Gathering momentum

Changes to the current global financial architecture are needed in order to make it fit for purpose for today's markets. David Green, co-author of Global financial regulation: the essential guide, explains

In the first half of 2007, Howard Davies and I wrote a book suggesting the system of international financial regulation was no longer fit for purpose. We made recommendations as to which reforms might be made before the existing arrangements found themselves tested to the limit by a crisis that demonstrated just how far global markets have changed from when the current architecture of regulation was designed.

In the event, the current turmoil started to unfold just as we were finishing the book. How far has the response been in line with the recommendations we made? What still needs to be done?

We looked at the extremely complex architecture for financial decision-making at the international level, which had never been mapped before, and concluded in the summer of 2007, before the crisis struck, that the still largely sectoral international decision-making structure for regulation no longer corresponded to the realities of the marketplace.

Channels of financial intermediation had changed. No longer did most business flow through the balance sheets of banks or insurance companies, or through a limited range of investment funds usually dealing in products trading on regulated markets. There had been an explosive increase in world wealth held privately, which had led to the creation of a wide range of non-traditional investment vehicles funded by high net worth investors on an informal, largely unregulated, basis. New instruments had emerged which made it possible to transfer risk on a far larger scale and in more complex ways.

We judged last summer that 'while these instruments make it possible to lay off risks over a vastly greater range of risk-bearers, which probably increases the system's resilience, they also mean that when risks crystallise they may well have an impact in hitherto unfamiliar places, anywhere in the globe. They may make it easier to ride through small crises, but larger ones will have many more dimensions of which we currently have no knowledge'.

Inadequate structure

We had several concerns: that the international supervisory infrastructure to address these changes was inadequate or over-complex, with obscure relationships between the bodies; there was lack of leadership by organisations of questionable legitimacy; emerging markets were inadequately represented or not at all; there was confused accountability; there were too many warnings; and there was too little action.

Many of our recommendations, of which only a few are discussed here, relate to reforms of the existing infrastructure dealing with the conventional business of banking, securities and insurance. We concluded, for example, that the role played by sovereign wealth funds in providing capital to the leading global financial firms provided a sharp reminder of the need to amend more generally the global institutional structures for regulation to provide proper representation for those whose interests are at stake. The need to bring China, as well as other countries, into full membership of the key groups has become more urgent.

At the same time, we also devoted some attention to judging the extent to which concerns that were being expressed about less traditional forms of financial intermediation had validity. So we looked, for example, at how the regulation of hedge funds and private equity (as well as Islamic finance, which we also discuss in our book) fitted into the global regulatory architecture. In relation to the first two of these, we concluded that some of the concerns expressed were addressed, at least in principle, by existing regulation. For instance, the market and investment advice activities of alternative investment vehicles are covered by existing legislation in relation, say, to market abuse.

Lending to such firms by regulated banks and insurance companies is, in principle at least, covered by existing prudential requirements.

In general, retail investors are protected in relation to access to such alternative investments. If there is a concern about shareholder activism, and particularly private capital interfacing with publicly quoted companies, the debate goes far wider than financial regulation and is essentially about the nature of contemporary capitalism. The financial stability aspects of the behaviour of such entities are capable of enhanced surveillance by the financial authorities and this is increasingly being done.

Nevertheless, underlying all of this is the need for reliable financial reporting across all companies of public interest, wherever they are located, on an internationally comparable basis. Without this, many of the other tools for risk assessment by the private sector or by regulators can be seriously undermined. The credit crunch has brought the issue of financial reporting to the fore, encompassing accounting, actuarial and auditing standards.

Unlike in the international committees, which set standards in banking, securities and insurance, the standard-setters in both accounting and auditing have never been representatives of national regulators. Thus, there remains a fundamental question about how these standards are set and how the standard-setters should be held accountable.

Setting standards

In both the accounting and the auditing field, more needs to be done. International accounting standards are no longer set by those regulated, but satisfactory arrangements for ensuring there is adequate input from key stakeholders, without the risk of inappropriate interference of national governments, have not yet been achieved. In the case of international auditing standards, the accounting profession itself is still formally responsible for setting the standards.

In the case of both accounting and auditing, there need to be fully independent standard-setting boards and adequate arrangements to oversee the standard-setting process. The funding of the standard-setters should be provided through the budgets of the national authorities responsible for accounting and audit regulation rather than from the current unsatisfactory ad hoc group of accounting firms and corporations. Further legitimacy could be added to this process by making the standard-setting structure ultimately accountable to the Financial Stability Forum, which brings together the finance ministries, central banks and regulators of the most important financial markets. It would then be possible to put the audit, accountancy and, in due course, actuarial standard-setters within a single overarching framework, perhaps by extending the remit of a reformed IASC foundation.

In the insurance field, no potential independent international actuarial standard-setter exists. However, public interest oversight of the standard-setting process has been introduced in countries such as the UK and the steps being taken there and elsewhere to bring core principles to bear in the setting of actuarial standards will need to develop into moves to generate international standards, particularly as cross-border insurance groups need to develop a consistent group-wide approach to risk assessment and measurement.

Financial reporting depends not just on the audit standards, but also the auditors themselves. Independent regulation of the audit industry has been introduced over the last few years in a number of countries and is becoming increasingly common in emerging as well as developed markets. Many of the audit firms being overseen at the national level will form part of the global audit firm networks. These networks exercise a powerful influence over audit quality across the globe and their brand reputation is crucial. At the same time, the global firms' international networks remain outside national oversight. The national regulators, which have only relatively recently banded together into the International Forum of Independent Audit Regulators, will need to decide how they can collectively address this gap in the oversight system, whether through some sort of college or a form of consolidated supervision.

This gap is potentially important because the high degree of concentration in the market makes it vulnerable to the loss of one or more of the networks because of contagion arising from a major financial or legal hit to part of the network and a confidence run leading to loss of clients of the kind which destroyed Arthur Andersen after Enron. Loss of a further firm could lead to a disruption in the supply of the high-quality auditing services on which financial markets and their regulators rely.

While auditing standards provide conduct of business rules, much like those elsewhere in financial regulation, there is no comparable prudential regime to assess audit firms' risk of management systems, or to judge whether they have adequate financial reserves or insurance. Given the reliance placed on audit for the regulation of financial firms and of markets, we believe there is a case for the prudential regulation of audit firms at the national level and for a form of collective consolidated supervision to be exercised over the global networks.

These are just a few examples of the issues which need to be addressed in order to upgrade the global financial architecture to make it fit for purpose for today's markets. Changes need to be made to the representation in and accountability of the global regulatory groupings. New channels of intermediation need to be assessed constantly. To underpin all financial markets, whether at the global or national level, the financial reporting arrangements need to be further strengthened.

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