Month: April 2010

Last year, World Finance ran an article, ‘The Blame Game’, which tried to examine what degree of fault lay with financial regulators, executives, investors and so on for the banking crisis. It found that none of those put forward as suspects were squeaky clean, but it did point out that some of those in the firing line – regulators, in particular – had at least owned up to some degree of fault, learned lessons and had pledged to make changes.

One year on, we now look to see what changes have been made and what proposals to reform the sector have been put forward – and whether they are likely to work.

Regulation
Through the debacle of the credit crisis, it can be said that banks broke rules that were poorly enforced, or they were not kept in line because rules determining what they were actually doing did not exist. Regulators on both sides of the Atlantic were always at least one step behind what was taking place in the market, making rules for practices that had already moved on and developed into something a whole lot riskier and bearing little resemblance to what they thought was going on. The system of regulators relying on the work of other agencies and organisations to keep each other in check – institutional investors failing to challenge boards so long as returns were good, credit rating agencies assigning triple A ratings to the issuers who bank roll them, external auditors selling add-on services to clients they are meant to independently audit, risk managers failing to understand parts of the business they were meant to provide assurance on – illustrated how incestuous and flawed the process of oversight was. Strong measures had to be taken.

The US has taken a strong lead, say many commentators. On March 11, Senate Banking Committee members from both Democratic and Republican parties said that they had agreed to include in their regulatory overhaul bill a new Office of Research and Analysis that would provide early warnings of possible systemic collapses. The proposed agency, which has sometimes been referred to as the National Institute of Finance, is intended to give federal regulators daily updates on the stability of individual firms as well as that of their trading partners, including hedge funds.

By standardising financial instruments and reporting mechanisms, the agency would give regulators a broader view of the health of participants in the financial markets and the potential for problems to spread. The idea’s supporters say that kind of information was lacking in recent years as the housing bubble burst and troubles spread from firm to firm.

“One of the problems we observed in the recent crisis is that nobody knew who had what,” said Senator Jack Reed, a Rhode Island Democrat who in February introduced a stand-alone bill to establish a National Institute of Finance. “The result was a cascading effect of uncertainty and doubt.”

The new agency would have no policy responsibilities but would instead collect and analyse data, building models to assess relative risks and predict how one firm’s problems might affect others. As proposed, the new agency would be housed in the Treasury Department with a director, appointed by the president and confirmed by the Senate, who would be an ex-officio member of a systemic risk council that would be created by the bill.

The agency would draw its budget from assessments on the largest financial firms.

The agency would gather data from the largest firms and from a broad set of market participants, including all US-based financial institutions, which would be required to report all their financial transactions, regardless of whether the counterparty was based domestically or abroad. The agency would take steps to safeguard proprietary trading information, while also shining a light onto the so-called shadow banking system of mortgage brokers, sub-prime lenders and unregulated hedge funds that contributed to the financial crisis.

While the Senate may be behind some aspects of President Obama’s financial services reforms, Congress is digging its heels in, particularly over his proposals to reform the banking sector. The Volcker Rule (also known as the Volcker Plan), first publicly endorsed by President Obama on January 21, is a proposal by American economist and former Federal Reserve Chairman Paul Volcker to restrict banks from making certain speculative kinds of investments if they are not on behalf of their customers. His plan also prohibits banks from owning or investing in a hedge fund or private equity fund, as well as limiting the liabilities that the largest banks can hold.

But the plan needs the support of Congress, which favours a weaker bill that will allow federal regulators to restrict proprietary trading and hedge fund ownership by banks, but not prohibiting these activities altogether.

The plan (as it currently stands) also has its critics from outside the US. Leaders in Europe and Japan have said that they favour an international agreement on financial services supervision, and not just reform on a country-by-country basis, particularly with regards to the regulation of complex financial instruments – widely blamed for causing the crisis, and now for the economic turmoil in Greece. Several European leaders are pinning their hopes of greater international cooperation on this point at the G20 summit which will take place this summer. UK business secretary Lord Mandelson says that Volcker’s plan is “too difficult” to implement. “Whatever their size, whatever their range of activities, you need good regulation. It’s the principle and practice of regulation you have to focus on, not the size of banks,” he added. Michel Barnier, EU internal market commissioner, has also warned that the Volcker plan could not be imported in the same form to Europe.

Given the UK’s prominence as a banking centre, it was inevitable that it was going to suggest some kind of reform. And it has also recommended substantial changes to the way banks manage risk. At the end of November Sir David Walker published his final recommendations on UK banks’ corporate governance, pay policies, and approaches to risk management. His key recommendations included strengthening the role of non-executive directors so that they can provide an effective challenge in the boardroom, disclosing pay policies including deferring two-thirds of cash bonuses and favouring long-term investment reward schemes (though not capping executive remuneration), and having non-executives chair risk committees which will have the power to scrutinise and, if necessary, block big transactions.

However, some have given Sir David’s review a lukewarm reception. The review’s remit was to look at corporate governance concerns in banks – not to propose broader structural reforms to the financial system. While the review recognises that the “old model” of governance contributed to the crisis, he proposes to have a new model of governance on an old banking model. The review contains no critical discussion of the role of banks and has no real comment on the issue of bankers’ pay – one of the most contentious issues to come out of the entire financial crisis.

Investors
Institutional investors have been heavily criticised during the credit crunch and global recession. Although they had three mighty weapons in their armoury – the vote at the annual general meeting, the option to disinvest, and the ability to issue governance warnings, like the ABI and its “red-top reports” – critics say that they were rarely used, and that pension funds are largely “toothless tigers” or “sleepy”. The Trades Union Congress’ Fund Manager Voting Survey 2008 found that a significant number of fund managers support the large majority of remuneration reports, even when there are contentious issues at stake. It also found that half of the fund managers responding to the survey supported 80 percent or more of the remuneration resolutions on which they voted, despite widespread public and professional condemnation of the levels of executive pay.

Furthermore, investors’ were also criticised for being slow to challenge “positive” financial data. Their over-reliance on the reports and ratings of credit ratings agencies such as Moody’s and Standard & Poor’s led to a burgeoning trade in high-risk investments, such as collateralised debt obligations. Arthur Levitt, a former chairman of the SEC, said in September 2007 as the scale of the crisis was dawning, that “credit ratings agencies play a critical role in the capital markets, but their judgments are guides, not stamps of approval. Too often, institutional investors have been investing in sophisticated credit products on the basis solely of the credit rating and without fully understanding the inherent risks they are undertaking.”

Under the threat of having new duties imposed on them, the UK’s Institutional Shareholders Committee (ISC), which is made up of the Association of British Insurers, the Association of Investment Companies, the Investment Management Association, and National Association of Pension Funds, issued its new Code on the responsibilities of institutional shareholders in November in an attempt to put its own house in order. Made up of seven principles, the code aims to enhance the quality of the dialogue of institutional investors with companies to help improve long-term returns to shareholders, reduce the risk of catastrophic outcomes due to bad strategic decisions, and help with the efficient exercise of governance responsibilities.

The code says that institutional investors should publicly disclose their policy on how they will discharge their stewardship responsibilities, and any potential conflicts of interest. Institutional investors also need to monitor their investee companies. As part of this monitoring, institutional investors should seek to satisfy themselves that the investee company’s board and sub-committee structures are effective, and that independent directors provide adequate oversight, and they should also maintain a clear audit trail, for example, records of private meetings held with companies, of votes cast, and of reasons for voting against the investee company’s management, for abstaining, or for voting with management in a contentious situation. The code also presses institutional investors to publicly disclose more information on their voting procedures, and under what circumstances they would escalate their concerns about a company board and its strategy.

While more disclosure is always welcome, so would greater usage of there three weapons: signs are, though, that they aren’t being used too readily.

Bankers and risk management
The UK’s financial regulator wants to make sure that boards have a proper understanding of risk, and that there is greater accountability within financial institutions to single out those who don’t cut the mustard. In January the FSA reviewed the structure of its “significant influence controlled” functions after finding that they are “not currently sufficiently detailed” to allow the regulator to segregate and capture specific key roles within governance structures.

The FSA plans to increase the number of roles for which executives must be vetted 14 to 22.

The proposals, detailed in the FSA’s Effective Corporate Governance consultation paper, will give the watchdog the power to block the appointments of new categories of financial services personnel. These include the chairmen, senior non-executive directors, chairs of audit and risk committees, as well as those responsible for finance, risk and internal audit.

The regulator began vetting those in “significant influence functions” in 2008 and has the power to refuse candidates if they are not deemed fit and proper. To date the FSA has interviewed 332 candidates and has not rejected any – although 25 have dropped out following the interview. The consultation period closes on 28 April 2010. The FSA hopes to have final rules in place during the third quarter of 2010.   

In its review, the FSA found that three of the six current functions capture too broad a range of individual roles which means that it is unable to track and vet individuals who may change roles within one of those functions, even though the competences required for each role might be different.

For example, under current rules an individual approved as a non-executive director may also take on the role of chair of a key board committee without any further assessment of the individual’s competence and capability to perform that new role.

The FSA is also proposing other changes. Until now, the regulator had excluded from the regime those firms whose parent entity or holding compan- was itself FSA-authorised. While some individuals based in FSA-authorised parent entities may already be subject to the approved persons regime and may already be approved for a significant influence controlled function, it does not apply to his actions in respect of the subsidiary. Under the FSA’s proposals, however, such individuals may need to seek approval for the subsidiary as well.

Some lawyers believe that the FSA’s vetting process may also be flawed, particularly the interview process. Alasdair Steele, partner in law firm Nabarro’s capital markets group, says that “we have heard from clients who have been through the approval process that they have been asked misleading questions. For example, one was asked what he considered to be the five key risks facing the organisation he worked for.

This sounds simple, but he could not possibly give a correct answer: he would need to know what the board’s view of risk was, what its’ strategy was, and what its priorities were.”

He adds: “Another was asked what the FSA’s first general principle was. The answer is that ‘a firm must conduct its business with integrity’. But is a candidate unsuitable to be an approved person if he does not know the answer to that specific question? There is a danger that candidates are having unsuitable questions just thrown at them, rather than the FSA trying to ensure that the skills and experience of the person being interviewed relate properly to the role he is seeking approval for.”

Hatfield at Reed Smith also feels that the vetting process for approved persons needs to be more transparent. She says that candidates are not told why they are not suitable for the role they have sought approval for and are dissuaded from appealing the decision because details of their unsuccessful application would be made public. “The issue with vetting directors and non-directors is controversial in that a number of individuals who have been recommended to withdraw their application are not having the opportunity to appeal. They would rather stand down rather than for it to be made public that they had had their application turned down. This may deter a lot of suitable people from applying for senior roles.”

While some may debate the pros and cons of the vetting process, one lawyer believes that the FSA may be focusing on the wrong issue. Ann Bevitt, partner at law firm Morrison & Foerster, believes that extending the vetting new appointees is only a very small part of the good corporate governance picture.

She says: “Given the roles that are now to be vetted, it seems to me that what may be more important than vetting on appointment is an ongoing review of how, and how effectively, the board challenges the executive before decisions are taken on major risk and strategic issues. The additional vetting could be seen as a bit of a knee-jerk reaction to the financial crisis.”

Pay and boardroom accountability
While the Walker Review may not have dealt head on with the issue of banker executive pay – in fact, the only tactic that seems to have worked is forcing them to give their bonuses to charity following public ire, as happened with Michael Geoghegan, chief executive of HSBC, who gave his £4m bonus away – the US has taken a firmer line. And the government, and lawyers, expect it to work. On December 16 2009, the SEC, the US listings regulator, approved rule changes that will force companies to provide more disclosure in proxy and information statements regarding risk, compensation and corporate governance.

Experts say that the rules are designed to provide investors with greater assurance about how directors are chosen and how their remuneration is linked to the risk profile of the business. Harriet Territt, of counsel in the financial and regulatory compliance practice at US law firm Jones Day, says that “the new rules are really giving investors more assurance on the ability of management to identify and manage risks to the business, as well as more information on their backgrounds so that shareholders can judge whether they are appropriate people to act in that capacity.”

The new rules – which came into force from February 28 – require companies to disclose the relationship of a company’s compensation policies and practices to risk management, the background and qualifications of directors and nominees, and the legal actions involving a company’s executive officers, directors and nominees. They also require companies to disclose how candidates for director are considered for nomination, the board’s role in risk oversight, stock and option awards made to company executives and directors, and potential conflicts of interests of compensation consultants.

The SEC hopes that its rule regarding wider disclosure of compensation policies and practices will help investors determine whether a company has incentivised excessive or inappropriate risk-taking by employees. Among other things, the SEC believes that the new rules will require a narrative disclosure about the company’s compensation policies and practices for all employees, not just executive officers.

Kristian Wiggert, partner in the corporate group at law firm Morrison & Foerster, says that it is unclear at this stage what impact the rules will have on improving corporate governance. “As ever with a disclosure-based regime, whether there will be any major improvements in corporate governance will depend on what market participants do with the new information. There is a big debate going on in the US about whether shareholders in US companies have sufficient rights to exercise proper control over management, even with improved information disclosure,” he says.

Credit rating agency reform
Attacks on rating agencies focus on two charges. Firstly, agencies receive fees from organisations issuing debt and constructing debt instruments such as collateralised debt obligations (CDOs), complex portfolios of fixed-income assets that are divided into “tranches”, with each tranche containing assets holding a different level of credit risk. This means that credit rating agencies are being paid by the issuers whose securities they rate. This, critics argue, makes them unable to provide objective information about the risks associated with investing in these debt instruments. Secondly, credit rating agencies’ methods of rating and categorising CDOs do not make it easy enough for investors to see the true levels of risks they carry. The triple-A ratings assigned by credit rating agencies would have led some investors to believe that these complex debt structures were bomb-proof.

But not all AAA securities are created equal. As demonstrated in the current credit crisis, structured products typically perform very differently from traditional corporate bonds, despite the identical symbols.

In July 2008 the SEC concluded that credit rating agencies failed to manage conflicts of interest in assigning top ratings to bonds backed by sub-prime mortgages and other assets. The conclusions were far from complimentary. “The public will see that there have been significant problems,” said Christopher Cox, SEC chairman. “There have been instances in which there were people both pitching the business, debating the fees and were involved in the analytical side”, adding that credit raters were “deluged with requests” for ratings and “the volume of work taxed the staffs in ways that caused them to cut corners” and “to deviate from their models”.

The then European Commissioner for Internal Markets Charlie McCreevy also let his anger be known, saying that the trust placed in many credit ratings to determine capital requirements had now been shown “to be wholly misplaced”. Unlike most regulators at the time, McCreevy was adamant that there needed to be further regulation imposed on credit rating agencies. He added that he was “flabbergasted at the naivety of anyone who thinks these same credit rating agencies should be trusted to abide by a non-legally enforceable voluntary code of conduct drawn up under palm trees – a code that has proven itself to be toothless, useless and worthless time and time again. Fool me once, shame on you. Fool me twice, shame on me.”

Due to a lack of coherent, and industry-wide momentum to suggest reform the EU and US passed their own rules. On July 14 last year the EU passed a directive on credit rating agencies aimed specifically at disclosing more information about how the rating was achieved and ensuring that the issuing of a credit rating is “not affected by any existing or potential conflict of interest or business relationship involving the credit rating agency issuing the credit rating, its managers, rating analysts, employees, any other natural person whose services are placed at the disposal or under the control of the credit rating agency, or any person directly or indirectly linked to it by control”.

Given the furore over categorising the inherent risks in some complex financial instruments, the directive also states that when a credit rating agency issues credit ratings for structured finance instruments, “it shall ensure that rating categories that are attributed to structured finance instruments are clearly differentiated using an additional symbol which distinguishes them from rating categories used for any other entities, financial instruments or financial obligations”.

A week later, the US followed suit. In July 2009, the SEC introduced new rules regarding improvements to the regulation of credit rating agencies to increase transparency, tighten oversight, and reduce reliance on their opinions. The legislation prohibits agencies from providing other services to companies that contract for ratings. The rules also prohibit or require the management and disclosure of conflicts of interest arising from the way a rating agency is paid, and require that credit rating agencies implement procedures to review ratings of an issuer if that issuer hired an employee of a rating agency within a year prior to its rating.

Each rating report must disclose the fees paid by the issuer for a particular rating and the total amount of fees paid by the issuer to the rating agency in the prior two years. Rating agencies are also now required to use different symbols for structured finance products to indicate that these instruments may raise heightened risks.

The SEC also wants more – and improved – disclosure accompanying ratings. The new rules require that each rating must be accompanied by a report that assesses data reliability, probability of default, estimated severity of loss upon a default, and the sensitivity of ratings to changes in the assumptions.

To reduce reliance on ratings, the President’s Working Group on Financial Markets will work with the SEC to determine where references to ratings can be removed from regulations. In its proposed amendments to the regulation of money market funds, the SEC requested comment regarding whether references to ratings should be removed. The SEC also has proposed to require that rating agencies disclose, on a delayed basis, ratings history information for all issuer-paid ratings. Added to that, in order to encourage additional ratings of structured products, the SEC has proposed a rule that would require that issuers provide the same information provided to one rating agency as the basis for a rating to other rating agencies.

Hopefully, such action will promote better corporate governance – until the next crisis exposes the flaws inherent in these reforms.

In an ideal world, investors want their deals to be risk-free and ripe for guaranteed, juicy returns. But it isn’t an ideal world. Instead, those countries that have been long regarded as investor safe-havens are losing their sheen. The UK, the world’s largest financial centre, has been downgraded by credit rating agencies and lost its treasured triple A rating because of the amount of government debt it is carrying. Investors are also worried about the prospect of a hung parliament in the forthcoming general election. Before Christmas Greece was downgraded to BBB+ with a negative outlook, the first time in 10 years a ratings agency has put the nation below the A investment grade, and some may say there’s still time for more.

While the world’s major markets such as the US and Europe have taken a bump, there are signs that they are on the road to recovery, though it may take longer than expected to bounce back. But other countries, particularly in emerging economies that may not have been adversely affected by the banking and financial crisis that engulfed much of the developed world, are showing worrying signs of corruption and government interference that might make investors think again about dipping their toes into these markets.

Here are some of the key markets that have stoked investor interest over the past few years, and an indication of the risks inherent in them.

Laos
Laos, with its abundant natural resources, has often been touted as one of Asia’s final frontiers for mining companies and the sector has been a major contributor to Laos’ increased growth of approximately six percent per year, largely due to FDI. But there are problems. According to the World Bank, the judiciary is vulnerable to interference by the government due to judicial appointments being made by the government and corruption is also common with the most powerful able to influence decisions. Furthermore, Laos has a poor record for protecting investors (ranked 180th out of 181 countries) and has an only slightly better record for enforcing contracts (ranked 111th out of 181 countries), according to the World Bank’s recent Doing Business report.

Laos adopted its Anti-Corruption law in 2006 and is now making attempts at more transparency and working towards reducing corruption in state departments. The reality, however, is that corruption continues to be a normal everyday practice affecting business and everyday life. Transparency in business transactions is low, according to Transparency International, which ranks the country 158th out of 180 countries in its Corruption Perceptions Index 2009 – the lowest rating in Asia after Burma. Government sectors involved with revenue collection and foreign investment are deemed to be particularly vulnerable to corruption.

Having the government as a partner seems to be the accepted way of moderating discretionary government actions. The level of fairness of the regulatory system appears to largely depend on if an investor is willing to allow the Laos government to take an option for, or an initial equity stake in the project, usually 10-20 percent, as can be witnessed with other mining operations in the country, such as Banpu’s Hong Sa coal mine and coal fired power plant, which is currently due for completion in 2012. In addition to joint ventures between the government and the private party, the Laotian government can be offered what is effectively an exercisable equity option to acquire a portion of a mining business. It has exercised these options with two large mining companies in 2008 (Oxiana and PanAust).

Vietnam
Vietnam has weathered the global economic crisis relatively well, but the country is still seen as a risky and relatively opaque investment destination. Corruption is endemic in Vietnam at all levels of government, and acts as a major barrier to foreign investment. Transparency International ranks the country 120th out of 180 countries in its latest Corruption Perceptions Index. The authorities had announced aggressive plans to fight corruption, and encouraged the media to act as a watchdog, but these efforts lost steam after several journalists were detained for reporting on major corruption scandals. As a result, progress on corruption will remain a key determinant of investment attractiveness.

In fact, investors say that the lack of accountability and transparency, and burdensome bureaucracy all impact the effectiveness of the government in formulating and implementing policy. Furthermore, recent history has shown that economic reform and the restructuring of inefficient state enterprises are vulnerable to being undermined by entrenched interests and conservative elements in the government more focused on security.

While the government stimulus package has boosted the economy, there are questions over how the budget deficit can be financed, how inflationary pressure can be contained, and how the crowding out of private investment can be avoided. Hanoi has embarked on a plan to trim bureaucratic procedures in government, but how that scheme plays out will be something to watch.

Vietnam’s fixed exchange rate policy also frequently causes economic pressures to build. The authorities are expected to widen the currency’s trading band or devalue it again gradually in coming months, and this has prompted hoarding of dollars. For now, the risk of a sudden big devaluation is considered small.

Vietnam has seen a rising number of strikes, protests and land disputes, often affecting foreign businesses.

Disturbances have erupted in rural areas due to state expropriations of land and the corruption of local officials.

But there remains no evidence for now that wider unrest is likely, or that there is any imminent risk of the regime being challenged from below.

India
India has attempted to improve investor sentiment by beefing up its corporate governance regime. Indian companies will have to raise their boardroom practices to comply with a new corporate governance code aimed at reforming corporate India after the Satyam scandal. The new code, produced by the Ministry of Corporate Affairs last December, tells listed companies to separate the role of chairman and CEO, change their external auditor every five years, and conduct an annual review of internal control effectiveness. The code also cuts the number of directorships one person can hold from 15 to seven.

To enhance the independence of non-executive directors, the code says they should be appointed on fixed, six-year contracts, after which they would not be able to hold any role at the company for three years.

Companies should change their audit firm every five years, so they get a “fresh outlook”, and rotate their audit partner every three years, the code says.

The code is voluntary, with listed companies expected to comply with its recommendations or explain to shareholders why they have not done so.

India launched a review of corporate governance practices a year ago after the exposure of a massive fraud at Satyam, one of the country’s largest IT companies. That fraud has so far led to charges against several partners at Satyam’s audit firm, PricewaterhouseCoopers, as well as Satyam’s now-former CEO.

But investors may have more concerns with India’s current security situation and its relationship with nuclear neighbour Pakistan. The bomb blast in Pune in western India on February 13 this year, which killed 15 people, has underlined India’s vulnerability to terrorism in spite of the authorities’ best efforts to improve security after the November 2008 Mumbai attacks. The latter severely strained relations between New Delhi and Islamabad after it emerged that the attacks were planned in and launched from Pakistan. But while the Indian government refrained from taking any retaliatory action after the Mumbai attacks (apart from cancelling the tentative peace talks between the two countries), political and public pressure would be considerably stronger for New Delhi to act in a more forceful manner if another high-profile terror attack with clear links to Pakistan were to occur.

Indeed, Indian frustration over the perceived unwillingness of Pakistan to take action against Lashkar-e-Taiba (widely believed to have been behind the Mumbai attacks) and Pakistani ire over India refusing to take up negotiations on Kashmir have seen goodwill between the two governments evaporate.

Pakistan
The fragile position of President Asif Ali Zardari remains a substantial political risk and there is a real possibility that he will be ousted before his term runs out in 2013. Zardari has failed to impress since taking office in September 2008 and is deeply unpopular both among the ruling elite and the wider public.

Constrained by a narrow political base, he has appointed former business cronies to key government positions, which has further alienated him from the powers-that-be in Pakistan – the army and the judiciary. The opposition has already demanded that Zardari and his cabinet resign on the back of corruption charges against him, leaving his fate in the hands of the Supreme Court, which may deem him unfit for the presidency. Zardari has sought to appease his critics by yielding powers to Prime Minister Yusuf Raza Gilani, but this has arguably undermined his position further and created confusion over who is really in power. The removal of Zardari, by the opposition, the judiciary, or the army, could cause serious political upheaval as competing factions fight for executive power. Any extended uncertainty about who is in control would be severely destabilising for the fragile Pakistani state and the wider region, while also having a negative impact on the economy.

The country has also been experiencing a series of home-grown terrorist attacks and the government seems unable to predict which areas, buildings, or organisations might be targeted. On December 7, 2009 three attacks took place in Lahore, Peshawar and Quetta. Two explosions in the Moon Market area of Lahore killed 49 people and injured 130. In Peshawar it is estimated that 10 people were killed and 45 injured in a suicide attack at the entrance to the Sessions Court. Ten people were injured when a remote controlled Improvised Explosive Device was detonated in Quetta. On January 1, 2010 an attack at a volleyball match in Lakki Marwat, NWFP killed at least 93 people. On March 8, 2010 a bomb exploded in the Model Town area of Lahore, Punjab. Reports said that at least 11 people have been killed, and 60 injured.

Japan
The new Democratic Party of Japan (DPJ) government of Prime Minister Yukio Hatoyama is rapidly losing support, with its approval rating having fallen to 37 percent in February from more than 70 percent last September. A key reason for this is public dissatisfaction with a funding scandal centred on DPJ Secretary-General Ichiro Ozawa, who has refused to resign. He is a key campaign strategist and political fixer for the DPJ, and his departure would be a major blow for the party ahead of Upper House elections due in July. While the DPJ has an overwhelming majority in the Lower House, an Upper House majority would allow it greater freedom in policy implementation. Although Japan is officially out of recession, its recovery is looking very shaky, and any further deterioration in economic conditions could further undermine the DPJ’s popularity.

But there are some positive points, particularly in terms of business and investor appetite. At the end of February the country’s financial services regulator announced that companies with a listing in Japan will have to disclose more information about their corporate governance practices and how much they pay directors. The new disclosures, released by the country’s FSA, are aimed at giving investors more of the information they need to hold companies to account. Currently, Japanese companies are allowed to withhold information that is taken for granted in the US.

Companies will have to reveal the names of any directors earning more than $1m and give a breakdown showing salary, bonus, stock options, and pension payments. The same applies to “statutory auditors,” who are the Japanese equivalent of non-executive or supervisory directors. Companies will also have to disclose the roles of their independent directors, whether they have any financial or accounting expertise, and the details of their relationship with the company’s internal audit function.

The FSA also wants to make companies report more about the outcome of resolutions put to their annual shareholder meetings. Currently, Japanese companies only have to report if a resolution was passed or not. In the future, they will have to reveal the number of votes cast for or against and the number of votes withheld. More detailed voting disclosures, “will give a clearer picture of the decisions made by shareholders, which will entail a better functioning of the market pressure over the management,” the FSA said. The proposals will take effect on March 31.

In December, the Asian Corporate Governance Association (ACGA) said that Japan’s corporate laws should be reformed to make the country’s rules on independent directors clearer. The lobby group used a new position paper on governance reform to argue that Japan’s current legal definition of what constitutes an “outside director” is “weak and often confusing to foreign investors and others.”

The ACGA called for listed companies to bring independent voices into the boardroom and to enable their boards to play more of a strategic oversight role.

Brazil
Brazil has signalled that it wants to collect a much bigger chunk of the profits from the oil that it produces. The country, which produces about 2.4 million barrels of oil a day, currently requires oil companies that do business on its soil to pay around 50 percent of their profits to the government in either royalties or corporate taxes.

That’s in line with the rates paid in other “low-tax” countries like the US and Canada. But a major new discovery off of the country’s coast, estimated to contain as much as 50 billion barrels of oil and natural gas, could change all that. With this new resource in mind, Brazilian lawmakers are considering a bill that would push the effective tax rate for outside oil companies north of 80 percent, terms similar to countries like Iraq or Norway.

The legislation would require that international energy outfits get the majority of the materials used to extract oil from Brazilian suppliers, and would give the government final say over which projects get developed. The new law would also require any oil firm operating in the country to partner with Brazil’s state oil company Petrobras, which would be solely responsible for laying the infrastructure required to extract oil and ultimately overseeing all the production. International oil firms would be relegated to providing funding and technical know-how in exchange for a share in the profits.

While oil firms may not be reluctant to offer praise for the proposed legislative change, they are still interested in operating there. But the problem is working with Petrobras. Analysts and industry experts believe that by requiring Petrobras to be involved in every Brazilian project, the whole country’s oil production process could be slowed down as the firm would not have the resources or manpower to carry out the work as the new oil and natural gas fields cover thousands of square miles of ocean.

Nigeria
Like Brazil, Nigeria is considering hiking its royalty rate and requiring much of the material used in construction projects to be locally made. It also wants its state oil firm to have a bigger role in projects. The major difference is that Nigeria, unlike Brazil, lacks both a technically advanced state oil company and a major industrial base to make home-grown equipment for the industry. Another problem is that Nigeria may very well introduce these new oil-producing terms despite the major shortcomings within its domestic industries.

The proposed law has prompted one major oil firm operating in the country to call it “a cumbersome document that lacks insight into the very basics of our industry”, adding that the royalty provisions are some of the “harshest in the world.”

But other oil producing countries are moving in a similar direction. Kazakhstan, a lucrative spot for a consortium of international firms including British Gas and Italy’s Eni, may also tighten its tax policy. Venezuela, which is experiencing a decline in oil production, has made more fields available for the international oil firms to bid on, although the terms remain tough.

As the world slowly seems to be recovering from one crisis, some countries seem to be heading for yet another precipice. Greece, the only EU country that was denied the right to enter the Eurozone at its birth, is wreaking havoc on the currency now. Though undoubtedly a mixture of poor budgeting and heavy government spending play their part in the Greek drama, a more palatable alternative explanation has been bandied around – that the economies of debt-laden member states are prey to speculators on Wall Street and in London.

The crisis unfurled quickly. Early this year, fears of a sovereign debt crisis developed concerning Eurozone countries such as Greece, Spain, Ireland, and Portugal. This led to a crisis of confidence as well as the widening of bond yield spreads and risk insurance on credit default swaps between these countries and other Eurozone members, specifically Germany and France.

At the beginning of February, a Ä500m government bond auction in Portugal only successfully raised Ä300m, raising the cost of insuring against a Portuguese debt default. The failed Portuguese bond auction further intensified the fear that the emerging sovereign debt issues could become a global contagion. These fears led to a weakening of the euro and a widespread global stock and commodity sell off.

Since then, Greece has been the focal point of the crisis. The country’s government debt was estimated at Ä216bn in January and its budget gap, at 12.7 percent of GDP, is the EU’s biggest and is more than four times EU limits. A market frenzy has seen traders make bets worth billions of dollars against the euro and on the chances of Greece not repaying its massive debts. Those market worries have undermined the 16-country currency and spilled over to other vulnerable states such as Spain and hiked their borrowing costs. Eurozone leaders have blamed speculators in London and New York for worsening Europe’s government debt crisis.

At the beginning of March the Greek government outlined measures to save Ä4.8bn, including higher fuel, tobacco and sales taxes, as it seeks to lop four percentage points off the budget deficit. The EU has sought to restore stability by boldly announcing that the country is “on track” to achieve its deficit-cutting goals following the passage of extra austerity measures. The new measures put Greece “onto the path of fiscal adjustment for 2012 below three percent” of GDP, according to the EU’s Economic and Monetary Affairs Commissioner Olli Rehn.

Stepping in
José Manuel Barroso, European Commission president, has promised to examine whether legislative action is needed to limit trade in complex financial instruments such as credit default swaps amid concern that international speculators have made Greece’s financial problems worse.
 
Addressing the European Parliament in Strasbourg on March 9, Barroso said: “If it is true that the current problems in Greece were not caused by speculation on the financial markets, it is also true that this speculation was an aggravating factor.” He added that there was a need for “ad hoc reflection” on credit default swaps on sovereign debt.

Credit default swaps are a form of insurance for buyers to protect them against the risk that a seller or borrower would default on a security such as a government bond. In “naked” sales, the buyer does not hold the underlying asset and faces no such risk – but can make a profit on the swap itself.

The Greek government has blamed hedge funds for driving up its borrowing costs by speculating on such swaps on its government bonds. Prime Minister George Papandreou has compared the practice of selling naked credit default swaps to buying insurance on a neighbour’s house and then burning it down to collect.

At the time of Barroso’s announcement, he was in Washington to meet with President Obama. “Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system,” Papandreou said in a speech in Washington ahead of the meeting.

Barroso said the problem of “naked” practices “needs particular attention”. The Commission would therefore “examine closely” the relevance of banning purely speculative naked sales on credit default swaps of sovereign debt, Barroso said. He added that there must be co-ordination to ensure that member states take action together, as well as the need for international co-ordination.

“These markets are as mobile as they are opaque,” Barroso said, adding that the Commission would raise the issue with international partners in the G20 group later this year. He said there should be an “in-depth analysis” of the credit default swaps markets to see if “questionable practices” were taking place. If all else fails, he promised to put antitrust regulators on the case who could examine if dealers formed an illegal cartel in agreeing to place coordinated bets against the euro.

Barroso said that the Commission had started an action programme to ensure an “efficient, safe and solid” derivative market back in 2009. A lack of transparency on derivative markets is generally regarded to be one of the contributing factors to the financial crisis as many derivative contracts were not traded on authorised exchanges but among financial markets players. When problems occurred there was no central clearing house to resolve disputes and establish a fair value for investments.

Barroso said that Michel Barnier, European commissioner for the internal market, would present a proposal on derivatives before the summer. There would also be new proposals on market abuse by the end of the year, Barroso said, which would “increase market transparency and limit risks”.

The US does seem to be listening – and it also seems sympathetic. On March 9, Chicago Federal Reserve President Charles Evans said that “I am a little concerned that instruments like that found their way into the current financial distress and found a way to generate additional inter-connectedness of agents and financial institutions beyond what most people understood, I think, in securitisation markets.”

While Evans said that credit default swaps can be useful for hedging purposes, he said the potential for spill-over effects from the instruments needs to be explored. He expects additional discussions at the international level on the issue. “I think that the proposals to net them at some clearinghouse level are potentially very useful,” he said.

Unseen debt
Ben Bernanke said in February that the central bank is looking into derivatives transactions that Goldman Sachs and other US banks made with Greece amid concerns that they might have been used to help the government hide its debt. The SEC is doing its own probe.

Other European leaders are also campaigning for action to be taken. German Chancellor Angela Merkel and Luxembourg Prime Minister Jean-Claude Juncker have called for urgent regulation of credit-default swaps to shore up the euro area and prevent a rerun of the Greek financial crisis. Merkel has said that “quick action is needed,” calling on the US to “make a gesture” and curb the trades. She has complained that “institutions bailed out with public funds are exploiting the budget crisis in Greece and elsewhere”. French President Nicolas Sarkozy is also turning to regulatory efforts to help tame the surge in Greek financing costs.

Germany, which can borrow at the lowest interest rates in the EU and has the union’s largest economy, has been looked to as the source of a potential bailout for the Greek government should it fail to raise the necessary money to fill its budget gap through the credit markets. While Merkel has stated that Germany “would stand by Greece”, a potential Greek bailout has proven unpopular with the German public and the country’s politicians, particularly as an election looms ahead. German politicians called on Greece to sell some of its islands to pay off its debts. Papandreou has suggested that his country could seek relief from the IMF – an idea that was met negatively by the President of the European Central Bank, Jean-Claude Trichet.

While there is consensus that something needs to be done to regulate the derivatives markets and credit default swaps in particular, as well as establish some kind of mechanism which can help EU members that suffer at the hands of speculators, no one is quite sure what that mechanism should be, how it can work, and how quickly it could be brought into effect. The European Commission has said that it will produce plans for a European monetary fund to help Eurozone countries that get into financial difficulties.

While the plan has the backing of Wolfgang Schäuble, Germany’s finance minister, who said it would work as “a measure of last resort” and only after “a cascade of sanctions” against governments that break euro rules, his chancellor is less keen, arguing that the fund would require a change in the Lisbon Treaty, which defines the EU’s constitution, that would be very difficult to achieve. French Finance Minister Christine Lagarde said a European monetary fund may not be the best option. “Other ideas need to be studied and those that respect the Lisbon treaty are much preferable,” she said. Luxembourg’s Juncker says any such fund should not create an opening “for countries that don’t take budgetary discipline so seriously.”

Bundesbank President Axel Weber, an ECB governing-council member, also questioned the fund proposal. Jürgen Stark, a member of the European Central Bank’s executive board, has also expressed doubts about setting up such a fund. Instead, Weber sees the need for more transparency in the credit-default-swap market. “The credit default swap market has developed very strongly and drives prices in bond markets,” Weber told reporters in Frankfurt. “Not everybody who buys protection has an underlying exposure. It’s a very opaque market and we need to have a much more transparency.”  

While European leaders seek ways to limit credit-default swaps, Germany’s BaFin financial regulator said market data lack evidence that the instruments were used to speculate against Greek bonds. Data provided by the US Depository Trust & Clearing Corporation did not show that new open positions were built up and also does not indicate “massive speculative action,” BaFin has recently stated.

London has also attacked the plans, calling them “misguided” and “unworkable”. Terry Smith, chief executive of broker Tullett Prebon, compared the plans to “someone suffering a major injury and then being supplied with a strip of Elastoplast”.

“Whether you reflect back on the Asian currency crisis of the nineties… or on 2008, when regulators banned short selling of financial stocks, the crises weren’t caused by speculators,” Smith added. Markus Allenspach, the head of fixed income research at Julius Baer, said credit default swaps may have accelerated market moves but did not cause any of the underlying imbalances. “This is shooting the messenger,” he said.

The crackdown on speculators has also got short shrift from bond market experts who say that it would be impossible in practice to unravel the complex interrelated web of credit default swap positions. “Unless policymakers make it absolutely clear what does and does not count, uncertainty will cause extreme volatility, and they run the risk of ending up with worse problems than they started with,” said Simon Thorp, head of fixed income at Liontrust Asset Management.