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The Future of Financial Regulation

POLICY PAPER


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ABOUT ACCA

ACCA (the Association of Chartered CertifiedAccountants) is the global body for professionalaccountants. We support our 131,500 membersand 362,000 students throughout their careers,providing services through a network of 80 officesand centres. Our focus is on professional values,ethics, and governance, and we deliver value-addedservices through 50 global accountancypartnerships, working closely with multinationaland small entities to promote global standards andsupport.

We use our expertise and experience to work withgovernments, donor agencies and professionalbodies to develop the global accountancyprofession and to advance the public interest.

AUTHORS

ACCA would welcome comments on this paper andlooks forward to contributing further to the currentinternational debate.

Ian Welch, head of policy, ACCA+44 (0)20 7059 [email protected]

John Davies, head of business law, ACCA+44 (0)20 7059 [email protected]

www.accaglobal.com

The Association of Chartered Certified Accountants,

June 2009

Contents

1. Introduction 1

2. The nature of the financial crisis 3

3. Principles of financial regulation 11

4. Conclusion 29

Quotes 30

Contributors to paper 32


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1THE FUTURE OF FINANCIAL REGULATION 1. INTRODUCTION

The current global financial crisis has been the biggest ofits kind for decades and will have consequences that willbe with us for many years to come.

The first steps in the worldwide response to the crisis havealready been taken. Governments in many countries haveborrowed huge amounts of money to help beleagueredinstitutions in the financial sector to survive. In some casesmassive public support has also been extended tostrategically important businesses in the 'real' economy.

Nonetheless, these are only the first steps in what must bea longer process. What is also essential is that weunderstand exactly what went wrong and take appropriate

action to ensure that the financial system as a whole ismore resilient and is better able to withstand future shocksof this magnitude so as to contain their consequences forthe wider economy.

The scale of the impact of the financial crisis explains whythere is currently so much interest being expressed inrespect of regulation. If we are to make meaningfulimprovements, we need to understand whether someaspects of regulation contributed to the problems andpossibly encouraged them, whether companies andfinancial institutions could have acted more responsibly,and if aspects of individual behaviour need to be

addressed.

1. Introduction

This paper is intended as a contribution to this processand is presented as a guide for governments, regulatoryauthorities and standard-setters. The paper is in two parts:the first sets out to explain the nature of the crisis and thesecond lays down a number of principles which ACCAbelieves should be reflected in the future design andadministration of regulatory systems in the financial andbusiness sectors.

The report incorporates comments provided by manysenior figures from the finance industry and accountancyprofession in major capital markets around the world,sourced by ACCA's network of national offices. It alsodraws on opinions offered at a round table event held in

London, which was attended by bankers and financialservices professionals. A full list of contributors appears atthe end of the paper and ACCA thanks all contributors fortheir time and informative insights into this importantsubject. The contents of this report represent ACCA's ownopinions and conclusions and so do not necessarily reflectthe views or policies of either the individuals quoted or theorganisations for which they work.


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SUMMARY

1. The apparent recent failures of the 'light touch' approachto regulation should not lead authorities to concludeautomatically that a heavy-handed approach would be theappropriate solution. While it is understandable thatgovernments wish to be seen taking decisive action inresponse to crises, it must be recognised that regulatoryfailures have occurred under both types of approach. Thecrisis in the banking sector occurred not because of a lackof regulation the sector has in fact been subject to a veryextensive rulebook but because of the ineffectiveness ofthat regulation. Regardless of the conceptual approachadopted, what is essential is that regulatory authorities are

effective in carrying out their various functions, inparticular the supervision of regulated entities, andsucceed in their regulatory objectives.

2. The element of competition is key to effective regulation.The greater the size and complexity of a business, themore difficult it becomes not only to regulate but tomanage. The phenomenon we have seen of banks that are'too big to fail' must stimulate governments and regulatorsto promote healthy competition in the marketplace, bothfor the benefit of the wider economy and for theachievement of more effective regulation. The benefits ofcompetition should also be borne in mind in determining

the extent to which international alignment of regulatorypractices is appropriate. Moves initiated by the recent G20meeting of world leaders to encourage the sharing ofknowledge and best practice on a global or regional basisare welcome, but this does not necessarily mean thatuniform requirements and procedures must be adoptedby all regulators regardless of local market circumstances.

3. The framework of regulation adopted in any countrymust have a clear purpose that is understood byregulators and regulated entities alike. In the bankingsector, the protection of depositors should be seen as theprincipal objective in the context of encouraging publicconfidence in the system. There must be mechanisms in

place for ensuring effective communication between thetwo sides, and regulators should endeavour to generate apositive commitment on the part of regulated entities tothe achievement of the objectives of the process.Regulatory authorities must also have sufficient resourcesto ensure that the market knowledge and skills of theirstaff are, and remain, adequate for the purpose ofexercising the effective supervision of complex businessstructures and evolving business practices.

4. Regulatory authorities should take reasonable steps toensure that regulated entities possess the skills andexperience, at all levels of the business, necessary forthem to comply with regulatory requirements and protectthe interests of their stakeholders. Authorities should alsoencourage the adoption, in financial institutions, of ethics-based corporate cultures that have the aim of ensuringthat they act transparently and with a real appreciation ofthe long-term interests of their stakeholders.

5. Regulators should adopt a systemic approach to thesafeguarding of stakeholder interests, ensuring all relevantfactors are addressed effectively. In the financial sector,this means, among other things, taking wider macro-

economic factors fully into account. This will complementmore effective monitoring of the capital and leverage ratiosof individual institutions. The activities of specialisedentities that are currently outside the regulatory net shouldbe reviewed and, where appropriate, brought within itsscope.

6. The accountancy profession must consider ways ofmaking the processes of financial reporting and auditingmore useful to stakeholders. Enhancing the quality ofreporting on risk should be central in this context, but it isneither necessary nor desirable to redesign accountingstandards so as to meet the specific information

requirements of regulators. Information that regulatoryauthorities need for their purposes should be obtainedseparately, via dedicated prudential rules.

7. The crisis has highlighted a number of seriousweaknesses in corporate governance and riskmanagement practices, even among companies whichfollowed the express requirements of official guidance onthese matters, and these failures need to be addressed.There needs to be a specific review of the role of non-executive directors, and in particular consideration ofwhether new measures could be taken to enhance theireffectiveness in exercising supervision of the executive inlarge and complex institutions. Companies can also do

much more to engage with their shareholders and toencourage them to play an active but responsible part inthe governance process.


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3THE FUTURE OF FINANCIAL REGULATION 2. THE NATURE OF THE FINANCIAL CRISIS

Regulation has rarely has such a high profile. Formerlyseen as the natural preserve of back-office compliancestaff, it has become big news since the global credit crisisand dominated much of the thinking of world leaders atthe April 2009 G20 summit in London.

Why is this? Politicians are determined to ensure that theunprecedented financial crisis and the widespread publicanger at the behaviour of banks, which was one of theprincipal causes of it can never happen again. Given thescale of taxpayers' money required to shore up banks'balance sheets, it is understandable that governmentsseek to reassure their electorates that lessons have beenlearned. Stronger regulation is seen as a visible way of

proving that point.

But have the right lessons been taken on board? Was thecrisis essentially a regulatory failure? Or were there othermore important factors? And what should the regulatorysystem of the post-crisis world look like? This paperreviews these issues and suggests a number of principleswhich should underpin effective systems of regulation.

ACCA has consistently argued1that the crisis was more afailure of governance in banks than of regulation per se. Alack of accountability, both within financial institutions andbetween management and shareholders, was at the heart

of the problem. This led to the following problems:

failure in institutions to appreciate and manage theinterconnection between the risks inherent in theirbusiness activities and management and remunerationincentives

remuneration structures/bonuses of banks werecharacterised by short-term goals, which neithersupported prudent risk management nor worked inowners' long term interests

risk management departments in banks did not havesufficient influence or power

weaknesses in reporting on risk and financialtransactions.

1. See Climbing Out of the Credit Crunch, ACCA, September 2008, and Corporate Governance and the Credit Crunch,ACCA, November 2008, .

2. The nature of the financial crisisand its consequences for regulation

Further contributory factors identified were:the over-complexity of financial products and lack ofmanagement understanding of the associated risks

an over-dependence on debt

the scale of issuance and the interconnectedness offinancial institutions

human weaknesses: a failure to appreciate theinfluence of cultural and motivational factors such asrigidity of thinking, lack of desire to change

the lack of rigorous challenge by non-executivedirectors possibly caused by poor understanding of thecomplexities of the business

bad habits and complacency after a ten-year bullmarket.

These, and related, factors have been subsequently pickedup by a series of high-profile reports which haverecommended new regulatory principles in an attempt toaddress them and to fix the wider financial system. Thesereports include:

Financial Reform: A Framework for Financial Stability, The

Group of Thirty (G30) (chaired by Paul Volcker),January 2009

The Global Economic Crisis: Systemic Failures and

Multilateral Remedies, United Nations Conference onTrade and Development (UNCTAD), February 2009

Lessons of the Financial Crisis for Future Regulation of

Financial Institutions and Markets and for Liquidity

Management,IMF, February 2009

The Turner Review: A Regulatory Response to the Global

Banking Crisis,FSA, March 2009

Financial Supervision and Stability in the EU (the DeLarosiere Report), European Commission, March 2009.


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In the report,A Critical Connection: Making the LinkBetween Regulation and Shareholder Value, 176 seniorfinance executives in China, Singapore and Malaysia weresurveyed, and almost 60% believed regulation enhancedshareholder value (defined as the ability to deliversustained steady growth in share price and cash flow overthe long-term) while fewer than 25% believed it hinderedeconomic growth. Executives said effective regulationallowed them to focus more on strategy, and had a positiveimpact on the key drivers of shareholder value within abusiness, such as data quality and risk managementcontrols the very issues that have proved to be a keyweakness in US and European banks.

International Financial Reporting Standards, taxregulations and stock exchange regulations all of whichaided investors and helped to place Asia-Pacific marketson a level playing field with the US and Europe wereviewed as the most helpful rules in creating shareholdervalue. Interestingly, even Sarbox, widely regarded in theWest as the epitome of knee-jerk over-reaction to a crisis,was found to be helpful by over half of respondents in thesouth east Asia region. Sarbox replicates financialdisciplines, processes and internal controls which alreadyexisted for most UK and US companies, but in thedynamic South East Asian market many newer businessesfound it useful that everything had to be documented and

audited, giving the business more confidence to focus ongrowth.

There are two crucial points here. The first is relevance the regulations were seen as directly applicable andappropriate for the markets. The second is the rightmotivation regulations were seen to be genuine attemptsat increasing transparency and helping businessesprosper, rather than as a way for governments to furthersocial goals or raise revenue by burdening business. Anyadditional form of regulation should pass this'acceptability' test.

The final point of note was mentioned by one Chinese

regulator, who said he had to 'consider the benefits andcost of securities regulation from the view of the wholecapital market, not a single company. The key factor isbalance and it is always difficult for the regulator to make adecision. If we can achieve balance, shareholder value willincrease.' Regulation only works when it is applied andenforced consistently.

There is a large degree of agreement in these reports, andthey all propose a considerable toughening of the 'light-touch' approach to regulation that is now deemed to havefailed to prevent the crisis. It should be noted, though, thatsome of the G20 leaders who have called for heavierregulation in the light of the banking crisis were praisingthat same light touch approach just two years ago. Thelesson from this is that great care should be taken whenthe new system is put together and knee-jerk reactions topolitical demands carefully avoided. Many would arguethat, while a strong reaction on the part of the USgovernment was inevitable following the Enron debacle,SarbanesOxley ('Sarbox') was nonetheless an over-reaction to that crisis which in turn created its own

problems. We should recall the mistakes made during thatepisode before jumping to easy conclusions this time.

In this paper, ACCA has drawn upon the views of itsmembers but also those other business and financialleaders from key financial centres around the world. It iscrucial that, in an interconnected global economy, viewsfrom broad perspectives and a wide range of capitalmarkets are heard.

NATURE OF REGULATION

Before we discuss the specifics of banking regulation, it is

worth examining aspects of wider business regulation and the starting point for any analysis of regulation is to beclear about what it is intended to achieve.

ACCA believes that the purpose of regulation is to facilitatelegitimate and competitive business activity, whileproviding safeguards for the interest of stakeholders. Theimportant point to note here is that regulation, which hasacquired, certainly in Western markets, a negative 'red-tape' connotation, should be regarded as making a positivecontribution to business success. If it is not doing this, theregulations should be reviewed.

A 2007 survey by ACCA and CFO Research Services

showed a distinctly more positive response to businessregulation in South East Asian markets, where it wasregarded as strengthening rather than hinderingshareholder value.


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ACCA would also point to lessons learned from theregulation of its own professional accountancy sector,which can be applied to the banking industry. First, the eraof self-regulation passed in the 1990s when it becameclear that a situation where the regulatory structures werecontrolled and funded by those being regulated no longercommanded sufficient public credibility to be acceptable.At the other extreme, direct government intervention inregulatory and monitoring processes can underminelegitimate business and professional judgements.

Instead, the generally accepted model for the professionnow is one where a strong independent central regulator isrequired, one with robust and transparent public oversight.

The governing board or council of a professional regulatorshould consist of a relatively small number of individualsand should be representative of the major stakeholdergroups. There should be public oversight of the systemwith heavyweight industry experts involved in monitoring,who have legal and regulatory teeth to pursue issuesidentified. There is also separation of policy making (rulesand regulations) and compliance (monitoring andenforcement).

BANKING REGULATION

Turning specifically to banking regulation, the G30 report

refers to the need for a system 'in which those responsiblefor prudential regulation and supervision have a highdegree of political and market independence and theresources necessary to supervise giant institutions and tokeep abreast of market innovations'. We would stronglysupport this view.

The G30 report also calls for 'stronger regulatoryincentives for holding large (systemically significant)institutions to the highest standards of governance andrisk management'. It has already been made clear thatACCA believes the crisis to be essentially one ofgovernance. Risk-based and principles-based regulationshould be at the centre of any new system and Large

Complex Financial Institutions (LCFIs) should be expectedto satisfy the authorities that they are continuously,actively and competently managing risk in the particularcircumstances of their business. Regulators need to beacutely aware of responding appropriately to those firmsthat have fundamentally changed their business model.

This means targeting those banks that are strategicallyimportant with specific and tailored regulatory policies,rather than using a 'one size fits all' approach. ACCAagrees with the suggestion that there should be a form of'systemic risk surcharge' for certain institutions, requiringthem to hold more capital against risks. The Turner and deLarosiere reports, amongst others, argue that there iscurrently no adequate way of regulating LCFIs. ACCAsupports the concept of some form of segmentedregulation, similar to the GlassSteagall principles ofseparating investment banking from deposit taking, whilerecognising the practical difficulties of establishing acomplete barrier between the two functions.

The GlassSteagall principles are sound because theyensure clarity of purpose on what banking regulation issupposed to achieve. Given the severity of the collapse inconfidence in financial institutions, it is essential that thepublic is reassured that consumer protection is at theheart of the regulatory system. A clear separation ofdeposit-taking from investment banking must be the aim.Effective and efficient compensation schemes must bepart of the system, while the regulators should be urged togive more priority to increasing public 'financial awareness'as part of consumer protection. It is also important thatconsumers and their representative organisations areengaged in the regulatory process as far as possible.

There is going to be a natural aversionto risk-taking associated with complexproducts.

PETR KRIZ, PWC CZECH REPUBLIC

While this paper does not seek to make recommendationson the specifics of capital adequacy, ACCA agrees thatBasel 2 needs reform by re-weighting the comparative

liquidity risks with market and credit risks and beingsimplified so as to allow better practical application. Withregulators, as mentioned by de Larosiere, seeking toreduce the problem of pro-cyclicality in the existing capital(and accounting) rules, we are attracted by the Bank ofSpain's policy of carefully scrutinising banks' internalprovisioning models or imposing its own dynamicprovisioning model. The aim is to allow an accumilation ofa general cushion in good times, to be released in badyears as specific provisions for loan losses need to bemade. This is the sort of measure that could be usefullymade in the short term, while allowing properconsideration to be given to any longer-term structural

changes.


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A sensible model was put forward by the de Larosierecommittee, which proposed a European Systemic RiskCouncil to bring together representatives from all thecentral banks and financial regulators in Europe and for abinding mechanism to be set up to ensure that suchgreater macro-prudential findings are followed through bymicro-supervisors in the various EU states. PhilippeDanjou,2a former director of the French securitiesregulator, the Autorit des Marchs Financiers, andcurrently a member of the International AccountingStandards Board (IASB), believed this was a much moreattractive approach than trying for a 'European SEC'. Whileregulations and standards can be agreed at a regionallevel, practical supervision and enforcement need to be

carried out at a national level. Danjou said the secret ofgood supervision was to be close to the institutions beingregulated, using the analogy of a good police officerknowing his or her 'beat'.

An issue that arises here, though, is that of 'who pays?'when there is a crisis. As we saw with Lehman Brothers, itwas not 'colleges of supervisors' who discussed the issueover the crucial weekend, but finance ministers. Politicianshave a key role to play here in upholding agreements,rather than undermining them as we have seen in the fieldof accounting standards, with banks in both the US andEurope successfully lobbying their own governments to

secure concessions to 'mark to market' rules from theInternational Accounting Standards Board (IASB), which ismeant to be an independent body. Such short-termpolitical loss of nerve can only damage the prospects ofglobal accounting standards at a cost of long-term damageto business and does not bode well for wider financialregulation.

It is essential that the new body, the Financial StabilityBoard (FSB) agreed at the G20 meeting works well withthe International Monetary Fund to spot developing risks inthe world's financial system and to provide early warningof emerging problems. The board has already madepronouncements about the future supervision of hedge

funds and credit rating agencies and, it appears, the FSBwill also review the existing standards-setters such as theIASB and the Basel committee. It is essential that they dothis with the long-term interests of the world economy inmind.

2. Danjou is speaking in a personal capacity and not on behalf of theIASB or its staff.

ACCA believes that better micro-regulation by regulators inareas such as this could have prevented the hugeincreases in leverage in the banking sectors. In 20034,after the easing of the GlassSteagall Act in the US (and apossible delayed reaction to the dot-com crash of 2000)banks' ratios of capital to debt increased from 1:12 to upto 1:40. It is hard to dispute that keeping a closer eye onindividual banks would have been worthwhile here.

ACCA supports the Dubai Financial Services Authority'ssubmission to this paper, which like that of othersignificant institutions, highlighted the need forsystemically important products and instruments to beregulated. The DFSA gave the analogy of how new medical

products are examined by the Federal Drugs Agency toensure their impacts are understood. This is an idea worthfurther consideration.

INTERNATIONAL COORDINATION

The difficulties of regulating LCFIs would be immense evenif they were purely national firms, but the depth of theproblem was shown most starkly by the crash of theso-called 'global in life, national in death' firm LehmanBrothers. This left administrators in various countriesdealing with very different insolvency rules, which cannotbe sustainable.

It is essential that there is greater cooperation andcoordination between national governments andregulators, although the G20 summit understandablystopped short of calling for a single global regulator, givenboth the principles of subsidiarity and the reality thatnational sovereignty demands that national regulatorscarry out day-to-day activity in each country. It can bereasonably argued that a global regulator could onlyfunction if there were a global government.

Enforcement must be carried out at

national level. Regulators should beclose to those being regulated.

PHILIPPE DANJOU, EX-DIRECTOR, AUTORIT DESMARCHS FINANCIERS


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Given also that the effects of problems in the internationalfinancial system have the potential to exert an immediateand lasting effect on all countries, any new internationalstructures to be established should be truly global andshould allow the voice of the developing world to be heard.

ACCA firmly agrees with UNCTAD and the World Bank thatthe developing countries must be given a safety net in anyrevised global system of regulation. The emergingeconomies in Africa, Asia, Latin America and Central &Eastern Europe have a huge role to play in boosting theworld economy and it is essential that their interests arefully recognised. One concrete way of doing this is byundertaking a review of the international bodies

themselves, such as IMF and the World Bank, which wereset up in the post-war era and whose membership reflectsthe needs of that era. Just as the G7 has become the G20,all such bodies need to adjust to modern realities.

COMPETITION OF IDEAS

Although ACCA believes that greater coordination andlearning between regulators is important, it is essentialthat improved cooperation does not exclude competitionof ideas. We have already made reference to the Bank ofSpain's current work on provisioning, which other nationalregulators should examine for applicability to their own

domestic markets. Regulatory arbitrage must beprevented, but it is vital that regulators continue tooriginate solutions and ideas. In the US, having onedominant accountancy body did not prevent the Enronaccounting debacle, while the bailed-out mortgageproviders Freddie Mac and Fannie Mae effectively had theirown regulator. Healthy regulatory competition can preventthe risks of complacency.

The G20 leaders also committed themselves to achievinghigher levels of cooperation between authorities in theirdifferent countries and consistency in regulatory practices.ACCA believes that the regulation of the financial sectorwill be enhanced if coordination in matters of controls andstandards can be achieved in practice. Learning from bestpractice is one way to achieve this. Many of those spokento in the compilation of this report called for more regularformal and informal forums where national regulatorscould discuss issues of common interest, particularly atregional level where there may be common culturalunderstandings.

The success of any regulatory regime isthe ability to protect ordinary investorsbefore an unpredictable man-madedisaster happens.

US FINANCIAL REGULATOR

The regulation of the financial system should certainly aimto reflect the system's global character but it should at thesame time respect the fact that different countries and

regions are at different stages of market development. Andit must also be understood that the imposition ofregulatory rules on a standardised basis in all marketsmay be not only unrealistic but undesirable. For example,in relation to regulatory strictures for company boards toappoint a minimum number of non-executive directors,there may not always be an adequate pool of individualswho are sufficiently qualified and experienced to performthat role effectively. And if all countries imposed uniformregulatory standards, and we subsequently experiencedanother major crisis, all countries would suffer in exactlythe same way.

In pursuing a strategy of coordination, it should be bornein mind that the impact of regulation depends to a greatextent on the effectiveness with which regulatoryauthorities carry out their responsibilities: this aspect will,as ever, call for adequate levels of resources to be madeavailable. It seems likely that the international communitywill need to address not only the issue of achievingcoordination of standards but also the implications ofresources for consistency of application.


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INTERNATIONAL BANKING

The internationalised and interconnected nature of themodern banking system makes it essential that whateversteps are taken to enhance the effectiveness of theregulation of the sector, they are coordinated as far as ispractical. The big retail and investment banks operate on aglobal basis and their successes and failures haveconsequences for economies across the world. It shouldfollow that the systems and practices adopted for thepurpose of regulating such entities should aspire to adoptand enforce common standards, albeit with provisionmade for significant variations in market conditions indifferent countries and regions.

It is also important that authorities recognise the cross-border realities of banking business. The president ofGermany's Bundesbank3has argued that the EuropeanCommission's tougher rules on state aid for banks,introduced as a response to the financial crisis, will havethe side-effect of making lenders withdraw from cross-border markets and become more nationally focused.Regulation should not focus on short-term problems at theexpense of damaging business in the long term.

HEAVY OR 'LIGHT-TOUCH' REGULATION?

It is understandable that some of those we contacted inthe preparation of this paper argued that the time forheavier regulation had come. Edgar Zhi, RBS's CFO inShanghai, said that the relatively minor damage sufferedby Chinese banks showed that 'an interventionist andhands-on approach would be more effective in regulatingthe current financial services industry, especially forderivatives and creative products. A highly leveragedbalance sheet should not come under light touchregulation methods.'

In Johannesburg, there are those who argue that SouthAfrica has been well insulated from the world economiccrisis by stricter credit regulation. Raj Mahabeer, CFO,

Auditor General's Office, South Africa, believes that 'theworld needs a highly regulated banking sector, whichshould be rules-based. Any transgression should bepenalised harshly, including imprisonment of certainleaders and shareholders. Such additional regulation willresult in better control of our economies and thepromotion of real growth'.

3. Axel Weber in an interview with Financial Times, 22 April 2009.

And in Europe, Danjou pointed to the relative lack ofexposure of French banks to riskier activity compared withthe UK as a possible indication that heavier regulation,such as tighter rules on bank capitalisation than wasrequired by international standards, had proved effectivein avoiding the worst of the trouble. He accepted, however,that this was not proof of a causal link, and it can certainlybe argued that the traditional caution of French banks inlending to homebuyers and other borrowers was equallysignificant. Danjou also argued that it was essential thatregulation should cover 'shadow banking' activities andthat all assets and liabilities were brought back onto banks'balance sheets.

Associating 'light-touch' regulation with'principles-based' and intrusive or closemonitoring with rules-based ismisleading. Those terms are notmutually exclusive.

DUBAI FINANCIAL SERVICES AUTHORITY

Other experts consulted in the compilation of this reportbelieved that the risks associated with off-balance sheetexposures were not always clearly understood, and theirramifications not always evident. One of the Big Four firmsin Dubai said that 'in many cases what was perceived to bean off-balance sheet activity turned out to be an on-balance sheet one, or became one, for example implicitsupport provided by the banks to service the CDOtranches in order to protect themselves against thereputational damage at the time of default'. ACCA wouldagree that institutions such as hedge funds and privateequity firms must also be regulated if quasi-bankingactivity is happening it should be regulated, no matterwhat the name of the institution.

Detailed rules-based regulation may have anunderstandable attraction for politicians in the light of thecrisis, but it can be convincingly argued that the problemin the banking sector was not lack of regulation of whichthere was no shortage but a lack of effective supervision.Too often regulators suffer from an insufficient number ofskilled and experienced staff to supervise complexinstitutions properly. Adequate funding of the newregulatory system is essential if it is to make a realdifference.


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Although there will always be a remuneration gap betweenregulators and banks, the UK's FSA is making efforts tobridge the gap by providing more attractive packages. Asenior FSA representative said the regulator was recruitingexperienced staff as it enhanced its supervisory approachand applied the increasingly intrusive style, as outlined inthe Turner Review. This additional recruitment had alsoenabled the FSA to increase its 'significant influence'function reviews, which have led several individuals towithdraw applications to take up senior City positions. TheFSA said, however, that it had 'to be mindful not to stifleinnovation. We do not want to regulate firms out ofexistence'. Striking the right balance is the key.

Richard Sun, a PricewaterhouseCoopers (PwC) auditpartner in Hong Kong SAR, argued that it was essentialthat regulators made every effort to understand theirmarkets and commit their staff to keeping up to date.Edgar Zhi also said that regulators were 'often academicsand from government bodies rather than banking and solagged too far behind the advanced banking behavioursand products'. More hands-on experience was essential.Several of our respondents pointed to the growing skillsgap between the regulators and those regulated.

These days a typical problem of theregulators and NEDs is that they are toofar from the banking industry.

EDGAR ZHI, CFO, RBS BANK, SHANGHAI

Even for those regulators with sufficient resources andknowledge, are there still inevitable limitations as to whatthey can achieve in terms of risk assessment?. Sun said hebelieved that risk management had risen sharply up theagenda in China, with companies typically having separaterisk-management committees.

Yet the late Lord (Eddie) George, former Governor of theBank of England, said in a lecture in September 2008: 'Idon't know of anyone who saw the sudden freezing up ofthe wholesale markets coming as it did, and I don't seehow one can realistically expect the regulator to foreseewhat happened when the financial experts operating in themarketplace didn't.'4

4. Annual lecture to The Worshipful Company of Chartered Accountants,Cass Business School (3 September 2008).

Is this a reasonable statement of reality or an attempt todeflect blame from regulatory failure? Regulators hadeffectively given their blessing to diversification and thespreading of risks via securitisation. Many managementteams and boards considered they were following the newbest practice and managing risk effectively by transferringthe risk of mortgage default to the buyers of the securities especially given that they were usually AAA rated.

Is it inevitable that regulators will always be one stepbehind those who are determined to find the loopholes inany system and push the rules to their limits? ACCAbelieves we must recognise that the spirit of enterpriseencompasses innovation and pushing of boundaries. We

cannot afford to crush this spirit if we are to allowhumankind to benefit from wealth creation and economicgrowth. So the challenge is to create a control frameworkwhich is not a straitjacket: it could be argued SarbanesOxley came close to this and it is where over-centralistremedies could take us.

The accountancy profession has much to contribute interms of fresh thinking on financial reporting and auditing,which are key parts of any financial regulatory system.Although some audit partners we spoke to insisted thatauditors were now asking more intrusive questions ofclients than ten years ago PwC's Sun talked of the

'watchdog becoming a bloodhound' others believed thatexpanding the scope of audit from checking financialstatements to companies' risk strategies was the key. TheDubai Financial Services Authority also floated the idea ofexpanding the audit committee's mandate to include risk.


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It must be remembered that no regulatory system iscost-free. The impact of compliance costs is alwaysgreatest on smaller companies, which will be the source ofmuch of the economic recovery. A Big Four partner inDubai warned that adoption of a rules-based approach,while helping in areas such as capital and liquiditymanagement, ran the risk of incurring a 'high cost ofregulatory compliance resulting in an extra burdenaffecting profits, and limiting necessary financialinnovation especially if these rules are derived as areaction to the recent crises and written in haste'.

It is essential that light-touch regulation, which hasbecome so disparaged in the political debate, is not

regarded as being synonymous with a principles-basedapproach. As the DFSA has pointed out, such anassumption is 'misleading'. ACCA believes that a principles-based system, sufficiently flexible to be relevant in afast-paced business environment but with strongeremphasis on ethical codes and practices, should be thebedrock of the new approach. While recognising thecomplexity of trading in global markets (and addressingthe over-complexity of some of the financial products,which was a major cause of the problem) is essential,regulation should nonetheless be grounded in simplicity.

'Auditors too need to assess moreforward-looking risk information and notjust financial statements. Accounts areimportant but out of date.'

DAVID WU, PWC ASSURANCE PARTNER

ACCA believes instinctively in market solutions rather thangovernment intervention, but we think the financial crisis issuch that all parties must work together to re-establishcredibility in financial regulation. A recent McKinsey reportpoints out that 'regulation is about solving problems thatsociety or businesses cannot solve alone, as well asmaking trade-offs among different objectives and theinterests of various stakeholders'.5

That report rightly points out that companies need to raisetheir sights and that lobbying against any regulation thataffects their sector should not be the default position forresponsible businesses: 'In the coming new era ofregulation, executives and regulators need, more than ever,

to learn from each other. Companies should take astrategic view of regulation and strive for solutions thatbenefit a wide range of stakeholders.'

This, ACCA believes, is the practical ethical approach thatwas lacking in the boom up to mid-2007, and that must bethe basis of the new regulatory era. As Adam Smith, thefather of modern political economy, taught the world,ethics and trust are the basis of an economy. We would bewise to revisit Smith in the search for the new regulatoryregime.

5. The McKinsey Quarterly, December 2008: 'Managing regulation in anew era'.


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11THE FUTURE OF FINANCIAL REGULATION 3. PRINCIPLES OF FINANCIAL REGULATION

The principles set out in the following pages comprise a number of what ACCA believes amount to core guiding aims forthe regulation of business activity. They cover not only matters that stand to be addressed and controlled by regulatoryauthorities but also those that call for action by business entities themselves. They have been influenced by a number ofconcerns that have come to light as a consequence of the banking crisis that began in 2007 and are intended to applyprimarily to the financial sector. They are, however, framed broadly enough to be capable of application, whereappropriate, to the regulation of business activity more generally. Similarly, the principles are directed at the regulation oflimited liability companies but may well be capable of extension to other types of entity, where there is a strong publicinterest in the conduct of their affairs.

The approach to regulation

Regulatory authorities should aim fundamentally toprovide assurance to the stakeholders of regulated entitiesthat a responsible authority is exercising the supervisionand control over those entities that they as stakeholdersare not in a position to do themselves, and to give themconfidence that this is being done effectively.

Regulatory authorities should have a thorough understandingof the business sector that they are supervising and shouldaim to acquire a similar understanding of the operationalpractices of individual regulated entities.

An effective approach to regulation should aim neither to

be ostensibly 'light touch' which would risk underminingconfidence in the integrity of the system or excessivelyrules-based, an approach which risks causing regulatedentities to lose sight of the overall objective of theregulatory process. The more sustainable alternative is toadopt a principles-based approach, which requiresregulated entities to focus on the purpose and objectivesof the exercise. Rules will always be needed, but thevolume of the rules imposed on regulated entities, and thelevel of their prescription, needs to be kept within thelimits of what is necessary in the context of the overallobjective. It is also crucial that all rules imposed must becapable of supervision and enforcement.

The extent of the supervision that is appropriate in relationto particular types of entity and business activity will varyaccording to the nature of the entities and activitiesconcerned and the risk posed to each entity, itsstakeholders and the achievement of the overridingobjective. Recent experience suggests, for example, thatsome types of activity and product, such as derivatives, docall for closer supervision than others. The regulation ofany large and heterogeneous sector should not thereforeassume that a uniform approach will always be effective:an effective system of regulation needs to be sufficientlyadaptable to be able to deal not only with different levels ofcomplexity but also with changes in the marketplace. What

should always underpin the system is a strongcommitment to principles, with an emphasis on ethicalpractices.

3. Principles of financial regulation

3.1 PURPOSE OF REGULATION

The overriding purpose of regulation shouldbe to facilitate legitimate business activitywhile providing safeguards for the interestsof stakeholders and ensuring faircompetition in the market. 'Safeguards forstakeholders' include:

deterring and restraining companies frompursuing illegal or excessively riskypractices that have the potential to have

wider social or economic consequences,and

intervening and responding appropriatelyand effectively where breaches areconsidered likely to occur or have alreadyoccurred.


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Compliance responsibilities should be imposed on entitieson a proportionate basis and should not have the objectiveor effect of inhibiting innovation and legitimate businessactivity unreasonably. Individual complianceresponsibilities should be commensurate with theregulator's need to know and should avoid imposingbureaucratic burdens that lack regulatory 'relevance'. Inorder to facilitate supervision, entities should be requiredto maintain full and accurate records detailing the actionsthey take to secure compliance with their variousobligations.

Regulation of the business environment, in whole or inpart, should adopt a systemic approach and aim to ensure

that all factors with a bearing on the achievement of theoverriding objective are addressed effectively. Thissystemic approach should take fully into account theimplications of wider macro-economic factors for theeffectiveness of regulation in the financial sector. In thecase of the banking sector, the regulatory authorities andthe central bank should actively contribute to the goal ofachieving stability in the financial system. Depending onthe area of business under review, relevant factors arelikely to include capital levels, risk management, financialreporting, internal controls, external audit, corporategovernance arrangements, actuarial practice and creditrating activities. Specialised types of entity that are

currently outside the regulatory net, but whose practicesmay have material or indirect economic consequences forstakeholders, may need to be brought within its scope.

Supervisory procedures should ensure that entitiescontinue to comply with their responsibilities and enablethe authority concerned to identify quickly failures andweaknesses that may call for expeditious regulatoryintervention.

Regulatory authorities should aim to establish effectivecommunication links with regulated entities. This isdesirable to achieve two outcomes. First, effectivecommunication is needed to promote understanding

among individual businesses of the purpose of theregulatory process and of the regulator's expectations ofthem. Second, it is in the interests of regulatory authoritiesthat they encourage a positive attitude towards complianceon the part of the regulated community. They should takepractical steps to convey to individual businesses that theprocess of regulation is intended to be a genuine attemptto increase transparency and to help good businessessucceed in a competitive environment. The intentionshould thus be that those subject to regulation shouldthemselves benefit from the process in meaningful ways.

EffectivenessIt is essential that any regulatory authority is and is seen tobe credible and effective, both by those who are subject toits scrutiny and by all interested stakeholders. This meanssupplementing necessary regulatory requirements witheffective supervision of entities' compliance with thoserequirements. With this in mind, the requirements that areimposed on regulated entities must in the first instance becapable of being monitored and supervised by theauthority concerned. Effective monitoring, supervision andenforcement must then happen in practice. To be in aposition to achieve these ends, regulatory authorities needindividuals who have skills, expertise and experience in thefield being regulated and who are capable of remaining

alert and responsive to developments in businesspractices. These factors will necessarily require authoritiesto have access to sufficient resources to allow them toperform their role properly.

It is also essential that authorities have a clear, strong andpublic commitment to carrying out their regulatoryresponsibilities. This commitment should be promotedfrom the top of the organisation and communicated to andadopted by staff at all levels.

As well as having the right human skills, effectiveregulation requires the authority to establish the

procedures necessary to exert proper supervisory controland to be prepared to vary and add to those procedureswhere developments in business practices render itnecessary. The banking crisis has shown how important itis that regulatory frameworks are designed and resourcedin such a way that they are capable not only of dealingwith increasingly complex structures, products andpractices but also of devising effective regulatoryresponses to them. Regulatory procedures need to identifythe types of information that are likely to be of materialsignificance to the regulator in carrying out its functionsand to ensure that such information is always available tothe authority and to an appropriate level of materiality,taking risk into account. At the heart of these various

procedures should be the goal of establishing an ethics-based culture among regulated entities.

Regulatory sanctions should be sufficient to encouragecompliance in the first place and to penaliseproportionately in cases of proven breach. Regulatoryauthorities need to be prepared to make full use of thepowers that are available to them.

AccountabilityRegulatory authorities should be independent of politicalcontrol but accountable to the democratic authorities forthe exercise of their functions.


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3.2 COMPETITION

Governments and national and regionalauthorities should regard the promotion ofhealthy competition in the market place ascrucial for enhancing the potentialeffectiveness of their regulatory systems.

One of the issues that needs to be addressed urgently inthe international response to the global banking crisis iswhether governments and regulatory systems whetherostensibly 'light' or 'heavy' touch in nature may havecontributed to the scale of the crisis by allowing entities tobecome ever larger and more powerful. This process,whereby some markets have become dominated by fewerand fewer mega-entities, has led to questions aboutwhether these entities have become too big to regulate.Are they now too big for governments to allow them to fail?It seems clear that the concentration of market power inthe hands of a few very large entities has presentedsignificant challenges to regulators. It is also beyond doubtthat the economic importance of many such entities has

caused governments around the world to take the viewthat on no account should they be allowed to collapse,even if it means spending huge amounts of public moneyto prevent it.

The implications of this continuing process ofconsolidation for the effectiveness of regulation are suchthat they need to be at the heart of the response to thecrisis. Regulatory authorities should see the promotion ofhealthy competition as being a key aspect of theirfunctions. Most importantly, it should not be consideredthat the scale of regulatory activity must always be allowedto expand in proportion to the increasing size of regulated

entities. Instead, there needs to be an acknowledgementthat as an entity becomes larger and more complex, therewill be consequences for the effectiveness of regulatoryactivities of all kinds: these will include not only activitiesconnected with external regulation but also those such asexternal audit, internal controls and board-levelsupervision of management. Governments and regulatoryauthorities need therefore to consider whether the level ofmarket concentration that has been allowed to develop isitself an indicator of regulatory failure. Whether or not theyagree that this is the case, they must address thefundamental point that the regulatory authority mustalways be capable of understanding the regulated entityand exerting effective supervisory and regulatory control

over it. If they consider that the process of marketconcentration has gone so far that this capability is beingundermined, they should consider acting to rectify thesituation.


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It should also be acknowledged, in the context of howregulatory authorities are likely to respond to issues ofmarket concentration, that there are wider implications forcompetition. The instinctive reaction on the part ofregulators may be to impose on entities in, for example,the financial sector very detailed compliance requirements,on the assumption that this is an appropriate risk-basedresponse for them to make. It needs to be borne in mind,however, that extensive regulation can have theeconomically undesirable effect of discouragingparticipation in the market by smaller entities, thustending to inhibit competition and lead to furtherconcentration.

The issue of healthy competition is also relevant toregulatory systems themselves. The experience of thebanking crisis suggests that the regulatory approachesthat were adopted in certain countries, including Spain,Australia and Canada, have helped to ensure that thosecountries, and their financial institutions, have avoided the

worst consequences of the crisis. Although there shouldcertainly be pooling of information, best practice andexperience among regulators, along the lines that havebeen suggested by world leaders, it may not be safe toconclude that there is any one best solution to the designof national regulatory systems that should be imposed onall countries, regardless of local market circumstances. Itmust also be borne in mind that different regulatoryobjectives are likely to be more appropriate for national,retail banks than for global, wholesale banks in theformer, consumer protection will be key while, in the latter,the main driver is likely to be the need to achievetransparency in the markets so as to enable participants tooperate at speed and on a large scale.

Any new global framework should therefore allow fordivergent approaches to be followed where the authoritiesreasonably consider such approaches to be effective formeeting the particular regulatory objective, andappropriate for application in the market concerned.


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3.3 STANDARDS OF BUSINESS CONDUCT

Companies should be expected tocarry out their activities inaccordance with high standards ofbusiness conduct.

The role of the boardA company's board of directors is ultimately responsible for ensuringthat the company complies with the requirements of the law, ofregulatory rules and of any codes of practice (or similar) that itchooses or is obliged to follow. The board is also ultimatelyresponsible for setting the tone for the various behavioural practicesundertaken in the name of the company. The board should beexpected to commit the company to standards of business conductthat aim to ensure, as a minimum, that the company conducts itsbusiness affairs transparently and treats fairly all those parties, bothinside and outside the business, with whom it deals. Such actionshould involve, as a priority, ensuring the active commitment of boththe board and senior management to company-wide policies andpractices on standards of responsible business conduct that

collectively amount to an ethics-based culture.

Members of the board, and members of any special committees of theboard, have a particular interest in ensuring that all necessaryinformation relating to the exercise of their functions, and that isavailable within the company, is transmitted to them. Members shouldbe prepared to insist that the management of the flow of informationto them is conducted in such a way as to ensure that they areprovided with all the information that is or may be material to theirdecision-making and governance responsibilities.

The board should ensure that its policies and practices on businessstandards are observed by keeping their application under regular review.

The responsibility of individualsIndividual members of the board of directors (or equivalent) shouldact not only in accordance with their legal duties but with duerecognition of the importance of high standards of business conductfor the long-term interests of their company. Individual employeesshould be expected to act in accordance with the policies andpractices adopted by the company.

The role of the regulatorRegulatory authorities should note and act upon the followingconclusion of the G20 meeting of April 2009:

'Strengthened regulation and supervision must promote propriety,

integrity and transparency'.

This statement was intended to refer to the financial sector alone, butthe objectives identified are appropriate for application to all areas ofbusiness regulation. It should be understood that the credibility, forregulatory purposes, of an entity's actions, reports and statements willbe a function of its compliance with these criteria.

A company's written and actual commitment to standards of businessconduct should be monitored by the regulatory authority and seen asan indicator of the extent to which reliance can be placed on thecompany's various compliance assurances. Companies should berequired to disclose, on an annual basis, the actions they have takento establish and administer policies and practices on standards ofconduct. Those reports should include details of any specific matters,eg regulatory investigations and fines, that could be viewed as havinga bearing on the company's reputation.


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3.4 STANDARDS OF COMPETENCE

Companies should be expected to haveappropriate skills and human resources atall levels of the business.

The responsibility of boards and directorsThe directors of a company are ultimately responsible fordirecting and supervising the activities of the business.They should thus be sufficiently competent andexperienced to perform their role. Just like regulatoryauthorities, company directors both executives andnon-executives have an obligation to acquire an effectiveunderstanding of the nature of their company's business,its management structure and its various operationalprocesses.

The level of expertise and experience appropriate forindividual directors should be related to the nature, sizeand complexity of the business and the particular role, if

any, that an individual director fulfils. Those directors whosit on specialised committees of the board, for exampleaudit committees and remuneration committees, shouldsimilarly be expected to ensure that they are sufficientlycompetent and experienced to perform those particularroles. Where directors are entitled by law to delegateresponsibilities in defined matters to other directors oremployees, the board should still keep such delegationsunder review and monitor their operation so as to ensurethat the directors are able to exercise effective supervision.Boards should ensure continuously that suitable training ismade available to directors in respect of mattersconcerning the business activities of the company.

The board is also responsible for ensuring that thecompany, below board level, possesses adequate numbersof staff with the skills and experience that the companyneeds to fulfil its business objectives.

The role of the regulatorIt is in the direct interests of the regulatory authority thatcompanies comply with this principle. Companies shouldbe expected to satisfy the authority, on a regular basis,that they do so.


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3.5 CORPORATE GOVERNANCE

Boards, shareholders and stakeholdersshould share a common understanding ofthe purpose and scope of corporategovernance.

In the spirit of this principle, companies should begoverned by the board with the core aims of

(i) generating trust and confidence in the company, and

(ii) defending and promoting its long-term interests.

Boards need to acquire an effective understanding of theconcerns of their shareholders, and where appropriateother stakeholders, and take these concerns into accountin the decision-making process. Shareholders should beprepared, where practical, to play an active role insupervising the board while remembering that theresponsibility of the board is to secure the long-term

interests of the company as a whole and not necessarily tosatisfy the short-term interests of any individual or groupof investors.

The role of the boardThe board of a company (and the equivalent governingbody in other types of entity) is responsible for directingand controlling its affairs. It does this for the primarypurpose of serving the interests of the company's owners.The board should therefore establish approaches that willhelp it to ensure that the company's business is beingconducted successfully and that will allow it to accounttransparently to shareholders (and, where appropriate,

regulatory authorities) for its stewardship. This will applyregardless of the size or the nature of the company.

In many countries, guidance on optimal corporategovernance arrangements is the subject of legal rules,codes of practice and/or regulatory rules. Corporategovernance rules and codes aim to maximise the quality ofthe decision-making process within a company's board.Most do this by trying to ensure that, inter alia:

decision-making is not concentrated in the hands ofone individual or small group

the board is 'refreshed' by the addition of new

members on a regular basis

the board contains non-executive members, who areexpected to bring an attitude of independence andobjectivity to the decision-making process

matters that are considered to be particularly sensitive,such as the company's financial reporting proceduresand executive remuneration, are addressed by separatecommittees of the board, which contain members whoare considered to meet criteria of 'independence'.


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Where any such rules or codes apply, companies shouldcomply with their requirements to the fullest practicalextent. Good corporate governance should, however,involve not solely compliance with the writtenrequirements of rules but a genuine commitment tocomply with the broader spirit of good corporategovernance. Merely having the requisite proportion ofnon-executive directors on a board, or separating the rolesof chairman and CEO, is not enough in itself: thefundamental objective should be to achieve a balancedboard and to avoid excessive concentration of power. Oneof the lessons learned from the banking crisis (andprevious corporate crises) is that some companies thatcomplied with the letter of corporate governance codes,

and considered themselves to follow best practice, werenot in reality well governed at all. Accordingly, companiesshould keep their corporate governance arrangementsunder constant review and consider making changeswhere they are called for. To assist in this, companies mayconsider it helpful to appoint a separate corporategovernance committee of the board. Companies should, inparticular, reflect on each case of governance failure theyhave experienced and consider why the board, orindividual directors, did not ask the questions or suggestand achieve the actions that might have prevented thatfailure from happening.

In the same way that individual companies should keeptheir practices under review and re-address them in thelight of failures, accepted wisdom on what amounts togood corporate governance practice should also be keptunder review by the authorities. The experience of thebanking crisis suggests that a review of thinking on thisissue is now opportune.

Even though the appointment of non-executive directors tocompany boards has for many years been widelyconsidered to be an appropriate means of challenging andoverseeing the executive, the presence of non-executiveson the boards of banks and other types of company does not appear to have succeeded in restraining

irresponsible and in some cases disastrous businesspractices. The reasons for the cases of apparentineffectiveness need to be explored and addressed. It maybe, for example, that failures can be linked to inadequateinformation flow to non-executives, to lack of appropriatetraining or to lack of support, in which case changes willneed to be made to corporate governance rules in severalrespects. There may also be a case for ensuring thatnon-executives, and boards in general, receiveindependent assurance about the actions of managementin implementing the policies of the board, especially inrespect of control matters.

Engagement with shareholders and other stakeholdersWhere a company's directors are legally responsible foracting in the collective best interests of the shareholders,they should ensure that they understand what thoseinterests are and act accordingly. It is right that thedirectors retain ultimate decision-making authority withina company, but taking active steps to engage effectivelywith them on key issues will help them to ensure that theyrepresent the interests of their shareholders.

Shareholders collectively own the companies in which theyinvest. It is to them that the board is accountable and inwhose name directors conduct the company's affairs.Although the traditional Anglo-Saxon model of shareholder

primacy is increasingly being challenged, in the UK and inmany other countries, the membership remains a keyelement in the governance framework of entities of allkinds.

Except in small businesses, however, few shareholdersactually exercise their rights of participation: most investfor their own financial reasons and, in normalcircumstances, show little interest in monitoring themanagement. Although the large, institutional investorgroups do monitor and engage with company boards on aregular basis, the banking crisis has shown that even at thelisted company level, organised shareholder groups often

fail to engage with boards to the extent that they can exertbeneficial influence on them and restrain them fromcourses of action that, in retrospect at least, should havebeen regarded as unwise and likely to be detrimental toshareholder interests.

Institutional investor groups often own substantial holdingsin the largest companies. Although the powers available toshareholders will vary from country to country, institutionalgroups should be prepared to use the authority they have,by virtue of their holdings, to exert influence on companyboards wherever circumstances make this appropriate.Shareholder groups of whatever kind should not seek tointerfere with matters of day-to-day management.

Nonetheless, it is reasonable, and helpful from agovernance perspective, for institutional shareholders inparticular to become involved with strategic and structuralissues and to establish effective working relationships withcompany boards in relation to those issues.

Investors also owe it to themselves and their ownstakeholders to monitor the company's actions and tochallenge them where this may be appropriate.


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It is not realistic to expect shareholders always to be ableto take effective action to protect the value of theirinvestments, but neither is it realistic to expect that, in allcases, external regulation will be able to do it for them.Investors should accept their own responsibility to evaluatecritically plans and decisions which are likely to affect theirinterests directly, and act accordingly.

As long as shareholders only have rights to participate incompany affairs, rather than responsibilities to do so, it willremain impractical to think that high levels of memberengagement can be achieved in the case of largercompanies. Nonetheless, if boards allow themselves tobecome disconnected from their shareholder bodies to the

extent that they act in effective ignorance of members'concerns, the result may be not only a governancedysfunction but also breach of their legal duties by thedirectors.

The role of a company's body of shareholders shouldtherefore be seen as an element of the governanceframework that has the potential for exerting beneficialinfluence on board behaviour. In this light, companyboards should be expected to explore ways of enhancingboard-member communication with a view to facilitatingactive interest in the way that company affairs are beingdirected and controlled. For example, they should consider

whether the information that is provided to memberscould be presented and communicated in different, moreaccessible ways; whether the potential of narrativestatements such as the Operating and Financial Review (orsimilar) could be better exploited so as to meet theinformation needs of shareholders and others; andwhether the company's annual general meeting could bestructured more imaginatively. Regulatory authoritiesshould also consider ways in which members might beactually required to participate more in the governance oftheir companies.

In the context of encouraging greater levels of shareholderparticipation, however, it must be remembered that it is for

the company's directors to make the decisions about whatis ultimately likely to be in the best interests of theircompany. Shareholders should not expect to pressuriseboards into making decisions, especially financialdecisions, that are motivated by their own short-terminterests, and directors for their part need to be entitledand prepared to withstand such pressures if they believethey are not in the best interests of the company.

The role of the regulatorIt is in the interests of the authorities that shareholdersplay their part in the governance process by asking theright questions and holding their boards to account. Inassessing the compliance risk posed by individualcompanies, regulatory authorities will wish to considerwhether they are governed in a way which reflects bestapplicable practice and which serves to engender trustand confidence on the part of their shareholders and otherstakeholders. Where boards are required to take widerstakeholder interests into account in the way that theydirect the affairs of their companies, the authorities shouldalso consider this aspect when reviewing companies'governance arrangements.

Companies that are expected to implement corporategovernance rules or codes of practice should comply withany associated requirement for disclosure regarding theircompliance or otherwise. Compliance should be effectivelymonitored and enforced. This should extend not only toany requirement to make a 'comply or explain' statementbut to compliance with the substance of the guidanceitself: it is not reasonable to expect a company'sshareholders to take action in respect of non-compliancewith guidance on this issue.

As a matter of course, when directors of regulated entities

leave their positions, either by resignation or otherwise, theregulatory authority concerned should considerconducting interviews with them with the objective ofidentifying any matters connected with their departuresthat might be of regulatory interest.


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3.6 ACCOUNTABILITY

Companies should be expected to accountfor their activities transparently, thoroughlyand with due regard for, as appropriate, thedemands, rights and information needs oftheir stakeholders.

The role of financial reportingInformation on companies' financing and performance willbe required to be prepared and disclosed in different waysand for different purposes. Whether the informationconcerned is intended to satisfy the needs of shareholders,regulatory authorities or others, the preparation anddisclosure of accurate and credible financial information isessential for the effective supervision of companies'activities.

The specific requirements for the way that financial andother reports should be framed need to take account ofthe types of activity undertaken by the entity, its size andcomplexity, and the actual or perceived information needs

of the likely users of the reports. It should follow that themore specialised and complex the business, and thegreater its degree of economic materiality and stakeholderimpact, the more extensive the disclosure and reportingrequirements will need to be, if only because in suchbusinesses the information needs of a large and disparategroup of stakeholders will all need to be addressed withinthe same report.

The banking crisis has led to a number of criticisms aboutthe role of financial reporting standards. The majorcriticism concerns the use, as mandated by theInternational Accounting Standards Board (IASB), of fair

value accounting in the treatment of financial instruments.The argument concerns the fact that companies arerequired, under IASB rules, to value their financialinstruments at current market prices, rather than at theirhistoric cost values. Where current market values aresubstantially lower than the original cost of the assetsconcerned, entities have to make large write-downs ontheir balance sheets. In the exceptional conditions we haveseen, 'market' values for particular assets may simply haveceased to exist, in which case companies are forced toresort to 'mark to model' techniques, based on the fewsales that are taking place. It also means that assets thathad originally been held for trading purposes now have tobe retained, with any value now dependent on prospective

cash flows from interest and repayments.

Where this happens, as has happened on a large scaleduring the banking crisis, confidence in the reportingcompanies will be damaged and there can be massiveconsequences for their capitalisation. Thus the situationunder fair value rules is very different from what happenswhen assets are reported using the amortised costapproach, where there is no need to report write-downsunless the value of expected future cash flows is estimatedto be less than historical cost. Since banks will ordinarilyhave very substantial holdings of financial instruments, theadoption of fair value rules has affected their results much

more than it has other entities.


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There is no doubt that fair value accounting has hadsignificant effects on companies' reported results duringthis period and it is right that its further application toclasses of assets other than those currently encompassedby the IASB rules be deferred until such time as the fullramifications of the approach can be digested. There arecertainly technical issues with fair value that need to beaddressed. The use of fair value accounting has not,however, been a direct cause of the crisis and itsapplication should not be suspended. It remains the onlyrealistic method of accounting for derivatives and has thegreat virtue of transparency it discloses the value that anentity stands to gain by selling or settling the assetsconcerned at the balance sheet date, if it chooses to do so.

It should also be noted that investor groups, whoseinterests annual financial statements are primarilyintended to address, have been strong supporters of theuse of fair value accounting.

Another, related issue that has been raised in the wake ofthe crisis is whether the rules governing annual financialstatements should, in future, be framed so as to beconsistent with the express information needs ofregulatory authorities, rather than those of the company'sshareholders. The meeting of the G20 countries in April2009 expressly called on the IASB and other standard-setters to work with regulatory authorities on ways to help

ensure that accounting standards serve the cause ofpromoting financial stability in the wider economy. Gearingfinancial statements so as to reflect compliance orotherwise with prudential and regulatory requirementswould be a material departure and would require afundamental re-think of the purpose of accounting.Financial statements, in their traditional form, are designedessentially to enable directors to report on theirstewardship of their company to their shareholders, so asto help them make informed decisions about theirinvestments in the company.

It would not be helpful to make a fundamental change ofthis kind since the information needs of investors and

regulatory authorities are different and should beaddressed by different routes. If regulatory authoritiesneed different or additional financial information in orderto increase the effectiveness of their own regulatoryfunctions, changes should be made. Any specificinformation needs that the regulatory authorities have fortheir purposes, and that are not met by the generalpurpose financial statements in their current or anyrevised form, should best be addressed by means ofseparate and dedicated prudential reporting requirements.

The key contribution that financial reporting can make tofinancial stability should be seen as providing timely,

neutral and transparent information to investors andothers that they can trust and rely on to report economic

events as they happen and describe their impact oncompanies, their performance and financial position. Thisprocess helps the cause of stability by helping to correctthe natural pro-cyclicality of markets in over-estimatinglosses at times of great uncertainty, by providing the basisfor more rational pricing decisions.

This is not to suggest that the financial reporting processwithin its existing parameters cannot develop so as toenhance the understanding of investors and others of thefinancial standing, performance and prospects of reportingentities.

One pressing issue in this area concerns the extent of loan

loss provision by banks. Accounting standards generallyare built on the reporting of losses that have beenincurred, but it seems probable that regulators in thebanking sector will in future expect losses to be anticipatedby institutions, or else look to models adopted in Spainand elsewhere. It is worth exploring the extent to whichthose two approaches could be brought together. Forexample, has the incurred loss model been too slow inallowing losses to be recognised as the economic cycleworsened? Is there scope for going beyond this andrecognising expected losses through the life of loans?

It seems likely that regulators, for prudential purposes, will

wish to go further than this and develop models thatrequire reserves to be created in the good times for lossesthat can be expected at worse times in the economic cycle.Should this materialise, how should such reserves beshown in financial reports as a separate designatedreserve within equity or as reductions in asset values, thuscreating losses (in the good times) and profits (in the badtimes)? The first of these would be the better representationof economic reality. Any additional regulatory buffers of thiskind should be disclosed in banks' accounts in a transparentway, as they may provide useful insights for investorsregarding the longer-term risks of different areas of lending.

Another significant issue concerns the effects of the

accumulation of legal and technical reporting rules for thesize and complexity of financial statements, especiallythose of banks. This situation is giving rise to questionsabout whether such statements can still serve a coherentinformation purpose for any class of user (and contributeto the goal of member engagement discussed elsewhere inthis paper). The UK and International AccountingStandards Boards are both looking at this issue and thisdevelopment is welcome.

Additionally, the profession needs to address a number ofimportant technical questions concerning the same coreissue of how to render accounting practices more

transparent and useful to users. These questions includethe following.


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What should be the key purpose of accounts to reflect

an accurate picture of what has happened, informabout the present, or predict the future?

Are financial statements currently expected to do toomany things, resulting in a lack of balance betweenunderstandability and transparency?

How could accounts communicate more effectiveinformation on risk?

Does narrative reporting as it is currently framed servea useful purpose and if not, is there a better way ofcommunicating non-financial information?

Would it serve the interests of the various users ofaccounts if the concept of materiality was expanded soas to require financial information to be presented inranges of probability?

These, and other key questions are for the profession toaddress.

The role of external auditThe process of external audit is integral to the objective ofprotecting the interests of a company's members and anecessary component of regulation. First and foremost,

the audit process should be, and should be seen to be,objective and independent of management. Auditorsshould have all necessary powers available under the lawto allow them to operate freely: to obtain the informationthey need and to carry out the procedures that arenecessary for them to form their opinion on the company'sfinancial statements. Auditors must also be free to frametheir audit report, in whatever way they feel appropriate(subject to their conformity with applicable auditingstandards) and to communicate any relevant concernsthey have to the appropriate levels of management andgovernance within the client company.

External audit evolves over time as auditing standards andpractices within the audit profession change and respondto developments in the business world. For example, in thecurrent economic circumstances, auditors are likely to bespending more time on assessing a company's 'goingconcern' status and management's strategies on risk.Nonetheless, it is not just through the audit of financialstatements and associated disclosures that auditors cancontribute to the effective regulation of companies. Giventhe investigative nature of auditing, the auditor acquiresknowledge of a company's internal controls and itsbusiness practices, which may have direct relevance to thework of a regulatory authority. One specific way ofharvesting this, which has already been adopted in some

countries (UK auditors are currently subject to aprofessional duty in this regard), is for the auditor to begiven the entitlement (and/or obligation) to communicatecertain information to the regulatory authority. This isinformation that may have a direct relevance to theefficient exercise of the authority's supervisory functionsand that comes to the attention of the auditor as aconsequence of the audit. In some jurisdictions, and forcertain companies, such as banks, regulators may requirethat auditors examine specific information in a company'sreturn to the regulator.

Auditing itself is increasingly carried out in accordance

with International Standards of Auditing and, although theregulation of the financial system should aim to reflectthat, there is much scope for regulators and the auditingprofession to explore the potential that external audit hasfor adding new value to the regulatory process, whetherthrough changes in the nature of an audit or extensions toits scope. In the course of considering how audit could beexpanded, it will be essential to ensure that legitimateconcerns held by auditors about liability are satisfactorilyresolved.


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3.7 INCENTIVES

Remuneration schemes for directors andemployees should be integrated into acompany's strategic plans and should becareful not to distort behaviour which couldbe detrimental to the long-term interests ofthe company; in particular, incentiveschemes should be linked, primarily, to theachievement of longer-term shareholdervalue by the company as a whole.

The role of the boardCompany boards should have the basic freedom to offerremuneration, pension and incentive packages that, intheir opinion, the company can afford, are set at thefinancial level necessary to attract and retain individuals ofthe quality required and that provide bonus rewards thatare fair and commensurate with performance. Yet boardsalso need to recognise that there may be other relevantfactors with a bearing on this issue.

First, the way that incentive schemes are structured mayhave behavioural consequences that are not necessarilyconsistent with the best interests of the company. As hasbeen seen during the banking crisis, schemes that promise

high rewards for exceptional short-term performance mayencourage a degree of risk-taking which, unless tightlymonitored and controlled, can have adverse consequencesfor the company as a whole, its reputation and its long-term financial stability.

Secondly, boards need to be aware that, even where acompany's shareholders have the legal right to review andcomment on its remuneration practices, they usuallycannot change commitments that have already beenentered into, however much they disapprove of them.Where the company's interests suffer as a direct result ofthe board's agreed schemes, this could ha

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