The world's leading financial services firms are implementing far-reaching operational and governance reforms as they draw key lessons from the financial crisis. "The scale of the reforms being put in place in the financial industry is substantial," said Dr. Josef Ackermann, Chairman of the Board of Directors of the Institute of International Finance (IIF), Chairman of the Management Board and the Group Executive Committee of Deutsche Bank AG.
The IIF today published, "Reform in the Financial Services Industry: Strengthening Practices for a More Stable System - The Report of the IIF Steering Committee on Implementation (SCI)." The SCI Report is co-chaired by Mr. Richard Waugh, President and CEO of Scotiabank, and Mr. Klaus-Peter Mueller, Chairman of the Supervisory Board of Directors of Commerzbank AG.
Today's report includes an Ernst & Young survey based on interviews with chief executives, chief financial officers and chief risk officers at 38 banks, with additional information from a further 10 firms. The report provides the most comprehensive private-sector analysis to date of the far-reaching governance and operational changes that banks have pursued in light of the global financial crisis.
Mr. Waugh told a press conference here, "The financial industry is committed to carrying forward reforms. The actions that the industry has already taken provide solid grounds for beginning the process of restoring public confidence. To be sure, a great deal more needs to be done and we underscore this in our new report. Nevertheless, firms have drawn important lessons from the crisis and they are institutionalizing reforms as they make improvements in risk management practices, including risk governance and culture, controls, information analysis and stress-testing methodologies."
Not "Business as Usual"
Mr. MÅ±ller stated, "Today's report shows how the financial industry is establishing a reformed financial framework, addressing critical weaknesses in past practices, striving to restore investor trust and confidence in the financial industry, and responding to changes in requirements by national authorities. The reforms undertaken by financial firms so far are significant. Sometimes we hear that banks have gone back to -˜business as usual' but, as the analysis in the SCI Report attests, this is not the case."
Dr. Ackermann said, "The SCI Report highlights industry reform trends in compensation practices. While it is clear that a lot more work is needed in this area, today's report underscores that there is progress, and that the leading edge of current efforts in many firms reflects the first of the July 2008 IIF compensation principles, which stresses that incentives should be based on actual performance and aligned with shareholder interests and long-term, firm-wide profitability, taking into account overall risk and the cost of capital."
Dr. Ackermann added, "As we have said previously, the leadership of the IIF believes that as firms determine the levels of compensation it would be useful for all of us to recognize that the recent rise in profitability at many firms is attributable in part to exceptional support from governments and central banks and the impact that this has had on markets."
The SCI's work has involved senior executives from 48 firms and many more industry experts, including specialists in compensation. In July 2008, the IIF's Committee on Market Best Practices (CMBP) published its final report, containing extensive recommendations for reform, and the SCI Report assesses the extent to which firms have implemented recommended reforms in critical areas. These assessments and the progress that has been made are placed within the context of official regulatory reform developments. The report includes a range of recommendations in areas where firms may find that additional guidance will be helpful. In addition, the report notes key issues that governments, regulatory authorities, and auditing standard-setters should consider as they finalize new measures.
In commenting on its findings, Ernst & Young said, "The strong message from the firms surveyed was that the industry had indeed moved quickly to carry out assessments against the recommendations, particularly in the countries most affected by the crisis. Most firms in these countries had identified a substantial number of gaps and had instituted programs of work to address them. Another core message was these programs would be ongoing for several years or more."
Risk Management & Governance
A large part of the SCI Report relates to reforms taking place in the areas of risk management and governance. IIF Managing Director Charles Dallara stated, "The scale and speed of reforms in the governance and operations at major banks has been formidable. As a result, we can now confidently state that significant core changes will be accomplished by the end of 2009."
Mr. Dallara added, "The industry will keep working on continuous improvement, not just because of the impending regulatory changes, but because there's a commitment to building more resilient institutions that can withstand future shocks, as well as to rebuilding capital and profitability so that sufficient credit can be generated to sustain global economic recovery. The landmark July 2008 CMBP Report emphasized that strengthening risk management will take considerable time to become embedded in industry practice. It is crucial that firm managements now persevere with implementation in this important area. The sections of today's SCI Report dealing with this issue and the discussions of risk appetite, risk culture, models and cyclicality, will help firms further advance their own ability to manage risk and so contribute to systemic stability."
A review of industry practices (including the survey by Ernst & Young) showed that the majority of firms are enhancing the role of the CRO and the risk function. Specifically, firms have taken concrete steps to give the risk function a greater say in the development of corporate strategy and the development of new products. There is wide recognition in the industry that it is essential that the CRO have a strong voice and the ability to escalate any issue to the top of the firm for resolution by the CEO or, as appropriate, the board, taking full cognizance of the risk dimensions of the decision.
Risk governance changes are being made to increase board oversight of risk, along the lines of several of the IIF's recommendations. The SCI concluded that emerging trends are likely to develop into consolidated industry practices. Moreover, the SCI expects that many of the changes now being seen in firms are likely to be reinforced by emerging regulatory requirements. The Basel Committee is working on updating its guidance document "Enhancing Corporate Governance for Banking Organizations" and the IIF's Corporate Governance Working Group is contributing to its debates.
Some Key Risk Management Findings of the Ernst & Young Survey
- Reassessment of Internal Systems and Processes: All banks surveyed had undertaken an internal review of systems and processes in light of the losses incurred during the financial crisis.
- Senior-Level Oversight of Implementation Efforts: There was strong board and senior executive support for implementation efforts at most banks surveyed. In general, remedial action was a priority and a top-down, firm-wide approach was being taken to identify gaps.
- Specific areas of improvement in risk management included:
- Improved stress testing: A great deal of work is being done to improve stress testing, because some banks recognized that, prior to the financial crisis, stress testing had been rather limited and scenarios had been relatively simplistic. There is a desire to incorporate diverse financial and economic variables, and firms recognize the need to improve the reporting and analytics around stress-testing scenarios and that development of better systems and improved data will take time.
- Better liquidity management: Changes are being made to the measurement and management of liquidity risk, which is now being fully integrated in overall risk management. Chief Risk Officers (CROs) are increasingly playing a role in setting a formal liquidity policy, driving larger liquidity buffers.
- Improved risk measurement: Firms are becoming less reliant on credit ratings. Established metrics such as value at risk (VaR) and economic capital are being supplemented by new measures. However, substantial information technology (IT) investment is still required to provide the data and management information necessary to support the judgments that are the essential adjunct to risk management metrics.
The SCI found that some firms have revised their risk appetite approach in its entirety (in many cases, starting from scratch where no formal approach to identifying and articulating risk appetite previously existed). Others have focused on developing effective mechanisms to ensure that a clearly articulated risk appetite, translated into workable risk management parameters, permeates the different business and product lines in the firm.
The SCI Report noted that significant reforms in risk management relate to the quality of risk information available to senior management. Improvements that are now evident relate to strengthened internal risk models, better data on off-balance-sheet risks, improved underlying data quality, and streamlining risk reports to make information clearer. Moreover, noteworthy reforms have been made in stress-testing to improve both risk management and liquidity management in line with the CMBP Report's recommendations.
Mr. Dallara said, "Firms are moving toward a more comprehensive and systemic approach to stress-testing. Ad hoc approaches are being discarded, and robust approaches, solidly embedded in ongoing risk management frameworks, are increasingly the norm. The linking of stress-testing to the formulation of the risk appetite of the firm, as well as the integration of liquidity risk management, is having extremely positive effects on the robustness of stress-testing methodologies."
The SCI's findings point to an array of new practices used by boards to perform their oversight role. This is reflected in new governance trends such as:
- Greater risk management expertise among board members;
- Significant increase in board time devoted to risk-management issues;
- Strengthening risk management focus in board committees;
- Improved quality of information that is reported to boards on risk issues; and
- More direct involvement by boards in the definition of the firm's risk appetite and the discussion and analysis of stress testing exercises.
The broad conclusion of the SCI Report is that while compensation reform remains a difficult issue, it is being tackled responsibly by many firms in line with the guidance issued by the Financial Stability Board (FSB) and the requirements of national regulators. Much is being done to defer incentive compensation and to align it with long-term shareholder interests. The SCI underscored that a fully successful outcome will require that the official sector act resolutely to ensure a level playing field. The SCI and the IIF will continue to monitor developments and press for the implementation of best practices. Oliver Wyman, for example, will be undertaking a survey of industry compensation practices next spring.
Mr. Klaus-Peter MÅ±ller stressed that, "It is important to underscore that firms are improving corporate governance structures related to compensation policies and practices. Speaking as the chairman of a supervisory board of directors I can attest to the priority that boards are now giving to all aspects of compensation policy. The information obtained by the SCI suggests that there is a growing consensus in the financial services industry on the key goals of better aligning compensation with long-term performance as well as empowering boards to enable them to ensure that compensation practices are fully consistent with overall firm risk management strategies. The majority of firms already meet, or are close to meeting, the standards on how compensation should be determined that are emerging from a variety of national regulators, from the EU and from the FSB. Nevertheless, we recognize that reforms at many institutions will only be completed in the course of 2010."
Mr. MÅ±ller added, "I particularly want to underscore that many of us on the boards of directors of financial institutions are acutely aware of public concerns about compensation in our industry. We recognize how sensitive this issue is at a time of very heavy unemployment."
Some of the SCI Report's conclusions on reforms in the compensation area include:
- Firms have begun to revise and improve payout structures to align with risk appetite and long-term safety and soundness. Reforms are being seen at many banks that involve, for example, deferral periods being extended to ensure greater alignment with medium-term overall corporate performance. In addition, there has been widespread discontinuation of multi-year bonus guarantees. Fewer firms are offering "golden parachutes."
- Boards are increasing their involvement in approving compensation policies and setting guidelines for executive compensation, as well as aligning compensation with the firm's risk strategy. Boards are more greatly involving the risk functions in the compensation processes; back testing new compensation processes to ensure they do not encourage adverse behavior; and, ensuring that compensation of the risk and control functions is independent of the business areas they oversee.
The SCI Report noted that senior managements have become much more involved in the liquidity risk management process. Not only are managements seeking out a more top-down, group-wide view of their liquidity positions, but they are also reviewing business models in light of the changed market conditions in order to incorporate the appropriate funding costs in light of the "real" liquidity costs in external markets instead of the cheap funds that were available in the run-up to the crisis.
Liquidity risk is getting stronger consideration when it comes to business strategy. Managements are seeking to create a more ingrained culture of liquidity risk awareness across the firm. Improvement in internal pricing of liquidity is also a major focus of financial firms now.
Valuation and Ratings
The SCI Report indicated that firms have been actively engaging in addressing valuation process issues highlighted by the crisis, on a basis consistent with the CMBP Report's recommendations. Financial institutions also have been working to extend their sources of valuation inputs and improving the utilization of pricing services or broker quotes. In addition, firms are in the process of streamlining valuation systems and technology platforms for financial instruments of similar characteristics, thereby enhancing the consistency of the valuation process. There is a marked increase in the involvement of the CFO and risk functions in assisting with valuation issues and in the control and validation of valuations. Firms have also added additional resources to develop teams, independent from the front office, to review valuations. Moreover, the accounting standard setters have issued guidance that has helped clarify many of the issues about valuation in difficult markets.
The report stated that firms will continue to adapt their valuation approaches in line with guidance from the official authorities and decisions taken by the accounting standard-setters. The SCI stressed the importance of the current debate over the use of fair-value measurements and noted that convergence of major accounting standards is of the utmost importance. The SCI pointed out that short-term or local issues should not be allowed to impede progress toward a fully converged international framework, one that is globally acceptable to all constituents and fully reflective of the nature and use of financial instruments.
On credit ratings, today's report stated that firms are strengthening their internal processes to reduce reliance on ratings. The SCI acknowledged that, despite shortcomings, it is impossible to eliminate references to ratings, particularly in investment mandates or guidelines for money managers. It stated that there appears to be some progress with educating the market as to the purposes and limitations of ratings, which may help prevent blind reliance in the future.
Transparency & Disclosure
Today's SCI Report pointed out material improvement in the approaches of firms to transparency and disclosure, including through Pillar 3 disclosures of internal risk management issues, including with respect to off-balance-sheet exposures, as mandated by Basel II.
Together with industry initiatives to reform securitization and other enhancements of product disclosure, firms are working toward developing more transparent, liquid, and standardized markets for securitized products. The SCI stated that important work has been pursued to establish standards for increasing transparency in the securitization markets by the American Securitization Forum (ASF) and the European Securitization Forum (ESF). Moreover, a range of detailed initiatives are now underway to improve the operation of the OTC derivatives market, including CDS.
Between these private-sector initiatives and ongoing public-sector work to which the industry is providing input, such as recent CEBS and IOSCO reports on transparency, and accounting changes that are being developed, the transparency both of products and of firms will be substantially enhanced compared with the period before July 2007, addressing the concerns raised by the IIF and by the various G20, FSB and other public-sector reports about deficiencies of transparency as a cause of the crisis.
Mr. Waugh stated, "Reform has to be an ongoing process. In the course of the work of the SCI over the last year we have learned a great deal about many of practical issues related to strengthening practices in the financial industry. We are seeing encouraging reform trends unfolding across the industry. Our SCI Report today underscores the need for firms to further review their operations and to consider, as appropriate, additional actions. The fact is that changes in many areas will take time-”they are complicated and will involve substantial resources. However, we believe there is a solid base today for confidence in the industry's commitment to continue to build on the efforts so far to institutionalize risk management reforms."
Mr. Dallara pointed out that, "This report and the IIF's Restoring Confidence Report, published in July 2009, together with the recommendations of the July 2008 CMBP Report, present an industry view on building a new financial world. The combination of effective regulatory reform and the efforts by the industry to lift its own standards can lead to a more resilient global financial system."