some practice recommendations on issues such as risk, compensation policies, valuation of assets, liquidity management, underwriting and the rating of structured products. It also promises to boost transparency and disclosure.

Dr Josef Ackermann, Chairman of the IIF board and Deutsche Bank, said implementation of the proposals would: “strengthen the financial services industry and help to restore confidence. Our challenge is to move forward with implementation, and we are determined to do just that.”

The industry recognises the need to improve its performance, and many firms have already introduced better practices, claimed Dr Ackermann.

The report stated that firms are committed to undertaking regular self-assessment and to adjusting plans and policies accordingly. But once the current turmoil subsides, will they have the same enthusiasm for reform?

Rick Waugh, President and Chief Executive of Scotiabank, who co-chaired the IIF committee that wrote the report, said they would. “While a number of firms are already meeting many of the leading practices, it is clear the financial sector as a whole needs to do much better,” he said. “Taking measures in line with the Principles of Conduct and the Recommendations that we have proposed in this report will not only serve as a significant contribution to best practices, but as a platform and reference point for going forward.”

Indeed, Dr Ackermann suggested that support for the proposals might even be welcome. “This report is not intended to be an exercise in self-regulation. We recognise that it is essential for the industry to reform and that there is an emerging consensus on the benefits of reinforcing these efforts through effective regulatory incentives and structures.”

He added that the report also highlighted proposals to help reduce the risk of crises in the future. This included a plan to create a global financial Market Monitoring Group to detect new vulnerabilities in the financial system. “This represents a major initiative,” he said. “It is clear that timely warnings about possible future weaknesses or declining standards will have to be given a higher priority.”

Rubbish at risk?
The main area where the sector needs to improve is risk management. The report’s first principle of conduct states: “A robust and pervasive risk culture throughout the firm is essential. This risk culture should be embedded in the way the firm operates and should cover all areas and activities, with particular care not to limit risk management to specific business areas or to have it operate only as an audit or control function.”

Mr Waugh explained that: “Risk management should be our core expertise and what determines our individual success as firms and ensures a positive contribution to efficient financial markets. The best firms have gotten this right more times than not. Those who strive to be the best will see it is to their advantage to implement these best practices as it relates to their own circumstances.

“Our industry has made mistakes, and for some this has been very costly. There is a need in many institutions, we believe, for improved oversight by boards of directors on risk management and for strengthening senior management engagement in both current risk issues and in forward-looking strategic risk management analysis.”

The report contains extensive management recommendations. It notes that firms should make clear that senior management, in particular the chief executive, is responsible in this area and that the chief risk officer has the ability to influence key decision-makers in the firm. He or she must have “the mandate to ascertain that the firm’s risk level is consistent with its risk appetite and provide a thoughtful, integrated view of the overall risks the firm faces.”

The recommendations also note that stress-testing should be an integral part of assessing the bank’s risk profile in relation to its risk appetite across all business activities, risk types and exposures. The report emphasises that firms should ensure that risk management does not rely on a single risk methodology.

Tackling pay
The proposals also set a new tone on pay policies. “Incentive pay was one of the weaknesses in business practices, and will require the industry to exercise greater self-discipline on compensation-related issues,” said Dr Ackermann. He said he was convinced that adoption of the IIF principles would “play a meaningful role in strengthening our industry and ultimately public confidence.”

Its principles on pay conduct include three main points. First, pay incentives should be based on performance and should be aligned with shareholder interests and long-term, firm-wide profitability, taking into account overall risk and the cost of capital. Second, compensation incentives should not induce risk-taking in excess of the firm’s risk appetite. Third, firms should take into account the performance realised for shareholders over time in determining severance pay. These proposals represented “an unprecedented effort”, said Dr Ackermann, adding that some firms had already taken action.

The report underlines that the severity of the liquidity strains in financial markets were unprecedented and generally not anticipated. A problem leading to adverse market conditions was that the market did not recognise how sensitive investors providing liquidity would be to the issues of asset quality and credibility of ratings for structured vehicles such as conduits or to assurances of short-term access to funds invested in such vehicles, regardless of either the term of investments or the legal structure of transactions.

Better diligence
The report highlights a range of shortcomings in lending and due diligence practices, and makes extensive proposals. It notes that mortgage brokers were arranging loans, and non-bank originators were often making loans, without applying bank-equivalent lending standards. With a particular focus on the US, the report recommends that non-bank institutions involved with originating mortgages should be held to the same standards as banks.

More broadly, the report is blunt in suggesting that financial firms involved in the originate-to-distribute process should make sure adequate due diligence is conducted at all stages to maintain the integrity of the process. “Financial institutions should apply the same credit due diligence for structured products that they plan to originate and distribute as they do for similar assets that are to be carried on the firm’s own balance sheet,” said Mr Waugh.

It is not just banks that need to improve, the report says. It calls for change by underwriters and distributors, as well as ratings agencies. The work of the rating agencies has been found wanting, particularly with regard to structured financial products. The report said the market needs to be assured that agencies maintain a robust procedure for reviewing and validating their models and assumptions, and that they have adequate resources. It is also proposed that there should be an independent evaluation of the processes in order to restore market confidence in ratings, which play an important role in global finance.

Openness
One common thread links many of the proposals in the report: the need for firms to enhance transparency. “Restoration of confidence requires more accessible and useful information about products on the part of firms,” it says. To that end, it includes principles of conduct that relate directly to transparency and disclosure. The main ones are:

Risk disclosures should provide the clearest possible picture of a firm’s overall risk profile and the evolving nature of risks as well as salient features of the risk management processes.

Global standardisation and harmonisation of market definitions and structures are essential for the future development of the structured-products market.

In fulfilling disclosure mandates, firms should ensure that disclosures include the most relevant and material risks or exposures arising under current market conditions at the time the disclosure is made, including off-balance-sheet risks or exposures, especially for securitisation business.

Firms’ disclosures should include quantitative and qualitative information about valuation processes and methodologies, assumptions, sensitivities and uncertainties.
Spotting problems

These are all fixes aimed at dealing with problems exposed by the current crisis. But to truly regain trust, the financial industry will need to convince people that it is better able to spot emerging problems and deal with them before they become too serious.

That is what the IIF’s Market Monitoring Group will aim to do. The idea is to bring together a select group of senior executives and seasoned industry veterans to assess “market developments with systemic implications”. There are groups that do this already, but this one is different as input will come from people who are active in the markets.

To begin with, the group will focus on perceived mispricing of risk, crowded trades and concentration risk, and the potential for contagion among markets. Its deliberations and findings will be made public, so that any firm can feed the group’s insights into its own risk management processes.

Will the proposals make a difference? They are all good ideas. The IIF clearly means well. It is clear that the financial sector will not be able to escape a regulatory crackdown, and the IIF report accepts that more regulation is inevitable. How severe it will be remains to be seen, and could depend on the extent to which the failings of the industry inflict pain on the wider global economy.