13 March 2008

PWG sets out policy recommendations on financial turmoil

The Presidents Working Group issued a policy statement which analyses the underlying factors contributing to the recent financial turmoil and provides policy issues and recommendations for supervisors and market participants on the national as well as on the international level. The statement focuses on changes needed from financial regulators and all market participants, including mortgage originators and brokers, financial institutions, issuers of securitized products, credit rating agencies and investors. The statement also discusses the challenges presented by securitization and over-the-counter derivatives.

“The turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for U.S. subprime mortgages”, the paper states. “The loosening of credit standards and terms in the subprime market was symptomatic of a much broader erosion of market discipline on the standards and terms of loans to households and businesses.”

Other maim factors identified by the PWG include:

- Although market participants had economic incentives to conduct due diligenceand evaluate risk-adjusted returns, the steps they took were insufficient, resulting in a significant erosion of market discipline.

- Faulty assumptions underlying rating methodologies and the subsequent re-evaluations by the credit rating agencies.

- Serious weaknesses in risk management practices atseveral large U.S. and European financial institutions;

- In some cases, regulatory policies failed to mitigate those risk management weaknesses.

The PWG recommends to:

-  reform key parts of the mortgage origination process in the United States;

- enhance disclosure and improve the practices of sponsors, underwriters, and investors;

- reform the credit rating agencies’ processes for and practices regarding rating structured credit products to ensure integrity and transparency;

- ensure that global financial institutions take appropriate steps to address the weaknesses in risk management and reporting practices that the market turmoil has exposed; and

- ensure that prudential regulatory policies applicable to banks and securities firms, including capital and disclosure requirements, provide strong incentives for effective risk management practices.

In particular, credit rating agencies should disclose what qualitative reviews they perform on originators of assets that collateralize ABS rated by the CRA and should require underwriters of ABS to represent the level and scope of due diligence performed on the underlying assets. CRAs should also reform their ratings processes for structured credit products to ensure integrity and transparency.

The PWG will support formation of a private-sector group to reassess implementation of the Counterparty Risk Management Policy Group II’s (CRMPG II) existing guiding principles and recommendations.

Also, U.S. banking regulators and the SEC should promptly assess current guidance and develop common guidance to address the risk management weaknesses revealed by the recent market turmoil.

To enhance prudential regulatory policies the PWG recommends that regulators should adopt policies that provide incentives for financial institutions to hold capital and liquidity cushions commensurate with firm-wide exposure (both on and off-balance sheet) to severe adverse market events.

Also, the Basel Committee on Banking Supervision (BCBS) should update its guidance on liquidity management. Both, BCBS and IOSCO should review capital requirements for ABS CDOs and other re-securitizations and for off-balance sheet commitments.

Furthermore, regulators should concentrate more on detailed and comprehensive disclosures, and their quality. They should also review the current use of ratings in regulation and supervisory rules.

Further recommendations target in particular on the OTC derivative market infrastructure.

The PWG plans to issue a follow-up statement in the fourth quarter of 2008.

Press release

Policy statement

see also: Statement Paulson

© Graham Bishop