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Friday, 13 March 2009

Financial Services Authority: bird's eye view

We expect the FSA to be like a hawk, an owl, an eagle, a warning look-out, noting smallest signs of foolish risk-taking, a regulator bird of prey... if the FSA is bird-like, it's not a 'raptor' as per 'bird of prey', more a vulture, a Turkey Vulture Shaver probably? Raptors kill their prey. Vultures, also crows and ravens, eat carrion, Nature's and our road-kills. In the 1980's Charles Sibley, using DNA-DNA hybridization to check genetic taxonomy of avian species, found vultures especially perplexing. Tweny years on, no academic consensus has been reached. So it is with the FSA (set up in 1997 to amalgamate financial regulators, much as the G20 agenda hopes to do by creating a global IMF umbrella inter-linking bank regulators worldwide). The FSA started out well, but had so much to do, and then along came Basel II. It is by far Europe's biggest regulator. Half of Europe's financial assets are variously managed or operated in London and the UK. The FSA is smaller than the USA's SEC, but has twice the scale of work,. The SEC (set up in 1934 after the '29 crash) receives half a million statements from over 100,000 firms but actually supervises 16,000 securities firms and can only scrutinise about one in seven annually. The USA's FDIC and the regional Federal Reserves cover banks and other firms taking deposits and selling loans etc. The FSA has relatively more to do but much less resources. Its budget is charged to the firms it supervises. It covers all financial sectors and 28,000 firms. It approves over 170,000 persons. It regulates, monitors, supervises, licenses insurers, investment funds, brokers and banks (about 400 UK licensed banks and building societies including foreign-owned). The flow of new regulations, especially CRD (Basel II and Solvency II), and their complexity is enormous, on top of a great number of other laws and procedures, plus national and international coordination - hard for anyone at the top to fully comprehend. It is unimaginable how the jobs of the FSA or the SEC or other such large agencies today could be done, publications alone, without the internet. Compared to ministries of state, the FSA is a minnow, yet it has jobs to do as important, broader and deeper, and a lot more difficult technically. The sums involved in bailing out the banking system are such that now everyone can see just how serious all this is. This graphic shows only a fraction of the UK response. The FSA has a budget of about £350m and employs 2,700 spends two third of its budget on staff costs. The SEC has 900 more personel and twice the budget of the FSA, only half the number of firms to closely regulate, most on a rolling 3 year basis, and even it should be doing much more. The FSA staff and budget is slightly more than the Bank of England, but the FSA probably does several times more work, or it should be doing that much more if it was properly resourced. The FSA's work is as varied and complex or more so than any of our largest banking groups. It acts in theory like a non-executive oversight, to challenge executives like a massive audit committee. The UK has sought to have regulation cheap, not slightly cheap but at least 4 times too cheap (my guess)! Some people imagine regulation is like health-checks. Get the patient in, stick monitors on, go through some tests and scans, process the data, and then ask some searching questions like do you smoke, drink, suffer anxieties, take medications, but exercise enough? Then, if complaints persist, we expect the FSA to write a prescription? Unfortunately, there is a large element of that being how the FSA itself thinks, it is here to help the clients get well, to work with them, privately, collaboratively, non-threatening except in most exceptional circumstances, an emergency. Now its plague and the FSA hasn't got the manpower or the equipment for the job. It has to rely on risk teams in the banks and that's a curate's egg too. There are massive health-check manuals, but regulation is based on expecting the banks and others to read and comprehend it all and mostly self-medicate. In a mature stable world when all the new reulations are one day well imbedded and second nature for bankers, insurers and so on that might be possible, but it is very far from possible today. The FSA is certainly negligent and partly culpable for the credit crunch, but not nearly so much as he regulated firm themselves. And government with the FSA has some self-assessment to do as to whether the FSA has been at all adequately resourced? It has not been light-touch regulation though. That's a myth. The regulations are heavy-duty, comprehensive and even brilliantly conceived, elegant, legalistic, comprehensive, but presuming on a level of intelligence, priority-setting nd resource commitment by banks and others that is simply not happening more than half as much as should be. Where the FSA has fallen down is in the expertise of people and systems at both the FSA as well as the banks. The mass of guidance reports, firm rules, reporting requirements, processes advised, and scrutiny is enormous. The flow of publications exceeds that of any other of Europe's regulators. But, the FSA should have warned of the risks of being under-resourced! Risk experts are in very short-supply, high quality experts as rare as sea-eagles, and the FSA has a constant problem of staff being poached. Audit firms cannot take on the burden, not yet. They are not tasked to cover risk - while they have expertise not enough of that either. Will the full scale be fully addressed now, probably not! There will be 10% increase in FSA professionals to be trained up, when several times this are needed.
Hector Sants today, yet again, defended the FSA while at the same time accepting some blame. but not enough ruthless self-assessment. Echoing his boss, Lord Turner, Hector Sants blamed the credit crunch on world trade and payments imbalances and politically-driven credit-boom culture. (This is noteworthy: These causes are new, gaining recognition in the last few months - from economists and models that predicted the crisis - the Levy Institute models of my economist friends Wynne Godley, Alex Izurieta, Francis Cripps, Gennaro Zezza, Marc Lavoie and others now lauded as seers in the WSJ, FT, UN, Goldman Sachs, Cambridge Judge Institute and elsewhere by Paul Krugman, Martin Wolf and others.)
Sants said today (echoing his Chairman's view Lord Turner): "...the main drivers of the crisis as follows. ...a set of macroeconomic and macro-prudential issues... global imbalances caused by the response of the Asian countries to the last crisis... period of historically very low interest rates and in general globally, particularly in the US, a drive by the wider authorities – governments, finance ministries and central bankers - to encourage a significant credit boom particularly for the benefit of consumers who wished to purchase housing. In addition ...a set of cultural drivers ...that credit was good for votes and would be possible for the authorities to avoid a boom/bust culture." This is well and good, but problems persist in that we don't have models that fully link the macroeconomic to the financial sector in enough detail to guide the micro-prudential or even to assess the impact of government bail-out measures. Clues will come out in the wash only when we see how the top US and European banks complete the scenario stress-tests they have been tasked with - something Basel II regulations have insisted upon for years but too few people in the world have known how to accomplish. The big question is can banks be saved from making the recession worse by withdrawing credit and will better regulation play a role in this now? Then in a mea culpa, not unlike David Cameron's today apologising for the Conservative Party's failure to warn about the credit-boom economy (as a challenge to Gordon Brown to do the same), Sants went on to say, "These wider social and economic drivers were ...facilitated by ...weaknesses in the regulatory framework, respect of the rules, particularly in the way the prudential and accounting regime works in a procyclical way, but also ...fragmentation of the regulatory architecture both in many national locations and globally." This is the FSF, IMF and G20 agenda view.
In taking this to the FSA's role, sants said, " the UK... the principal gap in the regulatory architecture was in ...‘macro-prudential’, with the local supervisors of the FSA primarily focusing on individual companies and the central bank on interest rates. There was also, here in the UK, an inadequate depositor protection regime and bank resolution mechanism." No reference to Bank of England's role in Systemic Risk monitoring and its warnings in stability review reqports!
Sants said, "Other countries... had their regulatory architecture ...massive fragmentation, such as in the US which led to a lack of oversight ... of which AIG is the best example... lack of oversight of ‘bank-like institutions’, otherwise known as 'shadow banks'. So... economic... social and cultural... regulatory... market participant drivers ...failure of market discipline: markets did not self-correct... underpinned by ...investors and ... those who sell products not to ...'buy things you don't understand'... facilitated by credit rating agencies. Investors and banks ...too willing to accept their analysis as relevant to a whole set of risks ...not actually addressed by the research of the agencies... structural failures ...magnified by ...governance failures and poor business judgements by the financial institutions themselves."
The above provides blanket criticism but also get-out sub-clauses; blame fully-risk-dispersed!
Sants, "The key question then is where do we go from here and ...minimise ...this sequence of events ...happening again recognising... a belief we can fully abolish cycles' is an illusory goal? seeking to learn lessons very careful that we are not sowing the seeds for the next crisis. ...FSA's view ...will be laid out in our Discussion Paper ...18 March... responses that the authorities in aggregate can make... the FSA has already embarked on a programme of change ...greater supervisory resource of a higher quality... 280 extra specialist and supervisory staff ...30% increase in our supervisory capacity... new Training & Competence scheme ... right mix between professional regulators and market practitioners. ...working in partnership with the Bank of England and the Treasury is as a supervisor that we should be primarily judged ...under two headings: 'our philosophy' and our ‘operating model’... FSA characterised its approach as evidence-based, risk-based and principles-based. We remain, and must remain, evidence- and risk-based but the phrase 'principles-based' has...been misunderstood... principles alone is illusory ...policy-making framework does not allow it. ...limitations of a pure principles-based regime ...does not work with individuals who have no principles. What principles-based regulation does mean moving away from prescriptive rules to a higher level articulation ...emphasise that what really matters is not that any particular box has been ticked but rather that when making decisions, executives know they will be judged on the consequences - the results of those actions... FSA, when it supervises, needs to supervise to a philosophy that says 'It will judge firms on the outcomes and consequences of their actions not on the compliance with any given individual rule'... 'outcomes-focused regulation'. ... philosophy was that supervision was focused on ensuring that the appropriate systems and controls were in place and relied on management to make the right judgements. Regulatory interventions would thus only occur to force changes in systems and controls or to sanction transgressions based on observable facts. It was not seen as a function of the regulator to question the overall business strategy ...possibility of risk crystallising in the future." This is saying FSA was not responsible for criticising and stopping or changing the Northern Rock business model or similar models of excessive liquidity concentration risk. A look back to see that defaults could rise 3-400% higher than currently experienced in 2007. Funding risks were also not that hard to look back historically to see they could also suddenly spike sixfold.
Sants on the future: "...we will seek to make judgements on ...senior management and take actions risks to our statutory objectives ...moving from regulation based only on observable facts to regulation based on judgements about the future. This will of course carry significant risk and our judgements will necessarily not always be correct with hindsight. Furthermore, too aggressive intervention will stifle innovation and arguably reduce risk to a level that inhibits economic prosperity. ... what society as a whole expects regulators to be doing... what they thought we were doing. This more 'intrusive' and 'direct' ...'the intensive Supervisory Model'. ...'our credible deterrence philosophy' ...use all our powers including criminal prosecutions to deliver our mandate ...not ducking that responsibility. This week the first of our insider dealing criminal prosecutions has come to trial ...more in the pipeline." In the USA, the FBI already has over 200 such prosecutions in their pipeline.
Sants: "There is a view that people are not frightened of the FSA. I can assure you that this is a view I am determined to correct. People should be very frightened of the FSA... focuses on delivering credible deterrence in respect of its Financial Services & Markets Act (FSMA) mandate... on market-related offences ...not seek to be the responsible agency for prosecuting financial fraud in its ‘conventional’ or wider sense. ...responsibility is shared elsewhere and ...was not taken seriously enough but we are clear about our responsibilities and are delivering on them. To split enforcement powers from supervision would in my view make both tasks immeasurably more difficult... A comprehensive understanding of risk requires both prudential and conduct oversight responsibilities. The idea that 'twin peaks' regulation would have helped mitigate the current crisis is, in my view, not supported by events at all. Events such as the failure of AIG clearly demonstrate the value of integrated risk assessment delivered through a single supervisory authority. As the FSA ...was an operational and managerial failure in our supervisory area which was responsible for large UK institutions but the response to that should be to address the operational failure not to change the operating philosophy and structure. The problem was not structural, it was cultural. Much has been made recently of the importance of understanding business models. The twin peaks approach creates structural barriers to a full risk assessment of an institution and would sow the seeds of the next crisis. My second point, however, is to emphasise that effective risk assessment of a firm requires industry knowledge and ...not done in the past, but will be done in the future...involve both central banks and supervisors. The process should be 'top down and bottom up'. It needs to be a balanced partnership. My third point ...greater emphasis on outcomes testing relative to & controls. In the past ...focus was ...adequate management information and controls ...relying on management to address the issues. ...we will switch resources to outcomes testing...e.g. 'mystery shopping' and 'branch visits' rather than detailed reviews of high-level management information. This switch to outcomes testing is also central to the delivery of 'credible deterrence'." This revives ARROW reviews approach, which did frighten the horses, while detailed assessments did not because the ultimate penalty was taking away a bank's banking license and no bank believed in that threat! Now the climate permits FSA to recommend change of management, penalties and reputational criticism in public, "name and shame". This will be backed by the Treasury Committee report.
Sants: "..this switch causes risks... due to finite resources, we cannot test all outcomes and failure will be missed... ‘with hindsight’ criticism....better if the systems limitations were recognised, upfront, by all. ...changes are required but ...not realistic that we could deliver to perfection. ... fourth and critical of supervision has to be done in partnership with responsible firms, shareholders and auditors. The supervisors cannot operate alone. All ...must ensure ...strategies and behaviours ...greater engagement by all particular by shareholders and the non-executive community... central to this ...non-executives responsibilities... need to commit more time and raise their technical skills to exercise rigorous oversight. ...more support and indeed compensation for these individuals... more willing to challenge executives. ... more like full-time 'Independent Directors'. Sir David Walker’s report ...addressing these issues in more detail ...we cannot ignore that the principal responsibility for managing firms responsibly lies with the management themselves. ...ultimate responsibility for what has happened rests with firms’ senior management. ...specific decisions and strategies can be seen to be at the root of those firms' demise. ...improve the quality of management decision making to minimise failure. Yes, regulators can intervene more decisively, could have greater technical skills ...through changes to our authorisation process judge competence as well as probity. ...issue is behavioural. Markets have shown not to be rational; excesses have not been corrected by market discipline. ...managers... must acknowledge and fight against the ‘herd mentality’; ‘the collective wisdom’. ...'Do not take risks you do not understand.' 'Ensure the focus is on the long run franchise and profitability of the institution not the short term. 'Ensure a healthy and ethical culture in your organisation!' 'Recognise the future is not predictable and ensure at all times you understand the circumstances under which your firm will fail and that you are happy with the degree of risk mitigation you have.' 'Ensure a healthy and thoughtful culture of challenge from the independent directors.' These rules ...regularly ignored.... financial markets are not rational but ...a behavioural system built around personal aspirations is critical ...changing this time round... this crisis the reaction of society ...a contributor to the severity of events. ...a negative feedback loop... between wider society and the financial sector has been a unique characteristic of this crisis. ...require further consideration by us all... FSA has been seared by recent events but it is tougher and better as a result. The FSA has grown up." The idea of principle-based stated as late as Dec.08: "Detailed rules clearly have limitations. They have not always delivered the outcomes they were supposed to achieve. Detailed rules cannot cover all circumstances and eventualities - we cannot hope to devise a set of detailed rules to cover all types of business and all types of firm; and we cannot expect detailed rules to be responsive to market innovations and structural changes. Detailed rules tend to address processes, not outcomes - this can encourage a narrow approach to compliance, and can inhibit innovation and competition. And regulators need to avoid tackling problems by writing yet more detailed rules to address yesterday's problems - shutting the stable door after the horse has bolted."
There is sophistry here. It is based on the FSA's limited resources. The banks in practise could only adequately implement the regulations when they had detailed guidance. Primnciples, though just as mandatory, they found hard to implement, hard to do anything when innovation and some creative judgement was required. What the shift to principled-based supervision really reflected was not just being under-resourced and having insufficient expertise, but also a view that Pillar I, the quantitative accounting of current financial risk positions was completed and banks had to next move on to Pillar II, which everyone said was really about qualitative assessments and supervisor challenge. This was a general mistake, mistaking the principle-based definitions of Pillar II for qualitative and failing to see the massive amount of quantitiative modeling in economic capital models and how to integrate liquidity and all other risks. This is only being discovered now with scenario stress-tests in the wake of the credit crunch being placed centre-stage in risk management.
Principle-based supervision sought to shift the burden onto the banks and for some reasons, like 'innovation' and 'competition' imagine this is better? Basel II regulation is principle-based where it becomes too complicated to explain everything in precise etail. Bankers should understand, and also that the requirements have the force of law, therefore must be implemented thoroughly. In the UK it seemed that the legal force of Basel II was under-estimated. Verena Ross in a Dec 08 speech explained the new FSA policy in terms also of the need to convince Europe to follow the UK lead saying,"Finally we are also conscious that regulation and legislation that is coming from Europe is not always yet written in a fully principles-based way and ...we need to take a more prescriptive approach than we would probably have decided ...working actively in Europe to ensure that the Commission and other member states move increasingly towards more principles as well... worth at this point just dealing with some of the myths ...FSA's regulatory approach...being described as "light-touch" or "soft-touch". We are emphatically saying that it is not... It is purely about how we best achieve that regulatory standard ...we continue to regulate the areas the most effective and efficient way ...We strongly believe that the more flexible approach the right way forward ...we have limited regulatory resources ...we need to allocate ...where the greatest risks are... risk-based and proportionate, certainly not "light-touch". ...recent events surrounding the credit crunch, more properly called liquidity crunch ...reinforces, rather than contradicts the need to focus on the outcomes ...than just on the compliance of the action with a set of detailed rules. We are not operating a zero failure regime. We recognise that a successful financial market place requires innovation and competition and... there will occasionally be failures. But ...a more principles-based regime provides the best chance of achieving the requisite balance between benefits and risks ... such as conflicts of interest management or stress-testing, ...very difficult to ever have very prescriptive rules in those areas... businesses and their circumstances ... difference needs ...a flexible approach ...of either managing conflicts or conducting proper stress-testing." Note where this ends up! All roads in regulation and bank bailouts now lead to stress-testing, to Pillar II of the three Pillar Basel II. Banks and others failed to understand that it is not the accounting in PIllar I that is the essential detail, but the economic capital modeling in Pillar II that holds up and makes sense of the risk regulations. Just like liquidity risk was bottom of most banks' risk agenda until he credit crunch crunched them, so too was stress-testing the treated as least important of all concerns among the banks about getting their numbers right and systems in for Basel II compliance.
Not many can says events have validated their models and predictions. But I and my colleagues can rightly claim that. Getting unwelcome messages through at various banks was almost always a political and bureaucratic thicket.

1 comment:


From Ian Fraser (

Last week (week ending 22, March'09) I met two Edinburgh-based academics who specialise in the field of finance and risk. They told me that, in their view, Lord Turner’s review on the future of financial regulation, published last Wednesday, is flawed.
They said this is largely because it failed to push for a more integrated approach to risk management at the level of either financial institutions or within national economies.
The review, which was published by the FSA (of which Turner has been chairman since September 2008) has, perhaps optimistically, been pitched as a means of setting the international regulatory agenda ahead of the G20 summit in London next month.
But Dr Gavin Kretzschmar, director of finance and risk at the University of Edinburgh business school, said he is dissappointed at what was left out.
“There was very little on how risks and understanding of risks need to be pulled together within an integrated, institutional risk management framework,” said the South African born Kretzschmar. “The lack of such a framework was arguably one of the main causes of the 2007-9 credit crisis: It could easily have lead to macro-prudential oversight failures by the Treasury – and failures in micro-prudential oversight and supervision of financial institutions by the FSA.”
Kretzschmar went on to say that in using simplistic “basic asset correlations” to calculate their economic capital, UK banks had failed to account of the inter-dependence between asset classes and risk factors, and therefore capital, that occurs at times of stress.
He believes the Turner review is flawed since its fails to address such weaknesses. “Guidance as to risk integration at the institutional level is still completely lacking. To us it is a surprising oversight.”
Alexander McNeil, professor of quantitative risk management at Heriot Watt University who wrote one of the seminal textbooks on financial risk (Quantitative Risk Management: Concepts, Techniques, Tools), said the reason that European banks entered the credit crisis seriously under-capitalised was precisely because they lacked an integrated or “economic capital” approach to assessing the risks to which they are exposed.
He said that the old-fashioned “silo” approach - in which financial risks are computed in silos for different parts of a very large enterprise and then added together in a simplistic way - is “fundamentally flawed”.
“What an institution really ought to have is a model that explains the sources of dependence and tells an economic narrative about what could happen also as a tool for stress-testing in the future.”
McNeil also said that, if a bank the size of RBS lacked a fully integrated understanding of the risks to which it is exposed, it would inevitably encounter “problems”.
“To an extent these organisations were rather opaque and there were risk concentrations that they may well have been unaware of.”
Kretzschmar believes that banks’ failure to use integrated risk modelling becomes even more dangerous when they are exposed to multiple economies, as RBS was. “When you’re global and you’re exposed to multiple asset classes, there’s a heightened need for integrated risk-modelling.”
The Turner Review seeks to blame the near systemic meltdown on the use by banks and other institutions of complex mathematical formulae to calculate their risk . A key passage read: “Mathematical sophistication ended up not containing risk, but providing false assurance that other indicators of increasing risk could be safely ignored.”
However McNeil disputes this, arguing that mathematics is part of the solution, not part of the problem. He said: “Quantitative modelling can be done better and integration is probably the most important part.”
He says that to blame the crisis on mathematical geniuses who had little understanding of economics – so-called “quants” who put together ‘black box’ valuation tools and complex derivative products – is a form of “scapegoating”.
“To blame the rocket scientists and the people who brought in the fancy maths is a little bit simplistic. You can’t wish it away.
“It’s a bit simplistic. You cannot wish the mathematics out of modern finance. What you have to do is raise the skills throughout financial organisations and communicate a better understanding of risks – and indeed mathematical modeling of risk - to people at a higher levels.”
Kretzschmar said: “Mathematical risk models provide a framework for understanding the risks of a wide range of asset classes.”
Both McNeill and Kretzschmar are advisers to the Edinburgh-headquartered global risk management consultancy Barrie & Hibbert, in whose offices we met. Both universities are launching new Mscs in finance and risk this October. The two academics have ambitions to create an inter-disciplinary centre of excellence for finance and risk in Scotland.
Turner’s recommendations represent the first systematic and detailed attempt by a regulator to tackle the whole field of regulatory reform. His review of banking regulation was commissioned by the Treasury in November 2008.