state of regulatory reform 2015: special report

REUTERS | Andrew WInning

STATE OF REGULATORY REFORM 2015: SPECIAL REPORT

STATE OF REGULATORY REFORM 20152

REPORTING TEAMHONG KONGTrond Vagen

LONDONAlex Davidson

Peter ElstobSusannah Hammond

Jane Walshe

NEW YORKJulie diMauroHenry Engler

SINGAPOREPatricia Lee

SYDNEYNiall Coburn

Nathan Lynch

TORONTODaniel Seleanu

WASHINGTON, D.C.Emmanuel Olaoye

EDITORSAlexander Robson in London

and Randall Mikkelsen in Boston

DESIGNPaige Nazinitsky

accelus.thomsonreuters.com 3

2015 looms for compliance and regulatory professionals with the threat of ever bigger fines and sanctions after the huge billion-dollar penalties meted out last year. The environment for financial services firms will differ little, except for the clear downside for getting it wrong. The benchmark and foreign exchange manipulation scandals proved that the culture at firms needs considerable reform, with much of the bad behaviour occurring sometime after the onset of the financial crisis. Culture and the treatment of customers will remain at the fore and the new Senior Managers' Regime in the UK will concentrate minds. A significant date for wholesale market participants will be the expected publication of the Fair and Effective Markets Review in June 2015.

There will be no rest for compliance officers anywhere. Just days before Christmas, European regulators published the revised Markets in Financial Instruments Directive 2/Regulation, which were the best part of a thousand pages of new policy proposals. The new European Commission will try to push through its flagship policy for Capital Markets Union and there will be further progress on resolution regimes and ring-fencing by banks of some of their financial activities.

In the United States, firms will need to keep one eye on regulators and one eye on Congress. The federal regulatory apparatus will push to complete a post-financial crisis regime, even as the Republican party's increased clout could start to slow the regulatory wave. Look for the Volcker rule, with a full-compliance deadline looming in July, to provide one field for skirmishes.

Bankers are facing a reform campaign led by the New York Federal Reserve Bank, which warns that they will face breakup pressures if they are unable to return to a culture of integrity and compliance that critics say they lost in the years before the financial crisis.

In addition, cyber security has finally seized the attention of financial services boardrooms, which are scrambling to avert damaging hacks as well as to prepare for intense exam scrutiny on the issue from a range of oversight bodies.

Elsewhere, the Australian Financial System Inquiry published 44 recommendations, which will take years to implement.

One big threat is regulatory fatigue. Boardroom agendas in financial services firms have been overwhelmed by regulatory matters, whether it is a briefing on changing regulatory expectations, the latest round of enforcement action or the additional skilled resources and investment needed to implement the latest round of regulatory change.

INTRODUCTION


TABLE OF CONTENTSPERFECT STORM BREWING BETWEEN U.S. BANKS AND REGULATORS 5

REPUBLICAN WAVE POISED TO SPLASH U.S. FINANCIAL RULEBOOKS 6

CYBER SECURITY, AML TO PLAY BIG ROLES IN U.S. COMPLIANCE EXAMS 8

CANADA TO LAUNCH NEW CAPITAL MARKETS REGULATOR 10

GREATER INDIVIDUAL ACCOUNTABILITY TO BECOME REALITY IN 2015 11

UK’S FAIR AND EFFECTIVE MARKETS REVIEW IS PART OF A GLOBALLY COORDINATED SHIFT TOWARD BETTER WHOLESALE CONDUCT 13

LONG JOURNEY NEARS COMPLETION FOR SOLVENCY II 15

SHADOW BANKING: STILL BOTH BOON AND BANE? 16

ASIA SET FOR STRONGER FOCUS ON CULTURE AND CONDUCT RISK 18

MARGIN REQUIREMENTS FOR NON-CENTRALLY CLEARED DERIVATIVES TO TAKE CENTRE STAGE IN ASIA 20

REGULATORS MAKE STRONG PROGRESS BUT MAY SEEK FURTHER OPPORTUNITIES FOR COOPERATION 20

FUTURE OF FINANCIAL ADVICE: THE UNCERTAINTY CONTINUES 22


AMERICASPERFECT STORM BREWING BETWEEN U.S. BANKS AND REGULATORSWith bankers at large institutions showing little sign of shedding their bad habits, and the U.S. Congress coming down ever harder on regulators for a lack of policing, 2015 may be a tipping point in terms of wholesale structural changes for the financial industry.

Few are willing to predict that U.S. regulators will take out their big guns and break up some of the largest firms in the world. But recent events have pointed to an escalating frustration with the management of such institutions, leading to unveiled threats of imposed breakups should the seemingly endless string of misdeeds continue.

“There’s a lot of talk coming from Citigroup about how the Dodd-Frank Act isn’t perfect,” said U.S. Senator Elizabeth Warren after the reversal by Congress in December of a contentious Dodd-Frank rule for certain swap transactions.

Citigroup, one of the largest players in the derivatives market, was reported to have lobbied hard for the rule change. Warren is a leader of a populist Democratic wing that has championed Wall Street reforms. “So let me say this to anyone who is listening at Citi: I agree with you. Dodd-Frank isn’t perfect. It should have broken you into pieces,” she said.

Moreover, the dynamic between lawmakers and regulators was set on a new, unpredictable path by the Republican takeover of the U.S. Senate in November elections, which gave the party control of both houses of Congress.

“With one party in control it is more difficult for regulators to avoid taking certain types of action. But what kind of action is not

clear,” said Donald Lamson, partner at the law firm Shearman & Sterling.

CULTURE AND BEHAVIOR NOW PART OF SUPERVISORY REVIEWAt the heart of the debate is regulatory alarm at a perceived breakdown in culture and behavior, particularly on the trading side of the largest institutions. Whether one points to the recent cases of Libor rate rigging or foreign exchange price manipulation, or to the fine paid by Citibank for failing to supervise adequately communications between its equity research analysts and its clients, dismay and bewilderment among regulators has intensified.

“I’ve got to tell you. I was close to the Libor situation, and when I started to see the conduct in FX, it stunned me. It stunned me because it comes after Libor,” said Thomas Baxter, general counsel of the Federal Reserve Bank of New York, at a December conference sponsored by Thomson Reuters Accelus and Harvard’s Safra Center for Ethics.

The Federal Reserve Bank of New York has been in the forefront of warning bankers that behavior must be reformed, and that how they manage culture will now be part of the supervisory review process. In October, the bank’s president, Bill Dudley, left no uncertainty about how seriously the regulator was taking this issue.

If the bad behavior persisted, Dudley told the industry leaders, “the inevitable conclusion will be reached that your firms are too big and complex to manage effectively. In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively.”

REUTERS | Charles Platiau


BUSINESS MODEL: SIMPLER MIGHT BE BETTERFurther insight into regulators’ skepticism over the ability of large firms to manage risk and behavior came in their judgments on individual resolution plans. Wells Fargo, one of the country’s largest banks, but whose business model is far less complex than others, received a stamp of approval on its so-called living will plan for 2014. Both the Federal Reserve and the Federal Deposit Insurance Corporation in November said the bank’s plan “provides a basis for a resolution strategy that could facilitate an orderly resolution under bankruptcy.”

Some observers took the decision as a sign that bank size was not the main issue. The real problems may be complexity and interconnectedness. A large institution that can easily pull apart when it fails might also be easier to manage, and pose less systemic risk, when it is thriving. Size and complexity may also be at the root of cultural dysfunction.

“It’s almost as if, with all of the consolidation that we’ve seen, it’s fair to say we’ve lost what was the culture of a lot of these firms. And as they get larger, it’s harder to infuse them with a single culture,” said Annette Nazareth, partner at the law firm Davis Polk, at the Thomson Reuters Accelus conference.

SUPERVISORY PROCESS: HOW WILL REGULATORS MEASURE IMPROVEMENT?For banks wishing to maintain the status quo and essentially retain the trading side of their franchise along with commercial and consumer banking, the onus on them will be even greater than before to demonstrate that their controls in monitoring and, ultimately, curbing excessive behavior are working.

What remains unclear is exactly how regulators will evaluate whether a bank is making progress in cultural reforms. If large firms have different and often complex business models, adopting metrics that seek to measure banks horizontally in terms of culture may be unfeasible.

“Different firms have different business models to begin with. So you’ve got to have a different way of operating,” said Patricia Callahan, chief administrative officer of Wells Fargo, in a recent interview with Thomson Reuters. “What we say to our employees might not work at a pure investment bank.”

What is clear, however, is that compliance and senior management will have to engage regulators on this issue in a continuing dialogue about the steps they are taking to impose more effective controls on individual behavior. Failure to do so may open the door to alternatives that both management and shareholders will find unsettling.

REPUBLICAN WAVE POISED TO SPLASH U.S. FINANCIAL RULEBOOKSWhen Congress passed the Dodd-Frank Act in 2010, only three Republican senators voted for the bill. Four years later, with the Republican Party having recaptured the U.S. Senate in a big mid-term election victory, it stands poised to exert new influence on the financial reform law and regulation policy in general. Even through President Barack Obama still wields a veto pen that can thwart legislation he opposes, and regulators already have a significant pipeline, Republicans will carry more clout, which may be felt in areas including bank regulation and enforcement.

“Regulators treat you differently when you are in the majority than when you are in the minority,” said Mark Calabria, a director

of financial regulation studies at the libertarian think tank Cato Institute, and who as a former Senate staff aide has experienced both sides of the power equation.

“Now the Republicans will have control of both Houses in January. We will see a shift with the way the regulations are implemented, the way the enforcement is done and the policy decisions that are made with the regulators. They [regulators] will shift a little bit towards the Republican positions, and that is despite the fact that there are independent regulators,” he said. Calabria is a former aide to Republican Senator Richard Shelby of Alabama, who is due to take over as chairman of the Senate Banking Committee.

Many observers believe Shelby holds the key to the Republicans’ strategy for Dodd-Frank. A leading public advocacy group said Shelby would push hard on some rules but not necessarily go easy on Wall Street.

“Senator Shelby has a long record of being appropriately skeptical of the big banks, and he has a healthy regard for the danger that too-big-to-fail banks pose to the country,” said Dennis Kelleher, president and chief executive of Better Markets Inc., a public advocacy group in Washington.

Among the potential ways in which the greater Republican power is likely to be felt, Calabria cited the Volcker rule that limits risky trading by banks, and regulatory enforcement priorities.

“Let’s take the Volcker rule. It’s really discretionary … The aggressiveness of how much the Fed is going to go after banks for proprietary trading is going to change,” he said.

Many Republicans have long opposed several areas of the Dodd-Frank, including capital restrictions that Dodd-Frank places on financial institutions and the costs of complying with the law.

Shelby, however, was a vocal critic of “too-big-to-fail” banks (institutions with more than $50 billion in assets) in the aftermath of the financial crisis. As the committee’s chair between 2003 and 2007, he voted for legislation that aimed to limit the size of the country’s biggest banks.

Shelby is unlikely to try to push through many changes at once, a Wall Street bank industry lobbyist said. “He has two years left as chairman. He’s probably going to start a little slow doing oversight hearings. After two or three months we’ll know what he wants to push first.”

As an example of potential incremental change, the lobbyist said a full repeal of a Volcker rule mandate for banks to sell off certain banned holdings was unlikely. Instead, he said banks might be given more time to sell their holdings.

Republicans gave a taste of how they might use their new clout in the final days of the 2014 session, when they persuaded Democrats during year-end budget negotiations to reverse the Dodd-Frank “Lincoln amendment”, which forces banks to move some swaps trading to subsidiaries that are not federally insured.

Kelleher said he expected Shelby to remain critical of big banks but to look to pare down some powers at the new Consumer Financial Protection Bureau and the Federal Reserve. “I think over time you’ll see a huge Dodd-Frank corrections bill. The question is whether it will be a technical corrections bill or whether they will load it up (with major repeals).”


IMPACT ON REGULATORSMany of the rules required to implement Dodd-Frank are already on the books. As of December 1, 2014, a total of 280 Dodd-Frank rule deadlines had been passed, according to law firm Davis Polk. Although 104 deadlines were missed, 176 were met with finalized rules.

The largest banks have already invested in new systems and trained their staff to prepare for major rules including the Volcker rule and cross-border swaps regulations. The approach taken by regulators could be affected if they have to go Congress for funding. Congressional Republicans may also push back on the enforcement priorities of federal regulators.

“Some of it is the aggressiveness of enforcement and some of it might be the guidance that might be issued,” Calabria said.

In the meantime, regulators will press ahead with initiatives already in the pipeline and priorities already outlined.

These are additional issues and agencies to watch in 2015:BENEFICIAL OWNERSHIP

A final rule on “beneficial ownership” is expected to be released by the U.S. Treasury’s Financial Crimes Enforcement Network, or FinCEN, in 2015. The rule will aim to ensure that banks know the true beneficiary of the money that is held in accounts, and will require that bank officers verify the identity of the beneficial owner. They will also have to train their account representatives to ask the right questions when an account is being opened.

Most big banks have prepared for the final rule by investing in new systems and training their staff, but financial institutions will need to make changes to their systems when the rules come out.

CLEARING HOUSE REGISTRATION The European Union and the U.S. Commodity Futures Trading Commission have clashed over the registration of swaps clearing houses. The CFTC wants foreign clearing houses to register in the United States while the EU wants the jurisdictions to establish a regime where they recognize each other’s rules. If the two sides cannot agree, European swap dealers will have to meet the costs of complying with the CFTC’s clearing rules.

POSITION LIMITS The CFTC has re-proposed a rule intended to prevent excessive speculation in commodities markets by limiting speculative positions. Financial industry trade groups had successfully challenged the original plan in a U.S. federal court.

If the new position limits rule, proposed in December 2013, is finalized, it would impose speculative position limits for 28 exempt and agricultural commodity futures and options contracts. Late in 2014, however, the CFTC reopened its comment period on the proposal, suggesting a difficult wrangle remains before any final rule is adopted.

Regardless of the outcome of the debate on position limits, CFTC chairman Timothy Massad has warned financial institutions that the agency will be vigorous on enforcement and compliance. With most of the Dodd-Frank rules finalized, the agency will shift its focus to compliance. The CFTC demonstrated its intent when it ordered banks including Citibank and HSBC to pay $1.4 billion to settle charges that they manipulated foreign currency benchmark rates.

TOO BIG TO FAILRegulators in 2015 may revisit the challenge of how to decide whether a bank is “too-big-too-fail”, or systemically important to the extent that a failure would threaten the health of the financial system. Take, for example, commercial banks such as SunTrust Bank and Regions Financial Corporation Bank. Both banks have more than $50 billion in assets — the threshold for enhanced regulatory scrutiny as systemically important — but their business models are different from the Wall Street banks considered the main target of the too-big-to-fail provisions. The definition may be reviewed in 2015 to ensure that banks that have simple business models are not caught up in a web of regulatory requirements.

MARKET STRUCTUREU.S. Securities and Exchange Commission Chair Mary Jo White has ordered her staff to work on a series of initiatives to fix the fragmentation problems in the equities market. This means dark pools and brokerage internalizers will have to disclose more to the public about how they operate.

REU

TER

S | D

anie

l Mun

oz


Brokerage firms will also have to disclose more information about how they handle orders for large institutional investors. White’s staff is also working on plans that would force some proprietary traders to register as broker-dealers with the Financial Industry Regulatory Authority (FINRA).

CYBER SECURITY, AML TO PLAY BIG ROLES IN U.S. COMPLIANCE EXAMSThe U.S. Securities and Exchange Commission (SEC) each year sends its examiners out to thousands of investment advisers, as does the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization which oversees brokers. Both organizations publish their examination priorities in January, giving firms an up-to-date guide to the issues on which they are most likely to focus.

In releasing its 2015 examination priorities of U.S. brokerages, FINRA focused on the industry’s practices involving risky, high-yield products, plus sales of “smart beta” funds, a growing segment of the exchange-traded fund market. It also cited cybersecurity and conflicts of interest.

Thomson Reuters Accelus asked some experts how firms could ensure that they were ready for the examiners’ priorities. The experts stressed that, although the published priorities were a good start for preparations, they did not necessarily represent the full picture.

“In 2014, FINRA did not specifically make outside business activities a priority area, but then they examined on it,” said Lisa Roth, co-founder of Monahan & Roth, a consulting and litigation support firm in San Diego and a member of the Public Company Accounting Oversight Board’s Standing Advisory Group. FINRA wanted in particular to see how firms retested their systems, amended their disclosures and monitored their conflicts of interest after adding new business lines, she said.

STOPPING HACK ATTACKSTopping the expected 2015 priorities list was cyber security. Every expert interviewed cited technology protections as paramount, whether for broker-dealers or investment advisers, after regulators spent much of 2014 detailing their concerns.

The massive hack attack of Sony Pictures Entertainment shed a dramatic light on the issue, highlighting the importance of cyber risk management in a wide array of industries. The company’s cyber intrusion led to the extensive disclosure of personal and corporate data, including embarrassing executive email communications.

The attack reportedly prompted U.S. corporate executives and their companies to review their own security measures and reconsider what is said in email exchanges, and spurred lawmakers to take a closer look at corporate cyber security protocols.

REGULATORS WEIGH IN The SEC’s 2014 financial report listed governance and supervision of information technology systems as a priority of its enforcement and examination efforts. This included areas such as business continuity planning and cyber security.

The SEC’s Office of Compliance Inspections & Examinations (OCIE) last year launched a cyber security initiative which it said would examine more than 50 registered broker-dealers and investment advisers on the issue. The exams are to focus on cyber

security governance, risk identification procedures and the risks associated with vendors and other business partners, among other areas.

The SEC also adopted new rules designed to strengthen the technology infrastructure of the U.S. securities industry toward the end of 2014. The rules, known as “Regulation SCI” (for Systems, Compliance and Integrity), require certain market participants to reduce the occurrence of systems problems and ensure that they are promptly corrected and communicated to other participants and the SEC.

Furthermore, the New York State Department of Financial Services has said it will examine banks in its jurisdiction for cyber security preparedness. Assessments that are targeted to each bank’s particular risk, internal as well as external, will be part of the examination process, Benjamin Lawsky, New York State’s superintendant of financial services, said. Examiners will consider each bank’s cyber security protocols, governance, third-party vendor information technology security and other issues. The assessments will be integrated into the regular exam process.

Areas of focus will include the management of cyber security issues, including the interaction between information security and core business functions, written information security policies and procedures and the periodic reevaluation of such policies and procedures in the light of changing risks. Resources devoted to information security and periodic information security testing and monitoring were also mentioned.

The main U.S. swaps regulator, the Commodity Futures Trading Commission, will also focus on cyber security in exams of the exchanges and clearinghouses it regulates. “The risk is apparent,” CFTC Chairman Timothy Massad told Congress.

The increased scrutiny will have some professionals reevaluating their traditional roles.

“The important thing for compliance professionals to bear in mind in this regulatory environment is that information security is not just the responsibility of the IT team,” Roth said.

”The compliance department needs to have effective policies and procedures that address breach reporting and notification processes, plus the training of all employees, including those in remote locations,” she said.

CONFLICTSPreventing conflicts of interest was a huge area of concern for both the SEC and FINRA in 2014, and all signs point to a continuing emphasis in exams.

In an October 2013 report on conflicts of interest, FINRA said exams would focus on firms’ approaches to identifying and managing conflicts in three areas: the top-down ways in which a firm introduced new products and services; the approaches the firm took to handling these conflicts when creating and distributing the new products; and the ways in which compensation was paid to associated persons, especially those acting as brokers for private clients.

“That 2013 report is still the basis for how FINRA examines conflicts of interest, and it will be on the agency’s radar screen in 2015,” said Deirdre Patten, president of Patten Training & Review in The Woodlands, Texas.

“I would recommend that firms do a top-down review of any conflicts posed by subsidiaries and by all of the representatives


working in remote locations, and then disclose any they find, plus incorporate the review they used into their supervisory procedures,” she said. “The techniques that prove effective must be used quarterly, not just annually, and then retested to make sure they are still effective over time.”

FINRA’s exams were tailored to the risk posed by the firms they examined, Patten said. The regulator would use a checklist with all of them, but look more deeply into firms that posed greater risks in particular areas, she said.

Examiners would further expand their high-risk broker program to ensure those brokers with a misconduct record were subject to more scrutiny by their firms, Patten said. “The adequacy of the firm’s supervision processes with these high-risk brokers will continue to be assessed, as well as the firm’s overall hiring practices with regard to all brokers,” she said.

Compensation is also being watched. “FINRA follows the money. It looks at the fees you are charging, and whether you’re paying brokers more to sell one product in lieu of another,” she said.

ADVISER FEES AND EXPENSESOn the advisory side, fees and expenses were repeatedly invoked in speeches and 2014 enforcement actions.

Andrew Bowden, director of the SEC’s National Exam Program, cited dangers posed in particular by private equity advisers who have broad characterizations of fees and expenses which enable them to pass on many of the costs to unwary investors. “Poor disclosure in this area is a frequent source of exam findings,” he said.

An investor’s ability to understand fees, SEC commissioner Kara Stein said in a speech, “is one of the most important tools for evaluating any investment — and for encouraging healthy competition in the marketplace”.

The SEC has discovered that fee disclosures in private equity are lacking in important ways, she said. For instance, some firms have been describing “consultants” in ways that obscure the fact that they are separately paying these “consultants” for services they provide portfolio companies. Without more specific disclosure, many investors may wrongly believe that they are employees of the adviser that are being paid from the agreed-upon management fee.

“Disclosure about fees and expenses must be clearly defined, and this point can be underscored by some recent and telling enforcement actions,” said Linda Smith, managing director and private funds regulatory consultant at SEC Compliance Consultants in New York.

Smith referred to an SEC case in which an advisory firm was cited for reneging on its fiduciary duty to its clients by using inadequate language in its disclosures. The case showed that fee disclosure issues that might in the past have been addressed with a regulatory deficiency letter could now be treated as an enforcement matter, raising the stakes for a firm.

In this case – and another involving an investment advisor — the SEC sanctioned the advisory firm for inadequately disclosing to investors that it “may” receive compensation from a broker when it was, in fact, receiving payments from it.

“Advisers must review their disclosures to make sure they are adequate in the light of the SEC’s wording in this case, being

extra careful in the wording relating to fees they charge portfolio companies and investors,” Smith said.

AML UPDATESFederal examiners also got a new anti-money laundering playbook to use for 2015. The Federal Financial Institutions Examination Council released its “Bank Secrecy Act/Anti-Money Laundering Examination Manual”, outlining what examiners are to look for during their audits. The manual includes the expectations of the Department of the Treasury’s Office of Foreign Assets Control (OFAC), which administers a U.S. sanctions program that has been wielded with increasing force and sophistication.

This guidance was last updated in 2010, and the revised version has been eagerly awaited by compliance professionals seeking greater clarity on what regulators expect regarding the quality of AML compliance at their businesses.

EARS TO THE GROUNDThe compliance officer must act as the firm’s “ears to the ground” in anticipating the demands of the exam process, said Allison Charley, chief compliance officer at MIP Global Inc. “The role challenges the compliance professional with the task of protecting a firm from itself and meeting the requirements of the regulators, but it can be done.”

“The answer is executive leadership buy-in,” Charley said. “Effective examinations begin and end with a compliance department that has the resources, authority and executive leadership support it needs to do its job.”

This did not always happen, she said: “Let’s just say that the largest firms seem slower to fully appreciate the value of compliance and the cost of non-compliance.”

CANADA TO LAUNCH NEW CAPITAL MARKETS REGULATORCanada will work this year to launch the Cooperative Capital Markets Regulatory System, a nationally centralized regulation mechanism intended to replace the fragmented network of provincial securities commissions. This follows the completion in 2014 of consultations on provincial and federal laws allowing participating provinces to delegate their regulatory powers to a national entity, while allowing the federal government to address national systemic risk in capital markets.

The new framework will include whistleblower protections and new provisions on issues including enforcement and market conduct.

So far, five provinces have agreed to participate, including Ontario and British Columbia, which preside over Canada’s largest and most important capital markets, such as the Toronto Stock Exchange (TSX). Two other major jurisdictions, Alberta and Quebec, have strenuously opposed the initiative, citing sovereignty concerns. The participants expect the cooperative system to be operating by autumn 2015.

LEGAL FRAMEWORKThe uniform Provincial Capital Markets Act (PCMA) will update and harmonize existing provincial securities legislation by blending the regulatory approaches taken by British Columbia, Ontario, New Brunswick and Saskatchewan. In conjunction, the complementary federal Capital Markets Stability Act (CMSA) will empower the federal government to collect trading data


from provincial jurisdictions and intervene to reduce systemic threats. The legislation also will modernize the definition and prosecution of criminal offences related to capital markets and will consolidate derivatives regulation under one regulator.

The resulting system will be administered by the newly formed Capital Markets Regulatory Authority (CMRA), under the oversight of a council consisting of the federal minister of finance and one minister from each participating province. Ministers representing the “major capital markets jurisdictions” will have special influence; they can veto CMRA board appointments, and at least one of them must agree to certain actions. These major jurisdictions will be defined as those whose financial services industries represent at least 10 percent of the national gross domestic product, namely Ontario and British Columbia, as well as Quebec and Alberta if they choose to join.

The regulatory authority will be governed by an expert board of nine to 12 directors and operate independently. A “chief regulator” will lead the CMRA’s regulatory division, which will be responsible for policy, regulatory operations, advisory services and enforcement functions. Enforcement and other administrative proceedings will be handled by an independent tribunal of adjudicators led by the “chief adjudicator”. The two divisions will interact through the CMRA’s Regulatory Policy Forum which, according to supporting documents, will “support the Tribunal’s expertise and promote a consistent approach to policy, oversight and adjudication”.

The Authority’s executive headquarters will be in Toronto, and each participating province will have its own regulatory office. The regional offices will have authority to make day-to-day regulatory decisions and will continue to provide the services that are currently supplied by existing local securities commissions.

The legislative proposals have not addressed how the CMRA will interact with non-participating jurisdictions.

NEW ENFORCEMENT AND CONDUCT PROVISIONSWhile the proposed provincial legislation is largely consistent with existing securities laws, it includes some new market conduct provisions. Notable examples include prohibitions against benchmark manipulation that forbid the submission of false or misleading information, as well as other conduct that may improperly influence or corrupt a benchmark’s determination.

At the federal level, the stability law will create new criminal offenses specific to capital markets, while moving existing offences from the Criminal Code and updating them. New offenses will include securities and derivatives fraud, deceitfully affecting market price, market manipulation, insider trading, misrepresentation, criminal breach of trust by dealers and investment fund managers, forgery of securities or derivative documents and manipulating financial benchmarks. The attorney general of Canada and the attorneys general of participating provinces will have concurrent jurisdiction over the prosecution of these offenses.

Violating the stability legislation could result in penalties of up to $25 million for firms, and up to five years in prison and/or $5 million fines for individuals. If firms violate the act, their directors and officers could be held liable if they are found to have acquiesced. Additionally, firms may be held liable for infractions committed by employees acting within the scope of their employment.

Both pieces of legislation will also introduce whistleblower protections, which prohibit firms from retaliating against employees who provide information and other assistance to the CMRA or law enforcement. The federal legislation goes a step further by making it a criminal offense to retaliate against employees who cooperate in investigations or who refuse to follow orders that would contravene the Stability Act. In certain circumstances, the law will also provide immunity from civil action to persons who disclose information to regulators.

To enhance its enforcement capabilities, the CMRA will have new evidence-gathering tools for investigating criminal and quasi-criminal securities offenses. For example, the CMRA will be able to compel the production of evidence through the courts, which will gain access to new production orders tailored for capital markets.

SYSTEMIC STABILITY LEGISLATIONOperating a national systemic stability regime will be a first for Canada. The proposed federal legislation will create three channels through which the Capital Markets Regulatory Authority will manage systemic risk. First, the act will give data collection powers to the authority, allowing it to monitor, identify and mitigate the accumulation of systemic risk in capital markets. Second, the CMRA will have special authority to take “decisive action” to address threats to financial stability. Third, the regulator will interface with other provincial, federal and foreign financial authorities.

The CMRA will have power to impose national data reporting standards and to designate trade repositories, though it is currently unclear how a federal reporting regime would affect such systems in non-participating provinces.

To reduce risk, the CMRA will be able to designate certain market infrastructures, participants and products as systemically important, as well as to determine that certain practices are systemically risky. The CMRA will also be able to impose additional requirements relating to risk management, transparency, margin/collateral, trading rules, default rules, governance, capital adequacy, business continuity and conflicts of interest.

Conspicuously, the law also permits the federal finance minister to transfer the administration of certain banking regulations from the Office of the Superintendent of Financial Institutions (OSFI) to the CMRA. This will give the new regulator authority over banking activity related to derivatives.

In cases of emergency, the federal minister of finance can, after consulting the CMRA and “major” council ministers, direct the CMRA to act against an immediate and serious systemic risk related to capital markets. The authority will also have the power to suspend or restrict derivatives trading without giving affected parties an opportunity to make representations.

Additionally, the CMRA will have a compliance group empowered to review systemically important trading facilities, clearing houses, credit rating organizations, intermediaries and trade repositories. Those powers will include the ability to enter the premises of any market participant and make inquiries, examine data, order the production of records, use communications and remove or copy material. The CMRA’s chief regulator will also be able to summon individuals and compel them to give evidence.

The chief regulator could also order such intrusions to examine compliance with a foreign jurisdiction’s capital markets legislation.


GREATER INDIVIDUAL ACCOUNTABILITY TO BECOME REALITY IN 2015The ability of UK regulators to hold senior individuals in banks and insurers to account when failings occur in their firms is set to increase over the next year, once the draft rules published by the Prudential Regulation Authority and the Financial Conduct Authority come into effect. The changes introduced by both the Senior Managers and Certified Persons Regime (SM&CP) for banks, and by the Senior Insurance Managers Regime (SIMR), herald the arrival of an age wherein regulators provide a high degree of prescription over the employer/employee relationship in these categories of regulated firm.

The drive to increase personal liability carries with it a hope that it will lead to more effective identification, management and mitigation of risks on the part of senior managers in critical roles, who will be aware that their necks are on the block if things go wrong. Inherent in this is the idea that in the lead-up to the crisis some senior managers took excessive risks with impunity, safe in the knowledge that, should things go wrong, the worst that was likely to happen was redundancy, followed by a few months off and then a new role elsewhere.

Once the SM&CP regime comes into force for banks, public humiliation, a large fine that must be paid out of personal funds (it is not possible to insure against a fine) and a prohibition order effectively ceasing someone’s career in financial services are all more likely. Insurance senior managers may also be more likely to face enforcement action.

TIPPING THE BALANCEThe new rules could come into force as early as summer 2015 if the regulators have their way, or six months later if they listen to industry sentiment. Under the new rules, regulators will find it more straightforward to take successful enforcement action for two main reasons. The first is that the requirement for senior managers in banks to produce a document which contains a list of all the matters for which they are responsible — a “Statement of Responsibilities” — means it will be far easier than previously to pinpoint exactly who was in charge at the relevant time.

The second element is the introduction of a reverse burden of proof, which means that where a regulatory failure is discovered it will be assumed that the senior manager responsible is guilty of misconduct, unless he can prove to the regulator he took all reasonable steps to stop it happening.

The regulators will consult on the precise form and content of the Statements of Responsibilities during the coming year. What is clear at this stage is that they will need to contain a list of all the “prescribed responsibilities” that an individual owns. Although the statutory requirement for a Statement of Responsibilities only applies to those in banks, in effect senior managers in insurance companies will be required to produce something similar, as they too have a list of “prescribed responsibilities” that must be divided between the leaders of the firm and be housed in a firm-wide “governance map”. For banks, this document will be known as the “responsibilities map”.

EUROPE

REUTERS | Niel Hall


DELIBERATELY “VAGUE”?

The lists of prescribed responsibilities marks one of the biggest departures from the old Approved Persons Regime. Beyond the requirement to have certain people in charge of “compliance oversight”, or “systems and controls”, for example, little detail was provided on the content of a job description in either the Senior Management Arrangements, Systems and Controls (SYSC) section of the FCA Handbook or in the Code of Practice for Approved Persons (APER).

This was deliberate; pre-crisis, the UK regulator had no desire to be too prescriptive with firms and the move was towards a principles-based world where detailed rules were only necessary in limited circumstances, and where possible firms were expected to comply with general principles. The future regulatory environment will be one in which both rules and principles are king; further, there are likely to be plenty of rules about principles, which will make for a complex picture.

The regulators’ consultation on individual accountability in banking set out 20 prescribed responsibilities, which must be allocated to specific senior managers; the insurance consultation listed 10. Prescribed responsibilities common to both include a requirement to have a senior manager responsible for leading the development of the firm’s culture and standards in relation to the carrying on of its business and the behavior of its staff. Firms also need to assign to a specific senior manager the responsibility for embedding the culture and standards in the firm’s day-to-day management. This is an illustration of the application of rules seeking to hold senior managers to account for the implementation of principles.

EMBEDDING CULTUREThe specification of a responsibility for developing and then embedding ‘culture’ ought to encourage the role holders to elucidate, in the context of their firm, what the ‘culture’ is and what it ought to be, and then to come up with a plan of how to get there. This need not be as difficult as it initially sounds.

Once culture is broken down in this way, and viewed via a series of indicators of a firm’s conduct in various scenarios, it becomes less of an elusive concept, and more measurable. This will not make it necessarily more straightforward to achieve sustainable internal change in a way that keeps regulator, customer and shareholder happy, but from the perspective of the senior manager bearing overall responsibility it is a good place to start.

The introduction of a reverse burden of proof in misconduct cases should also make regulators’ task easier. The default legal and regulatory position is that whoever brings a case bears the burden of proving it. This has been reversed in the case of regulatory misconduct, where senior managers in banks are concerned, in that if the regulator finds misconduct it will be for the senior manager identified as responsible, through his Statement of Responsibilities, to prove, on balance of probabilities, that he is not guilty of misconduct.

If the manager can satisfy the regulator that he took such steps as a “person in his position could reasonably be expected to take” to avoid the contravention occurring (or continuing), he will be not guilty. Whether or not misconduct has been identified will be the regulator’s opinion, potentially untested, as there is no requirement for a successful enforcement action to have been brought against a firm before action can be taken against an individual.

This new provision is likely to pit the interests of a senior manager directly against the interests of a firm when misconduct is identified, because firms generally want to settle and move forward as quickly as possible, whereas it is unlikely to be in the individual’s interests for the firm to agree with everything the regulator says.

The new accountability rules are being considered in detail by those likely to be affected. One outstanding question is the extent to which a senior managers regime will apply across firms not in scope (so all firms bar banks, PRA-regulated proprietary trading firms and insurers). The entire industry should be alert to the likelihood of a more general shake-up of the legacy Approved Persons Regime, at some point in 2015 and early 2016.

The position is that three regimes governing individual conduct will be running as of some point next year: the SM&CP for banks; the SIMR for insurers (which has pieces taken from the SM&CP, tagged on to the existing Approved Persons Regime); and the current Approved Persons Regime for everyone else. This is far from ideal, and runs the risk of the regulator overseeing a system seeking to govern individual behavior that becomes a “complex and confused mess”, which was the Parliamentary Commission on Banking Standards’ vivid description of the original Approved Persons Regime.

BURDENSOME WORKLOADConsideration should also be given to the possible chilling effect these new rules may well have on the recruitment and retention of talented senior individuals. Those who might potentially apply for a senior job in a bank (and face the reverse burden and statement of responsibilities requirements, as well as, in much more extreme cases, the threat of criminal sanction), might opt instead for a role with an investment manager.

“It is certainly my view that having the right culture is essential for achieving good conduct performance. This is not, though, a fluffy view of vague corporate aspirations or value statements, but a need for a more hard-edged embedding of business practices that define how decisions will be made through the firm at critical points of engagement with customers or dealing in markets. … there are key drivers that set and re-enforce the right conduct-focused culture with the most important being clear and ongoing leadership from the top of the organization, constant re-enforcement, incentive structures, effective performance management penalties for not doing the right thing.” Clive Adamson, then director of supervision at the FCA, May 2014.


The resignation of Alan Thomson, non-executive director at HSBC, was due in part to “incremental concerns surrounding the application of the new senior manager’s regime to NEDs”, according to a letter from Andrew Tyrie, Treasury Committee chairman, to Douglas Flint, chairman of HSBC, released in early December. In the same letter, however, Flint said the resignation had occurred because of likely burden of work that would have been faced by Thomson, who was due to become chair of the UK arm of the bank’s audit committee. The regulators will want the most capable individuals to remain in charge of large, systemically important banks in the UK, and it is hoped an exodus of such people will not be an unintended consequence of the new rules. This threat may be overstated.

2015 will see the biggest shake up of regulatory oversight of individual behavior in financial services since the inception of the Approved Persons Regime 15 years ago. After all their rhetoric about holding individuals to account it is likely the regulators will try to apply the new rules, and their new powers, wherever possible. It will be an interesting year.

UK’S FAIR AND EFFECTIVE MARKETS REVIEW IS PART OF A GLOBALLY COORDINATED SHIFT TOWARD BETTER WHOLESALE CONDUCTThe UK authorities are keen to find out if the fixed-income, foreign exchange and commodities markets (FICC markets) that trade in their jurisdiction are both “fair and effective”. HM Treasury (finance ministry), the Bank of England and the Financial Conduct Authority (FCA) are therefore carrying out a “Fair and Effective Markets Review” (FEMR) to look carefully at current trading practices in both regulated and currently unregulated FICC markets operating in the UK.

The review will consider what the optimal scope of financial regulation might be (in December, the government decided to add manipulation of seven financial benchmarks traded in London to the regulatory and criminal regime that already covers the London Interbank Offered Rate (Libor)); the cumulative impact of recent and forthcoming new regulation at both the UK and the European Union level; and the implication for the supervision of financial firms of all the continuing and prospective changes in regulation. The three bodies intend to feed the resulting regulatory insights into the wider international debate on trading practices, and the progress of the review is already being watched by a number of regulators throughout the world.

“Throughout, the review is conscious that the FICC markets are global in scope, and shaped by forces far wider than those in the United Kingdom alone,” they say. “In each case, the review will need to evaluate the extent to which change is: (a) for the industry (which has the capacity to act globally) to implement; (b) for the UK authorities; or (c) for wider discussion with international authorities.”

Martin Wheatley, the FCA’s chief executive, said the FICC markets’ global nature made effective cooperation among regulators essential to bringing about successful reforms. “Our work on FX, and broader reforms to benchmarks through IOSCO, offer a clear template for international coordination to address the underlying structural issues that drive poor conduct,” he told Thomson Reuters Accelus.

The FEMR defines fair markets as those which “have clear and consistently applied standards of market practice; demonstrate sufficient transparency and open access; ... allow market participants to compete on the basis of merit; and provide confidence that participants will behave with integrity”, and it

REUTERS | Luke MacGregor


defines effective FICC markets as those which “enable market participants to trade at competitive prices; and allow the ultimate end-users to undertake investment, funding, risk transfer and other transactions in a predictable fashion, underpinned by robust infrastructure”.

The review, which is headed jointly by Wheatley, Charles Roxburgh, HM Treasury’s financial services director general, and Nemat “Minouche” Shafik, the Bank of England’s deputy governor for markets and banking, has been holding numerous bilateral and small-group discussions with market participants. There has also been a three-month consultation, closing at the end of January, which aims to garner feedback from industry and other stakeholders in the FICC markets before the review makes its final recommendations in June 2015.

In a speech at the London School of Economics at the end of October when the consultation was launched, Shafik warned that some of the benefits of the post-crisis prudential reforms were being offset by “a long tail of outrageous conduct cases ... like salt rubbed into the wounds to public confidence in financial markets”. She believed most of those working in FICC markets were ashamed of such bad behavior, and looking for a way to put it behind them. The well-worn “few bad apples” adage did not seem to be credible in relation to what had gone wrong, Shafik said: “Perhaps there is something also wrong with the barrel?”

In relation to fixed-income markets, the FEMR has asked for views on whether an extension of electronic trading to more participants is possible or desirable, and whether barriers exist to a more transparent market structure for this asset class. It has asked whether standardization of corporate bond issuance is possible or desirable, if issuance of other fixed-income products could be standardized, and if so, how. It would also like to know

if auctioning, or published allocations, “or some other route”, should be pursued to increase transparency of the fixed-income new-issues market.

In relation to foreign exchange, the review has asked if risks exist with internalization of trading via single-dealer platforms, etc., and with the recently developed “last look” practices that allow market makers to decide just before acceptance of a trade whether or not to accept, as a way of protecting themselves against automated trading strategies. It would like to know if barriers exist to greater pre- and post-trade transparency in FX markets, or to the development of more comprehensive netting and execution facilities for fix orders.

In relation to the over-the-counter commodity derivatives markets, the consultation has sought views on whether “material barriers” exist preventing greater transparency, and if so, how they could be removed.

In relation to all FICC markets, the review has asked if there are any areas where new regulation or internationally coordinated regulatory action are needed to address any fundamental structural problems. It has also asked if there are regulatory measures the UK authorities could take to strengthen personal accountability or otherwise improve the way firms manage incentives and governance, in particular whether Britain’s strict new Senior Managers and Certified Persons Regime (SM&CP) for banks should be extended to non-bank firms active in FICC markets.

In its initial discussions with market participants, the review encountered some industry uncertainty over the boundary between acceptable and unacceptable practices in situations not as straightforward as those involving a clear, and enforceable,

REUTERS | Andrew Winning


breach of market conduct standards. These uncertainties included:

• A lack of clarity regarding the dealer/end-user trading relationship, such as whether a dealer is acting as principal or agent, or whether a counterparty is placing an order or only communicating an expression of interest.

• The distinction between legitimate trading activity involving knowledge of a forthcoming trade (to hedge pre-existing inventory, or to pre-hedge the coming trade), and inappropriate front-running.

• The distinction between legitimate trading activity, such as trading around a benchmark setting for portfolio-balancing or risk-management purposes, and market manipulation (e.g., trading aimed at improving the payout of a benchmark-referencing contract).

• The lack of clear industry guidance on when providing “market color” for buy-side clients could become the communication of market-sensitive information about other market participants’ trading activity. This arises because dealers need to share some information with each other for risk management purposes, and this also leads to a concern they could be accused of collusive behavior.

• Standards for internal communication of market activity. Here again, some market participants worried about a lack of clear industry standards to manage conflicts between the need for a firm acting as agent to keep clients’ business confidential and the need for a firm acting as principal to communicate internally client trading information to risk-manage its own trading positions.

• A lack of granular market-wide standards for client suitability, which leaves scope for subjective interpretation of suitability, leading to differing standards of client categorization among different dealers, and possibly a race-to-the-bottom or “regime-shopping” competition between them.

• Questions concerning the allocation of new issue bond syndications, which in the absence of well-defined and widely understood market-wide or industry guidelines tended to be based on a combination of issuer and dealer judgment, varying between primary dealers and also between different syndications.

Wheatley said that at the heart of its enforcement actions in relation to both FX and Libor, the British regulator had found a failure to manage conflicts of interest and apply the appropriate controls to trading behavior, and the FX cases showed that actions banks had taken to address the flaws exposed by Libor had not gone far enough, resulting in a genuine loss of confidence in the integrity of the financial system.

LONG JOURNEY NEARS COMPLETION FOR SOLVENCY IISolvency II is reaching its final countdown as the January 2016 implementation deadline approaches, and this is the year where the priority will shift toward ensuring consistency across all European Union member states. Gabriel Bernardino, chairman of the European Insurance and Occupational Pensions Authority

(EIOPA), said at the association’s annual conference in November 2014 that, with such a shift in mind, EIOPA would be helping to upgrade the quality of national supervision and would be strengthening oversight of cross-border groups.

At a time when a low interest environment is, according to EIOPA’s assessment, the main risk for the insurance sector, insurers need to be on top of their models. The UK Prudential Regulation Authority made it clear at a conference late last year that insurers’ senior managers should engage much more closely with internal models. This will be a bigger problem for some than for others, however. Jeremy Irving, partner at Eversheds, said that, given the tight deadline, there would undoubtedly be other issues for insurers to address, and they would need to fire on all cylinders.

From the authorities’ perspective, the detail of the timetable has been mapped out. By April this year at the latest, the European Council and the European Parliament will have scrutinized the delegated acts, and these should then come into force across the EU without having to be transposed into national regulation. They introduce, most importantly, a more favorable capital treatment within the standard formula for simpler, standardized securitizations.

There are still teething issues in the implementation of Solvency II, but no longer major delays. This is a far cry from the situation two years ago when Andrew Bailey, chief executive of the Prudential Regulation Authority, expressed concern about whether the implementation of the directive would ever happen; he was not alone.

For asset managers, however, there are unresolved concerns. They will need to provide much more detailed data to insurers and, as the Investment Management Association (IMA) has made clear, they have not budgeted for such a requirement. It is insurers who are calling the shots. EIOPA has said that from January 2016 insurers may choose how they get data from asset

“Rebuilding trust in [FX and Libor] markets will take time and each institution active in these markets has a role to play. This isn’t about ticking boxes or adding layers of compliance; it requires fresh thinking and a change in culture at every level.“The Fair and Effective Markets Review will consider steps that regulators can take to drive this culture — one option may be extending provisions from the UK’s accountability regime for senior managers in banks to other sectors.”Martin Wheatley, chief executive of the UK Financial Conduct Authority, speaking on the publication of the FEMR consultation document, October 2014.


managers but should not blindly trust the information received, and should get a second opinion to enhance risk management.

The IMA has said asset managers should be taking action: asking insurance clients how they want to receive data, how quickly they need it and just how big the data is likely to be. Security issues arise from the sheer detail of line-by-line security data that must be provided, complicated by the fact that many of the third-party administrators to which asset managers outsource data also perform a similar function for their insurance clients. As a smaller concern, asset managers are finding that they need to check the insurer has the appropriate licenses to use and manipulate market data.

The stakes are high, because if an asset manager is not Solvency II-compliant, the insurance client may decide to change mandates; it is still all about having that conversation. As the Association of British Insurers has noted, if there is to be a smooth transition, insurers and asset managers will need to discuss the timelines and asset data required by the legislation. Solvency II has a history of delays, and given the unpredictability of world events, no timetable can be set in stone, but now, as the deadline nears, it seems increasingly unlikely that there will be further delays.

SHADOW BANKING: STILL BOTH BOON AND BANE? Although shadow banking’s explosive growth was slowed by the financial crisis it is growing fast, with the International Monetary Fund (IMF)’s October 2014 Global Financial Stability Report estimating that it is now worth more than $70 trillion. Two of the perennial challenges have been how to define shadow banking and then how to measure it (driven at least in part by the difficulty of getting a complete data set on shadow banking sources and flows). This point was illustrated by a Financial Stability Board update to the November 2014 G20 summit in Brisbane, where the fourth annual shadow banking monitoring exercise was, for the first time, accompanied by the publication of a comprehensive dataset.

The “conservative estimate” given by the FSB covered the areas where shadow banking-related risks might potentially arise, and estimated the size of the marketplace as $75 trillion (having grown by $5 trillion in 2013). This is the broadest measure covering the Monitoring Universe of Non-Bank Financial Intermediation (MUNFI) which, worldwide, represents about a quarter of total financial assets and about half of banking system assets. A more tightly-focused estimate filters out entities which are not part of a credit intermediation chain and those that are prudentially consolidated into a banking group. On this basis the MUNFI estimate was “only” $35 trillion.

The numbers remain huge and the potential issues equally large. The shadow banking system can broadly be described as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”: in short, non-bank credit intermediation. Such intermediation, appropriately conducted, can provide a valuable alternative to bank funding

that supports real economic activity. This is a genuine boon for many economies, particularly where the traditional banks are pulling back from lending as they recapitalize and rebuild their balance sheets. The bane was shown in stark terms during the financial crisis where some non-bank entities and transactions operated on such a large scale that they created bank-like risks to financial stability due, in simple terms, to longer-term credit extension based on short-term funding and leverage.

Experience has shown that, like banks, a leveraged and maturity-transforming shadow banking system can be vulnerable to “runs” and generate contagion risk, as well as amplifying systemic risk. While banks were supported through the financial crisis, many shadow banks simply stopped doing business, contributing to a spiraling credit crunch. As part of its wider work the FSB is seeking to ensure that shadow banking is subject to appropriate oversight and regulation to address bank-like risks to financial stability which emerge outside the regular banking system. At the same time, however, it will want to be careful to avoid inhibiting sustainable non-bank financing models that do not pose such risks. In other words, it is seeking to balance the boon with the bane.

Bodies such as the IMF and the FSB are keen to steer a policy line between facilitating the market liquidity provided by shadow banking activities and the continuing concerns about firms which, although they provide credit intermediation and borrow and lend money like banks, are neither regulated nor have a formal safety net. Many of the planned next steps focus on further analysis, definition and refinement of the datasets gathered, including:

“The system-wide monitoring of shadow banking is a core element of the FSB’s work to strengthen the oversight and regulation of shadow banking in order to transform it into a transparent, resilient, sustainable source of market-based financing for real economies. To this end, the FSB launched in 2011 the shadow banking annual monitoring exercise, which aims to identify and measure potential sources of systemic risks beyond the current bounds of prudential regulation. The progressive refinements of this exercise have sharpened the risk-monitoring capabilities not only of the FSB but also of national and regional authorities.”

Mark Carney, chairman of the FSB and governor of the Bank of England, FSB Global Shadow Banking Monitoring Report presented to the G20, November 2014.


• In future, the FSB’s monitoring will benefit from further improvement in data availability which is necessary for national authorities to be able to capture adequately the magnitude and nature of risks in the shadow banking system. In future monitoring reports, the continuing work to narrow down the estimate of the shadow banking sector will benefit from the results of the information-sharing exercise on shadow banking entities and activities which started in 2014.

• The hedge funds sub-sector remains significantly underestimated in the FSB’s data collection exercise. Further refinement of the data for this sector could provide important additions to future iterations of the shadow banking report. The International Organization of Securities Commissions will contribute hedge fund data and analysis.

• The IMF has considered different calculation methodologies and has put forward an alternative measure for consideration, derived from flow of funds accounts, for a smaller set of countries. It focuses on “other financial intermediaries” and excludes non-money market investment funds, since the latter mainly manage assets on behalf of clients and thus do not engage directly in credit intermediation.

• The IMF has also proposed a new, alternative definition of shadow banking as financial activities using non-traditional funding, independently of the financial institution involved. The focus on activities is one advantage of this approach.

For example, securitization is classified as shadow banking, whether it is conducted on-balance sheet by banks, or off-balance sheet through special purpose vehicles.

• In 2015, the FSB intends to launch a peer review regarding member jurisdictions’ implementation of its policy framework for other shadow banking entities. Based on the findings, the FSB will evaluate the case for developing further policy recommendations for relevant shadow banking entities and report the results to the 2015 G20 summit.

The jury is still out on shadow banking. On the one hand it is a valuable source of liquidity but on the other there continues to be a lack of transparency about the detailed nature and size of the risks. While policymakers will almost certainly continue to seek to monitor shadow banking activities, much more detailed data will be needed to enable effective monitoring. If nothing else, policymakers and regulators alike will need a better understanding of the risks that shadow banks may or may not continue to pose to the smooth-running of the financial system.

Considerations regarding definitions and data are fundamental, as are questions as to whether shadow banks engage in excessive maturity or liquidity transformation, how much leverage is involved, how risky their credit positions are, and how interconnected they are with the rest of the financial system. To date, the only consensus seems to be that the shadow banking sector has grown, but only time will tell whether that is good or bad for financial stability.

REUTERS | Arnd Wiegmann


ASIA SET FOR STRONGER FOCUS ON CULTURE AND CONDUCT RISK Regulatory action in the Asia-Pacific region has shown that although compliance is costly, a material breach in compliance or regulatory issues will prove more expensive in the long run, and hurt a firm’s reputation.

In 2015 regulators in the region will place a stronger focus on culture, conduct risk and alignment with other risk functions, raising expectations of firms’ ability to identify issues and disclose them. Under direction from the G20, the region will experience still more regulatory reform, with an emphasis on strengthening the resilience of financial institutions. In particular, regulators will look to strengthen prudential supervision and customer outcomes. Firms will have to understand and plan to implement these policy expectations to ensure that they are more accountable for their dealings with customers.

CULTURE AND REGULATORY DISCLOSUREPrudential and financial regulators will pay more attention to the culture of firms and refine requirements and supervisory practices accordingly. This was reinforced in Australia’s Financial System Inquiry (FSI) report in December, in which David Murray, who chaired the inquiry, said: “Appropriate firm culture is critical, but needs to be supported by proactive regulators with the right skills, culture, powers and funding.”

BANKING CULTUREMisconduct in the setting of benchmark interest rates and foreign exchange rates as revealed in the West and Asia have focused

regulators’ attention on the importance of banking culture. The Securities & Futures Commission of Hong Kong (SFC) in mid-2014 said it would focus on targeting decision-makers and incentive-setters in regulated firms, in a bid to avert future misconduct by holding individuals accountable. Few of the international banks in the territory will find the Hong Kong’s regulatory attitude to conduct any more lenient than that of their home U.S. and UK regulators. With an active enforcement record, the SFC will be looking to make its position on culture clear.

Hong Kong will not be alone; other Asia-Pacific regulators have also shown themselves to be keen to address the issue of misconduct. For example, at the end of 2014 South Korea’s Financial Supervisory Service had brought in new rules that will hold chief executives personally responsible for compliance lapses at financial institutions.

There appears to be a cultural distinction between financial institutions that commit continual regulatory violations and those that do not. This seems more apparent in the United States and the UK, where significant fines were given to numerous global banks for what were, in some instances, intentional violations. In future, regulators will be expecting boards to exert a critical influence on the culture and management of the business at a grass-roots level, and on the quality of firm governance.

Regulators will come down hard on institutions that fail to “self-disclose” material compliance or regulatory breaches in a timely manner. Disclosure with integrity is now seen as connected to a firm’s culture.

ASIA PACIFIC

REUTERS | Jason Lee


CONDUCT RISKThere is a greater emphasis on “conduct risk”, and the need is growing for institutions to reassess the way they conduct their business and how regulatory risks and expectations are managed. This will challenge firms not only to deal with regulatory obligations but also to look at how they to monitor, analyze and manage their customer relationships. Banks internationally have had to pay billions of dollars in claims for the shortfalls which have resulted from the negligence toward customers.

The numerous recommendations in Australia’s Financial System Inquiry are an interesting read for all governments, regulators and institutions. “Financial products and services should perform in the way that customers expect or are led to believe” it said as a fundamental principle to the fair treatment of customers.

In Australia, the current framework was found insufficient to deliver fair treatment. Institutions throughout the Asia-Pacific region will have to consider how they can better align their interests with those of their customers and improve customer outcomes in terms of product disclosure, accountability and technology.

HARMONIZATION OF ISLAMIC FINANCE PRODUCTSThe global sukuk market has increased significantly and has now become a feature of financial centers such as London, Luxembourg, Dubai, Hong Kong, Malaysia and Indonesia. This has been facilitated in part by improved capital and regulatory frameworks within the Islamic finance industry. For example, in August 2014, the Securities Commission Malaysia launched the sustainable and responsible sukuk framework to facilitate the financing of Islamic investment initiatives.

Asia is increasingly a focus for Islamic finance, especially in the global sukuk market, with 68 percent or $120 billion of total sukuk funds originating from the Asia-Pacific region. The sukuk market will play an important part in financing large-scale projects for infrastructure development in the region.

One of the most important issues is closer harmonization and mutual recognition of sharia interpretations of financial instruments across jurisdictions between Asia, the Middle East and Europe. Progressive harmonization that is properly supervised and regulated will be a driving force for internationalization of Islamic finance.

CLOSER COOPERATION BETWEEN CHINA AND HONG KONG IN RELATION TO SUPERVISION AND ENFORCEMENT ACTIONSSecurities regulators in Hong Kong and China signed agreements to increase cross-border cooperation on regulatory, supervisory and enforcement issues as part of the launch of the Shanghai-Hong Kong Stock Connect trading platform. The Securities & Futures Commission of Hong Kong (SFC) and the China Securities Regulatory Commission (CSRC) signed a memorandum of understanding in which they pledged to strengthen cross-boundary regulatory and enforcement cooperation.

This will increase regulatory oversight between China and Hong Kong and may prove effective in closing regulatory gaps. There also has been more regional cooperation between China and Australia, Malaysia and Japan.

PLANNING FOR FINANCIAL GLOBAL REFORMS AND CAPITAL REQUIREMENTSProposals made by the Financial Stability Board, which were endorsed at the recent G20 summit, will require global systemically important banks to hold additional loss-absorbing capacity that will further protect tax payers if these banks fail.

In Australia, the Financial System Inquiry final report emphasized the need to ensure that financial institutions were prepared for the next crisis and that regulators had the necessary resources and funds. In considering approaches of other governments and regulators, the FSI concluded that further crises would happen, and when they did, financial institutions needed to be better prepared and stronger to face them.

The reforms agreed at the G20 summit in Brisbane are to be implemented internationally during the next two years. Financial institutions will have to understand these considerations and start planning for them.

MARGIN REQUIREMENTS FOR NON-CENTRALLY CLEARED DERIVATIVES TO TAKE CENTRE STAGE IN ASIA Mandatory clearing of over-the-counter derivatives trades and margin requirements for non-centrally cleared trades in Asia are expected to come under the spotlight in 2015 as new regulations are put in place in a number of jurisdictions.

Hong Kong and Singapore both amended their legislation in 2014 to pave the way for OTC derivatives reform. Although neither jurisdiction has yet introduced a final set of regulations for mandatory clearing, Hong Kong is expected to do so during the first quarter of 2015, and take a phased approach.

Singapore amended its Securities and Futures Act in 2014 to prepare for OTC derivatives reform. The Monetary Authority of Singapore has not publicly announced when detailed regulation for mandatory clearing will be implemented, although market participants expect this to be some time in 2015.

MANDATORY REPORTINGMandatory reporting of OTC derivatives trades was a primary job for many Asian regulators last year. Singapore has adopted a phased approach and April 1, 2015 will be the first trade reporting deadline for market participants, beginning with banks that have foreign exchange derivatives contracts booked in the city-state. The same reporting deadline applies to banks that trade in interest and credit derivatives contracts. The MAS has also proposed that foreign exchange derivatives traded in Singapore must be reported by October 1, 2015.

Hong Kong has already implemented an OTC trade reporting regime for licensed banks. The reporting obligations will be expanded to include other institutions such as securities companies, which will begin trade reporting in the first quarter of 2015. Reporting obligations will be extended to other types of licensed entities in the fourth quarter of 2015. In Australia, the first reporting deadline for phase 3 entities with reportable OTC positions below A$50 billion will kick in on April 13, 2015, beginning with interest rate and credit derivatives products.


MARGIN REQUIREMENTS FOR NON-CENTRALLY CLEARED DERIVATIVESMargin requirements for non-centrally cleared derivatives were the most controversial topic at the end of last year. The Basel Committee on Banking Supervision and the International Organization of Securities Commissions had recommended that national regulators implement their rules on margin requirements for non-centrally cleared derivatives trades by December 1, 2015. The proposed deadline received massive pushback from market participants, who have called the deadline unrealistic.

The implementation timelines and the potential extraterritorial impact of rules that diverge from the standards set out by BCBS/IOSCO were the two main industry concerns in Asia. The European Union issued its consultation paper on margin requirements for non-centrally cleared trades in April 2014, while the United States followed with its consultation paper in October.

The European draft regulatory technical standards on margin requirements for non-centrally cleared derivatives, in particular, were criticized for their divergence from BCBS/IOSCO. Much time will be required to finalize the rules and ensure that the rules introduced in the various jurisdictions are harmonized. In Asia, the Hong Kong government had said it would aim to meet the December 1, 2015 timeline as recommended by BCBS and IOSCO, but no consultation paper has so far been released, nor has Singapore issued its consultation paper.

CHALLENGESThe fact that each jurisdiction plans to issue its own rules will complicate cross-border transactions, and it may prove hard to determine which margin rules apply to each type of transaction. Differences in margin requirements for uncleared swaps in individual jurisdictions will also govern the type of collateral that can be used and which entities will be affected. Moreover, the various jurisdictions in the region are currently at different stages of consultation on margin rules.

In Asia, relatively few types of instruments can be centrally cleared compared with the United States and Europe, so many derivatives trades have to be carried out on a bilateral basis. The Asia-Pacific region therefore has a higher percentage of non-centrally cleared derivatives trades. Market participants in Asia will need to post higher margins compared with market participants who clear their products through CCPs which require lower margin.

REGULATORS MAKE STRONG PROGRESS BUT MAY SEEK FURTHER OPPORTUNITIES FOR COOPERATION The stream of initiatives from the G20 and the Financial Stability Board, together with the continued need to meet the requirements imposed by U.S and EU legislation, have presented some particular challenges for the financial services industry in the Asia-Pacific region.

REUTERS | Ali Jarekji


BASEL IIIAsian banks are well prepared for the Basel III capital adequacy regime, which will begin to introduce higher capital standards over a four-year period from January 2015. In Hong Kong, banks have an average capital adequacy ratio of more than 14 percent, well above the Basel III requirements. Some problems may arise in terms of satisfying Basel III’s liquidity requirements, however, given the dearth of “high-quality” liquid assets that satisfy the regulatory requirements. Moreover, Hong Kong has introduced additional asset requirements to ensure the continuous stable funding of those banks which have considerably increased their credit exposure to the mainland China economy in recent years.

Hong Kong has also begun to implement a recovery and resolution regime for banks, in accordance with international standards set down by the Financial Stability Board. The first of several consultations on the potential regime has already been concluded, and so the territory enters 2015 ahead of its regional peers, many of whom are still only at the drafting stage.

NEW HONG KONG INSURANCE REGULATOR, IPO REGIME, DARK POOL RULESInsurers in Hong Kong will also face a more regulated future, with the territory’s new independent insurance regulator to begin operating in 2015. Until now, the insurance industry has been largely self-regulated, under the supervision of a thinly staffed government department. The arrival of the new regulator, in the planning for nearly a decade, has coincided with an effort by Hong Kong authorities to attract more insurers to the territory.

Investors and regulators will watch for an update on Hong Kong’s new regime for sponsors of initial public offerings (IPOs), which took effect in 2014, ushering in criminal liability for shoddy work in preparing IPO prospectuses. Hong Kong is also likely to see the emergence of new rules for trading in dark pools during 2015, with the SFC expected to make recommendations following an industry consultation in 2014.

INITIATIVES IN CHINA AND JAPANIn China, shadow banking and internet finance have continued to grow. The government has sought to support the growth of these companies, from curbside lenders to internet giants such as Alibaba, as an alternative to the already highly leveraged traditional banking industry.

The Chinese government will also introduce a deposit insurance scheme in 2015, the first of its kind in the country. The current proposal will cover deposits of up to 500,000 yuan ($81,395), or the entire bank savings of 99.63 percent of all depositors. The move will allow the government more leeway in seeking to liberalize interest rates and allow banks to compete on a wholly commercial basis.

With China recently having overtaken Japan as the second-largest stock market in the world, investors will be looking for an expansion of the Shanghai-Hong Kong Stock Connect program, which launched in late 2014.

Investors will also want to note China’s anti-corruption drive, which has shown no signs of abating as President Xi consolidates

his grip on power in China. Chinese authorities have stepped up their search for illegal assets stashed in overseas bank accounts, and have signed several agreements on information-sharing with overseas governments.

Meanwhile, the Japanese government will tighten its regulations on anti-money laundering and terrorist financing in 2015, having been criticized by the Financial Action Task Force (FATF) for a number of deficiencies in its current regime. In particular, FATF found that the criminalization of terrorist financing was incomplete, and that there was as yet no requirement for banks to conduct customer due diligence.

INFORMATION SECURITY AND DATA PRIVACYAcross the region, regulators and governments will be looking to impose stricter requirements for information security and data privacy, following a string of high-profile cyber attacks and data leaks in 2014. Hong Kong’s banking regulator has asked banks to complete a review of their existing customer data controls by the first quarter of 2015, and introduced new rules on data privacy. In South Korea, regulators announced new and tougher regulations for data privacy, following leaks of sensitive credit card information from firms doing outsourced work for banks. Increasing requirements to keep sensitive banking data “onshore” will not, however, be good news for developing economies such as India and the Philippines, which have traditionally served as outsourcing centers for the global financial industry.

Ultimately, Asia is a net importer of financial services, in that most of the region’s biggest banks are headquartered outside the region and many operate in several countries across Asia. They must juggle local and international regulatory demands, making implementation and regulatory compliance complex. Compliance with extraterritorial regulations such as the U.S. Foreign Account Tax Compliance Act can also be a challenge in some jurisdictions, given the risk of falling foul of local data privacy laws.

NEED FOR COLLABORATIONFollowing their successful collaboration over the last couple of years regarding the extraterritorial application of rules such as Dodd-Frank and the European Market Infrastructure Regulation, Asia-Pacific regulators are likely to be looking for more avenues for cooperation in the future. Whereas Asian jurisdictions once sought competitive advantages against one other, the global nature of financial services and the increase in G20 and FSB-driven regulation has led many to conclude that cooperation is vital for the future prosperity of the region.

While change will not come overnight, the increasing work being done by the Asia-Pacific Regional Committee of IOSCO and the growth of mutual fund passports around the region point to a future in which Asian regulators will seek more common ground and the opportunity to speak with a unified “Asian voice” in international regulatory matters.


FUTURE OF FINANCIAL ADVICE: THE UNCERTAINTY CONTINUESNot for the first time since the Future of Financial Advice (FOFA) reforms were proposed, financial advisers will again begin the year with uncertainty about the regulatory framework they will face. The FOFA regime has been in flux since it was first proposed five years ago. Industry figures have complained that advisers are now suffering from reform fatigue and need a period of regulatory stability to implement the FOFA changes.

Late last year some last-minute wrangling in the Senate thwarted the government’s controversial wind-back of key FOFA elements. Many commentators said the maneuvering of cross-benchers had been a significant win for consumers and had prevented attempts to water down the protections contained in the legislation. Others said the uncertainty regarding FOFA would continue given the government’s determination to resume pushing for its desired reforms in 2015.

The Senate’s disallowance means the FOFA provisions on conflicted remuneration, the “best interests” duty, the two-year opt-in requirement and the fee-disclosure requirements will all remain in place for the time being.

The Senate has agreed to pass some of the government’s non-controversial reforms that had secured bipartisan support. These include amendments to the grandfathering provisions; carving out education and training benefits from the ban on conflicted remuneration; amendments to the stamping fee provisions in relation to capital raising and investment entities; and an extension of the brokerage-related provisions of FOFA to the ASX24 futures market.

The Australian Securities and Investments Commission (ASIC) has said that it will take a “practical and measured approach” to enforcing the FOFA laws, given the continued uncertainty that advisers and other market participants have faced.

ASIC said that many Australian financial services (AFS) licensees would need to make system changes to take into account the Senate’s disallowance of the FOFA rollback. The regulator will take a facilitative approach to enforcement in particular areas, including fee disclosure statements and remuneration arrangements. “We will work with Australian financial services licensees, taking a facilitative approach until July 1, 2015,” ASIC said.

AUSTRALIA

REUTERS | David Gray

THE FINANCIAL SYSTEM INQUIRY: PICKING UP WHERE WALLIS LEFT OFF The Australian Financial System Inquiry’s (FSI) final report is likely to have the single greatest impact on the domestic regulatory front over the coming 12 months. The government has welcomed the FSI’s report, saying that its findings could improve regulatory independence and accountability and minimize the need for future regulatory change. Joe Hockey, the federal treasurer, has said the report will act as a “blueprint” to guide the financial system over the next decade.

More than one-third of the report’s recommendations sought to foster greater competition in the highly concentrated Australian financial sector. Regulatory recommendations included the establishment of a new Financial Regulator Assessment Board (FRAB) to advise the government on how successfully financial regulators have implemented their mandates. The report called on the government to give regulators a more stable funding outlook by committing to funding in three-year cycles and increasing their ability to pay competitive remuneration.

The report is expected to lead to ASIC securing a new user-pays funding model, which will lead to more stable budgets from year to year. The FSI has also acknowledged the high cost of compliance in Australia and stressed that the government needs

to lower the burden on regulated entities and give them more time to implement complex regulatory changes.

Banking sector resilience was another focus of the report’s recommendations. Given Australia’s reliance on offshore funding, the report said banks had to be “unquestionably strong” on a global basis. In practice, this would mean they need to be among the top 25 percent in the world in terms of capital adequacy.

The government has given the Australian Prudential Regulation Authority (APRA) the go-ahead to increase bank capital levels as appropriate, using its existing regulatory powers. Immediately after the report’s release APRA took steps to crack down on risky residential mortgage lending, saying that residential mortgages now comprised 65 percent of Australian banks’ balance sheets. During 2015 APRA is expected to crack down on high-risk lending practices, including interest-only loans, high loan-to-income loans, high loan-to-valuation (LVR) loans and loans with extended payment terms.

David Murray, who chaired the inquiry, said that the average mortgage risk weights in the banking system had fallen under the Basel capital accord’s internal-ratings-based (IRB) system. Murray said this exposure to residential mortgage lending had created a concentration of risk within the country’s banking system.

MEYRL DIETER GERMANY

The Thomson Reuters Governance, Risk & Compliance (GRC) business delivers a comprehensive set of solutions designed to empower audit, risk and compliance professionals, business leaders, and the Boards they serve to reliably achieve business objectives, address uncertainty, and act with integrity.

Thomson Reuters Accelus dynamically connects business transactions, strategy and operations to the ever-changing regulatory environment, enabling firms to manage business risk. A comprehensive platform supported by a range of applications and trusted regulatory and risk intelligence data, Accelus brings together market-leading solutions for governance, risk and compliance management, global regulatory intelligence, financial crime, anti-bribery and corruption, enhanced due diligence, training and e-learning, and board of director and disclosure services.

Thomson Reuters has been named as a category leader in the Chartis RiskTech Quadrant™ For Operational Risk Management Systems, category leader in the Chartis RiskTech Quadrant™ for Enterprise Governance, Risk and Compliance Systems and has been positioned by Gartner, Inc. in its Leaders Quadrant of the “Enterprise Governance, Risk and Compliance Platforms Magic Quadrant.” Thomson Reuters was also named as Operational Risk Software Provider of the Year Award in the Operational Risk and Regulation Awards 2013.

THOMSON REUTERS ACCELUS

For more information, visit accelus.thomsonreuters.com

© 2015 Thomson Reuters GRC02082/1-15

state of regulatory reform 2015: special report

Documents