Student Number: 2010982505

Regulation of Financial Markets

LLAW 3069
Dr. Emily Lee

Student Number: 2010982505

Word Count: 6441

Student Number: 2010982505 (1). Critically analyze how and why the credit crisis, sparked by Bear Stearns

default on subprime mortgage bond payments in summer 2007 and confined largely to the US/investment banking circles, could evolve and eventually turn into the global financial crisis of 20082009. (Please note that your discussion on the failures of those financial institutions in question and the domestic/international rescue which ensued should include important issues such as (a) systemic risk/crisis, (b) securitization (i.e., the originate and distribute model), (c) over-leverage, (d) market/credit/liquidity risks faced by financial institutions, (e) international repercussions, (f) policy/regulatory/legislative responses at both domestic (mainly the US) and international levels; the latter includes FSF/Financial Stability Board recommendations and G-20 meetings, after the financial crisis.) In the summer of 2007, two hedge funds ran by Bear Stearns faced difficulty meeting margin calls after the subprime mortgage collapsed, leading the investment firm to inject $3.2 billion in order to protect its reputation. However, by March 2008, the firm could no longer raise sufficient private capital to fund its daily activities and, with liabilities amounting to billions of dollars, faced bankruptcy. Fearing a collapse of the investment bank would set off a chain of financial institution bankruptcies, the Federal Reserve System collaborated with JP Morgan Chase to provide a $29.5 billion bailout for Bear Stearns. While there were many signals in the market before this event, the downfall of Bear Stearns marked the beginning of a global financial crisis that would shake the financial system worldwide and result in a global recession. Diagnosing the precise cause of the financial meltdown is by no means an easy task. In its "Declaration of the Summit on Financial Markets and the World Economy, dated November 15, 2008, leaders of the G-20 cited the various factors: During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the

Student Number: 2010982505 same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.1 Indeed, it was a combination of complex and interdependent factors that had caused losses in the subprime mortgage market to amplify into such large dislocations and turmoil in the financial markets. Background Against the backdrop of a bullish housing market and historically low interest rates between 20002006, the market was inundated with liquidity and many financial institutions were extending credit to subprime borrowers with FICO (Fair Isaac Corporation) scores lower than 6202 in the face of the increasing competition. Evidence of mortgage fraud and negligence were abound, with the number of reported cases of mortgage fraud growing from 3,500 to 28,000 during that period of time3. Housing speculation was rife, with housing prices nearly doubling between 200020064. At the end of 2007, the average U.S. household was highly leveraged, with the percentage of debt to annual disposable personal income hitting 127%5. This period of strong global growth,
1

Declaration of the Summit on Financial Markets and the World Economy (November 15, 2008) at 3, available at: http://georgewbushwhitehouse.archives.gov/news/releases/2008/11/20081115-1.html. 2 FICO score is the most widely used credit score model in the U.S., and prior to the lowering of the interest rates, a prospective loanee would generally require a FICO score of 620 and above in order to obtain a loan. 3 Alexandra Basak Russell, What Gave Rise to the Global Financial Crisis? (March 2010), available at: http://www.uiowa.edu/ifdebook/ebook2/contents/part5-I.shtml. 4 McKinsey & Company Inc., Valuation: Measuring and Managing the Value of Companies, 5th ed. (Koller, Tim et al. eds., 2010: New Jersey, John Wileys & Sons Inc) at 383. 5 http://www.stat.unc.edu/faculty/cji/fys/2010/subprime-mortgage.pdf at 4.

Student Number: 2010982505 growing capital flows, and prolonged stability paved the way for opportunistic financial innovations, which proved instrumental in creating vulnerabilities in the system. Securitization The implementation of the Basel Capital Accord in 1988 uniformed the regulation of the goal ratio between capital and risk assets, which provided a level for measuring the risk exposure of the international banking financial institutions. Under the Capital Accords framework, banks have two options to achieve the adequate capital ratio (1) by increasing the capital appearing in the numerators of the ratio, or (2) by decreasing the total riskadjusted assets appearing in the denominators. The financial innovation known as securitization meant that a bank could meet the level of capital-adequacy ratio on the surface by exploiting this regulatory capital arbitrage, viz, by reducing its total risk-adjusted assets and the regulatory capital requirements with little or no reduction in the overall economic risks. The advent of securitization heralded a new era in banking: the traditional banking model, in which the issuing banks held loans until they were repaid, gave way to the originate-and-distribute model, under which the originating institution, traditionally a bank or savings institution, will transfer mortgage titles to a special-purpose vehicle (SPV) or a conduit, a specialized institution that puts a large set of mortgages into a package and that refinances itself by issuing mortgage-backed securities. The securities are structured into different tranches bearing varying degrees of risks and therefore correspondingly different interest rates, which are then sold to investors with different propensities for risk. Hence, under the mechanisms of securitization, the originating institution is able to divest itself of the interest rate risk that is associated with real-estate finance and fragment it by distributing it into the hands of a large pool of investors who are supposedly in better positions to bear this risk, as some investors actually have longer investment horizons. The result it that the originating institution is able to issue more loans, thereby boosting bottom lines by generating more transaction fees. In theory, the purpose of securitization, viz, to substantially improve the allocation of risks in the worldwide financial system, is a worthy and legitimate one. However, why securitization did not fulfill its theoretical underpinnings and instead contributed ultimately

Student Number: 2010982505 to the global credit crisis was a result of at least four factors. First, given that other investors bore a substantial part of the risk, originating banks essentially faced only the pipeline risk of holding a mortgage for a few months until the risks were passed on. Under such circumstances, they had little incentive to be prudent and instead had greater impetus to engage in highly profitable but risky strategies, particularly against the backdrop of growing investor demand for subprime loans packaged as AAA bonds. Indeed, the originating banks were speculating on a continuous hike in housing price and mortgage borrowers continuing to repay their mortgage. Furthermore, as evidenced by the US$23.9 billion in bonuses paid to Wall Street executives in 20066, there was clearly a huge financial incentive to engage in risky strategies. Second, the system was taken to excess. Securitization buttressed banks returns by freeing up capital that they would normally have to hold against an asset for profitable lending operations. Whereas credit was previously limited because a banks balance sheet was fully extended by the mortgages and other loans it held, with the advent of securitization, the limits on credit were boundless as long as investors kept purchasing the securitized packages. As such, both originators and securitizing institutions were more interested in generating volume rather than ensuring quality control. Third, many of the mortgage-backed securities ended up in the portfolios of highly leveraged (the ratio of debt to equity or the rate at which an investor uses borrowed money to finance further transactions or investments.) institutions that engaged in substantial maturity transformation (the process of converting short-term liabilities into longer-term assets) and relied on international money markets for constant refinancing. The danger with such maturity transformation is that in the event of any shock to the availability of funds for refinancing, such an institution would face liquidity issues since it will not have the requisite funds to pay off its short-term debts. Fourth, in the event, the international money markets for refinancing these highly leveraged institutions disintegrated when their liquidity issues started to become apparent. Systemic Crisis

Office of the State Deputy Comptroller, New York City Securities Industry Bonuses (December 19, 2006), available at: http://www.osc.state.ny.us/press/releases/dec06/bonuses1206.pdf.

Student Number: 2010982505 The magnitude of the losses stemming from the flaws in subprime mortgage finance and securitization which led to the eventual collapse of this system should have been more contained but for the systemic linkages and repercussions. The pervasiveness of these systemic linkages can be attributed to various factors. Firstly, the markets absorbed huge amounts of these securities. With the AAA ratings being ascribed by the credit rating agencies to most of these securities, market confidence was extremely high. Pension funds, money market funds, mutual funds, banks and investors from all over the world purchased these securities thinking that they were low-risk. As for the as for the riskier securities, they were no short of clientele either, viz, the hedge funds. At the end of 2007, global issuance of collateralized debt obligations stood at a staggering US$1.2 trillion7. Secondly, as alluded to earlier, many commercial and investment banks were highly leveraged, expanding the scale of their operations far beyond what the equity base could support. Many of these highly leveraged institutions depended on international money markets to fund their maturity transformation activities. When the rating agencies instituted a mass downgrade of hundreds of mortgage backed securities in 2007, growing apprehension over the securities actual values and the solvency of institutions that were holding them rippled throughout the economy. As a result of the ensuing fragile confidence, interbank lending markets dried up and refinancing broke down. In addition, many of these commercial and investment banks like Bear Stearns, whose portfolio was largely constituted by asset-backed securities, faced cash or collateral calls from lenders that had accepted asset-backed securities as loan collateral. Thirdly, should such institutions not be able to find alternative funding sources to meet their immediate debt obligations, they must either deleverage or sell off their longterm assets in a highly depressed market at firesale prices. This will cause a market wide depression of the price of the assets sold, affecting every institution holding such assets in its portfolio. When these institutions are not able to generate sufficient liquidity through the firesales to cover their debt obligations, their collapse will set off a chain reaction. Thus when Lehman Brothers went bankrupt, it exerted domino effect through contractual links on clients, sponsors, creditors and the insurers of the risk that Lehman Brothers might
7

International Monetary Fund, Global Financial Stability Report: Containing Systemic Risks and Restoring Financial Soundness (April 2008) at 56.

Student Number: 2010982505 default, notably AIG. Consequently, the impact of the subprime mortgage crisis was magnified several times throughout the entire highly interconnected financial system. Domestic Responses In the wake of the financial crisis, the U.S. Federal Reserve and various central banks around the world have pursued expansionary monetary policies to avert the risk of a deflationary spiral reminiscent of the Great Depression. By the end of 2008, these central banks had purchased at least US$2.5 trillion worth of government debt and troubled private assets from various affected banks, constituting the largest liquidity injection into the credit market in world history. In addition, governments have enacted large fiscal stimulus packages to offset the deflation in private sector demand caused by the crisis. The U.S. has executed two stimulus packages, totaling nearly $1 trillion during 2008 and 2009. Governments have also bailed out a conglomerate of organizations such as Fannie Mae, Freddie Mac, Citigroup and Bank of America. International Responses The sheer magnitude of the meltdown has prompted various initiatives on the international level. In April 2008, the Financial Stability Forum (FSF) delivered a report8 to the G7 Finance Ministers which details out its recommendations for enhancing the resilience of the financial markets and financial institutions. These recommendations include: (1) strengthened prudential oversight of capital, liquidity and risk management9, with particular emphasis on revisions to the Basel II capital rules and new standards for liquidity; (2) enhancing transparency and valuation10, with particular emphasis on risk disclosures by market participants and accounting and disclosure standards for off-balance sheet entities; (3) changes in the role and uses of credit rating11, with particular emphasis on
8

Financial Stability Forum, Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (April 7, 2008), available at: http://www.financialstabilityboard.org/publications/r_0904d.pdf. 9 Ibid at 1221. 10 Ibid at 2231. 11 Ibid at 3239.

Student Number: 2010982505 establishing rules for the proper role and conduct of rating agencies, and encourage proper use of the ratings by investors; (4) strengthening the authorities responsiveness to risks12, with particular emphasis on developing supervisory colleges for financial institutions; and (5) robust arrangements for dealing with stress in the financial system13, with particular emphasis on establishing less stigmatized mechanisms designed for meeting frictional funding needs. The subsequent meeting of the FSF in October 2008 extended its focus to four new areas, viz, (1) improving international interaction and consistency of emergency arrangements and responses; (2) mitigating procyclicality; (3) addressing the scope of financial regulation to emphasize currently unregulated aspects; and (4) better integrating macroeconomic oversight and prudential supervision14. When the G-20 met on November 15, 2008, it established five main principles to guide reform, viz, (1) strengthening market transparency of complex financial products and accountability of financial institutions that sell these products; (2) enhancing the regulatory regimes, prudential oversight, and risk management over financial markets, products and participants; (3) promoting and preserving the integrity of the worlds financial markets, as well as promoting global information sharing; (4) reinforcing international coorperation through regulatory consistence; and (5) reforming international financial markets like the Bretton Woods Institution, the FSF and the IMF in order to increase their legitimacy and effectiveness15. Finally, in the second G-20 meeting on April 2, 2009, the leaders, in addition to their continued commitment towards implementing the action plans set out in November 2008, pledged to restore confidence, repair the financial system, strengthen financial regulation, reform international financial institutions, promote trade, and build sustainable recovery. Significant progress towards reforming international financial regulation was made at this summit, with the G-20 agreeing to rename and reconstitute the FSF as the
12 13

Ibid at 4044. Ibid at 4549. 14 FSF, Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience: Follow-up on Implementation (October 10, 2008) at 2, available at: http://www.financialstabilityboard.org/press/pr_081009f.pdf. 15 G-20 Declaration of the Summit on Financial Markets and the World Economy (November 15, 2008) 3, available at: http://www.iasplus.com/crunch/0811g20declaration.pdf.

Student Number: 2010982505 Financial Security Board (FSB) and expanding its membership. It was also decided that the FSB and International Monetary Fund (IMF) would provide warnings of financial risk and take necessary actions needed to address them. Also agreed was a global approach towards financial sector compensation and the setting of international standards for accounting sectors and credit rating agencies. Further, the G-20 also issued the Declaration on Strengthening the Financial System, which urged the FSB to maintain financial stability by enhancing transparency of financial products and institutions, implementing international financial standards and undertaking periodic reviews. The leaders also emphasized the importance of international cooperation in addressing failure of cross-border financial institutions. With respect to prudential regulations, the 8% minimum international capital adequacy ratio standard would remain unchanged, and the Basel II capital framework would be adopted. The G-20 also set new liquidity, capital and leverage standards to promote strong liquidity buffers at financial institutions. As for the scope of regulation, the G-20 regulators would be empowered to gather relevant information on all material financial institutions, markets and instruments in order to assess the potential for their failure to contribute to systemic risk. The FSB and IMF would also issue guidelines for national authorities for assessment of financial institutions, markets and instruments. Finally, disclosure requirements on the part of taxpayers and financial institutions with respect to transactions with non-cooperative jurisdictions were made more stringent, while international institutions and regional development banks were required to review their investment policies.

Student Number: 2010982505 (2)(1). Whether amendments to the Basel II Accord (i.e. Basel III Accord) can effectively help curb future financial crises? What possible impact would Basel III Accord have on (a) BANKING regulation and supervision, (b) CORPORATE GOVERNANCE, and (c) FINANCIAL CONGLOMERATES? The Basel Committee on Banking Supervisions decision to strengthen the existing capital requirements and to introduce a global liquidity standard will no doubt reinforce the capacity of banks to withstand another financial crisis. Basel III will increase the minimum common equity requirement, the highest form of loss-absorbing capital, from 2% to 4.5% of risk-weighted assets by January 2015. While requiring that capital be held in the form of common equity as opposed to a broader capital measure is very onerous, it addresses one of the primary weaknesses of the previous regime, viz, capital requirements of certain activities were partly or entirely covered by subordinated debt which did not absorb losses on a going-concern basis. In addition, banks will be required to hold a capital conservation buffer of 2.5%, so as to enable banks to better withstand periods of economic and financial stress, bringing the total common equity to 7%. The capital requirements are also countercyclical, so in times of economic prosperity where aggregate credit growth is excessive, regulators are empowered to require banks to increase their capital levels to a higher ceiling of 9.5% as a macroprudential measure. The definition of equity is also tightened to exclude things like minority investments from equity and retained earnings, some tax credits, and goodwill. So in effect, many banks would need to raise equity requirements to over 10%. On paper, therefore, Basel III triples the quantum of capital that banks will need to maintain. However, there are significant drawbacks to the new regime. Firstly, the transition period of Basel III is, perhaps exceedingly, lengthy. Banks have until 1 Jan 2015 to get their common equity capital to 4.5% of risk-weighted assets, and up to 1 Jan 2019 to reach the full 7%. Thats more than eight full years, and if history, which suggests that the financial industry faces a crisis typically every 710 years, is anything to go by, then there is certainly real risk of an interim crisis. It is arguable nonetheless that most banks may feel pressure to show investors that they can comply with the new regulations sooner rather than later in order to ensure that they are not disadvantaged in raising capital.

Student Number: 2010982505 The second and principle failure of Basel III can be described as merely rearranging the Titanics deck chairs instead of providing effective regulatory measures capable of preventing another financial shipwreck. What contributed to the precipitation of the credit crisis and ensuing bank bailouts of 2008 was not that the preceding Basel II capitaladequacy requirements were too low, but rather that the banks had found a way to circumvent the rules. One of the key components of Basel II was to increase the amount of capital banks had to hold against riskier assets, and extremely low-risk assets, meanwhile, could be held with very little or even no capital. Risk, moreover, was calculated primarily by reference to the rating assigned by one of the recognized ratings agencies, an issue which Basel III failed to address, unlike the Dodd-Frank Act in the United States. As the subsequent crisis proved, ratings are a very poor indicator of an assets riskiness. The consequence of this Basel II reform was to disincentivize lending to risky enterprises, and to encourage the stocking up on apparently risk-free assets. This was one of the primary contributors to the systemic financial meltdown, as securitization was a way to "manufacture" apparently risk-free assets out of risky clusters. What brought banks like Citigroup and Bank of America to their knees was not direct exposure to sub-prime loans, but exposure to AAA-rated securities backed by clusters of such loans. Basel III, instead of improving on the failures of Basel II, perhaps has the perverse effect of amplifying its unintended negative externalities. Since banks will now need to hold more common equity against their risk-weighted assets, the incentive to find low-riskweight assets with some return is greater, since these assets can be leveraged much more than risky assets. To illustrate, if a bank lends to a start-up business, it would require 8% in capital; on the contrary, if it lends that money to the government of a sovereign rated AAA to AA like Greece instead, then the bank needs only 1.6% in capital, therefore being able to leverage its capital 62.5 times to 1. One can only imagine what impact a sovereign default would have on the lending bank and the financial sector as a whole. While Basel III introduces a simple 3% leverage ratio of Common Equity to Total Assets as a backstop to the risk-based measures, this still translates into an uncomfortably high maximum leverage of 33 to 1. To put things into perspective, Lehman Brothers levarage was 30.7 to 1 just before it went into liquidation16. What the Basel Committee explicitly ignored was
16

Lehman Brothers Holdings Inc Annual Report at or for the year ended November 30,

Student Number: 2010982505 the fact that perceived risk of default is already cleared for in the market by means of the risk premiums charged and so making a difference for it in the capital requirements accounts twice for the same risk. This in turn causes access to those perceived as less risky be even easier and cheaper, creating perfect storm conditions, as financial crises have historically, as evinced by the recent financial crisis, only occurred as a result of excessive investments or lending to what is ex ante perceived as low risk. The lack of address on the issue of incentivization, which is part of corporate governance, is also not addressed, and thus the moral hazard associated with excessive risk-taking by bank executives is not eliminated. Furthermore, Basel III does not adequately address shadow-banking practices. As evidence by the financial crisis, the Basel II rules gave rise to a derivatives market to allow banks to circumvent the capital rule by transferring risks to entities beyond the jurisdiction of bank regulators, such as to an insurance sector in a least regulated jurisdiction, via derivatives such as credit default swaps. In addition, there was no attempt to harmonize accounting standards on all non-banking entities such as special purpose vehicles, pension funds and derivative nettings, leaving accounting practices to vary so vastly that they do not lend themselves to any reasonable basis for comprehension or comparison. Hence, there is a powerful argument for making the leverage ratio the primary capital control tool instead of a backstop. However, the probability of regulatory oversight over unforeseeable risks always exists. Consequently, regulators need to be dynamic in their response to changes in the marketplace, and anything that appears to be low risk but generates healthy returns should raise a red flag. Banks will remain vulnerable unless rules-based regulation of the kind propagated by the Basel Committee is supplemented by proactive and competent supervision.

2007, available at: http://fclass.vaniercollege.qc.ca/~laroccag/FOV1-00043009/FOV100051364/Lehman%20Brothers%20yr%202007%20Annual%20Report.pdf? FCItemID=S002288FE&Plugin=Loft.

Student Number: 2010982505 (2)(2). How can IAIS Insurance Core Principles and Methodology (Oct. 2003) be expected to improve insurance regulation and supervision? Will the new proposal in Hong Kong for the establishment of an independent insurance authority help achieve the goals set out by the above-mentioned IAIS Insurance Core Principles? In October 2003, the IAIS revised and adopted the Insurance Core Principles and Methodology (ICPM) for the purpose of clarifying essential principles that need to be in place for a supervisory system to be effective and sound. In turn, an effective and sound regulatory and supervisory system is necessary for maintaining efficient, safe, fair and stable insurance markets which benefit and protect policyholders and for promoting growth and competition in the sector. The IAIS set out twenty-eight Core Principles subsumed under 7 aspects of insurance industry regulation and supervision, viz, (1) conditions for effective insurance supervision; (2) the framework of the supervisory system; (3) the scope of supervision over the supervised entity; (4) requirements for on-going supervision; (5) prudential requirements of supervised entities; (6) supervision of intermediaries and market integrity preservation and protection; and (7) combating money laundering and funding of terrorism. These principles provide a basis for the evaluation of insurance legislation, supervisory systems and procedures. The ICPM also explained the need for insurers to implement sound and prudent reinsurance management practices, the mismanagement of the risks of which can threaten an insurers financial soundness and, ultimately, damage its reputation. The ICPM not only expanded its scope from its predecessor, it also emphasized the element of implementation of the principles and standards therein, which is crucial to the improvement insurance regulation and supervision. As explained at paragraph 11, the ICPM can not only be used to establish or enhance a jurisdictions supervisory framework, it can also serve as the basis for assessing the existing supervisory framework and in so doing may identify weaknesses, some of which could affect policyholder protection and market stability. The self-assessment on observance of standards therefore allows the insurance supervisor, and in some instances the government, to initiate an appropriate strategy for improving insurance supervision.

Student Number: 2010982505 The Hong Kong government issued a Consultation Paper in July 201017 on its proposals to set up an independent Insurance Authority (IA) with powers, functions, and autonomy in accordance with international regulatory standards. Legislation facilitating the establishment is expected to be tabled in the Legislative Council in 2011. ICP 1: The establishment of an independent IA is to maintain the stability of the insurance industry and protect the interests of existing and potential policyholders18. The Insurance Companies Ordinance (ICO) governs the insurance industry. The independence of the Hong Kong judiciary is constitutionally entrenched and alternative dispute resolution is widely available. Accountancy is regulated by the Hong Kong Institute of Certified Public Accountants under the Professional Accountants Ordinance. Hong Kong has a Census and Statistics Department that provides adequate, relevant, reliable and timely statistics for reference by the Government and various sectors of the community. Hong Kong is a major global financial centre with sturdy financial infrastructure. ICP 2: The independent IA will be established to maintain the stability of the insurance industry and protect the interests of existing and potential policyholders. The independent IA shall also seek to strike a reasonable balance between regulation and market development, and enhance the competitiveness of the insurance industry. It shall perform its regulatory functions on a par with international standards and having regard to local circumstances, without stifling market innovation necessary for promoting market efficiency and diversity19. ICP 3: the independent IA is to be established with the view of being given regulatory, operational and financial independence subject to reasonable safeguards. It will be given necessary powers to discharge its statutory functions effectively and financed independently on a full-cost recovery basis by the 6th year of operation. Staff will be recruited from the open market in order to attract, retain and motivate people with the right skills, caliber and experience. The Governing
17

Financial Services and the Treasury Bureau, Proposed Establishment of an Independent Insurance Authority (July 2010), available at: http://www.fstb.gov.hk/fsb/ppr/consult/doc/consult_iia_e.pdf. 18 Ibid Executive Summary 2. 19 Ibid Executive Summary 2.

Student Number: 2010982505 Board would comprise predominantly non-executive directors, who could be appointed by the Government from a cross-section of the community including relevant professional fields, the Consumer Council, the academia and Government20. Confidentiality was not addressed. ICP 4: A statutory appeals tribunal to be established to handle appeals from insurers and insurance intermediaries against relevant decisions made by the independent IA. Apart from that, the supervisory process was generally not delineated. ICP 5: There would be robust communication and collaboration arrangements between the independent IA and other regulators in order to bridge any regulatory gaps and minimize duplication of efforts21. ICP 6: Insurers are currently required to be registered under the ICO in order to carry on insurance business in Hong Kong. The mechanism of such communication was not delineated. ICP 7: Not addressed. ICP 8: Not addressed. ICP 9: Not addressed. ICP 10: Not addressed. ICP 11: Not addressed. ICP 12: Not addressed. ICP 13: Not addressed. ICP 14: The independent IA should be given the necessary powers to discharge its statutory functions effectively22, but the scope of these powers have yet to be legislatively defined. ICP 15: The independent IA will be given the necessary powers to discharge its statutory functions effectively23, but specific details pertaining to enforcement or sanctions are yet to be specified. ICP 16: These are provided for in the ICO.
20 21

Ibid 7.2. Ibid 7.7. 22 Ibid 2.6(b). 23 Ibid 2.6(b).

Student Number: 2010982505 ICP 17: The definition of an insurance group is specified in s.2 of the ICO. Groupwide supervision was generally not addressed. ICP 1823 (Prudential Requirements): Not addressed ICP 24: The independent IA would exercise direct supervision over the conduct of insurance intermediaries through the introduction of a licensing regime 24. The purpose of direct supervision is to ensure the professionalism and therefore quality of the intermediaries, thereby enhancing public confidence25. It will also enable the independent IA to adopt a more pro-active approach in following up complaints by policyholders and misconduct of individual intermediaries26. Also, a range of disciplinary powers is to be given to the independent IA as well as the Hong Kong Monetary Authority27. As noted28, detailed transitional arrangements for the smooth migration of existing insurance intermediaries to the licensing regime would have to be worked out in consultation with the industry, and outstanding criteria that have to be met under the ICPM include requiring intermediaries who handle clients money to have sufficient safeguards in place to protect those funds, and requiring intermediaries to give information on their status to customers. ICP 25: The independent IA is to assume the additional function of organising public education programmes to raise literacy among potential and existing insurance policyholders regarding the features and risks of insurance products, in order to facilitate informed decision-making by policyholders29. No mention about the minimum requirements for insurers and intermediaries in dealing with consumers was made. ICP 26: Not addressed. ICP 27: Not addressed. ICP 28: The IA will be empowered to enter into premises of the regulated entities to conduct inspections; initiate and pursue investigations; make enquiries; have access to records and documents; apply to the Court of First Instance for court
24 25

Ibid 5.7. Ibid 5.10. 26 Ibid 5.10. 27 Ibid 5.11 and 5.14. 28 Ibid 5.10. 29 Ibid 3.3(b).

Student Number: 2010982505 orders to compel compliance with the reasonable requirements imposed by the independent IA in the course of inspection and investigation; impose supervisory sanctions; and prosecute offences summarily30. As seen, much work still needs to be done in order for the proposed independent IA to be in observance with the ICPM and therefore achieve its goals of achieving an effective and sound regulatory and supervisory system through the guiding principles. Specifically, much of the principles regarding on-going supervision and prudential requirements must be observed, as they mostly went unaddressed in the Consultation Paper. Also, the issues of information, disclosure and transparency towards the market as will as fraud will need to be addressed. Additionally, various principles will need slightly more work in order to achieve full adherence, such as the need to delineate the minimum requirements for insurers and intermediaries in dealing with consumers was made, make specific the scope of enforcement powers, specify confidentiality policies as well as the mechanisms for interregulatory body communications. That said, the proposed model is an improvement from the previous one in terms as there is independence of funding as well as regulatory and operational independence. Independence is important to the achieving of the aforesaid goals as it enhances the credibility and effectiveness of the supervisory process31.

30 31

Ibid 4.7. ICPM 3.3.

Student Number: 2010982505 (3). Using examples from class lectures and the readings, please assess the

ramifications of increasing convergence or harmonization in international securities law for the regulatory objectives of investor protection, fair and efficient markets and systemic stability. Outside research is allowed but not required. There has been increasing consensus on the need for a globally harmonized securities regulation regime, particularly in wake of the recent financial crisis. As it has been noted, [o]ur markets are now interconnected and viewing them in isolationas we have for so longis no longer the best approach to protecting our investors [and] promoting an efficient and transparent [markets]32. Significantly, while securities are, in the modern world, almost universally circulated by way of book-entries in securities accounts, the legal effects of such entries still vary significantly across jurisdictions. The various governing rules for the transfer of securities and the creation of interests therein manifests a significant legal risk for investors who want certainty as to whether, and when, the securities have been validly transferred or the interest become enforceable by third parties. The combination of interconnected markets and assorted legal rules entails a significant degree of operational and systemic risks for the participants-investors, secured lenders, securities borrowers and lenders, and their intermediaries at all levels in the securities market. One area of securities regulation where efforts towards convergence have been actively pursued is international accounting standards. National accounting standards provide an essential means of disclosing critical information for the valuation and comparison of companies. With standardized national accounting practices, a basis on which performance of a multinational can be evaluated and compared internationally is provided. The function of investor protection is therefore served by the provision of comparable financial information that is crucial in assisting investors make informed investment decision. For instance, differences over fair-value accounting, which requires companies to mark financial assets to current market value, can skew calculations of banks risk-weighted assets and equity, the numerator and denominator of the capital-ratio
32

Ethiopis Tafara and Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework (2007) 48 Harv. Intl. L.J. 31 at 32.

Student Number: 2010982505 equation agreed to by the Basel Committee on Banking Supervision in September 2010. The result is that a U.S. bank and a European bank with identical loans could nonetheless end up having different capital ratios. Hence, convergence of accounting practices would enable investors to better compare lenders within and outside of the U.S., as well as allow regulators to better assess systemic risk. Many countries have already converted to and implemented the International Accounting Standards Board (IASB)s accounting standards (IFRS). The United States, however, continues to utilize the U.S. Generally Accepted Accounting Principle (U.S. GAAP), although the U.S.s Financial Accounting Standards Board (FASB) signed a Memorandum of Understanding with the ISAB in 2006 (reaffirmed in 2009), agreeing, inter alia, that the boards will work towards converging the IFRS and U.S. GAAP, with convergence in the areas of accounting for financial instruments, revenue recognition and leases to be achieved by 2011. However, not all efforts at convergence have further the objectives of securities regulation. In the wake of the recent market turmoil, many financial institutions wanted to reclassify their assets out of the trading and available-for-sale categories into the held-tomaturity category because their intentions for the investments had changed due to the declining markets and they did not want to suffer the write-downs under fair value accounting rules. In 2008, the IASB issued a revision to permit reclassification, which is permitted in rare circumstances under U.S. GAAP, under IAS 39 n the same circumstances as are available under FAS 157. Such convergence only leads to decrease transparency as there is even less price critical information reaching the market, therefore reducing investor protection. Another area of securities regulation in which harmonization has been avidly pursued is international disclosure standards. In 2002, the IOSCO published, in connection with the secondary retail investment securities market, the Principles for Ongoing Disclosure and Material Development Reporting by Listed Entities. This move towards adopting a uniform standard for ongoing disclosure enhanced transparency by eliminating ongoing disclosure requirement discrepancies between jurisdictions, placing investors on greater parity with listed entities from conforming jurisdictions in terms of information available. Investors can consequently access reliable and relevant information in a timely

Student Number: 2010982505 fashion, thereby creating a more level playing field for market participants, facilitating better decision-making and enhancing investor protection. Regulators will also be able to make appropriate systemic risk assessments and take corresponding responsive actions with greater access to relevant and timely information. Efforts have also been made recently to address the differences in regulatory standards over certain financial products like off-the-counter derivatives. Such discrepancies result in a lack of transparency, which has demonstrated devastating systemic impact in the recent financial crisis33. The move towards harmonization came in the form of the Disclosure Principles For Public Offerings And Listings Of Asset Backed Securities released by IOSCO in 2010. Such a move enhances transparency, therefore resulting in greater systemic stability and investors protection internationally. The actual effects of improved disclosure on investor protection are, however, questionable. The basic assumption is that investors with fair access to information will make rational choices, rational in this context meaning the capacity to use the information disclosed to act in their own best interests in market transactions. Nonetheless, behavioral economics has questioned whether disclosure in itself is sufficient to overcome particular human decision-making tendencies that inhibit the ability to be rational in market transactions34. Hence, the effects that harmonization disclosure rules may actually have on investor protection may be limited. The harmonization of regulatory regimes also improves investor protection through more effective enforcement mechanisms. Cross-border securities transactions have surged in recent years due to, inter alia, innovations in technology, thereby increasing investment opportunities for investors. However, this has also been met with an emergence of various cross-border challenges, such as the perpetuation of novel types of cross-border market manipulation and other fraud, inappropriate uses of exotic financial products, and extreme market conditions that exacerbate the impact of regulatory non-compliance by market participants. A harmonized securities regulation regime in the area of enforcement, as
33

Douglas Arner, The Global Credit Crisis of 2008: Causes and Consequences (January 1, 2009) AIIFL Working Paper No. 3 at 44. 34 See John R. Nofsinger, The Psychology of Investing (Upper Saddle River, NJ: Pearson Prentice Hall, 2005); M. Condon, et al., Securities Law in Canada, (Toronto: Emond Montgomery, 2005) at 87.

Student Number: 2010982505 sought to be achieved by IOSCO when they created the Multilateral Memorandum of Understanding Concerning Consultation and Cooperation and the Exchange of Information (IOSCO MOU) in 2002, will allow securities regulators to transcend national borders and obtain from another jurisdiction information, including statements and documents, that may be relevant to investigating and prosecuting potential violations of laws and regulations relating to securities transactions, thus effect international enforcement with more ease and speed. Despite the aforementioned positive effects on the principles of investor protection and systemic stability, the move towards an internationally harmonized financial regulatory system eliminates, to a large extent, the competition of states for the best regulatory regime. The quality and content of financial products are determined to a large extent by the domestic legal system under which they are created. This gives rise to regulatory arbitrage, which creates a competition of systems. The benefits of such competition derive from the notion that poor regulatory decisions resulting from either over-regulation or under-regulation as well as bureaucratic inefficiency will be punished through the capital markets, whereas more effective regulation will be rewarded. This plays a crucial role in the efficiency of financial markets as it cannot be said with certainty what constitutes an optimal level of regulation. The investors ultimately decide what balance between public oversight and private liberty they think is most appropriate to the risks involved. A uniform set of regulations that eliminates competition therefore deprives regulators of this "laboratory" effect, whereby regulators can assess the merits of regulatory approaches undertaken by other countries and adopt those approaches that best satisfy their unique mix of culture, legal environment and other considerations. Furthermore, instead of reducing the probability of financial fallout, a uniform global financial regime would possibly have the opposite effect of increasing the risk of global failures. There is considerable uncertainty regarding how best to measure financial institutions and instruments risks and contribution to systemic risk, particularly because such risks are dynamic and change with the business environment. Such uncertainty exacerbates the risk that regulators will get things wrong, as under a globally harmonized regime, regulatory error can result in heightened systemic risk. Regulatory incentives lead financial institutions worldwide to adopt similar business strategies, and when such

Student Number: 2010982505 strategies fail, they do so on a global basis affecting financial systems across the world, thereby precipitating a global financial crisis. Thus, no longer would there be safe havens that are more insulated than others, such as Spain or Italy who were relatively unaffected by the repercussions of the financial crisis in 200709. Moreover, it would no longer be possible to empirically determine, compare and evaluate the performance of different systems. Improvements could only be suggested in a theory, without being able to test their viability in practice. As such, a certain degree of decentralization or localization of financial law has inherent advantages. Not only does it work as a permanent laboratory in which different degrees and methods of legislation and supervision are tested, it also sets the stage for a system of multilayered or multilevel governance in the financial area. Under this system, regulation and supervision can be better adapted to the peculiarities of local markets and at the same time comply with the need for a uniform framework. In addition, regulatory arbitrage, a byproduct of regulatory diversity, provides a valuable hedge against systemic failure. Nevertheless, some have argued that it is exactly this type of international competition that must be eradicated through international consistency of regulation that regulation should be used to "level the playing field" among nations and avoid a "race to the bottom" or the least regulated markets, where arbitrage opportunities exist. Indeed, as stated by the U.S. Treasury Department, as we have witnessed during this crisis, financial stress can spread easily and quickly across national boundaries. Yet, regulation is still set largely in a national context. Without consistent supervision and regulation, financial institutions will tend to move their activities to jurisdictions with looser standards, creating a race to the bottom and intensifying systemic risk for the entire global financial system.35

35

U.S. Treasury Department, Financial Regulatory Reform: A New Foundation, Published June 17, 2009 at 8.