The market should be "very frightened" of its newly re-charged regulators, to judge from this week’s policy speeches by the heads of both the U.K.’s Financial Services Authority (FSA) and the U.S. Federal Reserve.  Faced with a collection of bogeymen, ranging from credit rating agencies (CRAs) to hedge funds, and facilitated by devices like securitization and credit default swaps (CDS), both the U.S. and U.K. are trying to recover from a near-meltdown propelled by a startling collection of failures. Determined to put into place the overall systemic regulations, top regulators are determined to prevent a recurrence. To this end, this week, Hector Sants, CEO of the FSA, and Ben Bernanke, Chairman of the U.S. Federal Reserve, have made groundbreaking policy speeches that boil down to the following: Simultaneous financial meltdown meets ironclad, harmonized financial regulation.

As background, Chief Executive Officer Hector Sants manages the Financial Service Authority, which is the primary regulator in the United Kingdom overseeing financial markets including listed companies with the London Stock Exchange as well as the banking, mortgage and insurance sectors. With London's markets in the heat of the glare of financial crisis, it's hard to imagine being in a hotter seat than Sants's today. Like the Securities and Exchange Commission, the FSA has been criticized for failing to detect the circumstances that have led the financial meltdown and has even heard calls for its abolition. In response, Mr. Sants stated his goals for the FSA as it seeks to avoid the confluence of circumstances that created the current crisis.

In a speech given March 12, hosted by Thomson Reuters (full disclosures, the parent company of Westlaw Business), Sants struck a set of broad themes, all focused on the FSA’s need to carry out a supervisory role focused on the risks to the overall financial markets rather than transgressions of specific rules by individual entities.  Likewise, Federal Reserve Chairman Bernanke touched on similar themes in a March 10 speech before the U.S. Council on Foreign Relations.

Sants’s speech covered a lot of ground, ranging from macro-prudential oversight to board-level fiduciary duties to the exercise of business judgment and proper due diligence. He steered away from explicit discussion of the Pandora’s box of issues frightening many today (such as CDS and securitizations).  Likewise he made only veiled references to some of the actors positioned as the dark villains in the drama of our recent economy: credit ratings agencies, hedge funds….and dark pools.

Instead, Mr. Sants noted that the current crisis is attributable to multiple layers of failure. These began with policy and cultural factors that drove the credit boom and continued with fragmented and inadequate regulation. The mis-steps culminated with poor appetite-curbing by greedy market participants who failed to exercise business judgment and who instead, turned to the credit ratings agencies as poor proxies for proper due diligence.

As a cure, Sants stated that the FSA intends to provide a credible deterrence through "outcomes focused regulation", where compliance with a single rule is not the goal upon which firms should be judged. The current philosophy in the U.K. and the European Union is that of a principals-based form of regulation, in which specific ideals are laid out for companies’ management to utilize as they operate within the marketplace. Mr. Sants does not see this philosophy changing so much as the terminology. Instead, he suggests that “outcomes-based regulation” may be a better term, since the judgments and decisions of a firm’s management and the resulting consequences are what really need to be examined. He suggests this definition differs from the current in that “it is moving from regulation based only on observable facts to regulation based on judgements about the future.”

Mr. Sants does acknowledge the need to balance aggressive intervention with the possibility that regulation may inhibit innovation within the financial sector. Acknowledging that, though, he points to AIG as an example of where a single supervisory authority was more than appropriate. Such a body would be much better suited to assess the risks of a firm than the fragmented regulatory structure that doesn’t allow for an overall understanding of the firm as a whole.

Of interest in our world of harmonized financial crises, financial regulation may be moving in that same converged direction.  Many of these same themes were echoed by Federal Reserve Chairman Bernanke on March 10, when he spoke before the U.S. Council on Foreign Relations. Chairman Bernanke recommended the establishment of a “systemic risk authority” that would focus on “risks to the financial system as a whole”. The Chairman went on to point out how this authority would be able to cross industries in an effort to identify regulatory gaps, assess deficiencies in risk-management practices and monitor exposures across markets. Chairman Bernanke also addressed the current problems caused by the perception of certain firms being “too big to fail”. These include excessive risk-taking, an artificial incentive to grow and the corresponding neglect of smaller firms which may also need assistance.

Both speeches indicate the respective regulators understanding of their current weaknesses and present potential solutions based on an overall risk mitigation function of authorities. Today’s regulators tend to be industry focused, particularly in the fragmented U.S. regulatory structure, but even in the FSA’s approach to its supervisory functions. Mr. Sants points out the fundamental change the FSA must take is to question the judgements by corporate executives, even if in hindsight these questions lead to FSA mistakes. Will U.S regulators be so bold?  Both leaders acknowledge that financial crises will continue and cannot be eliminated. But, as Mr. Sants notes, regulatory bodies need to take care not to “sow the seeds of the next crisis” as they attempt to address this one.


Published:  March 12, 2009