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Financial Services: Regulatory Approaches and Paradigm Shift
From an Irish Perspective with EU, UK and US Comparators
Author: Shaun Elder
PHD candidate, University of Limerick,
Plassey Campus, Limerick, Ireland
Contact email: [email protected]
Conference:
"The Financial Crisis, EMU and the Stability of Currencies and the Financial
System"
held at the University of Victoria (UVic), B.C. Canada
30 September-2 October 2010
(Please do not quote without author’s permission)
Shaun Elder 28/09/2010 Working Paper: Please do not cite without permission.
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Financial Services: Regulatory Approaches and Paradigm Shift
From an Irish Perspective with EU, UK and US Comparators
Abstract
Institutionalised regulatory control of financial services has been accepted
worldwide, and is based on domestic legal structure and practice. Regulatory
approach sets the tone for regulators including the enforcement sub-set. In
Ireland pre-crisis a „soft touch‟ principles-based approach was `adopted. It
failed. Government sponsored reports found „capture‟, supervisory failures and
resource gaps. A „retreatist‟ enforcement style was evident. Ireland‟s economy
post crisis is in turmoil. The new, assertive Irish regulator has adopted a mixed
principles/rules-based approach with a risk-based emphasis. Internationally too
reforms were mooted. The EU proposed new supranational structures dealing
with systemic risk. The US Paulson report advocated an „objectives-based‟
approach, while Dodd-Frank placed greater responsibility upon regulators. The
newly elected UK coalition government announced the abolition of the FSA
which operated a hybrid approach. Many „newcomer‟ reform proposals were
advocated to „risk‟, the definition of which is context specific. This paper, part
of a wider multi-disciplinary study, examines and analyses the approaches and
concludes that there is a confusing array of opinion internationally as to
regulatory approach, for Ireland there is a paradigm shift but its
implementation still awaits, while elsewhere there is much flux and uncertainty
with regulatory liberalism abounding. No institutionalised global regulatory
structure exists. Regulatory „outsourcing‟ to ad hoc international bodies is
evident. No single jurisdiction has assumed the lead in regulatory change.
Internationally, paradigm shift has converged towards risk. The EU has
approached issues on a piece-meal basis. The US has embarked upon the
mammoth Dodd-Frank institutional, rules and tools overhaul which will take
time to assimilate. The UK awaits further political input. Regulation of financial
services, as Black asserted, continues full of “contingency, complexity, dynamic
adaptability, and unpredictability”.
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Introduction
Financial rmarkets, according to La Porta et al (2000: 24), need protection for investors,
whether by government agency, courts or market participants, while the nature of financial
regulation, “....is deeply rooted in the legal structure of each country and the origins of its
laws”. Helm (2006) argued that institutional design is critical to regulatory quality and
extent, and controversially that most regulation followed the command-and-control pattern,
the latter an argument not borne out by this review.
Financial regulation is impacted by both international and domestic dimensions. Even pre-
crisis for instance, the Committee of European Securities Regulators (CESR) was producing
interpretative recommendations, common standards, peer reviews, and comparisons of
regulatory practice (van Leeuwen and Demarigny 2004). Domestically regulation is often a
creature of statute which may set the national model, while underlying such model is the
regulatory approach, often itself impacted by statutory objectives and interested party
consultation. There is no one model or approach and within the available spectrum there is a
continuum running from hard to soft (Ahern 2010:5). The international reform agenda is
expected to drive much future Irish regulation (Elderfield 09-06-10), with regulatory
liberalism the dominant ideology (Gamble 2009: 153-156).
From the early 1990‟s, as Regling and Watson (2010: 17) highlighted, academic and policy
debate focused upon regulatory adjustment in the face of increasing complexity of financial
products and institutions, and increasingly adaptive and innovative markets. Some countries
established separate regulators, others regulated through central banks, while in Ireland due to
a policy compromise a hybrid central bank and regulator experiment was implemented
(Regling & Watson 2010: 36; Westrup 2007: 14; McDowell Report 1999). Some moved
towards principles-based regulation which de-emphasised specific rules which could be side-
stepped. Some, like Ireland, went further and adopted a „light touch‟ version which was less
intrusive, a „flexibility‟ model (see below), but it was discredited.
While not alone due to regulatory failures, the Irish economy found itself in turmoil: property
and credit bubbles burst; banks were nationalised; the Anglo Irish Bank bail-out will cost
taxpayers between €22-25 billion at best estimates; an Irish agency called NAMA was
established to enable taxpayer purchase of „toxic‟ development and related property loans
with a book value of €90 billion; Irish bond market spreads in mid-August 2010 were more
than double those of Germany with risk premiums 300 basis points above German, and the
ECB stepped in to purchase government bonds; 13.7% unemployment was on an upward
curve in August 2010; 35,000 homeowners had mortgage arrears with many more in a
shadow cohort paying interest only; huge swaths of unfinished or unoccupied „ghost‟ estates
littered both urban and rural Ireland; large numbers of Irish homeowners were in negative
equity; emigration was on the rise; the much-vaunted „Celtic Tiger‟ economy was long dead
and buried.
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According to the new Irish Head of Financial Regulation, Matthew Elderfield (29-03-2010)
there are three main regulatory approaches applicable to Ireland post crisis: The principles-
led approach, the rules-based approach, and the risk-based approach. These may be inter-
mixed. In March 2010, Elderfield explained:
“Rather than making the artificial distinction between rules-based or principles-based
regulation, it‟s clear we need to have a mixture of both and take an approach rooted in a
clear understanding of risk. This will involve developing a regulatory model that allows for
the intensity of our regulatory framework and level of supervisory engagement to be
calibrated to the inherent risk and impact of a particular firm or sector”.
One example of differing national regulatory models, which sit above the regulator‟s own
approach, emerged from the work of Gadinis and Jackson (2007) in relation to global
securities markets regulation. Black (2010: 43) summarised the three different model types
(underlining added):
“......a „government-led‟ model, that preserves significant authority for central government
control .... albeit with a relatively limited enforcement apparatus (France, Germany,
Japan); a „flexibility‟ model that grants significant leeway to market participants.... but
relies on government agencies to set general policies and maintain some enforcement
capacity (UK, Hong Kong, Australia); and a „cooperation model‟ that assigns a broad
range of power to market participants in almost all aspects ....but also maintains strong
and overlapping oversight of market activity through well-endowed governmental agencies
with more robust enforcement traditions (US, Canada)”.
At the effective commencement of the modern era of banking regulation, Braithwaite and
Drahos (2000: 93) highlighted that by the end of the 1930‟s there was one overriding
principle, the relative independence of central banks from government, but two dominant
regulatory models. The first British, found within a highly concentrated market structure with
one powerful regulator which operated in a close-knit, exclusive community relying upon
understandings, convention, trust and tradition; and the second characterised by the US
Federal Reserve, with a highly decentralised market structure, and fragmented regulators both
federal and state, where regulation was more rule-bound, formal and bureaucratic. They
wrote that, “One of these two systems was generally used by other states as they began to
develop national systems of banking supervision” (2000: 93). Ireland followed the British
model, the Irish Central Bank was statutorily established in 1942, the hybrid Central Bank
and Financial Regulator in 2003, and the post crisis Banking Commission in 2010. While the
EU, grounded in civil law, and the over-riding „framework‟ Treaty of Rome where general
principles guidelines are set out (McMahon & Murphy 1989: 3-12), is a prime example of the
„sit-above‟ government-led model, where it is not a hands-on regulator but instead a
regulatory legislator for member states which regulate beneath it.
Contrastingly, the by now somewhat dated comparative work of Gunningham (1991) in
relation to the Hong Kong, Chicago, and Sydney futures markets, a form of private regulation
or even self-regulation grounded in the de-regulation era and with significant „efficient
market‟ undertones, was described by Black (2010: 43) as incorporating, “informal methods
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of social control [which] were more critical to maintaining order and preventing market
abuses than the formal rules either of government or the exchanges”. Black explained the
rationale thus: “Peer group pressures; fears of being ostracised, the leverage of large
institutional clients, and the transparency of market dealings all affected the definition,
motivations, and opportunities for abuse”.
When pondering the overriding supranational or national model therefore, or the underlying
domestic financial regulator‟s approach, Black‟s (2010: 48) warning as to research results of
the efficacy of the relationship between law and regulation and the markets themselves must
be considered:
“.....decades of research into markets, behaviour, regulatory dynamics, and policy-making
shows us that formal, linear, and absolute understandings of behaviour and of the
relationships between law and markets are bound to be wrong. What we have instead is
contingency, complexity, dynamic adaptability, and unpredictability. Any models of
financial markets or of behaviour and any policy prescriptions as to how to regulate either
which are not based on the acceptance of these assumptions are bound to fail”.
Paper Overview
First, we look at the principles-led approach operated in Ireland prior to and during the 07/09
financial crisis, contrast it with the rules-based approach, contemplate the hybrid proposal,
and then examine the risk-based approach. Then we look at the reform proposals of current
regulator Matthew Elderfield announced in his speech on the 29th
March, 2010 and assess
what they mean for Ireland. For completeness Paulson‟s (2008) Objectives-based approach
publicised mid-crisis is outlined. International comparators emerge from the text as do the
conclusions.
Regulatory Objectives
Whichever approach is adopted, and Murphy (2010) identified principles-based regulation as
“a big issue going forward”, for Ireland, Cain (2010) highlighted that regulation for the
public benefit must meet three objectives: (1) Set boundaries; (2) be a deterrent; and, (3) set
precedents for others to use as a benchmark.
Principles-Based Approach
In general terms explained Smith (2008: 481), principles-based approaches, “seek to focus
financial institutions on regulatory goals and outcomes and to transfer from regulators to
financial institutions (to a greater or lesser extent) the task of devising the particular
strategies that the financial institution should adopt to achieve those goals or outcomes – or
at least mitigate the risks of not doing so”.
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For Ford (2008: 5), Canadian securities regulation viewpointed a principles-led approach, “as
a New Governance regime-one that uses innovative, pragmatic, information based, iterative,
and dialogic mechanisms to gather, distil, and leverage industry learning in the service of
a...... more effective and less burdensome, public regulatory mandate”.
Black (2008: 3) extolled that, “For firms, principles-based regulation can provide flexibility,
facilitate innovation and so enhance competitiveness......[while] for regulators.... it can
provide ..... flexibility; facilitate regulatory innovation in the methods of supervision adopted;
enable the regulatory regime to have some durability in a rapidly changing market
environment; and enhance regulatory competitiveness”.
The regulatory philosophy adopted in Ireland pre-crisis was inherited from the best practice
at the Irish Central Bank asserted Honohan (2010: 59), and before that the British model
(Braithwaite & Drahos 2000: 93). Former Irish financial regulator Patrick Neary (05-03-
2008) described the then Irish principles-based approach as „open and collaborative‟. Being
found at the softer end of the spectrum it was known as „soft touch‟ and had found some EU
approval (Black 2008: 2 footnote 3). It was geared towards nine un-codified principles first
unveiled in 2006, which included sound governance, transparency and accountability,
prudence and integrity, risk control, oversight and reporting, sufficiency of financial
resources, and timely information production (Honohan 2010: 46). Neary (05-03-2008)
defined it in the following terms:
“Responsibility for the proper management and control of a firm, and the integrity of its
systems, rests squarely on the board of directors and its senior management. This in turn
requires appropriate governance, ethical behaviour and transparency in business
dealings.”
Numerous statements and restatements of the Irish regulatory view were published according
to Honohan (2010: 45-46), including one in 2004 by Liam O‟Reilly, former CEO of the
Financial Regulator, when he stated that the approach would be achieved by boards and top
management committing fully to, “a culture of integrity, competence and best practice”, the
expectation being that they would, “ensure that this culture flows throughout all levels of
their organisations”. Organisations would require, “compliance systems, controls, and
internal audit departments that have the standing and the powers to meet”, expected
standards of behaviour. “We set out those standards: they must invest in the system and staff
to ensure those standards are met”, O‟Reilly concluded.
Cain (2010) expressed his lawyer view that the Dublin IFSC as a unit regarded principles-
based regulation as cheaper and business friendly. The major constituents of the principles-
based approach for him were that the complete responsibility, even beyond the business
model, rested with the management of the firm or company itself with the regulator operating
a hands-off, light-touch approach (Cain 2010). In this approach, compliance risk should be
more however than the risk of internal firm regulatory breach and sanction, and involve proof
of risk assessment and interaction with external regulatory outcomes, within a context of an
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analysis of risk to the firm‟s customers, an exogenous goal and benchmark (Smith 2008:
485). Honohan (2010: 47) concluded that Irish “principles-based regulation referred not just
to the principles but also to the various rules, codes and regulations that underpin financial
regulation”.
From a pre-crisis UK insurance world perspective, Sklaroff (2006: 39-40) outlined an
alternative principles-based model. He argued that there was a need for the right set of
overriding high-level principles, with unambiguously permissive supplementary guidance,
enabling the financial services sector to devise their own methods of compliance, in either
self-regulatory initiatives or industry-led compliance advice. He envisaged a genuine
partnership between regulator and regulated (2006: 41). Teuten (2007: 36) explained the UK
FSA principles-based approach thus:
“The objective is to focus on the desired outcomes (the principles) and evaluate how well a
company manages the risks associated with those principles. Individual companies decide
how to meet these principles, and avoid or mitigate risks that will negatively impact them”.
Cain (2010) argued that for Ireland neither a rules-based nor principles-based approach was
effective, or would have been effective, in mitigating the 07/09 financial crisis, a view shared
by Murphy (2010) and Regling and Watson (2010: 17). Comparatively for example, Cain
argued, in the UK the FSA operated a principles-based approach and they encountered
problems with Northern Rock, and Bradford and Bingley; while in the USA where a rules-
based approach was applied, problems arose amongst others, with Lehman Brothers, Bear
Stearns, Bernie Madoff, and in 2010 Goldman Sachs.
As legal commentators, Connery and Hodnett (2009:90) clarified the Irish banking
experience: “Deregulation and light touch regulation would appear not to have worked for
certain aspects of the banking sector, rather they led to a lack of transparency and a lack of
prudence in relation to risk taking”. From the perspective of international bankers in Ireland,
Ward (2010: 11) as FIBI chairman stated: “......a light touch regulatory regime.....has not
served us well and has left a legacy of reputational damage in the domestic and international
arena”. Honohan (2010: 59-60) criticised in more particular terms that the Irish regulatory
approach was „deferential‟, that attempts to strengthen the approach had limited effect, that
key governance architecture elements were not put in place, that sanctioning was only
reluctantly applied to micro-prudential functions, and that the nine regulatory principles were
never codified. Further emphasising the apparent „capture‟, the academic critique by
professor Gregory Connor (2010) of NUI Maynooth, was that the Irish political establishment
created a, “regulatory system that was.....very lax, very secretive, and very accommodating,
and it was done deliberately”. Valencia (2010: 3) concluded: “The idea that markets can be
left to police themselves turned out to be the world‟s most expensive mistake”.
Cain (2010) contrastingly argued that Ireland was subject to a great deal of rules sourced
abroad, and in his opinion was “heavily regulated”, for instance, by the Basel Accords
capital requirements. In Cain‟s view while some institutions in Ireland took unacceptable
actions, these may have followed from poor business models rather than inadequate
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regulation. He concluded that the: “...quality and nature of supervision [was] the key, not the
approach”.
Murphy (2010), relying upon his experience as group Legal Advisor to the Bank of Ireland,
stated that he never liked principles-based regulation, and that while he could understand how
it developed in the UK, its application was never thought out or debated in Ireland. The real
regime objective, according to him, was a choice between firm rule or flexible principle,
while in Ireland the more flexible principles-based approach led to confusion and not clarity.
Enforcement he argued was the difference between the UK and Irish principles systems, a
point the Honohan report bears up, while Cain (2010) lamented “the quality and nature of the
supervision”, in Ireland. For Sklaroff (2006;41) UK supervisors must be trained, managed
and remunerated sufficient to encourage initiative and independent judgement, while the
preferably single regulator must resist political and media pressure.
This issue of supervision loomed very large in the post-crisis, government-sponsored,
Honohan report (2010: 63,75) when resource volumes, inadequate skill mixes, lack of
expertise, recruitment issues and especially salary, a pattern of inconclusive engagement
with regulatees, and lack of decisive follow through were pointedly criticised. Regling and
Watson (2010: 37-41) in their government-sponsored report, described Irish supervision as
the opposite of „hands-on‟ or pre-emptive in relation to increased macro-financial banking
risks or governance, lamented information deficits, and highlighted a socio-political context
un-conducive to pricking the Irish property bubble. Such a description sits comfortably
within McAllister‟s (2010) „retreatist‟ enforcement style. One essential element identified by
Honohan (2010: 48-49, 53) was the establishment of a governance architecture to include
directors‟ compliance statements, fit and proper standards of qualification and behaviour, and
a corporate governance code as a core requirement, while in two of these areas he found Irish
regulatory default. Post crisis Elderfield (09-06-10) told the Irish funds industry that
supervisors must have open and frank dialogue with senior management and must insist their
prudential judgement replaced the firm‟s commercial view where necessary.
Some of the identified pros and cons of the general principles-based approach, as opposed to
the „Irish soft touch‟ approach, were highlighted by Murphy (2010) as set out in the following
table:
In Favour Against
Engage senior management Legal obstacles
Develop more strategic view Lack of certainty
Offer flexibility Proliferation of guidance – it multiplies
Enhance speed of response Regulatory creep
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Harder to manipulate principles Accountability issues
Eliminate handbook Over-zealous enforcement
Reduce complexity Overlap with other legal requirements
Offer a dialogue basis with regulator
Murphy (2010) criticised regulatory overlap concluding that in Ireland there was duplication,
confusion, uncertainty and expense. Breslin (2010) argued that in the UK that they used a
principles and rules hybrid system, which he described as „attractive‟. Sklaroff (2006:39-40)
outlined three advantages to his UK model: (1) deeper and more rapid industry buy-in; (2)
easier alteration of informal guidance; and (3) an unfettered regulator who may add further
prescription as required.
In Ireland there was a need for proper remedies, Breslin (2010) asserted. For instance, he
pointed out that the Financial Ombudsman operated a ready and cheap scheme but that there
was a monetary limit for private investors. Large claims were problematic; Section 117 of the
Central Bank Act 1979 provided a civil sanction but some observers took the view that
private suit was excluded, while the code itself maintained that it was not intended to give a
private right of action. Furthermore, in criminal cases there was no mechanism for restitution.
Regling and Watson (2010: 43) concluded:
“In an adaptive financial system there is a case for principles-based supervision, in
conjunction with clear rules. But the “light touch” approach to supervision has been
discredited: it sent wrong signals to banks and left supervisors poorly informed about
banks‟ management and governance, potentially impairing crisis response capacity also”.
Rules-Based Approach
In 2005 Liam O‟Reilly, as then CEO of the Irish financial regulator, outlined his conception
of a contrasting rules-based approach (Honohan 2010: 47):
“....detailed rules across the whole range of regulatory powers are set out. The rules set
out clearly what must be done, and importantly, what will happen in the event that
something is not done. This method implies a very legalistic approach. It suggests doing
things right rather than doing the right thing. It allows no scope for interpretation. It is
slow to react to change. It punishes the compliant equally with the non-compliant”.
Here the regulator relies on supervision and detailed analysis in a prescriptive way; detailed
rules are established in a tick-the-box approach with little qualitative data; supervision may
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include dedicated teams embedded in the larger organisations, as the SEC require in the USA
and the FSA in the UK, where teams are put into investment banks; and the approach is more
inflexible and demanding than that of the principles-based approach (Cain 2010; Teuten
2007). For many years the USA has adopted a rules-based approach with regulators using
guidelines and rule books, but Teuten (2007: 36) criticised, “Companies pass the SEC‟s tests
yet corporate malfeasance persists rendering rules-based compliance an ineffective means
for managing risk”.
One method applied by the US SEC is compliance audits or monitorships, where as part of an
enforcement action on foot of a settlement agreement, a monitor or compliance auditor is
taken on by the acknowledged guilty, regulated, corporation at their own expense, for a
period up to 3years, to oversee compliance improvement so as to avert future violations, and
to report back to the agency (Ford and Hess 2009; Black 2010: 45). Originating from the
court appointed receivership process commenced by the SEC in the 1960‟s to preserve assets,
monitorships gradually evolved to ensure future corporate compliance with securities law
(Ford and Hess 2009: 684). Bathed in controversy surrounding whether or not the
enforcement technique is sufficiently punitive, monitors deep or shallow diving into
corporate culture, and conflicts of interest around monitor selection, Black (2010: 45)
synopsised the Ford and Hess research as finding a coalescing of incentives and motivations,
where corporations want a report just rigorous enough, monitors want to preserve reputation,
and the regulator only wants sufficient to close the file and move on.
In March 2007, immediately pre-crisis, Hank Paulson, then chairman of the Federal Reserve,
acknowledged that principles-based regulation was superior to a rules-based model, at a time
when US companies complained of annually paying $6 billion to comply with Sarbanes-
Oxley and north American firms paid out almost $30 billion annually for compliance
(Teuten 2007: 38; Ford 2008: 2; Black 2008: 2). Taking the matter further was stymied by the
crisis itself, although Ford (2008: 2) has highlighted that while internationally the US SEC
has been regarded as a “rules-oriented and prescriptive securities regulator” moves have
been made towards a principles-led approach, Black (2008: 2) highlighting their
„formalisation‟ concerning capital markets in the Paulson Report (2008: 11-12).
Despite the heavy rules emphasis in the US, nonetheless failure at the principal-agent level
and poor governance, argued Lang & Jagtiani (2010: 125), were prime causes of the risk
management breaches revealed in the sub-prime mortgage crisis for two reasons: (a) a lack of
incentive to worry about „fat tail‟ risk; and (b) internal controls and risk management were
inhibited by weak governance and principal-agent conflict issues.
Mixed Principles/Rules Hybrid
The UK operated a hybrid principles/rules based system (Breslin 2010), and this mixture was
the preferred post crisis option of Irish regulator Matthew Elderfield, appointed in January,
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2010, and formerly the regulator in Bermuda, when he envisaged a risk component being
added. Honohan (2010: 48) stated, “There must be principles to back up the rule book. Any
sensible model has both rules and principles”. However, one Australian study upon the use
of standard-compliant general purpose financial reports has highlighted conflicts between
principles and principle-based rules (Walker 2007). In the US system of fragmented and
institutionalised regulators, the CFTC has utilised a principles-based approach for the futures
industry (Paulson 2008: 11), while the SEC has favoured a rules-based philosophy.
Ford (2008: 6- 11) extensively reviewed the relevant authorities concerning the relationship
between rules – regulator determines factual issues based on pre-determination of permissible
conduct – and principles – regulator determines both permissible conduct and factual issues –
and found they are both points on a continuum, there is a good deal of overlap and
convergence, and that no statutory scheme is a pure type instead oscillating such continuum.
She stated: “Rules still admit of considerable discretion and interpretation. Principles, in the
fullness of context, may congeal around a particular meaning”.
One example, vectoring investor protection, disclosure, and regulatory responses may assist
in exploring the hybrid conceptualisation (Linsley & Shrives 2005). Disclosure of financial
information about sophisticated products especially, where findings of inability by initiates
and innocents alike to read, understand or act upon such disclosure, Black (2010: 40) argued,
have led to calls for simplification of disclosure, increased regulation of complex derivatives,
and product purchase restrictions. For instance, advisors throughout the EU and UK must
now focus upon the suitability of the particular product as well as investors‟ attitude to risk.
Black (2010: 41) goes on to argue that absent research, regulators themselves are filing the
gaps, and particularly in the UK, Canada and Australia, are researching and learning investor
decision-making rationales, risk perception and information understanding and usage. Since
the year 2000 the UK FSA for instance, have been „road-testing‟ disclosure documents with
consumer focus groups, a trend followed in Canada in 2006, and announced as pending by
the EU in 2008.
The UK FSA in 2006 announced retention of its Key Features Document (KFD) category for
disclosure, rebranding it a „keyfacts‟ document, in line with survey results which determined
consumer preference for shorter more focused material (FSA 2007). Each regulated firm
determined document content which had to include key headings outlining product, aims,
investors‟ commitment, risks, general questions and answers, and charges. The FSA outlined
that their new rules were less prescriptive, in line with a move towards a more principles-
based approach, although they declared finding only 15% of their two hundred document
sample as complying with their own standards.
In a general critical commentary of the European disclosure paradigm, designed to meet the
four objectives of remedying market failure, disciplining market actors, improving
investor/consumer choice, and preventing abuse, Avgouleas (2009) argued that the crisis
exposed the failings of disclosure as an effective regulatory tool in financial markets.
Avgouleas highlighted that the market failed to control both disastrous bank risk-taking and
bank reliance upon implicit government guarantees, despite most of those risks being fully
disclosed to the market, because they were not sufficiently understandable to market players,
due to product complexity and socio-psychological factors. It remains to be seen whether or
not the US Dodd-Frank disclosure reforms are successful.
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In 2009, Hector Sants, then UK chief executive of the FSA, who resigned in the wake of the
May, 2010 British election results, in a step up to McAllister‟s (2010) „legalistic‟
enforcement style, warned the UK financial industry of the introduction of an “intensive
supervisory model”, a statement followed by a new enforcement model of “credible
deterrence”, designed to garner maximum media headlines for punitive action (The
Economist 27-03-10: 73). Figures for fines revealed a big turnaround of over 650% in two
years:
2007 2008 2009
Stg£5.3 million £22.7 m £34.9 m
Adapted from: The Economist, 27-03-10, p73.
March, 2010 was a very busy month for the FSA for example:- on the 11th
a former
stockbroker at Cazanove was jailed for insider trading; on the 16th
a former Merrill Lynch
interest-rate trader was banned from London‟s financial markets for at least five years for
covering up losses; on the 23rd
in its biggest investigation into insider trading to that date,
police and FSA officers raided sixteen premises, and arrested six people, with a seventh to
follow next day (The Economist 27-03-10: 73). Despite this increased enforcement activity,
on the 16th
June, 2010, the new British Chancellor of the Exchequer, George Osborne
announced the abolition of the FSA effective 2012.
For 2010, the FSA projected recruitment of 460 extra staff, plans mirrored in Ireland also,the
increase of its budget by 10%, and the promise of increasingly more obtrusive inspection.
The largest UK banks were targeted to each have fifteen permanently stationed officials at
their headquarters, an increase from six each pre-crisis (The Economist 27-03-10: 73).
Contrast this with the pre-crisis Irish approach where there was no embedding, and three
supervisors were responsible for Anglo Irish Bank and the Bank of Ireland, while two
supervisors dealt with Allied Irish Banks and Irish Life and Permanent (Carswell 10-06-10:
8; Honohan 2010: 64).
Risk-Based Approach
Analysis and understanding of the risk-based approach, just as for other approaches, hinges
upon the individual commentators viewpoint or bias. Non-market public interest academic
comment includes Fisher (2003) who argued that risk was the new buzzword, one of the
central tasks of the UK executive state, and was such an overarching concept that we are
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witnessing the rise of a risk commonwealth. Black (2005: 512) asserted that UK internal risk
management and risk-based regulation together formed a „new public risk management‟. In
later research Black (2006: 1) added that risk based frameworks were an attempt to define
acceptable/unacceptable „failures‟ and thus to define the parameters of blame, although her
view may fail the systemic risk test. She added (2006: 1,2) that risk-based frameworks, a
„newcomer‟ to the risk and regulation lexicon, and possibly pouring old wine into new
bottles, are themselves not risk-free, and in seeking to manage risks they inevitably introduce
their own. She concluded (2006: 2) that, “The aura of “risk-based regulation”.... combines a
sense of strategy and control in the face of uncertainty in a way that is politically
compelling”.
This time from the regulatory viewpoint, for Black (2005: 514) the rationales for a risk-based
regulatory approach included political and organisational pressures within regulatory
agencies, coupled with government efficiency demands, and especially cost-effective
regulatory implementation and resource deployment. She later explained (2006: 1) that risk-
regulation involved, “the development of decision-making frameworks and procedures to
prioritize regulatory activities, organized around an assessment of the risks that regulated
firms and others pose to the regulator‟s objectives”. She went on to describe this regulation
as „flexible‟, a move away from standardised rules to a form of targeted or tailored standard
setting to fit particular risks (2006: 4)..
Academic commentary geared towards the public interest concerning market failure includes
the pre-crisis Barth et al (2009: 27) categorisation of bankers as higher risk takers gaining on
the up and protected by limited liability on the downside. Gamble (2009:37) who warned that
in economic booms that both the calculation of risk changed, and that actors become
complacent and careless, coming to believe the boom will be endless. And post crisis,
Reinhart and Rogoff (2009: xxv, 171-172) who nailed the lie of man‟s inflated claims of
financially engineered tamed risk, or no risk, market control, and highlighted the necessity to
balance the risk and opportunities of debt.
The pure market view, which pre-dates all „newcomer‟ regulatory „risk‟ control, is
exemplified by Mallaby (2010: 77) who conceptualised financial markets as “...mechanisms
for matching people who want to avoid risk with people who get paid to take it on”; while
Foy (1998: xvii) expressed more conservatively, “finance is fundamentally a question of
analysing risk; and reducing risk”. This risk momentum pre-crisis was clearly financial
market led, resulting in the politically popular regulatory response, also partly market led.
New Risk Paradigm: Market Focus
Pre-crisis, Braithwaite and Drahos (2000: 102-103) highlighted from a market focus, the
growth of risk protection through the creation of derivatives which are effectively collateral
hedging contracts, purposed to protect the risk of currency fluctuation, share market fall or
price risk, and also the securitisation of loans otherwise known as the „contractualisation‟ of
risk, purposed to identify, separate and transfer risk to those in the best position to bear it,
both of which created tradable markets in risk.
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In the decade after 1996 the financial industry entered a new risk paradigm, with low interest
rates, low volatility and high returns (Valencia 2010: 3). This new paradigm, Valencia (2010:
3) argued, hinged mainly upon three closely linked developments, the first two already
identified by Braithwaite and Drahos: 1) a huge growth in derivatives; 2) the decomposition
and distribution of credit risk through securitisation; and, 3) increasing risk management
reliance upon risk modelling based upon the combined power of mathematics and computer
technology.
Risk Modelling
Risk models, designed to ensure financial stability, are common to financial markets, while
regulators have followed the market lead in bank or credit agency securitised risk modelling
(Black 2010: 34). Credit, liquidity and operational risk are used to benchmark performance
(Simpson & Evans 2005). One of the most widely known models relates to capital adequacy
requirements for banks as set out in the Basel II Accords, where relying heavily upon banks‟
internal models „efficiency‟ was the focus, while in later Basel III reforms less reliance was
placed upon banks‟ own risk models and the focus was „robustness‟ (Valencia 2010: 3, 13).
In the EU the Capital Directive (CAD III) effectuated the Basel II reforms, which were
directed at operational risk, and widened them to include all credit institutions and investment
firms (Lastra 2004; Sheen 2005).
Two different modelling approaches, which originated from different sources, have been
adopted according to Black (2010: 34). Firstly, a statistical technique known as „Value at
Risk‟ (VAR) assessments, which assess the risk to the bank‟s proprietary trading portfolio,
and amount to an estimate of the worst possible monetary loss from a financial investment
over a future time period (Sollis 2009:1). They were developed by JP Morgan as a response
to the 1987 Stock Market crash, and nine years later added to the Basel Accords. Valencia
(2010: 3,5) asserted that this kind of modelling had its roots in academic work of the mid-
twentieth century, and especially in the mid-1970‟s when some in the Chicago „options pits‟
began using Fisher Black‟s model, while soon derivatives exchanges progressed to the Black-
Scholes model which used share and bond prices to calculate value; that the banks hired
phalanxes of highly educated „quants‟ to fine tune ever more complex models; and that the
increasing calibration of risk led many to turn debt into securities. Valencia described a false
sense of security which led on to ruin: “Regulators accepted this, arguing that the „great
moderation‟ had subdued macroeconomic dangers and that securitisation had chopped up
individual firm‟s risk into manageable lumps”. Unfortunately many VAR models, especially
standard ones, underestimated financial risk, especially rare or extreme event risk (Nielsson
2009; Sollis 2009).
Secondly, stress testing, which was primarily originated by regulators in the wake of the
LTCM hedge fund debacle in 1998, and which required banks to test their own models
against varied adverse market scenarios, and especially the statistically described „fat tail‟
rare occurrences, known to market insiders as (Nassim Nicholas) Taleb‟s Black Swans
(Black 2010: 34). Valencia (2010: 5-6) recorded critics describing default-probability models
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as „the formula that killed Wall Street‟, and Taleb accusing that they increased risk exposure
rather than limited it; and then, while accepting that interest rates and foreign exchange
versions performed as required, the critics denounced pre-crisis debt market models as
abjectly failing to take account of low-probability but high-impact events such as huge falls
in house prices. Additional bad features included both heavy model dependence which
changed the very markets they were reading in a process known as counter-performativity,
and the similarity of risk models which negated diversification because too many others held
similar positions (Valencia 2010: 6).
Black (2010: 34) argued that banks were modelling uncertainty which by its nature was an
impossible task, such stress tests subject to the limitations of the modellers‟ imaginative
skills, experiences and quantitative skills limitations, as well as the potential chain of events,
and their impacts upon correlations between portfolio component values and different risk
„baskets‟ (credit, market, liquidity). In addition, she highlighted deficiencies which emerged
before and during the 07/09 crisis including „herding‟ where followers disastrously ape the
model of a perceived better, failing to adhere to maximised statistical confidence levels in
scenario analysis, excluding a sufficiently full range of potential events, and significant
incentive problems including moral hazard, all of which led to under-pricing risk. Goodhart
(2009:9) argued that Central Banks and international institutions prior to mid-2007 were
pointing to a serious under-pricing of risk, as financial institutions in the low interest market
sought to increase yield by moving into increasingly risky assets.
In Haldane‟s (2009) view stress testing didn‟t manage risks, it managed regulators. A good
example is unfortunately found in Ireland when former Irish Central Bank governor, John
Hurley, stated on the 11th
of October, 2007 (re-iterated as late as the 28th
February, 2008)
that,“ ...stress-testing of the banking system and....extensive financial stability analysis
indicates that Irish banks are solidly profitable and well-capitalised” (Carswell 26-05-10:
14). Rebonato of the Royal Bank of Scotland, as quoted by Valencia (2010: 6) explained that
stress tests were not a predictive tool but instead a means of considering possible outcomes to
prompt nimble reaction to unexpected developments, a rapid reaction also sadly lacking in
Ireland pre-crisis.
Bank Risk Modelling Responses
Banks post crisis have responded in a number of ways to these modelling problems (Valencia
2010: 6-7), and particularly by:
Introducing new and extra elements into VAR calculations, some expanding to
COVAR under the urging of regulators, capturing spill-over effects in troubled
markets such as losses due to the distress of others, or like Morgan Stanley moving to
their own „Stress‟ VAR which factors in very tight liquidity constraints.
Introducing „Reverse‟ Stress Testing: Some regulators, and in the UK it became
mandatory for banks, building societies and insurers to submit them as and from the
14th
December, 2010 , require banks to introduce „reverse‟ stress testing, which
requires the bank to assume a hypothetical collapse and then work backwards to
determine the culprit causes or vulnerabilities.
Removing or upgrading technology legacy systems that prevent or slow
communication.
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Considering self-insurance by holding, as does JPMorgan Chase, a „model-
uncertainty reserve‟, in other words making provision in the good times for bad maths
mishaps.
UK and International Risk-Based Approach
In the UK, the FSA was formed in 1997, received full statutory power in 2001, was the
amalgamation of nine predecessors including the regulatory functions of the Bank of England
all of which utilised risk-based regulation, and was one of the first integrated regulators in the
world (Black 2005: 523). In 2001, as updated in 2003, the FSA in conjunction with its hybrid
approach, and updating the outmoded precedents as Black (2005: 523) has fully set out,
adopted an annually reviewed risk-based operating framework, known otherwise as risk-
based regulation. This used a set of strategic aims targeting achievement of statutory
objectives, designed to drive prioritisation and resource allocation for regulatory response at
four levels, the firm, consumer products, the market, and the wider industry, with financial
crime reduction and financial understanding especial contexts (Stewart 2005: 43-44; Black
2005: 528). Stewart (2005: 46) explained that the approach must, “identify the key risks and
ensure appropriate controls are adopted”, the key element being, “making the risk
assessment process transparent”.
The FSA, for instance, sought to protect consumers specifically in four risk areas (Gobert and
Punch 2003:313):-
Prudential Risk (investment failure due to bad management/financial collapse – the
focus is solvency, safety and soundness);
Bad Faith Risk ( fraud, misrepresentation etc);
Complexity/Unsuitability Risk (investment unsuited to needs/circumstances);
Performance Risk ( investment does not produce expected return).
Teuten (2007: 36) viewed the FSA approach as principles-based with risk as its key tenet, the
principles such as business integrity, fair treatment for consumers and adequate financial
resources, being objectives to be flexibly met by firms which may customise and innovate in
the most cost effective manner aligned to their own business strategy. He explained: “The
ultimate goal is to embed best risk management and compliance practices into the day-to-day
operation of the business in order to uphold the principles”.
Regulatory ideology moved compliance towards risk management practices not least because
Basel II defined legal risk as operational risk (Smith 2008: 484). The Basel Committee
incorporated into Basel II cross-border capital adequacy requirements supplemented by risk-
based supervision, early intervention and market discipline, as well as specifically
encouraging regulators to adopt a risk-based approach (Stewart 2005: 44). Similarly, EU
directive-based capital adequacy requirements, introduced by the Investment Services
Directive, were extended by the Markets in Financial Instruments Directive which became
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effective on the 1st November, 2007 in relation to investment banks, portfolio managers,
stockbrokers and broker dealers, corporate finance firms, and some futures, options and
commodities firms; while the Solvency II directive 2009/138/EC, introduced quantitative
capital requirements for the insurance industry, in force 6th
January, 2010, and to be
implemented by 31st October, 2012 (Carney 2010).
New Irish Risk-Based Approach and Influences
Filling in the back-story, Honohan (2010: 64,66) revealed that in 2005 a formal risk-based
framework was adopted in Ireland, the system evaluating risk using factors such as
supervisory complexity, corporate governance, and business and reputational risk, based on
regular statistical reports supplied by regulatees. The rationale was to have a single cohesive
approach across all sectors. The framework was used to draw up a list of on-site inspections,
which however only amounted to once a year for large institutions, bi-annually for the next
level, and as resources permitted for the rest, due to „thin‟ staffing levels.
Post crisis, Elderfield, in March 2010, made it clear that, in his view that Ireland needed to
have a mixture of both principles-based and rules-based regulation, and to take an approach
rooted in a clear understanding of risk, “to be calibrated to the inherent risk and impact of a
particular firm or sector”. Cain (2010), referring to Elderfield‟s speech, described it as
„assertive risk-based regulation‟, which is more intrusive in the face of higher risk, needs a
credible method of enforcement, and has a strong emphasis on supervision.
Unfortunately as Ross and Hannan (2007) highlight in relation to money-laundering: “Risk is
sometimes referred to as a property that is inherent in places, people or products, sometimes
as an outcome of financial activity, and sometimes as a property of the regulatory regime
itself. Rarely, if ever, does legislation attempt to provide a definition of risk, and regulatory
agencies provide few explicit criteria that can be used to differentiate high risk from low
risk”. The definition of „risk‟ therefore is context specific.
Elderfield (29-03-10) himself highlighted the need, “to take a sceptical and challenging view
of a firm‟s internal risk management practices, including the use of internal models”, and
indicated that his staff under the new risk-based approach would, “be more challenging and
assertive where this is required”. This new rigour was amply demonstrated in relation to
Quinn Insurance when in March 2010, an application was successfully made to the Irish High
Court for the appointment of examiners, due to a deficiency in the insurer‟s solvency margin
which had been ongoing for over two years.
All of this amply demonstrates Black‟s (2010: 44) view that, “regulators are active in
constructing their own perception of their role, and their appropriate institutional position
vis a vis other actors in the regulatory system; not just firms, but other state and non-state
regulators”.
With reforming zeal for Ireland, regulatory supervision must be analytically linked to asset
and liability risk, including legal links between connected borrowers, economic links between
connected assets which may decline in value simultaneously, and funding short-fall risks
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triggered by asset problems, argued Regling & Watson (2010: 43). A credit register, financial
stability analysis strongly integrated into supervision, a more confrontational risk analysis
culture especially at inter-agency level, and more intense and operational supervision at an
EU level are all tools recommended (Regling and Watson 2010: 43-44).
In the UK, where regulator resources were directed at the major risks and opportunities
(Sergeant 2002), the effectiveness of the system depended upon agreement with the regulator
about identifying risks to control, and the manner of such control, while the key need for
those regulated was to ascertain and understand the regulator‟s risk assessment of their
individual firm (Stewart 2005: 45). For example, the overriding consideration for the FSA in
any enforcement decision concerning alleged money laundering, where preventive effort
must be proportionate to the risk, was whether a firm had implemented an effective control
structure that identified and mitigated its own particular money laundering risk (Proctor 2005:
14; Ross & Hannan 2007). In addition, in terms of capital allocation to identified risk for
instance, the monitoring was on a real-time basis, the rationale being that risk is constantly
changing (Teuten 2007: 37).
Modern financial risk management must be rooted in three concepts, argued Lang and
Jagtiani (2010: 132). Firms must:
Account for unexpected losses as well as accurately measuring expected losses;
View risk from a portfolio perspective, taking into account correlations among assets,
implying concerns for concentrated exposures to common risk factors , a view shared
by Regling and Watson (2010: 43);
Develop measures of tail risk for assessing capital needs (as already identified).
Elderfield confirmed and fleshed out his vision for Ireland, when warning in May, 2010, of resource
gaps in the regulators office before promoting new limits on the number of directorships which
bank and insurance board members may hold, and the prevention of CEO‟s becoming board
chairpersons (Carswell 11-05-10). In addition on the following day, new rigorous proposals to set
standards for insurers selling variable pension annuities which paid guaranteed returns over
extended periods were outlined by Elderfield‟s assistant, as well as proposals for new public
disclosure regulations to force insurers to be open, frank and up front in describing their
business, and their risks, performance and financial position (Carswell 11-05-10). Two days
later, on the 13th
May,2010, Elderfield himself informed a Joint Oireachtas Committee that he
proposed, “clear and enforceable” stringent new rules curbing lending by banks and building
societies to directors, senior managers, related parties and shareholders, designed to prevent
abuse and conflict of interest (Carswell 14-05-10). Within a month Elderfield (09-06-10)
speaking to the funds industry, highlighted that risk management standards and controls had
eroded on the watch of unvigilant boards, but advocated a „proportionate‟ approach to
corporate governance standards, eschewing a „one-size-fits-all‟ model, and applying different
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criteria to the different risk profiles as between banking/insurance and funds. In the case of
funds the industry itself was invited to propose its own corporate governance code.
Two weeks later, in a major clarification, a new strategy upon banking supervision was
announced, which clearly reflects Black‟s (2006) flexible move to targeting, when four in-
depth review actions upon „supervisory themes‟ were planned, the results of which were to be
published at different future target dates, the themes being: (i) governance and risk
management at major retail banks; (ii) lending standards; (iii) the quality of banks‟ strategies;
and, (iv) remuneration practices (McMahon 21-06-10). Simultaneous to this announcement
the Regulator‟s office clarified that its risk model was the engine of its supervisory strategy
and that institutions of highest risk would primarily be targeted (Brady 21-06-10). In a speech
to the industry, assistant director general for policy and risk Patrick Brady (21-06-10)
outlined, mirroring the UK FSA approach (Black 2005: 533): “Risk will be assessed on a
number of parameters. For example, impact, inherent risk, probability. Within a risk
framework, companies will be assessed as high risk, medium high, medium low and low”. A
scorecard, which would be shared with each regulatee, was to be kept with „behaviour‟ a
significant part of the calculation. It was planned to capture a range of quantitative and
qualitative aspects, the quantitative indicators including, “level and quality of capital,
funding, liquidity, size of deposits, the nature, scope and extent of lending and so on”; while
the qualitative included, “corporate and internal governance, quality and experience of staff,
business strategies, remuneration policies etc.”. It is unclear as yet to what extent, if any, the
approach will amount to „meta-regulation‟ i.e. relying upon internal controls. The qualitative
additions are a step beyond the Black (2005) identified FSA practice. Brady (21-06-10)
concluded, “In relation to risk, what we need assurance on is that, at board level and
throughout your organisations, risk is identified, monitored, managed and mitigated.
Business decisions must be properly assessed and informed”. This approach appears firm-
and-industry-centric and, thus open to the criticism that trends may not be spotted (Black
2005), or may possibly fail the new systemic risk „buzz-concept‟. In a very clear statement of
regulatory approach, far from the former „retreatist‟ enforcement style, and harking back to
Smith‟s principles-led definition, Brady announced, “a paradigm shift in our regulatory
approach. Our supervisory strategy will be outcome focused, demanding decisive follow-
through by both supervisory staff and supervised institutions”.
And again within days in June, 2010, the Irish regulator‟s office proposed new rules to force
financial advisors and sales staff to undertake 15 hours of professional development training
annually (and to keep reporting records of it), and also proposed rules to phase out
„grandfathering‟ were announced (Carswell 01-07-10: 21). A new assertive Irish regulator
had clearly arrived, and seemingly grounded in a new political will.
On the Irish political front, also on the 13th May, 2010, and presaging some of the above
announcements, Irish Taoiseach Brian Cowen TD stated:
“There is a need for much more intensive and risk-based supervision of financial
institutions ......There is also a need for a radical change in culture in Irish banks.
Regulation, and legislation underpinned by the gardai and other regulatory agencies,
must effectively police this on an ongoing basis (Cowen 2010).
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This latter theme was taken up by the Irish DPP James Hamilton who was reported six days
later, to have stated that a regime of serious financial regulation must include the ability to
prosecute those infringing (Coulter 19-05-10). It is unknown how the gardai reacted to being
categorised as a ‟regulatory‟ agency by the Taoiseach!
Concerning risk-based approaches generally, and equally applicable to the new Irish
approach at least operationally, Black (2005: 542-543) identified a „four risks to the risks‟
paradox: (1) implementation risk; (2) model or design risk; (3) cultural or perception risk; (4)
„process-induced myopia‟. It remains to be seen if any, or to what degree if any, prove
relevant to the new Irish experience.
For the UK specifically even pre-crisis, identified risk-based approach drawbacks included:
public perception of its performance at both retail and governmental level, a possible failure
to identify and/or control a significant risk, and potential resource allocation gaps (Stewart
2005: 45). To counter problems the FSA emphasised both transparency and making the
process public for instance, by regular updates, the publication of its risk-rating process for
individual firms, the individual provision of a risk assessment, and the supply of a risk
mitigation programme (Stewart 2005: 46; Smith 2008: 486). On the micro level, financial
firms must have effective internal controls, accurate and timely financial and risk reporting
procedures to the correct management level, and a corporate-wide view of risk or an
enterprise-wide risk management programme argued Lang & Jagtiani (2010: 141).
Wider afield, and an area Ireland may not be big enough to influence heavily, Valencia
(2010: 5) asserted that regulators generally were inching towards a more „systemic‟ risk
approach discussed more fully below, that banks must find a better balance between the
mathematical numbers and „gut feeling‟, and additionally that, “rules will have to be both
tightened and better enforced to avoid future crises – but that all the reforms in the world will
never guarantee total safety”.
In a general survey in February, 2010, Bloomberg were quoted as counting fifty bills and
other serious proposals for financial reform in the US and Europe alone (Valencia2010: 15).
Regulators were recognised as having both blind spots and vulnerabilities to those they
police, as evidenced by the asset-backed mortgage fiasco. One suggestion for „players‟ was
new rules combating incentives for excessive risk taking in the private sector, since human
behaviour required more focus than financial instruments. Short-term pay incentives required
longer term alignment and no relation to leverage, while in securitisation originators must be
more transparent and disclose more detail about loan pools and also hold a slice of the
product risk (Valencia 2010: 15-16). Risk around credit rating agencies is a matter for
discussion elsewhere, but was addressed by both the EU and Dodd-Frank (see below), while
regulatory default has been highlighted throughout.
Valencia (2010: 16) concluded with a warning: “Post-crisis regulation has a long history of
unintended consequences.......Another danger is the pricing of risk by regulation, not
markets......After every crisis bankers and investors tend to forget that it is their duty to be
sceptical, not optimistic. In finance the gods will always find a way to strike back”.
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General Bank Risk Reforms
The Economist (13-02-10: 11-12) asserted that in the financial industry the balance of power
had shifted back to those who police risk takers. The highly influential magazine suggests
that chief risk officers must be appointed, or where so appointed, must be fully empowered;
traders must prove their case if they disagree with risk managers; boards must monitor risk
better, have more experience and expertise, be slimmed down in numbers, and directors must
attend more meetings; bank bosses must set a corporate risk tone or culture that encourages
flagging potential problems; and, approved a healthy scepticism of mathematical risk models
and metrics which should be supplemented by stress tests and scenario planning.
Valencia (2010: 9-10) identified a number of other practical and important bank reforms
which affect risk management:
Combine market and credit risk groups as HSBC did in 2009;
Change the culture by instilling a tradition of asking and repeating questions until
clarity emerges;
Establish new independent risk committees as UBS has done;
Boards must define the parameters of risk oversight and better police risk adjustment
in allocating capital internally;
Re-think pay structures for investment bankers and top executives, an issue upon
which a number of governments intervened, even if only temporarily.
In May, 2010 new EU Commission governance reform plans were announced, including the
restriction of the right of bank directors to sit on the boards of other companies, limitations on
the time any individual may spend on a board, and the reining in of pay structures which
reward excessive risk taking (Beesley 29-05-10).
Regulators‟ Risk Reforms
Apart from the stress testing reforms already mentioned, ECB president Jean-Claude Trichet
in November, 2009 highlighted three connected response areas for global regulators
(Valencia 2010: 11) :-
1. Firms regarded as Too-Big-to-Fail:
The focus here is to reduce the risk to market stability. Systemically important giant
institutions are the main risk, and during the 07/09 crisis forced government intervention.
Some of the stop-gap steps made the situation worse by shot-gun conglomeration takeovers
of sickly rivals, for instance, the Bear Stearns takeover. To illustrate this point, The
Economist special report on financial risk, published 13th
February, 2010 on page 13,
depicted the top five global banks in graph form post crisis as increasing their assets as a
percentage of the industry total by approximately 33%!
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Problem solving centres either on reducing size, for instance, by shrinking the giants or by
erecting internal barriers or firewalls, or else by focusing on potential failures by increasing
capital adequacy requirements or making special provision to wind down the „collapsers‟.
In July 2009 the EU Commission laid down a number of principles to govern the
restructuring of banks left struggling by the credit crisis and these included measures to limit
distortions on competition ( Hennessy 6-11-09 : 5).
Mervyn King, Governor of the Bank of England, on the 20th
of October 2009 called for banks
to be split into separate utility companies and risky ventures saying it was a delusion to think
tougher regulation would prevent future financial crises (21-10-09: 19). He was also
reported as stating that regulation is not enough to keep banks from becoming too important
to fail, that moral hazard is endemic and that banks should be split up (24-10-09: 41).
Professor Nouriel Roubini, aka „Dr Doom‟, of New York University, echoing the King
viewpoint, stated at the inaugural International Financial Services Summit in Dublin on the
5th
of November, 2009, that if a financial institution is too big to fail, it is too big, and if it is
too big it should be broken up ( Kavanagh 06-11-09: 2 ). He also warned that bigger banking
„monsters‟ had been created through the crisis management mergers as already illustrated,
thus worsening the problem. He advocated the disassociation of public utility banking
(commercial banking) from investment banking.
Mallaby (2010) argued both for a concerted effort to drive financial risk into institutions that
impose fewer costs on taxpayers by encouraging the proliferation of firms that are not too-
big-to-fail, and by favouring institutions where incentives to control risk are relatively strong
and perhaps where regulatory scrutiny assumes less of the burden. He asserted that the “key
question about the future of finance” was “How can governments promote small-enough-to-
fail institutions that manage risk well?” and answered, “Governments must encourage hedge
funds” (2010: 380).
Early examples of action occurred in November 2009, when then EU competition
commissioner Nellie Kroes insisted that Royal Bank of Scotland and Lloyds sell assets,
effectively to part with its Churchill and Direct Line insurance unit, while the UK Financial
Services Authority (FSA) indicated they must in future hold nearly 10% of tier one capital
namely four times what was required before the global crash (Hennessy 06-11-09: 5). Also,
under EU pressure Dutch bank ING agreed both to divide its banking and insurance
businesses by selling online bank ING Direct, and to pay the Dutch Government extra fees
(Hennessy 06-11-09: 5).
US President Barack Obama, during the tortuous Dodd-Frank wrangling, in January, 2010,
unveiled two initiatives:
(a) A Tobin type tax on bank activities. The late economist James Tobin first mooted his levy or
tax idea in 1972 in relation to currency exchange, as a way of making short-term speculative
trading less profitable. The concept had been taken up in September, 2009 by Lord Turner
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head of the FSA, and advocated by former UK Prime Minister, Gordon Brown, while
European leaders such as Sarkozy and Merkel and US economic adviser Larry Summers
were also early supporters (Gibbons 2009); while on the 26th
May, 2010 the EU Commission
also proposed a new bank levy joining the IMF and governments in Europe and America
(The Economist, 29-05-10: 77). However, as a result of successful lobbying, at the last minute the
$19 billion levy on large banks provision was stripped out of the Dodd-Frank Wall Street Reform and
Consumer Protection Act 2010 when passed in July 2010 (The Economist 3-07-10: 61).
And,
(b) The „Volcker Rule‟, subsequently watered down in the Dodd-Frank reform, which proposed
limiting bank size and activities, by banning deposit-takers from proprietary trading in capital
markets and from investing in hedge funds and private equity, and which plan received a
cautious welcome from the Basel-based Financial Stability Board (FSB) on the basis it would
be combined with tougher capital standards and other measures (Valencia 2010: 12-13).
These other measures must include the treatment of lenders, depositors, bond-holders and
taxpayers, all matters of great interest in Ireland especially in the wake of NAMA, the Irish
bad bank.
Counter-party trading exposures, which normally if uncollateralised are at the bottom of the
creditors pay-out pile, and which in the US received favourable treatment in the troubled
banks and AIG in 2008, and which have been protected to date by credit-default-swap
buying which were state underwritten, however remained undealt with (Valencia 2010: 13).
For the US, the Volcker Plan was seen as supplementing other proposals, the most important
of which was improved „resolution‟ mechanisms for failed giants, because standard
bankruptcy rules were too slow for financial firms where value evaporates rapidly (Valencia
2010: 13). The US approach was for regulators to seize and wind down the failures, although
obvious down-sides included both convincing the markets that these measures were not
another form of life-support, and the absence of an international agreement on handling
cross-border firms, for instance Lehman Brothers, which had almost 3,000 legal entities in
dozens of countries (Valencia 2010: 13).
2. Overhauling Capital Requirements:
The focus here is to ensure that banks have adequate capital cushions against losses. In a
graph re-published in The Economist special report on financial risk, of the 13th
February,
2010 at page 14, Haldane and Alessandri of the Bank for International Settlements, showed in
a comparison between the USA and Britain that the cushion became more „threadbare‟ over
th period of a century, from an approximate high in 1880 for the US of 24% and Britain 17%,
dropping through two world wars and intervening events to 1995, for the US 7.5% and
Britain 4%. Pre-crisis, banks held mainly common equity of as little as 2% of risk-weighted
assets, with markets post crisis demanding that banks hold four or five times such levels,
while regulators encouraged the introduction of convertible capital in the form of „contingent‟
bonds that automatically convert into common shares at times of stress (Valencia 2010: 13).
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Strengthening capital buffers, which are at the heart of reconciling the pull between cheap
and efficient credit and bank stability, may take different forms. Different national
approaches include a punitive capital surcharge, sectoral variations may enable regulators to
influence marginal costs of lending to riskier segments, or be related to the individual
lender‟s contribution to systemic risk based upon its size, complexity and the extent of
connections to other financial firms (Valencia 2010: 13). Contrasting examples include
Switzerland where the cash and equivalents cushion is 45% of deposits, and the UK where up
to 8% of banks‟ assets could be tied up in cash and guilts. In addition, the composition of
liquidity cushions has caused controversy with some desiring to restrict these to government
debt, deposits with central banks and the like, while others like the Basel Committee wanted
to include high-grade corporate bonds (Valencia 2010: 11). The Economist asserted that it
was vital that banks carried bigger safety buffers of capital and liquid assets and highlighted
that the job of ensuring this had been „outsourced‟ to the Basel club of regulators (The
Economist 29-05-10: 11).
Upon the global level, the Basel Committee of central banks and supervisors from twenty-
seven countries in December, 2009 proposed a two component global liquidity standard for
internationally active banks, effective 2012-2013, dubbed Basel III, which predictably
garnered feisty bank opposition (Valencia 2010: 11, 13-14; The Economist 29-05-10):-
(a) A „coverage‟ ratio, designed to cover a one month period of acute stress like a sharp ratings
downgrade and a wave of collateral calls, by having a large enough pool of high quality
liquid assets; and,
(b) A „net stable funding‟ ratio, designed to cover a year or more, and aimed at promoting
longer-term financing of assets with a view to limiting maturity mismatches. One
commentator, Credit Suisse was quoted as reckoning that this proposal would require
European banks alone to raise €1.3 trillion of long-term funding (The Economist 29-05-10).
In June, 2010 the G-20 group of countries meeting in Busan, South Korea, as represented by
their finance ministers and central bank governors, was reported as having „big differences‟
in relation to implementing Basel III reforms regarding the capital, leverage and liquidity
reforms which had been agreed in 2009, and which were due for implementation in
November, 2010. Disagreements were reported over the scale, scope and timing of increases
in capital and liquidity requirements for banks, as well as leverage allowable (Reuters 05-06-
10).
3. Improving Macro-prudential Regulation:
The focus is a system-wide approach in terms of overhauling day-to-day supervision in
conjunction with taking account of collective financial behaviour and contagion effects, while
in the US and Europe regulators have introduced pay comparisons, stepped up lending
standards, and introduced peer review (Valencia 2010: 14). The US SEC established a new
risk division with new oversight duties to include the scanning of derivatives markets, hedge
funds and the like for any emerging threats to stability (Valencia 2010: 14). The Dodd-Frank
reform inter alia provided for regulation of advisers to hedge funds, as already mentioned
limited bank involvement with hedge funds and proprietary trading under the Volcker rule,
imposed counter-cyclical institutional capital requirements, regulated OTC swaps markets,
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empowered the SEC to impose „point-of-sale‟ disclosure rules, imposed obligations regarding
executive remuneration and corporate governance, and allowed for regulation of credit
ratings agencies. Directly applicable EU Regulation1060/2009, effective 7th
December, 2010,
stipulated licensing of such ratings agencies, which must be IOSCO rule compliant, on the
„passport‟ system, with the CESR facilitating co-operation and co-ordination among member
states.
However, there is no global agreement as to how systemic regulation will or should work, or
who the regulator(s) should be. While central banks are mooted by some, there are political
obstacles particularly in the US, with international co-ordination equally tricky, the already
mentioned FSB recommending colleges of supervisors to regulate thirty of the largest banks
and insurers for cross-border scrutiny (Valencia 2010: 14). The EU has its own systemic-risk
council (see below), while private sector groups are vocally active. In the US Dodd-Frank
provided for a Financial Stability Oversight Council comprising ten voting members charged,
inter alia, with identifying risks to US financial stability, promoting market discipline, and
responding to emerging financial threats.
Some critique that the creation of an official global systemic regulator may only provide false
comfort, and suggest an independent body staffed by economic expertise to provide
institutional memory of past crises, with a brief beyond reactively setting rules post event
(Valencia 2010: 15). Such a body may deal with cross border capital flows, co-ordinate
regulation, and assist in dealing with political pressures where the looming next election may
stall corrective intervention (Reinhart & Rogoff 2009: 282). Some recommend the IMF as
international watchdog but highlight impartiality and governance reform issues (Gros et al
2009). This of course, will prove more problematic in the wake of many governments
themselves becoming market „players‟ as well as referees (Valencia 2010: 15).
Another very tricky task is how to deal with asset-priced bubbles. Pre-crisis the US under
Greenspan adopted a wait-and –see approach where the focus was aftermath clean-up,
whereas the Bernanke post crisis view was geared more towards intervention via regulation
or even by the use of monetary policy, Valencia argued (2010: 14). Noises from Ireland
made it quite clear that previous regulators regret not intervening in the growing Irish bubble
(Carswell 26-05-10). Valencia (2010: 14) quoted former US Federal Reserve governor
Mishkin, now of Columbia University, who, contrasting the more dangerous credit-boom
bubbles with irrational stock-market exuberance, suggested that in the former that pre-
emptive action is more warranted because the bubble is accompanied by a cycle of leveraging
against rising asset values. One possible approach is for regulatory action where credit and
asset prices grow above average rates (Valencia 2010: 15), but not alone does this penalise
flexibility, it means the intervention can only occur at national economic level, an occurrence
likely to be heavily influenced by domestic political issues.
In Ireland the institutional reform approach has been legislative change with the first of three
bills introduced in April 2010, the establishment of a new Banking Commission, and the
separate Financial Regulator has been restored to the aegis of the Central Bank, while the
Minister for Finance, claiming both international and market approval declared, “..... the new
fully integrated structure”, will upon further legislative change, “enhance the powers and
functions of the new restructured Central Bank in relation to: the prudential supervision of
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26
individual financial institutions; the conduct of business, including the protection of
consumer interest and the overall stability of the financial system”( O‟Halloran 21-04-10).
US Reforms
Objectives-based Approach
Mid-crisis, Henry „Hank‟ Paulson recommended a fourth regulatory approach, the
„Objectives-Based‟ approach, which resonating heavily with the risk-based approach already
discussed, and reflecting Smith‟s (2008: 481) view of the principles-led approach where
goals and outcomes are central, and Ford‟s (2008: 3) „outcome-oriented‟ Canadian regulatory
practice, advocated the use of three distinct regulators, and eschewed a specific industry
focus (The Paulson Report 2008: 13-14). The US Department of the Treasury report or
„blueprint‟stated the objectives-based approach was particularly focused on potential market
failures and incorporated three key goals:
• Market stability regulation to address overall conditions of financial market stability that
could impact the real economy. A second US view this time post-crisis, and outside the
report, from Acharya et al b (2009:283) complained that, “Current financial regulations seek
to limit each institution‟s risk (for example, market and credit risk) seen in isolation; they are
not sufficiently focused on systemic risk”. In Europe the De Larosiere Report was
commissioned with a view to examining the nature and magnitude of systemic risks, and how
a co-ordinating authority with prudential regulation and emergency powers could counteract
them (Donnolly 2010), and it was recommended that an additional constitutional layer, a
supranational systemic early warning council be established to deal with identified
decentralisation and fragmentation problems. Dodd-Frank reforms along similar lines have
already been and will be further highlighted below.
• Prudential financial regulation to address issues of limited market discipline caused by
government guarantees; and
• Business conduct regulation (linked to consumer protection regulation) to address standards
for business practices. Interestingly Goodhart (2009: 56) from the UK perspective opined that
the bulk of the work of a primarily supervisory body like the FSA, involved conduct of
business issues, with the dominant staff professions being lawyers and accountants.
Highlighting regulatory fragmentation in the US, the Paulson report claimed that a major
advantage of objectives-based regulation was that regulatory responsibilities were
consolidated in single regulatory areas where natural synergies take place, as opposed to
dividing them among individual regulators. Other advantages included: being better able to
adjust to changes in the financial landscape; providing a clearer focus on particular goals; and
establishing the greatest levels of market discipline by clearly targeting institutions by type.
However, when the proposal is investigated it reveals similar fragmentation minus overlap. In
addition to the three distinct regulators, each covering one of the key goal areas, the report
claimed that two other key authorities, a federal insurance guarantor and a corporate finance
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regulator, would be required. In addition a structure apparently rationalising the „chartering‟
of financial institutions was advocated with the establishment of three separate institutions.
Dodd-Frank opted for many new regulators for specific areas as detailed below, continuing
the US fragmentation model identified post-Depression by Braithwaite and Drahos.
Dodd-Frank
The US Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 which was
passed in July 2010 after enduring a twenty-two month, separate and then joint, Senate and
Congress rite of passage, may be characterised as a legislative leviathan comprising a series
of sub-topic pieces of legislation synergised into one great whole. Described as the most
sweeping change to US financial regulation since the Depression and a paradigm shift
affecting all financial regulatory agencies, it made changes in four key areas: (a) regulatory
oversight, establishing many new agencies; (b) derivatives, and especially accountability and
transparency; (c) dealing with troubled banks felt too big to fail, focused upon no more
taxpayer bail-outs; and (d) consumer protection. The impact of the legislation will largely
depend upon the way the regulators, namely the Federal Reserve and the newly established
consumer agency, enforce its provisions The Economist asserted (03-07-10: 10).
Regarded as too American to be a good template for elsewhere, Dodd-Frank is riddled with
“messy compromises”, the new law handing a great deal of discretion to regulators with
much of the text a mere template, while capital rule-making has been outsourced to
international bodies, The Economist critiqued (The Economist 03-07-10: 62, 64). One leading
US law firm, Davis Polk & Wardwell, estimated that the 2,300 page act required regulators to
enact 243 new rules, conduct 67 studies, and issue 22 periodic reports. Altering existing
regulatory structure, in addition to removing or merging some agencies, many new
institutional regulatory agencies and innovations were introduced – effectively, an
institutions, rules and tools reform- including (The Economist 03-07-10: 62):-
Establishing the Bureau of Consumer Financial Protection with broad powers to write
rules and ban financial products;
Establishing a resolution authority which extends to non-bank financial firms;
The resolution mechanism extends regulators‟ powers to force losses on creditors as
well as shareholders and requires healthy financial firms to cover the cost of winding
up collapsed rivals;
„Standardised‟ derivatives must be routed through clearing houses and traded on
exchanges, with higher capital charges for customised contracts;
Hedge funds and private equity funds overseeing $150 million or more in capital must
register with the SEC and give information about their trades and portfolios;
Establishing the already mentioned systemic-risk oversight council, comprising the
US Treasury, federal regulatory agencies and an independent member;
Establishing the office of the Director of Financial Research, charged to report
annually only to Senate and Congress, about inter alia potential emerging financial
threats;
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Establishing the Office of the Investor Advocate, an advisory committee, and an
ombudsman, all aimed at stifling regulator „capture‟;
Expanding FDIC powers to wind up bankrupt financial companies;
Establishing within the Department of the Treasury a Federal Insurance Office to
monitor the insurance industry;
Providing for rules obliging asset-backed securitisers to retain an economic interest in
the credit risk, and inter alia to meet disclosure requirements;
Requiring every three years for shareholder approval of executive remuneration in
public companies.
Paradigm: Changes and Shift
Different jurisdictions have taken the regulatory change lead from time to time. For instance,
Ireland followed the UK hybrid approach, and the disclosure of individual firm risk
evaluations to regulatees; the UK first mooted the Tobin tax, the EU led the US on regulating
credit rating agencies and the systemic risk council, while the US led on hedge funds as the
EU lagged.
When reviewing the Irish regulatory paradigm shift, the shift stretches the old British model
towards the new principles/rules/risk hybrid which the UK attained pre-crisis. The US shift
amounts to an institutional shift, with new rules and tools, where their eighty year old rules-
based model has moved towards a rules, principles and risk based approach. Accordingly
across the Irish, UK, and US regulatory approaches, and even the EU „sit-above‟ government
model, there is a convergence towards risk. This is conceptualised in the figure below.
Figure: Regulatory Approaches: Pre to Post Crisis Paradigm Shift Conceptualisation (Elder 2010)
Sources include Braithwaite & Drahos (2000); Gadinis & Jackson (2007); Ford (2008); Black (2008).
1930’s British Converge Risk 1930’s USA
Rules
Hybrid
Pr Risk Ru
Soft Hard
Principles
Hard Soft
EU Govt Model: shift Pr to Rk
UK Hybrid
USA (Canada) shift to Pr and Rk
IRL Pr shift to hybrid
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Conclusion
The new Irish financial regulatory paradigm which awaits implementation, continues to be
institutionalised although in a changed format, is principled in that it still relies partly upon
principles which are still however non-statutory and un-codified, is rules attentive, and
especially flexibly targeted risk-centric, is legally underpinned institutionally by legislation
both EU and domestic, while impactors such as the move to regulatory liberalism, a newly
appointed uncaptured and assertive regulator, and new regulatory issues are lurking at
paradigm margins or influencing the birth into strategy. Regulatory approach continues to be
key to regulation, monitoring and supervision, including the enforcement sub-set. Worldwide,
this paper reveals a fragmented, disjointed and confusing array of opinion as to regulatory
approaches, and an equally bewildering array of reform proposals especially tailored toward
„risk‟, the definition of which is context specific No institutionalised global regulatory
structure exists. Regulatory „outsourcing‟ is evident. No single jurisdiction has taken the
outright regulatory change lead. The EU has approached issues on a piece-meal basis. The
US, continuing their fragmentation model, has embarked upon a mammoth institutional, rules
and tools overhaul which will take time to assimilate. The UK position awaits further
political input. The regulation of financial services remains, indeed, as Black asserted, full of
“contingency, complexity, dynamic adaptability, and unpredictability”.
Addenda
1. Bank stress tests carried out May/June 2010 and see results in July 2010?
See computer file Irish times extracts, EU, bank stress tests.
2. NESC report July 2010 released August 2010. Recognised need for
enhanced domestic, EU and global financial regulation.
3. Herman Van Rompuy task force established March 2010 by the European
Council ECOFIN to examine EU economic governance; exploring for the
Euro area improvement of economic policy surveillance and co-
ordination; waiting for report. Report due out October 2010.
4. The European Commission’s Communication of 12 May 2010, ‘Reinforcing Economic Policy Co-ordination’; further development of these proposals is provided in a subsequent European Commission Communication of 30 June 2010. It was agreed to strengthen the rules on budgetary discipline. From 2011 onwards,
Stability/Convergence Programmes16 will be presented in spring. This will include advance
presentation of key budgetary parameters for the next budget, „taking account of national budgetary
procedures‟ (European Council, 2010: 5)17. It was also agreed to review the sanctions in the SGP
(stability and growth pact) and to ensure that all member states have budgetary rules and medium
term budgetary frameworks in line with the SGP. Broader macroeconomic surveillance (beyond
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budgetary matters) is to be improved. A new scorecard is to be developed to this end, with a view to
early detection of unsustainable trends along with an effective surveillance framework.
5. On the 26th August 2010 the US CFTC sought comment upon rules for OTC derivatives. It
acknowledged that it had identified under Dodd-Frank 30 areas in which rule-making will be
necessary. This included three enforcement areas: whistle-blowing, anti-manipulation, and
disruptive trading practises. See the sanctions file CFTC sub-file for more info.
6. Re page 3 and Irish economy. Late August 2010 Irish ten-year bond spread increased to 347
basis points over German rate; on 7th September it was 375 basis points above. 347 figure
occurred after S&P again downgraded Ireland. (17-09-10 interest rate rose to a record 6.3% at
day‟s end...spread probably about 4000 basis points above Germany!). Also as of 2/9/10 the
Irish Times was recording Irish unemployment at 13.7% end of July 2010 and 13.8% end of
August 2010, with 455,000 on the live register, with Dan O‟Brien suggesting Irish economic
data point to stagnation see Irish Economy paper file).
7. On 2nd
September 2010 (see Euractiv file) following on from proposals made as far back as
June 2009, the EU (reps from Council, Parliament and Commission) established a new
financial architecture. Three new watchdogs (EBA-banking based in London, EIOPA-
insurance & occupational pensions based in Frankfurt, and ESMA-securities & markets based
in Paris) supplement the European Systemic Risk Board ( ESRB) which will be chaired by
the ECB President, with powers to over-rule national bodies under three scenarios: (i) when
the national supervisor is in breach of EU law, (ii) when there is a disagreement between two
or more national supervisors and (iii) when an emergency has been called by member states(
Council define „emergency‟). Final approval will come from finance ministers on 7th Sept 10
and by the Parliament during plenary sessions on 20-23 Sept 10.
8. Beesley, Arthur, “EU continues quest for deal to strengthen economic system”, Irish Times, 6th Septmber, 2010: May 2010 due to sovereign debt crisis in Greece, the creation of a €750 billion EU/IMF rescue net for struggling euro zone members eased the sovereign debt crisis in the single currency area; Van Rompuy has been trying to get agreement upon tougher rules in the EU re national budgets, as Merkel wants member states in default of EU budget rules to be denied voting rights; most EU governments favour sanctions ( eg not receive structural funds; automatic/discretionary imposition) to help relieve the revealed systemic weakness in the Euro, and Van Rompuy is to make proposals while the EU economics commissioner Olli Rehn is set to produce a definitive set of proposals on sanctions on September 29th, 2010.
9. Irish Times 6th Septmber, 2010, editorial: THE NUMBER of residential mortgage holders who are more than 90 days in arrears on their loan repayments continues to rise. Figures from the Central Bank and the Financial Regulator for the second quarter to June 2010 show that one in every 20 mortgages are in some difficulty: 36,348 were in arrears out of the 789,814 mortgage loans outstanding. The Central Bank data may well understate the problem as the collection of mortgage arrears statistics only began a year ago (2009).
10. USA Dodd-Frank signed 21st July 2010 and by 20
th August 2010 the CFTC was holding a
roundtable discussion concerning rules re derivatives. See computer file re CFTC and look for
drop-down from their website August 2010.
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11. EU governance model note re the Helm quote p1 : Moloney (2008: 37) described EU
securities regulation as, “the zenith of the Community method....the triumph of the
command-and-control model for intervention”.
Source: Moloney, Niamh, EC Securities Regulation, 2nd
edition, 2008, Oxford
University Press.
12. Source: Konzelmann Sue, Wilkinson, Frank, Forargue-Davies, Marc, and Sankey,
Duncan, “Governance, regulation and financial market instability: the implications for
policy”, Cambridge Journal of Economics, 34(5), September, 2010, p929-952.
“Both Wall Street and London‟s Square Mile acquired and built their
influence as a result of „light touch‟ regulation-resulting in what is known
in The City as the „Wimbledon Effect‟: a great British tradition but
almost all the players are foreign. Initially attracted by the lack of
regulation, they would be likely to move on, should London tighten
regulation independently. The same would also apply to New York or any
other financial centre. Regulatory arbitrage thus necessitates a globally
enforceable set of rules. The over-reliance of post-industrial economies,
such as Britain and America, on the financial sector underscores the
imperative of such a system and the ineffectuality of independent national regulation”. (p 952)
13. Basle II reforms announced 12th
September 2010. See Irish Times 13th
Sept 2010 “Banks must bolster reserves”.
The reform package, known as Basel III, includes a new minimum core tier one ratio
for banks worldwide. This vital measure of bank safety compares a bank‟s equity plus
retained earnings with assets, adjusted by their riskiness. The current minimum is 2
per cent.
Banks in Europe are most likely to need to raise funds, notable in Germany, Spain and
other weak spots.
The Basel group, which announced details of the deal late yesterday, has set the new
minimum at 4.5 per cent and added, for the first time, an additional buffer of 2.5 per cent,
making the total 7 per cent. Banks within the buffer zone will face restrictions on their
ability to pay dividends and discretionary bonuses.
Although a solid group of countries agreed on the 7 per cent figure at a preliminary
meeting earlier in the week, some countries had wanted minimums as low as 4 per cent
and others as high as 10 per cent.
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The Basel group also announced that the new rules should be gradually implemented from
2013 to the end of 2018.
The reform package not only requires more capital but also tightens the definition of what
counts toward core tier one capital.
The Irish Times 14th
Sept 2010 article” Top bankers braced for tougher capital
requirements” by BROOKE MASTERS, JENNIFER HUGHES and NIKKI TAIT contained the
following:
LEADING BANKERS in Britain, the US and Switzerland are prepared for national
regulators to impose tougher capital requirements than those required by last Sunday‟s global
agreement, even as investors bid up bank shares on relief that the standards were not more
rigorous.
The 27 member countries of the Basel Committee on Banking Supervision agreed on Sunday
that banks will in effect be required to triple core tier one capital ratios from 2 per cent to 7
per cent by 2019. This ratio measures the buffer of highest-quality assets that banks hold
against future losses. The agreement was hailed by regulators and industry groups as a vital
step that would go a long way towards preventing a repeat of the fiscal crisis without
endangering the nascent recovery.
14. Beesley, Arthur of Irish Times “Temporary ban on short-selling proposed”, 16th
September 2010 reported that EU Internal markets Commissioner Michel Barnier
unveiled far-reaching plans to curtail short-selling and regulate derivatives trading.
The legal measures, which Mr Barnier hopes to put on the statute book by 2012,
would provide for a temporary ban on short-selling while radically increasing
oversight of the derivatives market.
“No financial market can afford to remain a Wild West territory,” said Mr Barnier. “We have
to limit risks of hyper-speculation.”
Mr Barnier said he wanted to address the absence of transparency in these markets, the risk of
negative price spirals and the risk of settlement failure in “naked short-selling” trades.
The proposals will have to be agreed by member states and the European Parliament before
they become law.
The commission said it was including credit default swaps in the proposal because they could
be used to secure a position economically equivalent to a short position in the underlying
bonds.
One proposal would give oversight of short-selling trades to the new EU markets regulator,
giving it the power to impose a three-month ban on such deals or unilateral national bans
such as controversial measures introduced by Germany earlier this year.
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In the case of “naked short-selling”, regulators would be able to demand that sellers
demonstrate their capacity to complete the deal. In essence this means that investors would
have to have borrowed an instrument or have pledged to do so before entering such a
transaction.
The EU executive wants information on over-the-counter derivative contracts to be reported
to trade repositories and be accessible to supervisory authorities.
It also wants standard over-the-counter derivative contracts cleared through central
counterparties to reduce the risk that one party to the deal defaults.
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Law, Society and Economy Working Papers 4/2010.
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law”, 2003,Autumn, Public Law, p 455-478.
Ford, Cristie L, “New Governance, Compliance, and Principles-Based Securities
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Ford, Cristie and Hess, David, “Can Corporate Monitorships Improve Corporate
Compliance?” 2009, 34, The Journal of Corporation Law 3, 680-737.
Gadinis, Stavros, and Jackson, Howell E, “Markets as Regulators: A Survey”, 2007, 80
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Gros, Daniel, Kluh, Ulrich and Weder di Mauro, Beatrice, “Reforming Global Governance:
How to make the IMF more independent”, Intereconomics, March/April, 2009, p72.
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Evans Conference on Stress-Testing, 9-10 February 2009, at
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Helm, D., “Regulatory reform capture and the regulatory burden”, Oxford Review of
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Credit Risk Management and Corporate Governance”, Atlantic Economic Journal, 2010,
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Shaun Elder 28/09/2010 Working Paper: Please do not cite without permission.
37
Lastra, Rosa Maria, “Risk-based capital requirements and their impact on the banking
industry: Basel II and CAD III”, Journal of Financial Regulation and Compliance, 2004,
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information in the banking sector”, Journal of Financial Regulation and Compliance, 2005,
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and Capacity”, 2010, Law & Policy 32(1), p61.
Nielsson, Ulf, “Measuring and regulating extreme risk”, Journal of Financial Regulation
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making”, Journal of Money Laundering Control, 2007, 10(1), p 106.
Sergeant, Carol, “Risk-based regulation in the Financial Services Authority”, Journal of
Financial Regulation and Compliance, 2002,10(4), p329.
Sheen, Andrew, “Implementing the EU Capital Requirement Directive – key operational risk
elements”, Journal of Financial Regulation and Compliance, 2005, 13(4), p313.
Simpson, John l., and Evans, John, “ Benchmarking and crosschecking international banking
economic and regulatory capital”, Journal of Financial Regulation and Compliance, 2005,
13(1), p65.
Sklaroff, S, “Regulation in an untrusting world”, Journal of Economic Affairs, 2006 26(2), p
37.
Smith, Herbert,“Legal and compliance risk in financial institutions”, Law and Financial
Markets Review, November, 2008, p 481.
Sollis, Robert, “Value at risk: a critical overview”, Journal of Financial Regulation and
Compliance, 2009, 17(4), p 398.
Stewart, Sam, “Coping with the FSA‟s risk-based approach”, Journal of Financial
Regulation and Compliance, 2005, Vol 13 No 1, p 43.
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2007, p 34.
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Shaun Elder 28/09/2010 Working Paper: Please do not cite without permission.
38
Walker, RG, “Reporting entity concept: a case study of the failure of principles based
regulation”, Abacus (Australia), Mar 2007, 43(1), p49.
Ward, Neil, “The IFSC: Charting a Course to Future Success”, About Banking, May 2010, p
10.
Westrup, Jonathan, “Regulatory Governance”, 12 November 2007, UCD GEARY
INSTITUTE DISCUSSION PAPER SERIES.
Newspapers and Magazines:
Beesley, Arthur, “EU plans new measures to restrict bank directors”, Irish Times, 29th
May,
2010, p16.
Carswell, Simon, “Elderfield criticises „spectacular failures of corporate governance‟”, Irish
Times, 11th
May, 2010 p 20.
Carswell, Simon, “Warning on varying rules for insurers”, Irish Times, 12th
May, 2010 p 18.
Carswell, Simon, “Stringent new rules to curb bank lending”, Irish Times, Business This
Week, 14th
May, 2010 p 1.
Carswell, Simon,“Central Bank sent out wrong message on crisis”, Irish Times, 26th
May,
2010, p 14.
Carswell, Simon, “Regulators showed „unduly deferential approach‟ to banks”, Irish Times,
10th
June, 2010, p8.
Carswell, Simon,“Stricter rules on financial staff training”, Irish Times, 01-07-10, p21.
Coulter, Carol,“DPP outlines challenges for justice system of strict financial regulation”,
Irish Times, 19th
May, 2010, p5.
Gibbons, John, “Tax on speculative trading a great way to raise billions”, Irish Times, 5th
November, 2009, p15.
Hennessy, Mark,“British banks bow to commission”, Irish Times, Business this Week, 6th
of
November 2009, p 5.
Kavanagh, Brian, “Summit hears call for global regulation”, Irish Times Business this Week,
6th
of November 2009, p 2.
King, Mervyn, “Split risky financial ventures, says bank governor”, Irish Times, 21st October,
2009, p19, as reproduced from the Financial Times; and Economist, “Splitting up banks Too
big to bail out”, 24th
of October 2009, p 41.
Shaun Elder 28/09/2010 Working Paper: Please do not cite without permission.
39
O‟Halloran, Marie,“Bill to merge regulator with Central Bank introduced”, Irish Times, 21st
April, 2010, p8.
Reuters report, as published in the Irish Times, entitled “Divisions in G20 on tougher banking
rules”, 5th
June, 2010 p 16.
The Economist, “Bar-knuckle in Basel”, 29th
May, 2010, p 11, and “The banks battle back”,
p77.
The Economist “Financial reform in America A decent start” 3rd
July 2010, p10.
The Economist “Not all on the same page”, 3rd
July 2010, p61-64.
TV interviews:
Connor, Gregory, RTE Prime Time, RTE 1 TV, broadcast 10th
June, 2010.