Emily Vogl, Frank Vogl
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Global Finance Leaders Release Comprehensive Proposals to Strengthen the Financial Industry and Financial Markets
Leading firms provide detailed response to the turmoil in global financial markets - the Institute of International Finance releases the Final Report by its Committee on Market Best Practices
Washington DC, July 17, 2008 — The world's leading financial services firms today released a far-reaching report 1 detailing best practice reforms for the industry. The report represents the global industry's response to the turmoil in financial markets that was triggered by the U.S. subprime mortgage market crisis in mid-2007.
Today's 200-page report is published by the Institute of International Finance, the association of leading financial services firms with more than 380 members across the world. The report proposes Principles of Conduct together with Best Practice Recommendations on critical issues such as risk management, compensation policies, valuation of assets, liquidity management, underwriting and the rating of structured products as well as boosting transparency and disclosure.
In presenting the report, Dr. Josef Ackermann, Chairman of the IIF Board of Directors and Chairman of the Management Board and the Group Executive Committee of Deutsche Bank AG, speaking on behalf of the IIF's members, said: "We believe that the implementation of this report's recommendations will serve to strengthen the financial services industry and, as a result, will help to restore confidence. Our challenge is to move forward with implementation, and we are determined to do just that." 2
Dr. Ackermann said, "The industry recognizes the need to improve its performance, and we have already seen many firms introduce better practices. Our report, which enjoys strong and widespread support, adds to the momentum for reform." The report stated that firms are committed to undertaking regular, critical self-assessment and to adjusting plans and policies accordingly.
Mr. Rick Waugh, President and CEO of Scotiabank, who co-chaired the IIF's Committee on Market Best Practices (CMBP) that developed the report, confirmed, "While a number of firms are already meeting many of the leading practices, it is clear the financial sector as a whole needs to do much better. Taking measures in line with the Principles of Conduct and the Recommendations that we have proposed in this report will not only serve as a significant contribution to best practices, but as a platform and reference point for going forward." 3
The CMBP was established nine months ago by the IIF's Board of Directors. CMBP co-chairman Cees Maas, Honorary Vice-Chairman and former CFO and CRO, ING., stated that: "The Final Report has been developed and reviewed by many of the leaders in our industry. More than 100 senior executives from over 65 leading firms participated in the work of the Committee and in its six working groups as we considered very important and complicated issues. We are confident that many leading firms will now move forward to put the Committee's proposals into action." 4
Dr. Ackermann added, "This report is not intended to be an exercise in self-regulation. We recognize that it is essential for the industry to reform and that there is an emerging consensus on the benefits of reinforcing these efforts through effective regulatory incentives and structures."
Mr. William Rhodes, First Vice Chairman of the IIF's Board of Directors and Chairman, President & CEO, Citibank N.A., and Senior Vice Chairman, Citigroup Inc, noted, "This report is most timely. We are seeing continued volatility in financial markets against a background of slowing growth in a number of major economies and rising inflation. It is especially important that confidence be restored in the financial sector. Many firms have already taken steps, for example, in the risk management area, and now the collective implementation of the proposals in the new report will make a further significant contribution to this objective."
Dr. Ackermann pointed out that the report also highlights proposals to help reduce the risk of crises in the future. He said, "We are establishing a global financial Market Monitoring Group (MMG) for the better and earlier detection of new, emerging vulnerabilities in the markets and the financial system. This represents a major initiative. It is clear that timely warnings about possible future weaknesses or declining standards will have to be given a higher priority going forward."
At a press conference at the National Press Club today, Dr. Ackermann emphasized that: "The central issue for improved performance by financial services firms is risk management. The Committee has placed the highest priority on this subject." The report's first Principle of Conduct stated: "A robust and pervasive risk culture throughout the firm is essential. This risk culture should be embedded in the way the firm operates and should cover all areas and activities, with particular care not to limit risk management to specific business areas or to have it operate only as an audit or control function."
Mr. Waugh explained that: "Risk management should be our core expertise and what determines, to a large extent, our individual success as firms and ensures a positive contribution to efficient financial markets. The best firms have gotten this right more times than not. Those who strive to be the best will see it is to their advantage to implement these best practices as it relates to their own circumstances."
He added, "Our industry has made mistakes, and for some this has been very costly, but our industry's role and expertise is essential in the financial markets and for the future of growing global economies. There is a need in many institutions, we believe, for improved oversight by boards of directors on risk management and for strengthening senior management engagement in both current risk issues and in forward-looking strategic risk management analysis."
The report contains extensive risk management recommendations. It notes that firms should make clear that senior management, in particular the CEO, is responsible in this area and that the CRO has the ability to influence key decision-makers in the firm "with the mandate to ascertain that the firm's risk level is consistent with its risk appetite and provide a thoughtful, integrated view of the overall risks the firm faces."
The recommendations also note that stress testing should be an integral part of assessing the bank's risk profile in relation to its risk appetite across all business activities, risk types and exposures. The report also emphasizes that firms should ensure that risk management does not rely on a single risk methodology.
In a speech today to the National Press Club, Dr. Ackermann discussed the issue of compensation policies in financial firms and noted, "Incentive pay was one of the weaknesses in business practices, and will require the industry to exercise greater self-discipline on compensation-related issues." He added, "We are convinced that adoption of the Principles on Compensation that we have set out will play a meaningful role in strengthening our industry and ultimately public confidence."5
Dr. Ackermann stated that establishing improved Principles of Conduct in this area represents an unprecedented effort by the industry in this domain. He noted that some firms have already taken actions that are in line with the report and said, "We believe our proposals can make a real difference as firms move ahead on this issue."
The Principles of Conduct on compensation include the following:
- Compensation incentives should be based on performance and should be aligned with shareholder interests and long-term, firm-wide profitability, taking into account overall risk and the cost of capital;
- Compensation incentives should not induce risk-taking in excess of the firm's risk appetite; and
- Firms should take into account the performance realized for shareholders over time in determining severance pay.
The report underlines that the severity and persistence of the liquidity strains in financial markets after July 2007, particularly at the longer end of the money market, were unprecedented and generally not anticipated. A fundamental problem leading to adverse market conditions was that the market did not recognize how sensitive investors providing market liquidity would be to the issues of asset quality and credibility of ratings for structured vehicles such as conduits or to assurances of short-term access to funds invested in such vehicles, regardless of either the term of investments or the legal structure of transactions.
The report stressed that it is important for firms to ensure implementation of the recommendations that were detailed by the IIF in March 2007 in its report, Principles of Liquidity Risk Management. The findings of that report have been updated and supplemented in the CMBP Final Report. Mr. Waugh said, "Just as it is important to create a strong risk culture in each firm, it is also important to create a well-understood and resilient liquidity culture, so that liquidity issues and costs are taken into account in planning, product design and decision-making."
Market Monitoring Group
Speaking at the National Press Club, Dr. Ackermann announced that the IIF is establishing a global financial Market Monitoring Group (MMG) for the better and earlier detection of new, emerging vulnerabilities in the markets and the financial system.
He said, "The timely assessment of market developments with systemic implications by a select group of senior executives from our industry and seasoned veterans in global finance can contribute to better risk management by financial services firms. By drawing on the wealth of its members' experience, the MMG can contribute to a greater awareness of the potential areas of systemic stress. What is unique about this approach is that the input will be from market participants and experienced practitioners."
IIF Managing Director Charles Dallara stated, "The report noted that the MMG will focus, inter alia, on perceived mispricing of risk, crowded trades and concentration risk, and take into account potential contagion among markets. The MMG is envisioned to include individuals reflecting a broad and balanced mix of functional responsibilities, institutions and geographic regions with a combination of current market experts and seasoned veterans in global finance. Findings of the MMG meetings are expected to be presented to the IIF Board and communicated to IIF members, and would be available for use by member institutions as input to their risk-management processes and business decision-making."
Lending, Due Diligence and Ratings
The report highlights a range of shortcomings in lending and due diligence practices, and it makes extensive proposals. Mr. Rhodes noted, "Mortgage brokers were arranging loans, and non-bank originators were often making loans, without applying bank-equivalent lending standards. With a particular focus on the U.S., our report recommends that non-bank institutions involved with originating mortgages should be held to the same standards as banks."
Mr. Waugh, commenting more broadly, stressed that: "Our report is blunt in suggesting that our member financial institutions involved in the originate-to-distribute process should make sure adequate due diligence is conducted at all stages to maintain the integrity of the process. Indeed, financial institutions should apply the same credit due diligence for structured products that they plan to originate and distribute as they do for similar assets that are to be carried on the firm's own balance sheet. We should not only ensure this, but investors should demand this and factor it into their investing decisions."
The report highlights the need for improvement by underwriters and distributors, as well as ratings agencies. Mr. Waugh pointed out that the work of the rating agencies has been found wanting, particularly with regard to structured financial products. The CMBP concluded that the market needs to be assured that the agencies maintain a robust procedure for reviewing and validating their models and assumptions, and that they have adequate resources to do this. It is also proposed that there should be an external, independent evaluation of the processes used by the agencies in order to restore market confidence in ratings, which play an important role in global finance.
Valuation and Considerations for the Official Sector
Mr. Maas stated at the press conference that the proposals in the report aim to assist firms to maintain robust valuation processes in accordance with applicable accounting and regulatory guidance, incorporating critical expert judgment and discipline as well as the most appropriate inputs available. He said, "We suggest that firms need to ensure consistent application of independent and rigorous valuation practices, and they need to apply expert judgment and discipline in valuing complex or illiquid instruments, making use of all available modeling techniques as well as external and internal inputs, such as consensus pricing services, while recognizing and managing their limitations."
In addition to major recommendations to the industry, the report's authors noted agreement with the Financial Stability Forum when it suggested in its April report that: "further work (involving the industry, standard-setters and appropriate regulators) is needed to provide confidence that valuation methodologies and related loss estimates are adequate, to clearly highlight the uncertainties associated with valuations and to allow for more meaningful comparisons across firms."
Mr. Maas explained that the CMBP endorsed pursuing a short-term technical dialogue among firms, auditors, rating agencies, investors, analysts, accounting standard-setters and supervisors to enhance understanding of valuations, exchange views on technical questions about valuations in difficult markets and discuss how best to summarize for disclosure the uncertainties, assumptions, adjustments and sensitivities of valuations in the mark-to-market environment, especially where indirect inputs are used or valuations are based on models.
Mr. Maas underscored that: "Fair-value accounting remains an essential element of global capital markets fostering transparency, discipline and accountability." He pointed out, however, that there is a need for an open-ended dialogue involving all the stakeholders that would include clarification of all the issues that arise in illiquid markets. He said the Committee is pleased to note that the International Accounting Standards Board has already launched an expert group to study technical questions of valuation.
Transparency and Disclosure
At the core of many of the proposals in the report is the need for firms to enhance transparency and disclosure. As the report noted: "In the wake of the credit market turmoil, the Committee recognizes that restoration of confidence requires more accessible and useful information about products and transparency on the part of firms."
Important Principles of Conduct that relate explicitly to transparency and disclosure in the report include the following:
- The content and clarity of firms' disclosures as well as the comprehensiveness of coverage are of primary importance.
- Risk disclosures should provide the clearest possible picture of a firm's overall risk profile and the evolving nature of risks as well as salient features of the risk management processes.
- Global standardization and harmonization of market definitions and structures are essential for the future development of the structured-products market.
- In fulfilling disclosure mandates, firms should ensure that disclosures include the most relevant and material risks or exposures arising under current market conditions at the time the disclosure is made, including off-balance-sheet risks or exposures, especially for securitization business.
- Firms' public disclosures should include substantive quantitative and qualitative information about valuations, valuation processes and methodologies, assumptions, sensitivities and uncertainties.
1 "Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations. Financial Services Industry Response to the Market Turmoil of 2007-2008," published by the Institute of International Finance
2 "Opening Statement of Dr. Ackermann", July 17, 2008
3 "Opening Statement of Mr. Waugh", July 17, 2008
4 "Opening Statement of Mr. Maas", July 17, 2008
5 "Dr. Ackermann's Address to the National Press Club", July 17, 2008
Emily Vogl, Frank Vogl