Regulatory reform – a henhouse welcoming the fox (Updated)

A nationwide demand for increased transparency fueled the demand for system and regulatory reform.

  • As we move to coordinate with international standards will our financial and regulatory systems become more transparent or opaque?
  • When all is said and done, how much control will our government have over our nation’s financial and regulatory systems?

Editing note: Taking my lead from Sop, earlier today, I positioned two posts from our files at the top of the page as points of reference.  However, in preparation for the week ahead, I’ve added excerpts from both posts following these brief comments or you can click on the title will take you directly to the full post of  the Future of Insurance and Regulatory Reform (January 26, 2009) and All the World’s a Stage... (December 5, 2008 ) in our files.

Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U. S. Financial Regulatory System (GAO, February 4, 2009) contains a graphic depicting the increasingly global aspects of financial markets.

… with the increasingly global aspects of financial markets, the current fragmented U.S. regulatory structure has complicated some efforts to coordinate internationally with other regulators. For example, the current system has complicated the ability of financial regulators to convey a single U.S. position in international discussions, such the Basel Accords process for developing international capital standards, and international officials have also indicated that the lack of a single point of contact on, for example, insurance issues has complicated regulatory decision making.

Take a look at Key Developments and Resulting Challenges That Have Hindered the Effectiveness of the Financial Regulatory System.pages-from-gao-financial-structure

We’ve seen the frameworks, we need to see the picture – and not just the snapshots of the future regulatory system found in earlier posts on SLABBED.

The perception of global that follows comes from All the World’s a Stage... (December 5, 2008 ) and is followed by a more recent look at various proposals in the Future of Insurance and Regulatory Reform (January 26, 2009).

All the World’s a Stage... (December 5, 2008 )

Having given insurance a great deal of thought since joining Sop on Slabbed, I see a clear connection between a federal backstop and the world stage that is the place where the men and women of the insurance industry will increasingly make their exits and entrances.  In that regard, I found Liddy’s comments recorded in a  transcipt of the PBS program, CEO Exchange, particularly interesting.

… I made a decision, oh six years ago or so, not to pursue the international arena. Insurance is different. It’s not as global as some other industries are. I think that was a good decision at the time. I question it… as I look at where the growth is, around the globe right now, and it’s many of the evolving or emerging countries, and we are not there, I wonder if that is a shortcoming in our strategy… Making a decision that’s good for the next 2-3 years, and making a decision that’s good for the next 20-30 years, sometimes are at odds with each other, and being able to balance those two, can sometimes be difficult.

Others made a different decision.  One was Deloitt Touche.  A recent reader comment brought the company to mind as well as a related post I wrote on cat bonds and Solvency II this past July.

Deloitt Touche traces its history from England in the late 1800’s and began focusing on a global future during a period that began in 1990.  Their leadership in Solvency II is understandable from that perspective.

The European Commission has proposed a ground-breaking revision of EU insurance law designed to improve consumer protection, modernise supervision, deepen market integration and increase the international competitiveness of European insurers. Under the new system, known as ‘Solvency II’, insurers would be required to take account of all types of risk to which they are exposed and to manage those risks more effectively...(emphasis added)

The new system would introduce more sophisticated solvency requirements for insurers, in order to guarantee that they have sufficient capital to withstand adverse events, such as floods, storms or big car accidents. This will help to increase their financial soundness. Currently, EU solvency requirements only cover insurance risks, whereas in future insurers would be required to hold capital also against market risk (e.g. a fall in the value of an insurer’s investments), credit risk (e.g. when debt obligations are not met) and operational risk (e.g. malpractice or system failure). All these risk types pose material threats to insurers’ solvency but are not covered by the current EU system.

Insurers would also be required to focus on the active identification, measurement and management of risks, and to consider any future developments, such as new business plans or the possibility of catastrophic events, that might affect their financial standing. Under the new system, insurers would need to assess their capital needs in light of all risks…[supervision]would shift [from a focus] on compliance monitoring and capital to evaluating insurers’ risk profiles and the quality of their risk management and governance systems. (emphasis added)

Solvency II is modeled after the European Union’s banking reform, Basil I and Basil II and reflects the same three pillar design with each pillar governing a different aspect of the Solvency II requirements and approach.uk_fs_solvency_pillars

An interactive version of the graphic is found on the Deloitt Touche website. As these three questions suggest, the FAQ publication of the European Union is also insightful (note the spelling is correct albeit by European standards).

32. What will the proposal mean for insurers that are headquartered outside the EU (’third-country insurers’)?

The proposal includes specific rules for branches of direct insurers headquartered outside the EU which are similar to those applied to branches of insurers headquartered within the EU. Conversely, the treatment of cross-border provision of insurance services and reinsurance activities conducted by third-country insurers and reinsurers essentially remains a matter for Member States as long as they respect their EU and international obligations.

However, in order to promote greater harmonisation with respect to the treatment of third-country insurers and reinsurers and to take account of the international nature of insurance markets today, the proposal includes a number of provisions that enable the equivalence of a third-country solvency regime to be assessed.(emphasis added)

The proposal also allows for the conclusion of mutual recognition agreements with third countries concerning the supervision of reinsurance entities that conduct business in the territory of each contracting party.

20. Will the new framework allow for securitisation?

The new solvency framework will recognise the economic substance of insurance activity and will focus on risk and the management of risk. Securitisations, as well as other risk mitigation techniques such as reinsurance and derivatives, can be a very useful tool for insurers in managing their risk exposures. The new solvency regime allows insurers to use such techniques and to get commensurate solvency capital relief arising from such a use, provided that insurers can demonstrate that they understand the nature and limitations of such techniques, and provided that there is a real transfer of risk.

39. Is the proposal a ‘Lamfalussy’-style Directive? What are implementing measures?

Yes, this is a ‘Lamfalussy’-style proposal for a Framework Directive. This means that the Framework Directive (’Level 1′) focuses mainly on elaborating the basic enduring principles, or political choices, underpinning the solvency system. The more detailed, technical rules will then be put in place by the Commission in the form of implementing measures (’Level 2′), which will be subject to scrutiny by the European Parliament and the Council of Ministers. (See Annex A.3 of the Impact Assessment for an explanation of the Lamfalussy Process).

Congress is currently being encouraged to pass legislation establishing a federal role in insurance regulation and provide a federal backstop – a proposal that has much in common with Solvency II.

The similarities are not coincidental.

The publication of draft framework Directive for Solvency II will also be closely monitored by non EU countries and there are expectations that US and Asian regulators will move towards a Solvency II type regime over time.

“The prospect of global solvency standards based on the EU standard should provide an early mover advantage to EU insurers in the same way that UK insurers are well positioned for the Solvency II…

Neither is the global use of technology.

A key component of CSC’s Office of Innovation, the Global Alliances Program works across CSC divisions worldwide to identify and bring innovative niche, business and technology companies into CSC’s Global Alliances Program portfolio. The program then leverages these partnerships to support the strategic business goals of CSC and our clients— geographically, horizontally by technology initiatives and vertically by industry… Through the Global Alliances Program, every one of our clients can benefit from the power and reach of CSC’s global IT leadership — and our unique partnerships with business and technology leaders worldwide.

Nor is it a coincidence the financial crisis is global.

Convergence between the insurance industry and the capital markets is now a reality.  Insurance linked securities are dramatically changing the landscape of the European insurance and reinsurance market.

What’s more, the European Union Commission has now released the first draft directive of Solvency II – the most far-reaching change to the framework governing insurance companies in the EU for over 20 years. This will encourage more risks to be securitised by allowing you to reduce your capital requirements.

Even Lamfalussy sounds a lot like proposals for a federal-state system.

The Lamfalussy Process is an approach to the development of financial service industry regulations used by the European Union. Originally developed in March of 2001…It is composed of four “levels,” each focusing on a specific stage of the implementation of legislation.

At the first level, the European Parliament and Council of the European Union adopt a piece of legislation, establishing the core values of a law and building guidelines on its implementation. The law then progresses to the second level, where sector-specific committees and regulators advise on technical details, then bring it to a vote in front of member-state representatives. At the third level, national regulators work on coordinating new regulations with other nations. The fourth level involves compliance and enforcement of the new rules and laws.

Change we need or a case of change we need to survive that we first have to survive to change?  Was the scheme a test run?

the Future of Insurance and Regulatory Reform (January 26, 2009).

Many (most) of these ideas come from yet another report.  In this case, the report is Financial Reform: A Framework for Financial Security from the Group of  Thirty.

The Group of Thirty, established in 1978, is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia. It aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers.

While there are some great people in the group, this is not a great group; but, according to this report in today’s Washington Post, it has attracted Congressional attention :

Congress is moving to create strong new oversight of the financial sector that would likely give the Federal Reserve authority to examine the workings of a wide range of companies in an attempt to address one of the key failures that led to the financial crisis…

The legislation envisioned by House Financial Services Committee Chairman Barney Frank (D-Mass.) would put the Fed, or less likely another government agency, in charge of protecting the stability of the entire system, Frank and other congressional sources said.

An abundance of federal agencies regulate the financial industry. But no agency is responsible for understanding or containing risks affecting the financial system as a whole. In fact, none even has a complete picture of the financial markets.

Under Frank’s legislation, the new regulator would likely be given the power to gather information about the inner workings of banks, investment firms, insurance companies, hedge funds and any other entity big enough or so intertwined with other companies that it creates the risk of a systemic collapse. These companies would have to provide detailed information about how they manage risk, their derivative contracts and the extent to which they use borrowed money.

“We need to give some regulator the power to restrain risk-taking that is excessive,” Frank said. He said he intends to move quickly, explaining that the Obama administration is eager to be able to show the Group of 20 [sic] finance ministers progress on financial regulation at a meeting in early April.

Apparently, it has the President’s attention and the support of the finance industry as well.  According to the Post,

President Obama…has not specifically endorsed the idea of making the Fed a financial system regulator, his administration has sent clear signals to Congress that they should proceed on that path. The idea was first widely discussed last spring as part of a blueprint for regulatory reform issued by then-Treasury Secretary Henry M. Paulson Jr.

“Someone needs to have all of the information,” said Scott Talbott of the Financial Services Roundtable, an industry group that represents 100 of the largest financial companies and that supports the plan.

It does not appear to be as well received among creative thinkers in the blogosphere.

It was as if a short, precise document had been washed through a “committee” until it achieved an acceptable level of fuzziness, that all could agree on and implement in their own separate, broken ways, arriving at … pretty much what we have today. But then I suppose that is exactly what happened.

Matthew Yglesias connects the dots – no wonder he calls his place Think Progress.

Initial ideas about the new financial regulatory regime are getting floated in the press. Perhaps not surprisingly, a lot of the material seems similar to the Group of 30 recommendations.

This all sounds pretty good to me. My main comment, though, would be that we shouldn’t put too much confidence in any regulatory regime. One of the things we’ve seen recently, I think, is that there’s a bit of a paradox around these kind of regulations. If they have any teeth, then there’ll be people who stand to make money from relaxing them or from finding and exploiting loophopes. And if they work, then for a long time there won’t be any major problems. And if you go for a long time without major problems, people are bound to get complacent and start not caring that loopholes are being exploiting. Indeed, they’ll start seeing the loopholes as a reason to relax the regulations. And then eventually you get a blow-up and a renewed interest in regulation.

Long story short, one of the big things we were missing heading into this crisis was not just prophylactic regulation but any clear guidelines for what happens if things go bust. One of the main virtues of the FDIC process is simply that it’s a well-understood crisis. FDIC regulations don’t always work, but bank failures on an FDIC level don’t lead to “bank panics” anymore because everyone understands that the FDIC has a process in place and is comfortable for letting it unfold. We need, I think, some more general prescription for what’s supposed to be in the box if the Fed Chairman or Treasury Secretary needs to reach behind the “break glass in case of emergency” barrier.

The dot he missed – and he was close – is that people will make money from whatever happens.  He also missed the big picture as did everyone else as far as I can see.  A rose by any name, so to speak; but while we talk banking and national regulatory control, insurance is walking in the backdoor and it, too, will be regulated nationally.

Mr. President, we really need to talk about where all of this is leading.

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