April 2009

REGULATION: UK regime change

FSA watchdogs are getting tougher, and not just with the banks. Fund managers are also affected. But challenges over the next twelve months do not end with the landmark Turner Review, finds Nick Fitzpatrick... Surprise visits from the financial watchdog to investment firms may become less of a surprise in future. The Financial Services Authority (FSA) has said that its regulatory approach will become more intrusive. With the recruitment of around 200 extra supervisors, it could mean that surprise visits and similar tactics like ‘mystery shopping’ may increase.

The purpose of surprise visits is to ensure that firms are conducting business correctly. But the manner of these visits is changing – and for the worse. Scott Soper, a senior manager at Grant Thornton, told a fund management conference recently that the FSA had employed “simultaneous interviews” in the past six months, whereby pairs of executives are hauled into separate rooms for individual, but simultaneous, investigation.

If senior managers are unlucky enough to be subjected to surprise, simultaneous questioning, they had better have their
stories straight.

This is a sign of how the FSA’s tougher regulatory approach – enshrined in the Turner Review by Lord Turner, FSA chairman, and published last month – will jettison the old notion of light-touch regulation in favour of “intensive supervision”, and though ostensibly focusing on banks, Turner makes it clear that the new regulatory approach is of significance to other regulated – and non-regulated – firms too.

Risk management
A principal focus of the review is risk management, and it reaches into far-flung corners of banking and finance such as capital adequacy, bonuses, complex derivatives and clearing houses. Now that the FSA has lost faith in trusting markets to act sanely, it wants banks and other regulated firms to do so instead. 

In fund management, calls for better risk management have been heard periodically over the last 10 years. But this time the call is more serious because it seems that a critical requirement by the FSA now is for senior managers at regulated firms to be able to give the regulator a detailed statement of risk at virtually any moment. In the past the FSA has focused on checking that appropriate systems and controls to measure risk were in place, but has left it to managers to decide how to deal with risk. Now, though, the regulator is more interested in the nature of risk and how firms act on it.

In a discussion paper released with the Turner Review, the FSA says (in section 11, which is the most relevant section to non-banks): “The current crisis has exposed significant shortcomings in the governance and risk management of regulated firms. Although these weaknesses have been most evident in banks and investment banks, other financial services firms have not been immune.

“In the future the FSA’s supervisors will seek to make judgements on the judgements of senior management and take action if, in their view, those actions will lead to risks to the FSA’s statutory objectives.”

This is a fundamental change, the FSA notes. It is effectively moving from regulation based on facts to regulation based on judgements about the future.

Dan Waters, asset management group leader at the FSA, pointed out where regulatory changes might most affect asset managers. Speaking at the Future of Fund Management conference last month, he highlighted three issues, the first being credit rating agencies, which the FSA may make subject to supervision in order to tackle conflicts of interest in their business models. He noted that fund managers’ failure to grasp that ratings for securitised credit were about credit risk and not about liquidity or market pricing, was a problem.

Investor understanding
He also said that market infrastructure, the second issue that Waters raised, posed real issues about disclosure and what fund managers understand about how their assets are handled at clearing houses. “It might not be reasonable to expect investors in the underlying funds to know,” he said. He added: “There may be regulation about how these assets are held.”

Finally he spoke about the scope of regulation and how this may affect the unregulated activities of otherwise regulated firms, such as hedge fund products. One effect is that supervisors should be able to request information from the unregulated sector to be shared with other supervisors in case a new structure posed a systemic risk.

But the burdens of risk-management oriented regulation do not end at the Turner Review. The FSA will later this year publish its views on capital adequacy requirements for asset managers, which are designed to bring investment managers into line with the minimum capital requirements of banks and insurance companies.

Since January 2007, all UK regulated entities have had to meet objectives set out in Europe’s Capital Requirements Directive. There are different pillars to this, but a requirement under pillar 2, called the ‘individual capital adequacy assessment process’ (ICAAP), came into effect in January this year. It centres on operational risks, such as how to wind down a fund in an orderly manner.

As an indication Henderson Group, the UK-listed fund management firm, published its ICAAP in its 2007 annual report. The firm’s regulatory capital surplus was £324m (€350m) at 31 December 2007 (£582m the year before). The firm said it did not foresee any significant change in the level of capital required – about £75m – to satisfy prudential regulations.

Waters said: “While asset managers generally appear to have been meeting the substance of what we require under pillar 2, going through the ICAAP for the first time has nevertheless been a challenge for many firms.”

Stress testing
He said that some firms had not provided sufficient information in their ICAAPs for the FSA to decide how to implement the directive for fund managers. 

One problem, he said, is that capital planning had not always included enough analysis of the costs, risks or processes involved in winding-down or transferring regulated activities in an orderly manner, should it be necessary to.

He also said that stress and scenario tests were not always severe enough and many capital forecasts had seemed overly optimistic.

Emphasising that the FSA did not want to be too prescriptive about how asset managers should implement ICAAP, Waters said: “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.”

He also said it had never been the FSA’s intention to increase the level of capital requirements across the whole of the industry through ICAAP, “but where the FSA identifies inadequacies in process, either in terms of its coverage or analysis, the FSA will recommend additional capital to be held”.

The ICAAP is part of the FSA’s call for greater focus on risk by asset managers. Waters said the FSA is creating a Conduct of Risk panel, which he will lead. “We want risk conduct specialists in the front line of firms.”

Tighter regulation in the UK has caused some, including the Lord Mayor of London, to question whether the likes of London will be able to maintain its lead as a financial centre, or lose out to lighter regulatory regimes.

Waters warned that regulatory challenges for UK fund managers would also be augmented by Europe. “Things are coming down from Europe very fast… Keep your eye on the European agenda. They are very, very busy.”

Whether they are based in the UK or not, fund managers that have not got to grips with regulation before it lands on their desks are probably too late to start. Fund managers need to be involved in regulatory developments from the moment financial watchdogs breathe life into a possible new law.

In the next twelve months they will have a crucial role to play, perhaps through local trade bodies, in how post-crisis regulation shapes up.

Take as just one example the future shape of credit rating agencies. If the new business model for these firms emerges as one where investors pay agencies for ratings on companies rather than the case at present where companies pay them, then fund managers who don’t or can’t pay will miss out. Equally if regulators govern rating methodology, how do fund managers know that the ratings on sovereign debt or on state-owned banks are not subject to bias?

Perhaps they can explain this when the FSA pays them a surprise visit. ©2009 funds europe

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