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An International Regulatory Approachfor Capital Markets

Author

Jamila Awad

Rights Reserved

JAW Group

DateMarch 29, 2014

Paper: “An International Regulatory Approach for Capital Markets” (2014) Rights reserved: JAW GroupAuthor: Jamila Awad JAW Group, 3440 Durocher # 1109 Date: March 29, 2014 Montreal, Quebec, H2X 2E2, Canada Mobile: (1) 514 799-4565 E-mail: [email protected]

Executive Summary

Capital markets buffer spillover and contagion effects from imprudent and risky procedures while acting as financial intermediaries. The disquisition strives to cement an international regulatory framework for securities markets. The narration is partitioned in three divisions. The first section articulates the International Monetary Fund oversight on securities markets. The second section shadows the main financial axes that are addressed in the Dodd-Frank Reform and elaborates about the Volcker rule. The third section expands about the Bank for International Settlements principle-based guidelines in four risk management components: liquidity, credit, operational, and, lastly interest rate risk. In brief, capital markets shall heighten sound practices between financial participants, enhance economic stability, and finally, foster investor confidence.


1.Introduction

Economic contributors quest for prudential financial risk management practices when they engage as participants in capital markets. The global financial turmoil of 2008, the unprecedented stream of fraudulent accounting practices, the automation of monetary transactions and the evolving era of globalization reinforce the rationale to cement an international regulatory framework in securities markets. The disquisition strives to map a global principles rule-based prescript to shield sound financial risk practices in money markets.

The narration is partitioned in three divisions. The inaugurating division umbrages the International Monetary Fund (IMF) oversight for capital markets. In light, the first segment is sub-divised in six points: quality of the legislation structure, effectiveness of enforcement, regulation of public issuers, legal frame of collective investment schemes, prescript of market intermediaries, and lastly, arrangement of secondary markets. The second section shadows the underlying guidelines articulated in the Dodd-Frank Reform and elaborates about the Volcker rule. The second section is segmented in four main categories: proprietary trading, hedge fund and private equity fund confinement, repercussion on securitizations, and lastly, impact on insurance company investment activities. The final chapter expands about the Bank for International Settlements (BIS) approach to safeguard a transparent and robust banking playground. Precisely, the third division is sectioned in four risk components: credit, liquidity, interest rate, and lastly, operational.

Capital markets serve as medium exchanges to price assets, operate financial transactions, transfer and mitigate various risk exposures, and finally, act as financial intermediaries. Furthermore, securities markets participate in buffering banking disruptions and contribute to promote financial stability, thus chamber investor confidence. The IMF expresses concern about significant spreads in efficiencies between money market systems in developed countries against emerging countries.

The Dodd-Frank Act in conjunction with the Volcker regulation pioneers a groundbreaking ordinance to introduce an innocuous trustworthy sage financial system. The Volcker rule intends to remove banking entities from proprietary trading. The reform addresses Systematically Important Financial Institutions (SIFIs) that are ordered to comply with fundamental changes in their trading and accounting practices given the complexity of contemporary modern settlement activities. The Act and the Volcker prescript are expected to impact various jurisdictions and affect the financial system as an ensemble.

The BIS guidelines depict a global frame of reference in banking principles. The BIS guides financial institutions in implementing sound banking practices and addresses arrangements in an array of axes such as credit risk management, liquidity risk administration, operational risk governance, and lastly, interest rate risk oversight. Credit risk is defined as the probability that an entity fails to meet its obligations in accordance with the mutual arrangement. Liquidity risk depicts the ability of a financial institution to heighten funding in assets as well as meet obligations without experiencing unacceptable losses. Operational risk governance strives to


promote sound management of operational risk systems and encourage entities to improve approaches. Lastly, interest rate risk depicts the exposure of an entity to adverse movements in interest rates.


2. The International Monetary Fund Oversight

The first chapter shadows the IMF oversight on worldwide securities regulatory systems and articulates the main proposed mechanisms to enhance compliance with existing regulatory frameworks. The section is segmented into six sub-divisions: quality of the legislation structure, effectiveness of enforcement, regulation of public issuers, legal frame of collective investment schemes, prescript for market intermediaries, and lastly, arrangement of secondary markets.

The IMF in collaboration with the World Bank examined the topic of systematic importance of securities regulation and published their results to encourage financial entities and economic participants to comply with the legislative ordinance (Appendix I). The main themes that emerged from the study are the lack of power confined to financial regulatory authorities, absence of resources, and finally, the shortage of experts to underpin deficient internal control systems and hazardous market practices.

2.1 The Quality of the Legislation Structure

The quality of the legislation structure comprises the regulation frame of initial public offerings, secondary markets, asset management, and lastly, market intermediaries. The prescript is destined to enhance symmetrical informational channeling between issuers and investors, safeguard sound trading and clearing mechanisms, and finally, heighten investor confidence. The regulation of public issuers is cemented on the principle of accurate, relevant and timely disclosure of information to investors. The purpose of divulgating obligations is required on a continuous basis. Legal practitioners in capital markets emphasize the need to implement sound corporate governance to ensure adequate accountability of management and board members to shareholders.

The regulation structure shall also enable designated intermediaries to enter and exit the market to conduct affairs without disruption. The guiding principles of asset management strive to ensure fair disclosure of investments and professional administrative services. The legislation of secondary markets aims to safeguard smooth functioning of these markets and secure financial markets efficiency. Enforcing rules also target to limit turbulent effects on the failure of intermediaries and warrant that participants comply with the prescript. The supervision of regulated entities is often delegated to public agencies. The assessment exposes a high correlation between the level of income of a jurisdiction and the degree of compliance: low-income jurisdictions adhere under 50% while high-income jurisdictions demonstrate levels of implementation above 70%. Precisely, a lack of funding and a shortage of experts in financial legislation represent pitfalls to cement an international regulatory frame in an era of globalization. Therefore, the legislation framework shall certify that the regulators hold sufficient powers, resources, and independence to oversight capital markets while limiting potential political interference (Appendix II).


2.2 Effectiveness of Enforcement

The effectiveness of enforcement refers to the capability of authority agencies to force compliance with regulation and to pursue actions against parties violating the legislative ordinance. The assessment states that regulators face challenges due to their inability to obtain relevant information in a timely fashion and to implement disciplinary measures. On the other hand, the study also reveals that practitioners lack investigation techniques to sanction delinquent entities. In addition, administrative authorities are also subject in some jurisdictions to credibility and effectiveness tests. The assessment recommends on-site inspections by skilled personnel and continuous supervisory programs to secure a trustworthy regulatory framework in money markets.

The mediocre quality and inefficiency of some judiciary systems also jeopardize the image and safety of transacting in securities markets. The study emphasized that emerging markets are deprived of impartial and transparent arbitrage dispute delegations to impose sanctions and safeguard capital markets. The accessibility and transmittance of public and non public information between various jurisdictions is a growing concern especially in an epoch of globalization with complex automated transactions (Appendix III).

2.3 The Regulation of Public Issuers

The quality of disclosures by issuers of securities relates to the pertinence of information revealed, the credibility of sources and the integration of fair minority shareholder treatment. The market must be able to value securities appropriately and hold tools to address conflicts of interest. The study suggests that disclosures be accessible in a timely manner to all shareholders whereas minority shareholders must be attributed sufficient voting rights to deal with issues such as insider transactions and takeover bids.

The study unraveled absent in-depth review of initial offerings in some jurisdictions, a shortage of skilled regulators in the domain, and lastly, a satisfactory understanding of business prospects. However, the report encourages the disclosure framework to be implemented in developed countries whereas entities are confined to disclose data on a quarterly basis. In some emerging countries, an alarming number of jurisdictions do not address obligatory disclosure of sensitive information in a timely manner. The study also points out weaknesses in enforcing legislation with respect to changes of control and related party transactions. Therefore, investors are compromised, and internationally entangled securities markets are jeopardized with potential malevolent stratagems (Appendix IV).

2.4 The Legal Frame of Collective Investment Schemes

The regulation of collective investment schemes strives to warrant fair disclosure to investors, adequate valuation of funds, and lastly, to secure investor assets from the personnel operating the funds. The legislation frame in the described area is extensive in developed countries but delinquent in some emerging countries. The supervisory prescribed arrangement is lagging in


both developed and emerging nations. Managers dealing with licensing requirements applicable to investment schemes sometimes lack technical and legal knowledge to safeguard investors and immune capital markets. In addition, in some jurisdictions, licenses are approved without thorough examination. The study emphasizes on the importance of on-site investigations to evaluate depository issues.

The assessment also signals the need to enforce a regulatory prescript to guide managers in conducting supervisory functions and condition them to sound business as well as market conduct. The study also divulgates the obscure frames in some jurisdictions destined to protect customers assets, and their resources in case of system failure such as bankruptcy of a financial entity. The valuation of illiquid assets remains incomplete and misunderstood by some regulators in various jurisdictions (Appendix V).

2.5 The Prescript for Market Intermediaries

The prescript for market intermediaries aims to safeguard clients from insolvency of entities, misappropriation of client assets by entity personnel, shield customer satisfaction in the event of market disruption, and finally, ensure that market intermediaries conduct affairs with due diligence and fairness when dealing with clients. The assessment also points out that regulator practitioners lack expertise knowledge to oversee market intermediary activities as well as detect potential system pitfalls. The study recommends that jurisdictions set high-levels of licensing standards, internal controls and financial risk management standards to pursue operations (Appendix VI).

2.6 The Arrangement of Secondary Markets

Secondary markets play a dominant role in the pricing of securities in capital markets. Exchange trading systems are confined to comply with licensing requirements, information technology systems, and lastly, risk management. They are also subject to supervision and reporting arrangements. However, the study informs that market activities are used to misrepresent, mislead and mischief investors. The assessment stipulates that there are insufficient measures in secondary markets to track technology issues and an over-reliance on standard reporting as means of settling oversight.

In conclusion, the study unravels the weaknesses of current regulatory frames and proposes alternatives to enforce capital markets and safeguard its participants. Risk management and internal control implementation are issues highly emphasized and recommended. The lack of experts to supervise and enhance legislation frames are also problematic in developed as well as emerging countries. The findings therefore deliver valuable information about the vulnerability of securities markets and introduce potential measures to heighten the safety and soundness of financial trading in a globalized environment.


3. The Dodd-Frank Reform and the Volcker Rule

The Dodd-Frank Act strives to safeguard financial participants from perilous banking practices and pledges a rigid banking code of conduct. The Volcker rule frame proscribes banking institutions to sponsor or invest in hedge funds or private equities. A sponsor is defined as an entity that contributes as a covered fund managing partner or commodity pool operator. The Volcker regulation addresses four financial sector axes: proprietary trading, hedge funds and private funds, securitizations, and lastly, insurance companies.

The legal ordinance heightens regulatory capital levels for systematically important financial and non-financial institutions and implements restrictions in the use of leverage. The prescript will impact various jurisdictions and the securities markets as an ensemble. The act does share similar guidelines with the Basel III principles whereas both frameworks address liquidity risks and establish robust arrangements to cement an era of prudential financial risk management in globalized financial markets. In addition, the Dodd-Frank legislation limits regulatory discretion in adopting Basel III requirements in the U.S.A.. The act also restructures over-the-counter (OTC) derivative arrangements whereas the Securities and Exchange Commission (SEC) as well as the Commodity Futures Trading Commission (CFTC) hold shared supervisory responsibilities. The International Swaps & Derivatives Association (ISDA) heightens clearing margins, instructs new minimum capital requirements, restricts limits in financial positions, and lastly, formalizes rigid business conduit standards for all participants in the financial playground. The ISDA intervention also encourages financial institutions to conform with forthcoming Basel III ordinance whereas the process of securitization and clearing requirements is reinforced to conscience entities about adequate credit risk mitigation techniques.

3.1 Proprietary Trading

The rationale of proprietary trading prescript is to dictate financial institutions managerial activities destined to ameliorate the safety of their operations while preserving traditional client-oriented financial services. The rigorous guideline imposes significant recordkeeping and reporting requirements to police frontiers between banned proprietary trading and acceptable activities. Hence, banking institutions are prohibited from proprietary trading in covered financial positions. Precisely, SIFIs are obliged to engineer fundamental changes in their trading accounting practices given the complexity of contemporary modern settlement practices and the panoply of accounting involved. Banking establishments are requested to articulate activities undertaken to manage liquidity. SIFIs are also confined to comply with Basel III bylaws by ensuring that available liquid assets meet short-term needs even during periods of market disruption. The Volcker frame of conduct promotes prudential and sage financial activities.

Market making underwriters compensation is subject to the Volcker governance whereas the rule forbids rewarding proprietary risk-taking. In addition, the ordinance commands entities to tailor internal compliance procedures that reflect the magnitude, specter and complexity of activities, and lastly, business structures. The legislation arrangement expects SIFIs to generate revenues from activities not attributable to the appreciation in the value of the financial positions it holds


or from the hedging of covered financial positions. The Volcker code authorizes banking entities to engage in underwriting activities when designed to warrant near-term demand of clients, customers and counterparties. The multifaceted legal approach dictates banking firms to render a reporting regime that discloses quantitative market making measurements. The Basel III framework invigilates monitoring instruments that enhance bona fide market making banking requirements and foresee liquidity near-term demand from large block trades and risk-mitigating hedging techniques exempt from prohibited proprietary trading. The regulatory structure orders banking entities to conduct evaluations that reasonably measure expected liquidity near-term demands of clients and document the process. Furthermore, the reform requisites market making-related functions to be coherent with surveillance agency instructions to distinguish proprietary trading from market making activities.

Finally, the Volcker manual addresses matters related to conflict of interest disclosures and supervisory roles to compartment interests of various parties commingling in financial transactions.

3.2 Hedge Fund and Private Equity Fund Confinement

The Volcker rule proscribes banking institutions to sponsor or invest in hedge funds or private equities however asserts certain exceptions. A sponsor is defined as an entity that contributes as a covered fund managing partner or a commodity pool operator. The Act cites concise definitions of covered funds to filter activities considered forbidden such as owning or retaining interest in certain types of covered funds. Therefore, retaining ownership of covered fund interests is tolerated to purpose risk-mitigation hedging techniques. Banking organizations are granted authority to acquire bank owned life insurances and transact with corporate organization vehicles to safeguard financial activities. Furthermore, the Act articulates guidelines to settle treatment of commodity pools. The Volcker protocol permits exceptions in covered funds such as legitimate services in compliance with statutory and regulatory requirements. Banking firms are demanded to document credible plans to outline bona fide services. The Act states that the limitation for a single fund investment is set up to three percent maximum of the total amount or value of the covered fund and three percent of its Tier 1 capital to structure banking firms’ investment boundaries.

The Dodd-Frank Act orders SIFIs to integrate a statutory language to prevent insurance covered fund obligations and performances. Precisely, authorized covered funds are prohibited to incorporate the word bank or share the name of the banking entity. In addition, administrators and employees directly engaged in activities with covered funds are forbidden to retain ownership interest in the funds they manage. SIFIs are required to document to current and prospective investors in covered funds disclosures to explain their conformity with the Volcker regulation. The Dodd-Frank Act examines U.S. and non U.S. jurisdictions to rule sponsoring covered fund activities in the pertained funds. Finally, the closing element of the hedge fund and private equity fund confinement addresses conflict of interest issues and managerial ordinance.


3.3 Repercussion on Securitizations

The Volcker frame of reference restricts banking entities from contributing in common securitization practices in asset-backed markets such as commercial papers and collateralized debt obligations. Furthermore, SIFIs are prohibited to engage ownership interest in covered funds aside from narrow exceptions. The alternative investment company act exempts certain groups of traditional securitizations such as mortgages, real-estate trusts, automobile and credit card loans. Banking institutions are however allowed to hold interest in asset-backed securities (ABS) with certain restrictions. However, the SEC oversights ABS transactions. The three percent exception ordinance is applicable to securitizations pertaining similar guidance with the hedge fund and private equity fund guidelines. The Act entitles SIFIs to retain amounts under risk retention procedures in securitized asset markets such as ABS transactions. The Volcker rule mitigates the effect of securitization on proprietary trading prohibitions by addressing ABS issuers. The concluding segment of the Act addresses conflict of interest relationships between ABS participants and its distributors with guidelines to cement bona fide risk mitigation methodologies.

3.4 Impact on Insurance Company Investment Activities

The Act forbids designated insurance companies to pursue proprietary trading as well as retain ownership interest in hedge funds and private equity funds subject to constringed exceptions. The Volcker code authorizes proprietary trading when the activity is conducted on behalf of customers. Precisely, the legal ordinance requires that entities carry customer transactions in separate accounts to warrant safe and sound practices. In addition, the Act insurance orders entities to formalize reports and recordkeeping procedures in order to adhere to a compliance program. Finally, the Dodd-Frank governance requires insurance companies performing investment activities to follow restrictions when they commerce with hedge funds and private equity funds.

In summary, the Act and Volcker rule introduce new regulations to ensure that economic frontiers and its participants entangled in an era of globalization benefit from rigorous and liquid capital markets as well as financial intermediation.


4. The Bank for International Settlements Framework

The Bank for International Settlements (BIS) plays a central role in safeguarding sound banking practices and in fostering investor confidence. The BIS guides financial institutions in cementing standardized robust and secure arrangements in an array of axes such as credit risk management, liquidity risk administration, operational risk governance, and lastly, interest rate risk oversight.

The final chapter shadows the main principles articulated in the BIS framework to complete the proposed prescript.

4.1 Credit Risk Management

Banking institutions face challenges related to lax credit standards for borrowers and counterparties, mediocre portfolio risk management, and lastly, a lack of supervision of economic indicators. Credit risk is defined as the probability that an entity fails to meet its obligations in accordance with the mutual arrangement. The objective of credit risk management is to maximize an entity’s risk-adjusted rate of return by maintaining credit uncertainty exposures within tolerated confidence levels.

The BIS guiding principles in credit risk administration addresses the following domains: adequate credit risk environment, credit attribution procedures, appropriate credit management, and finally, sound controls over credit uncertainty.

The board of directors is confined to play a proactive central role in approving on a periodic basis credit risk strategies and administer all policies relevant to credit peril. All entities are required to determine the acceptable trade-off between risk and return whereas the board oversights the credit risk methodologies. The remuneration arrangements shall also not contradict the credit risk methodologies. Senior management is held accountable for enforcing credit uncertainty systems with written procedures that enable to identify, measure, supervise and moderate credit risk. Credit modus operandi shall be communicated throughout the organization and consider changes in internal as well as external circumstances. Banks are demanded to diagnose existing and potential risks inherent to any product or activity. The board of directors and senior management are requested to ensure that credit operations are conducted with the highest standards and in compliance with the bank’s policies.

Financial institutions must employ sound, well-defined credit granting criteria that portray a transparent indication of the entity’s target market to apprehend the type of credit exposure and its source of repayment. Banks are confined to assess true risk profiles of borrowers and counterparties. All participants in loan syndications are ordered to perform their own due diligence to investigate credit risk assessments. Netting agreements are required to reduce interbank credit risks and confidentiality agreements shall be established to safeguard data between all parties involved. Banks are demanded to document credit exposure limits for borrowers and counterparties to capture exposure for particular industries or economic sectors.


Effective measures to place caps on credit exposures are required for both trading book and off-balance sheet activities. Entities must formalize clearly-established policies to approve, amend, renew and re-finance existing credits. Banks shall retain skilled personnel to exercise prudent judgment in approving and administering credit renewals. Extensions of credit must promote sound credit decisions and shall be made on an arm’s-length basis. The BIS prescript recommends public disclosures of the terms of credits granted to parties.

Entities are requested to apply programs for ongoing administration of their various credit risk-bearing portfolios with a solid organizational structure. Banks are demanded to ensure about the efficiency and effectiveness of credit management operations as well as their compliance. Financial institutions shall develop and implement frameworks to monitor the condition of individual credits as well as to determine appropriate provisions and reserves. Entities are encouraged to implement internal rating credit systems consistent with the nature, size and complexity of the entity’s operations. Financial institutions must enforce analytical techniques to measure inherent credit risk in all on- and off-balance sheet activities. Banks are compelled to settle an infrastructure that captures the overall composition, concentration, nature and size of various credit portfolios. Entities are demanded to pursue stress-tests and scenario analysis to assess potential areas of weaknesses in their credit policies and administration as well as ponder potential changes in economic indicators.

Financial institutions must enforce internal controls to warrantee that credit activities are operated in a timely manner and that credit exposures remain consistent with acceptable limits. Banks must implement processes to review the independence of qualified personnel in credit assessment from the bank’s business functions. Entities must cement a system to underpin early stage of deteriorating credits. Supervisors are enquired to conduct independent evaluation of banking policies and practices in the area of credit administration.

4.2 Liquidity Risk Administration

Liquidity depicts the ability of a financial institution to heighten funding in assets as well as meet obligations without experiencing unacceptable losses. Liquidity risk administration strives to ensure that entities are honoring cash flow obligations that are impacted by external events and chambering capital to thwart liquidity plunge, thus safeguard the economy and depositors. Banks are demanded to establish tolerable liquidity risk limits, secure a cushion of liquid assets, design stress-test scenarios for liquidity peril, and lastly, manage liquidity uncertainty.

Financial institutions are encouraged to implement robust liquidity risk administration arrangements that guarantee sufficient liquidity, high quality assets and efficient controls to measure liquidity retention and future demand. Entities are confined to ensure with a high degree of confidence that they are in position to address daily liquidity obligations. Supervisors are required to assess the bank’s liquidity management and its liquidity positions as well as take action to remedy pitfalls in the liquidity systems used. Entities are demanded to set liquidity risk tolerance in light of its business objectives, overall risk appetite and strategic direction. The tolerance should warrantee that the organization administers its liquidity strongly in normal times Paper: “An International Regulatory Approach for Capital Markets” (2014) Rights reserved: JAW GroupAuthor: Jamila Awad JAW Group, 3440 Durocher # 1109 Date: March 29, 2014 Montreal, Quebec, H2X 2E2, Canada Mobile: (1) 514 799-4565 E-mail: [email protected]

in such a way that it is capable of buffering prolonged periods of liquidity distress. Senior management is held accountable for developing liquidity risk management procedures in compliance with the entity’s risk tolerance as well as report to the board of directors pertinent changes on a regular basis. A bank’s board of directors is encouraged to revise and approve liquidity risk management policies and ensure transparent operational guidelines. Senior administration shall also guarantee that the firm has adequate internal controls to attest the integrity of its liquidity risk systems.

Entities are demanded to integrate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval procedures for all significant business activities. The analytical framework shall be reviewed to reflect changes in business and financial market conditions. Banks shall define and retain sage methodologies to identify, measure, monitor, and lastly, control liquidity risk with a robust protocol that projects cash flows accounting for on- and off-balance sheet items. Firms are enquired to consider the need to support the liquidity of special purpose vehicles under adverse conditions as well as the changes in liquidity positions from financial derivative instruments. Financial institutions shall ascertain tolerable levels of cash outflows for loan commitments and other forms of financial guarantees. Banks are demanded to assess its aggregate foreign liquidity needs to determine acceptable currency mismatches. Firms shall set limits to control its liquidity exposure and vulnerability.

Organizations are requested to actively monitor, control liquidity risks, measure funding needs within and across legal entities as well as consider operational restrictions to the transfer of liquidity. Banks shall establish funding arrangements that deliver effective diversification in the sources and tenor of funding. Entities are also enquired to sustain harmonious bonds with fund providers and regularly gauge its capacity to heighten funds as well as monitor factors that ensure fund raising capacities. Financial institutions are encouraged to actively manage intraday liquidity positions and risks to honor obligations under both normal and stressed conditions, thus promote smooth functioning of payment and settlement schemes. Banks are confined to actively monitor its collateral positions, differentiating between encumbered and unencumbered assets. Firms are also demanded to supervise legal physical locations that hold collateral and its mobilization process. Financial institutions are ordered to conduct stress-tests on a routine basis linked to firm-specific and market-wide indicators to underpin sources of liquidity constraints. These metrics shall enable firms to adjust liquidity risk management strategies and policies.

Banks are demanded to implement formal contingency plans (CFP) that articulate arrangements to address liquidity shortfalls in emergency situations. The CFP shall outline procedures to administer a range of stress environments such as invocation and escalation claims. Entities are encouraged to sustain a cushion of unencumbered, high quality liquid assets to be held as insurance against liquidity needs for stress scenarios as well as loss or impairment. Financial institutions are enquired to publicly disclose information on a regular basis that permit market participants to evaluate the soundness of liquidity risk management frameworks. Supervisors are encouraged to perform a comprehensive assessment of a bank’s overall liquidity administration program and supplement its governance by a combination of reports as well as market information. Supervisors are confined to remedy deficiencies in the entity’s liquidity positions


and liquidity administration systems. Finally, supervisors shall address relevant parties to facilitate effective cooperation of liquidity management oversight.

4.3 Operational Risk Governance

Operational risk governance strives to promote sound management of operational risk systems and encourage entities to improve approaches. Supervisors play a central role in developing sophisticated operational systems and administer mechanisms to heighten the advancement of the firm. The BIS guidelines address banking operational oversight with guiding principles. The board of directors is encouraged to cement a strong risk management culture that supports and delivers adequate standards and incentives for professional behavior. Precisely, the organization culture shall expose the nature and scope of operational risks inherent in the firm’s daily business operations. The board is enquired to set a code of conduct that articulates clear expectations for integrity and ethical values and acceptable business practices. Banks shall develop and integrate a frame of reference that fully represents the organization’s overall risk managerial system while considering the business lines of activities and products. A financial institution’s governance structure shall be commensurate with the nature, size, complexity and risk profile of its operations. The board of directors shall approve and periodically review the operational risk administration programs utilized by the bank as well as supervise senior management to warrantee that policies are adequately enforced at all decision pillars. Internal control systems shall be implemented to attest the independence between operational functions and business lines.

The board of directors shall authorize changes in the strategies related to risk appetite and shifts in tolerated operational threshold levels. The review shall consider modifications in external parameters and the quality of the control environment. Senior management shall enquire the board of directors consent to approve operational risk governance and maintain transparent communication channels with all levels of decision makers. Senior management is also responsible to ensure that designated personnel are qualified to address operational risk activities and shall encourage effective issue-resolution processes. The firm shall underpin weaknesses and vulnerabilities in the internal control techniques implemented to address operational risks. Entities are encouraged to proceed with business mappings to identify the key steps in the organizational functions and address risk interdependencies. Banks shall use risk and performance indicators to monitor the main drivers of exposure linked to key risks. Managers are required to brainstorm scenario analysis to diagnose potential operational risk events and weigh their potential outcomes. Entities shall cement policies that address the revision methods for approving new products, activities and systems.

Organizations are encouraged to monitor operational risk profiles and material exposures to losses. All key decision-makers in the firm shall ensure that reporting mechanisms are timely and accurate in both normal as well as stressed market conditions. Internal control methodologies should be designed to render reasonable assurance that the entity sustains efficient operations, secures its assets, produces reliable financial reports, and lastly, complies with regulations. Banks shall adhere to technology risk administration programs to warrantee that their Paper: “An International Regulatory Approach for Capital Markets” (2014) Rights reserved: JAW GroupAuthor: Jamila Awad JAW Group, 3440 Durocher # 1109 Date: March 29, 2014 Montreal, Quebec, H2X 2E2, Canada Mobile: (1) 514 799-4565 E-mail: [email protected]

organization is mitigating risks linked to technology. The board of directors and senior management shall insure that outsourcing arrangements do not inflate operational risks. Financial institutions shall adhere to business resiliency and continuity plans to secure the ongoing of operational activities and limit losses in the occurrence of disruptive events. Entities are demanded to disclose to the public its operational risk governance frameworks and have their policies authorized by the board of directors. Stakeholders shall therefore be able to evaluate the firm’s operational risk management arrangement to identify its strengths and weaknesses.

4.4 Interest Rate Risk Oversight

The interest rate risk oversight aims to provide entities with a guideline to manage interest rate risk, independent of whether the positions are related to trading or non-trading activities. The framework recommends procedures that include the development of business strategies, the implementation of internal control, and lastly, the effective monitoring of interest rate risk administration arrangements. Interest rate risk depicts the exposure of an entity to adverse movements in interest rates. Risk tolerance is considered a normal and integral banking activity and enhances shareholder value when the risk is adequately managed in compliance with regulations.

Organizations are encouraged to underpin all sources of interest rate risks: timing differences in maturities and repricing risks, yield curve risk from the changes in the slope and shape of the yield curve, basis risk arising from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics, and lastly, optionality occurring from embedded options bonded to assets, liabilities and portfolio management. An entity’s earnings and its economic value are sensitive to changes in interest rates.

The board of directors is held responsible for comprehending the nature and level of interest rate risk implemented by the entity. The board shall authorize interest rate policies and ensure that management steps up to underpin, measure, monitor, and lastly, control these risks. The board shall understand the interest rate exposures held by the firm and warrantee that the organization’s positions are in compliance with board-approved policies. Senior management must guarantee that the bank enforces robust procedures to manage interest rate risk both on a long-term and day-to-day basis. Reporting systems shall be transmitted to senior management to assess the sensitivity of the institution to changes in market conditions and other parameters. Banks are demanded to mandate key personnel to partition duties in business operations from risk management to thwart potential conflicts of interest. SIFIs shall designate independent units to pursue risk management programs in order to secure transparency and safety of risk administration arrangements. Entities must guarantee that interest rate risk policies are aligned with the regulatory framework and underpin quantitative parameters that define acceptable levels of interest rate bearing thresholds.

Organizations are confined to pinpoint all potential interest rate risks linked to the introduction of new products and services to ensure that the firm holds control measures to mitigate the risks. Paper: “An International Regulatory Approach for Capital Markets” (2014) Rights reserved: JAW GroupAuthor: Jamila Awad JAW Group, 3440 Durocher # 1109 Date: March 29, 2014 Montreal, Quebec, H2X 2E2, Canada Mobile: (1) 514 799-4565 E-mail: [email protected]

Major hedging techniques shall be approved in advance by the designated committee or supervising personnel. Banks engaged in business operations with embedded complex options linked to their products are demanded to implement sound interest rate mitigation methodologies to prevent economic value plunge. In addition, entities are encouraged to ensure that robust operational procedures are set in place before marketing new products and services with embedded options.

Financial institutions shall ensure that their interest rate measurement techniques account for all material sources of interest rate risk in line with the scope of their activities. Banks are required to maintain interest rate exposures with self-imposed parameters over a range of potential shifts in interest rates. Entities are requested to implement a risk measurement system that captures their vulnerability to loss under both normal and stressful market conditions to reassess interest rate administration policies. An adequate reporting procedure must permit firms to provide, on a timely basis, information about interest rate mitigation techniques and compliance with the regulatory framework. Interest rate modeling assumptions shall be articulated to various personnel involved in interest rate hedging activities.

The internal control system over interest rate risk management shall consider independent reviews and evaluations of the effectiveness of the system as well as promote reliable financial reporting. Supervisory authorities are enquired to revise information about the assessment of a bank in regards to its exposures in interest rate and comment on stress-tests used by entities. Financial institutions are ordered to sustain capital adequacy commensurate with the level of undertaken interest rate risk activities. In the occurrence of capital inadequacy to buffer interest rate activities, the entity must reduce its risk to remedy the situation to comply with capital conformity regulations. Entities are encouraged to disclose to the public and shareholders interest rate administration procedures in light of both their trading and banking books. Supervisors are responsible for evaluating internal measurement systems to promote safe and sound interest rate mitigation methods.

In conclusion, the BIS principles encapsulate guidelines to direct entities in implementing sage banking practices and safeguard depositors from perilous SIFIs misconducts.


5. Conclusion

The results of the IMF study performed in collaboration with the World Bank deliver valuable information about the vulnerability of securities markets and introduce potential measures to enhance the safety and soundness of financial trading in a globalized environment. The Dodd-Frank Act and the Volcker rule articulate new regulations to ensure that economic frontiers and its participants benefit from rigorous and liquid capital markets as well as financial intermediation. Finally, the BIS principles establish guidelines to enforce sage banking practices in the following risk axes: credit, interest rate, liquidity, and lastly, operational. In conclusion, the international regulatory approach for capital markets renders the financial community guidelines to heighten economic stability, strengthen operations between all parties, and finally, foster investor confidence.


References

Basel Committee on Banking Supervision (2000), “Principles for the Management of Credit Risk”, Bank of International Settlements, Basel, Switzerland.

Basel Committee on Banking Supervision (2004), “Principles for the Management and Supervision of Interest Rate Risk”, Bank of International Settlements, Basel, Switzerland.

Basel Committee on Banking Supervision (2004), “Basel II: International convergence of capital measurement and capital standards-A revised framework.”, Bank of International Settlements, Basel, Switzerland.

Basel Committee on Banking Supervision (2008), “Principles for Sound Liquidity Risk Management and Supervision”, Bank of International Settlements, Basel, Switzerland.

Basel Committee on Banking Supervision (2010), “Basel III: International framework for liquidity risk measurement, standards and monitoring”, Bank of International Settlements, Basel, Switzerland.

Basel Committee on Banking Supervision (2011), “Principles for the Sound Management of Operational Risk”, Bank of International Settlements, Basel, Switzerland.

Basel Committee on Banking Supervision (2011), “A global regulatory framework for more resilient banks and banking systems.”, Bank of International Settlements, Basel, Switzerland.

Barney Frank, Chris Dodd, Paul Volcker, “ Dodd-Frank Wall Street Reform and Consumer Protection Act”(2010), United States of America Congress, Pub. L.111-203.

Carvajal A. and Elliott J. (2007), “Strengths and Weaknesses in Securities Market Regulation: A Global Analysis”, International Monetary Fund, WP/07/259.

U.S. Securities Exchange Commission, “Dodd-Frank Wall Street Reform and Consumer Protection Act: Specialized Corporate Disclosure” (2010), http://www.sec.gov/spotlight/dodd-frank/speccorpdisclosure.shtml


http://www.sec.gov/spotlight/dodd-frank/speccorpdisclosure.shtml

http://www.sec.gov/spotlight/dodd-frank/speccorpdisclosure.shtml

Appendix I: List of Investigated Countries in Study Conducted by IMF and World Bank.

*The Canada IOSCO assessment was excluded in the statistics because grades were not assigned.

Source: Carvajal A. and Elliott J. (2007).


Appendix II: The Quality of the Legislation Structure

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Partiall

y Implem

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0%

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60%% of countries

Degree of implementation


Appendix III: Effectiveness of Enforcement

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Appendix IV: The Regulation of Public Issuers

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Appendix V: The Legal Frame of Collective Investment Schemes

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Appendix VI: The Prescript for Market Intermediaries

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Appendix VII: The Arrangement of Secondary Markets

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