Financial Services Authority asset management sector leader Dan Waters outlines the scope of the Turner Review, the FSA's view on the appropriate regulatory framework for hedge funds, and the impact on fund managers of the Internal Capital Adequacy Assessment Process, as well as the challenge of managing liquidity in open-ended funds.
The FSA published the Turner Review of global banking regulation last week. Our chairman, Lord Turner, was asked by the chancellor of the exchequer to review the events that led to the financial crisis and to recommend reforms.
The review identifies three underlying global causes of the crisis - macro-economic imbalances, financial innovation of little social value, and important deficiencies in key bank capital and liquidity regulations, underpinned by an exaggerated faith in rational, self-correcting financial markets.
In publishing a discussion paper alongside this review, setting out more detail on specific policy proposals, we are seeking to achieve five outcomes for the global banking regulatory and supervisory framework:
1. The global banking system is better capitalised and more resilient to liquidity shocks throughout the business cycle.
2. The regulatory framework in general, and its capital component in particular, are explicitly counter-cyclical.
3. Supervisory, crisis management and resolution arrangements for cross-border financial services groups are effective and reflect the interests of host countries as well as those of the home state.
4. Any material risks to financial stability posed by unregulated activities or firms are identified and controlled to the extent possible.
5. Macro-prudential and other risks to financial stability are identified at both the international and national levels and effective action is taken to mitigate them.
As the current crisis arose in the banking, investment banking and 'shadow banking' sectors, many of the policy proposals presented focus on these sectors. I do not intend to address the core areas of the review. Instead, I would like to highlight three areas of proposals which are likely to be of particular interest and relevance to fund managers: credit rating agencies, market infrastructure, and the scope of our regulation.
Credit rating agencies
Poor-quality credit ratings and poor use of credit ratings played an important role in the crisis. Credit rating techniques were extended from single name corporates, where they had worked well for decades, to complex structured credit products, where they performed badly. And the extensive use of ratings-based rules in investment and deposit placing - for example, where firms would only deposit money with a bank rated AA or above - introduced significant 'hard-wired' pro-cyclicality into the system.
We can and must fix some of these problems. There is a consensus among regulators globally that we should regulate credit rating agencies to ensure rigorous analytical independence, and ensure that they only rate instruments simple enough and with enough historic record to make consistent rating possible.
We can address some of the 'hard-wiring' concerns, but the use of ratings-based rules will continue, and so, therefore, will an element of pro-cyclicality, which we must offset by other means, such as countercyclical capital and liquidity policies.
Rating agencies and regulators should ensure that communication to investors about the appropriate use of ratings makes clear that they are designed to address credit risk, not liquidity or market price. These necessary improvements will not address the shortcomings in the use of ratings by the financial industry. It remains the responsibility of investors (and fund managers as their agents) to perform their own due diligence and research when making investment decisions and to use credit ratings responsibly. This is another illustration of the perennial truth that if you do not understand something, you should not invest in it.
Markets need to be appropriately transparent and resilient in order to underpin financial stability, as well as promote efficiency and investor protection. The crisis has highlighted questions about whether the rules and arrangements that govern the way that markets operate remain appropriate and effective. Our discussion paper discusses the robustness and effectiveness of the market infrastructure in supporting the trading process and reducing systemic risk, in a way that is appropriate to each asset class.
In particular, the FSA is reviewing whether there could be arrangements which more effectively support the holding and protection of client positions at clearing houses, and also whether the arrangements for settling defaulted OTC equity transactions could be improved. Part of this review aims to address fund management firms' concerns, raised strongly by the Investment Management Association, regarding difficulties experienced after the Lehman Brothers default. The discussion paper sets out proposals for strengthening clearing and settlement arrangements in light of this default and we look forward to receiving input from fund managers on this subject.
Scope of regulation
Although many of the causes of the current crisis originated within the regulated sector, the crisis also exposed risks that elements of the unregulated financial sector pose to financial stability, because of their connections, financial and reputational, to regulated firms, as well as the impact on market pricing of asset sales and other activity by unregulated entities.
The unregulated sector, for the purposes of the Turner Review, includes structured investment vehicles, conduits, and hedge funds. We acknowledge that the incentives to move activities outside the new regulatory boundary are an inevitable effect of the strengthened regulatory framework likely to emerge from the current debate. In anticipation of this, we propose that regulators take appropriate powers now.
Our objectives in this area can be summarised as:
• Supervisors must fully understand unregulated activities within otherwise regulated groups and regulated firms' exposures to unregulated entities, and take appropriate actions in line with the risks.
• There should be strong surveillance at a global level to identify risks from the unregulated sector to financial stability and the regulated sector.
• Supervisors should be able to request information from the unregulated sector to be shared with other supervisors.
• National authorities should have reserve powers to bring quickly new activities and entities into the regulatory perimeter.
Hedge funds - current FSA thinking
Hedge funds, as one type of potentially unregulated entity, have captured a certain amount of attention during the financial crisis, some of it misguided. In his Economist lecture in January, Lord Turner expressed the view - echoed in the review published last week - that while the rapid deleveraging by hedge funds in the latter part of last year may have played a non-trivial role in exacerbating financial instability, we are yet to see any concrete evidence that hedge funds have made a significant direct contribution to the underlying causes of the crisis.
This does not mean, however, that the effective regulation of the potential systemic impacts of hedge funds or clusters of hedge funds should not be an important part of the future regulatory framework at a global and national level.
It is unlikely that the current size or activities of any one individual fund results in any being systemically important individually. There is, however, broad consensus (including from the G20 working groups) that in aggregate, hedge funds can be a source of risk owing to their combined size in the market, maturity mismatches and their connectedness with other parts of the financial system. These are systemic effects which regulators need to understand, but where they face legal, structural and political barriers to the accurate assessment of the risks.
To overcome these barriers, there is global consensus that the institutional and geographic coverage of regulation needs to be reviewed and that its coverage should focus on the economic substance of institutions and vehicles and not legal form. We have been actively contributing to the debate taking place on the European and global stage as to how this coverage should be achieved.
The publication of a proposed directive by the European Commission in mid-April and the G20's London Summit on April 2 are the next key formal stages of the debate, which are likely to set the direction of travel for future work over the coming months and indeed years. The finer details of the regulatory framework are being developed by bodies including the European Commission, the G20 and the Financial Stability Forum.
The FSA considers the key components of an effective regulatory framework for hedge funds to be:
1. The mandatory authorisation and supervision of all hedge fund managers and systemically important hedge fund counterparties by the relevant regulator in their home domicile, including conduct of business, governance and prudential requirements (for instance in Europe appropriate elements of MiFID, CRD and MAD being extended to all hedge fund managers).
2. An enforcement regime in respect of fund managers, including hedge fund mangers and their counterparties, which creates credible deterrence, by the relevant competent regulator in their home domicile.
3. Regulatory powers to take remedial action where a hedge fund itself is domiciled offshore and poses a significant systemic risk that cannot be mitigated by direct regulation of the hedge fund manager and its counterparts.
4. Collection and sharing of data from hedge fund managers and counterparties and from other key market participants in systemically important or particularly vulnerable markets, for the purposes of identifying systemic and financial stability concerns.
5. Convergence in industry good practice standards at a global level, building upon the work already done by the Alternative Investment Managers Association and the Hedge Fund Standards Board in the UK and by counterparts in the US, to support but not replace an enhanced regulatory framework.
These components do not include proposals for the automatic direct regulation of hedge funds themselves in jurisdictions where they may trade. UK-domiciled hedge fund managers are authorised by the FSA and their business is subject to regulation and supervision under the relevant FSA rules and European directives. This includes prudential requirements on their capital and liquidity and the conduct of their business.
Hedge funds managed in the UK on the other hand, which are usually domiciled offshore, are not currently subject to UK prudential regulations affecting their capital adequacy and liquidity. We believe this is appropriate because hedge funds in general do not perform 'bank-like' activities. In particular:
• Leverage levels are in general (with some exceptions) far lower than those of banks.
• Hedge funds do not deal directly with the retail mass market but instead with professional sophisticated investors.
• They do not typically commit to providing investors with the ability to redeem on demand, instead retaining the right to invoke prohibitive redemption policies, such as gates and lock-ups, in the event of significant investor withdrawals.
• They are not performing the sort of contractual maturity transformation performed by banks and SIVs in the run-up to the crisis.
Hedge fund activity in aggregate can, however, have an important pro-cyclical systemic impact, which regulators need to understand. The measures I mentioned earlier, including particularly the collection of data from hedge fund counterparties and from key market participants in systemically important or particularly vulnerable markets, should enable regulators to understand the nature of this impact.
While hedge funds may not currently be 'bank-like' in their activities, it is possible that hedge funds could evolve in future years in their scale, their leverage and in their relationship and contractual commitments to investors, for instance in providing some sort of guarantee, in a way which could make them more bank-like and more systemically important.
There is wide-ranging political consensus that regulators need the power to apply appropriate regulation to hedge funds or any other category of investment intermediary or vehicle, or to otherwise restrict their impact on the regulated community, if at any time regulators judge that the activities have become bank-like in nature or systemic in importance.
If it ever did become appropriate to extend prudential regulation to hedge funds, the issue of the geographic coverage of regulation would become important, given that many hedge funds are domiciled in offshore financial centres. How to deal with these legal and practical challenges is an open question, but in any case global agreement on regulatory priorities should include the principle that offshore centres must be brought within the ambit of internationally agreed financial regulation, whether relating to the asset management, banking, insurance or any other sector.
'Business-as-usual' issues for fund managers
We recently completed the first iteration of our supervisory review and evaluation process of the capital adequacy assessments we have received from asset managers over the last 18 months. This process has brought the asset management industry into line with its banking and insurance counterparts which, in the latter case, have been undertaking Pillar 2 assessments for several years. While asset managers generally appear to have been meeting the substance of what we require under Pillar 2, going through the Internal Capital Adequacy Assessment Process for the first time has nevertheless been a challenge for many firms.
We will shortly publish an update to the observations we made in August 2007 on the early ICAAPs we received from asset managers. We are not seeking to be prescriptive in the approach firms should adopt but instead, to outline the common themes we have identified.
In completing the review and evaluation process, supervisors do not use a checklist against which to assess firms, but instead look for a rationale and justified explanation of the methodologies used and the conclusions arrived at by firms. The reviews undertaken by the firm (in the form of its ICAAP) and by the regulator (in the form of its review and evaluation process) are after all individual and therefore specific to the firm itself.
In some cases firms have not provided sufficient information in their ICAAPs to enable us to arrive at a judgement about the suitability of the approach taken. In publishing our observations we ask firms to consider them in undertaking further iterations of their processes
I would like to highlight three of these:
• Capital planning has not always included a sufficiently detailed analysis of the costs, risks or processes involved in winding-down or transferring regulated activities in an orderly manner, should an event occur which would trigger this course of action.
• Operational risk analysis has in some cases failed to quantity risk exposures at an appropriate confidence level and has made insufficient or inappropriate use of historical loss data, calling into question the robustness of the output produced.
• The calibration of stress and scenario tests has not always been appropriately severe and many base case capital forecasts have appeared overly optimistic. We see scope for firms to be more imaginative and demanding in their stress and scenario testing and to more closely embed this in integrated senior-management decision-making.
It has never been our intention to increase the level of capital requirements across the whole of the industry through our Pillar 2 assessment framework. We review each ICAAP on an individual basis and where we identify inadequacies in the process adopted, either in terms of its coverage or analysis, we will recommend additional capital to be held through the issuance of individual capital guidance. In some cases, we will also expect firms to undertake remedial or corrective action. Once this action has been taken, we will be able to remove that element of capital guidance from the firm at its next review and evaluation process.
Managing liquidity in open-ended funds
The case of the recent CF Arch Cru fund suspensions [involved] two non-Ucits retail schemes whose ultimate underlyings were illiquid assets. This is not the first open-ended fund suspension that we have seen during the current market crisis; other jurisdictions have seen a growing number of open-ended funds suspended as a result of liquidity problems.
Fund suspensions are a last resort for exceptional circumstances only. They are not a 'convenience' for dealing with problems caused by poor liquidity management of open-ended funds. We have recently consulted on proposals regarding liquidity and stress-testing for firms, but it is equally important that managers undertake proper liquidity testing within their schemes.
While used appropriately, suspensions act to protect the interests of all unitholders, but the detriment to individual investors who can no longer access their investment should not be underestimated. It is a reasonable expectation that an open-ended product should be accessible.
We expect managers to carefully consider, on an ongoing basis, the liquidity profile of both their current and potential future underlying investments, as well as the interaction with the scheme's overall liquidity requirements. Where a manager or depositary is concerned that a scheme is experiencing (or close to experiencing) liquidity stresses, we expect them to engage at an early stage with their firm's usual FSA contacts.
This is a slightly edited and abridged version of Dan Waters' address to the Future of Fund Management Conference in London on March 24.