financial crises suggestions

8/8/2019 Financial Crises Suggestions

1/36

Th t inni rtin

polIcy paper


2/36

36

aBouT acca

ACCA (te Association o Cartered CertiedAccountants) is te global bod or proessionalaccountants. We support our 131,500 membersand 362,000 students trougout teir careers,providing services troug a network o 80 ocesand centres. Our ocus is on proessional values,etics, and governance, and we deliver value-addedservices troug 50 global accountancpartnersips, working closel wit multinationaland small entities to promote global standards andsupport.

We use our epertise and eperience to work witgovernments, donor agencies and proessionalbodies to develop te global accountancproession and to advance te public interest.

auTHorS

ACCA would welcome comments on tis paper andlooks orward to contributing urter to te currentinternational debate.

Ian Welc, ead o polic, ACCA+44 (0)20 7059 [email protected]

Jon Davies, ead o business law, ACCA+44 (0)20 7059 [email protected]

www.b.m

Te Association o Cartered Certied Accountants,

June 2009

cntnts

1. itdt 1

2. T t t ss 3

3. Pps t 11

4. cs 29

Qts 30

ctbts t pp 32


3/36

1The FuTure oF Financial regulaTion 1. inTroDucTion

Te current global nancial crisis as been te biggest oits kind or decades and will ave consequences tat willbe wit us or man ears to come.

Te rst steps in te worldwide response to te crisis avealread been taken. Governments in man countries aveborrowed uge amounts o mone to elp beleagueredinstitutions in te nancial sector to survive. In some casesmassive public support as also been etended tostrategicall important businesses in te 'real' econom.

Noneteless, tese are onl te rst steps in wat must bea longer process. Wat is also essential is tat weunderstand eactl wat went wrong and take appropriate

action to ensure tat te nancial sstem as a wole ismore resilient and is better able to witstand uture sockso tis magnitude so as to contain teir consequences orte wider econom.

Te scale o te impact o te nancial crisis eplains wtere is currentl so muc interest being epressed inrespect o regulation. I we are to make meaningulimprovements, we need to understand weter someaspects o regulation contributed to te problems andpossibl encouraged tem, weter companies andnancial institutions could ave acted more responsibl,and i aspects o individual beaviour need to be

addressed.

1. Inttin

Tis paper is intended as a contribution to tis processand is presented as a guide or governments, regulatorautorities and standard-setters. Te paper is in two parts:te rst sets out to eplain te nature o te crisis and tesecond las down a number o principles wic ACCAbelieves sould be reected in te uture design andadministration o regulator sstems in te nancial andbusiness sectors.

Te report incorporates comments provided b mansenior gures rom te nance industr and accountancproession in major capital markets around te world,sourced b ACCA's network o national oces. It alsodraws on opinions ofered at a round table event eld in

London, wic was attended b bankers and nancialservices proessionals. A ull list o contributors appears atte end o te paper and ACCA tanks all contributors orteir time and inormative insigts into tis importantsubject. Te contents o tis report represent ACCA's ownopinions and conclusions and so do not necessaril reectte views or policies o eiter te individuals quoted or teorganisations or wic te work.


4/36

2

Summary

1. Te apparent recent ailures o te 'ligt touc' approacto regulation sould not lead autorities to concludeautomaticall tat a eav-anded approac would be teappropriate solution. Wile it is understandable tatgovernments wis to be seen taking decisive action inresponse to crises, it must be recognised tat regulatorailures ave occurred under bot tpes o approac. Tecrisis in te banking sector occurred not because o a lacko regulation te sector as in act been subject to a veretensive rulebook but because o te inefectiveness otat regulation. Regardless o te conceptual approacadopted, wat is essential is tat regulator autorities are

efective in carring out teir various unctions, inparticular te supervision o regulated entities, andsucceed in teir regulator objectives.

2. Te element o competition is ke to efective regulation.Te greater te sie and compleit o a business, temore dicult it becomes not onl to regulate but tomanage. Te penomenon we ave seen o banks tat are'too big to ail' must stimulate governments and regulatorsto promote ealt competition in te marketplace, botor te benet o te wider econom and or teacievement o more efective regulation. Te benets ocompetition sould also be borne in mind in determining

te etent to wic international alignment o regulatorpractices is appropriate. Moves initiated b te recent G20meeting o world leaders to encourage te saring oknowledge and best practice on a global or regional basisare welcome, but tis does not necessaril mean tatuniorm requirements and procedures must be adoptedb all regulators regardless o local market circumstances.

3. Te ramework o regulation adopted in an countrmust ave a clear purpose tat is understood bregulators and regulated entities alike. In te bankingsector, te protection o depositors sould be seen as teprincipal objective in te contet o encouraging publiccondence in te sstem. Tere must be mecanisms in

place or ensuring efective communication between tetwo sides, and regulators sould endeavour to generate apositive commitment on te part o regulated entities tote acievement o te objectives o te process.Regulator autorities must also ave sucient resourcesto ensure tat te market knowledge and skills o teirstaf are, and remain, adequate or te purpose oeercising te efective supervision o comple businessstructures and evolving business practices.

4. Regulator autorities sould take reasonable steps toensure tat regulated entities possess te skills andeperience, at all levels o te business, necessar ortem to compl wit regulator requirements and protectte interests o teir stakeolders. Autorities sould alsoencourage te adoption, in nancial institutions, o etics-based corporate cultures tat ave te aim o ensuringtat te act transparentl and wit a real appreciation ote long-term interests o teir stakeolders.

5. Regulators sould adopt a sstemic approac to tesaeguarding o stakeolder interests, ensuring all relevantactors are addressed efectivel. In te nancial sector,tis means, among oter tings, taking wider macro-

economic actors ull into account. Tis will complementmore efective monitoring o te capital and leverage ratioso individual institutions. Te activities o specialisedentities tat are currentl outside te regulator net souldbe reviewed and, were appropriate, brougt witin itsscope.

6. Te accountanc proession must consider was omaking te processes o nancial reporting and auditingmore useul to stakeolders. Enancing te qualit oreporting on risk sould be central in tis contet, but it isneiter necessar nor desirable to redesign accountingstandards so as to meet te specic inormation

requirements o regulators. Inormation tat regulatorautorities need or teir purposes sould be obtainedseparatel, via dedicated prudential rules.

7. Te crisis as igligted a number o seriousweaknesses in corporate governance and riskmanagement practices, even among companies wicollowed te epress requirements o ocial guidance ontese matters, and tese ailures need to be addressed.Tere needs to be a specic review o te role o non-eecutive directors, and in particular consideration oweter new measures could be taken to enance teirefectiveness in eercising supervision o te eecutive inlarge and comple institutions. Companies can also do

muc more to engage wit teir sareolders and toencourage tem to pla an active but responsible part inte governance process.


5/36

3The FuTure oF Financial regulaTion 2. The naTure oF The Financial criSiS

Regulation as rarel as suc a ig prole. Formerlseen as te natural preserve o back-oce compliancestaf, it as become big news since te global credit crisisand dominated muc o te tinking o world leaders atte April 2009 G20 summit in London.

W is tis? Politicians are determined to ensure tat teunprecedented nancial crisis and te widespread publicanger at te beaviour o banks, wic was one o teprincipal causes o it can never appen again. Given tescale o tapaers' mone required to sore up banks'balance seets, it is understandable tat governmentsseek to reassure teir electorates tat lessons ave beenlearned. Stronger regulation is seen as a visible wa o

proving tat point.

But ave te rigt lessons been taken on board? Was tecrisis essentiall a regulator ailure? Or were tere otermore important actors? And wat sould te regulatorsstem o te post-crisis world look like? Tis paperreviews tese issues and suggests a number o principleswic sould underpin efective sstems o regulation.

ACCA as consistentl argued1 tat te crisis was more aailure o governance in banks tan o regulation per se. Alack o accountabilit, bot witin nancial institutions andbetween management and sareolders, was at te eart

o te problem. Tis led to te ollowing problems:

ailure in institutions to appreciate and manage teinterconnection between te risks inerent in teirbusiness activities and management and remunerationincentives

remuneration structures/bonuses o banks werecaracterised b sort-term goals, wic neitersupported prudent risk management nor worked inowners' long term interests

risk management departments in banks did not avesucient inuence or power

weaknesses in reporting on risk and nancialtransactions.

1. See Climbing Out of the Credit Crunch, ACCA, September 2008, and Corporate Governance and the Credit Crunch,ACCA, November 2008, .

2. Th nt th fnni isisn its nsqns tin

Furter contributor actors identied were:te over-compleit o nancial products and lack omanagement understanding o te associated risks

an over-dependence on debt

te scale o issuance and te interconnectedness onancial institutions

uman weaknesses: a ailure to appreciate teinuence o cultural and motivational actors suc asrigidit o tinking, lack o desire to cange

te lack o rigorous callenge b non-eecutivedirectors possibl caused b poor understanding o tecompleities o te business

bad abits and complacenc ater a ten-ear bullmarket.

Tese, and related, actors ave been subsequentl pickedup b a series o ig-prole reports wic averecommended new regulator principles in an attempt toaddress tem and to te wider nancial sstem. Tesereports include:

Financial Reform: A Framework for Financial Stability, Te

Group o Tirt (G30) (caired b Paul Volcker),Januar 2009

The Global Economic Crisis: Systemic Failures and

Multilateral Remedies, United Nations Conerence onTrade and Development (UNCTAD), Februar 2009

Lessons of the Financial Crisis for Future Regulation of

Financial Institutions and Markets and for Liquidity

Management, IMF, Februar 2009

The Turner Review: A Regulatory Response to the Global

Banking Crisis, FSA, Marc 2009

Financial Supervision and Stability in the EU (te DeLarosiere Report), European Commission, Marc 2009.


6/36

4

In te report,A Critical Connection: Making the LinkBetween Regulation and Shareholder Value, 176 seniornance eecutives in Cina, Singapore and Malasia weresurveed, and almost 60% believed regulation enancedsareolder value (dened as te abilit to deliversustained stead growt in sare price and cas ow overte long-term) wile ewer tan 25% believed it inderedeconomic growt. Eecutives said efective regulationallowed tem to ocus more on strateg, and ad a positiveimpact on te ke drivers o sareolder value witin abusiness, suc as data qualit and risk managementcontrols te ver issues tat ave proved to be a keweakness in US and European banks.

International Financial Reporting Standards, taregulations and stock ecange regulations all o wicaided investors and elped to place Asia-Pacic marketson a level plaing eld wit te US and Europe wereviewed as te most elpul rules in creating sareoldervalue. Interestingl, even Sarbo, widel regarded in teWest as te epitome o knee-jerk over-reaction to a crisis,was ound to be elpul b over al o respondents in tesout east Asia region. Sarbo replicates nancialdisciplines, processes and internal controls wic alreadeisted or most UK and US companies, but in tednamic Sout East Asian market man newer businessesound it useul tat everting ad to be documented and

audited, giving te business more condence to ocus ongrowt.

Tere are two crucial points ere. Te rst is relevance te regulations were seen as directl applicable andappropriate or te markets. Te second is te rigtmotivation regulations were seen to be genuine attemptsat increasing transparenc and elping businessesprosper, rater tan as a wa or governments to urtersocial goals or raise revenue b burdening business. Anadditional orm o regulation sould pass tis'acceptabilit' test.

Te nal point o note was mentioned b one Cinese

regulator, wo said e ad to 'consider te benets andcost o securities regulation rom te view o te wolecapital market, not a single compan. Te ke actor isbalance and it is alwas dicult or te regulator to make adecision. I we can acieve balance, sareolder value willincrease.' Regulation onl works wen it is applied andenorced consistentl.

Tere is a large degree o agreement in tese reports, andte all propose a considerable tougening o te 'ligt-touc' approac to regulation tat is now deemed to aveailed to prevent te crisis. It sould be noted, toug, tatsome o te G20 leaders wo ave called or eavierregulation in te ligt o te banking crisis were praisingtat same ligt touc approac just two ears ago. Telesson rom tis is tat great care sould be taken wente new sstem is put togeter and knee-jerk reactions topolitical demands careull avoided. Man would arguetat, wile a strong reaction on te part o te USgovernment was inevitable ollowing te Enron debacle,SarbanesOle ('Sarbo') was noneteless an over-reaction to tat crisis wic in turn created its own

problems. We sould recall te mistakes made during tatepisode beore jumping to eas conclusions tis time.

In tis paper, ACCA as drawn upon te views o itsmembers but also tose oter business and nancialleaders rom ke nancial centres around te world. It iscrucial tat, in an interconnected global econom, viewsrom broad perspectives and a wide range o capitalmarkets are eard.

NaTure o regulaTIoN

Beore we discuss te specics o banking regulation, it is

wort eamining aspects o wider business regulation and te starting point or an analsis o regulation is to beclear about wat it is intended to acieve.

ACCA believes tat te purpose o regulation is to acilitatelegitimate and competitive business activit, wileproviding saeguards or te interest o stakeolders. Teimportant point to note ere is tat regulation, wic asacquired, certainl in Western markets, a negative 'red-tape' connotation, sould be regarded as making a positivecontribution to business success. I it is not doing tis, teregulations sould be reviewed.

A 2007 surve b ACCA and CFO Researc Services

sowed a distinctl more positive response to businessregulation in Sout East Asian markets, were it wasregarded as strengtening rater tan inderingsareolder value.


7/36


ACCA would also point to lessons learned rom teregulation o its own proessional accountanc sector,wic can be applied to te banking industr. First, te erao sel-regulation passed in te 1990s wen it becameclear tat a situation were te regulator structures werecontrolled and unded b tose being regulated no longercommanded sucient public credibilit to be acceptable.At te oter etreme, direct government intervention inregulator and monitoring processes can underminelegitimate business and proessional judgements.

Instead, te generall accepted model or te proessionnow is one were a strong independent central regulator isrequired, one wit robust and transparent public oversigt.

Te governing board or council o a proessional regulatorsould consist o a relativel small number o individualsand sould be representative o te major stakeoldergroups. Tere sould be public oversigt o te sstemwit eavweigt industr eperts involved in monitoring,wo ave legal and regulator teet to pursue issuesidentied. Tere is also separation o polic making (rulesand regulations) and compliance (monitoring andenorcement).

BaNkINg regulaTIoN

Turning specicall to banking regulation, te G30 report

reers to te need or a sstem 'in wic tose responsibleor prudential regulation and supervision ave a igdegree o political and market independence and teresources necessar to supervise giant institutions and tokeep abreast o market innovations'. We would stronglsupport tis view.

Te G30 report also calls or 'stronger regulatorincentives or olding large (sstemicall signicant)institutions to te igest standards o governance andrisk management'. It as alread been made clear tatACCA believes te crisis to be essentiall one ogovernance. Risk-based and principles-based regulationsould be at te centre o an new sstem and Large

Comple Financial Institutions (LCFIs) sould be epectedto satis te autorities tat te are continuousl,activel and competentl managing risk in te particularcircumstances o teir business. Regulators need to beacutel aware o responding appropriatel to tose rmstat ave undamentall canged teir business model.

Tis means targeting tose banks tat are strategicallimportant wit specic and tailored regulator policies,rater tan using a 'one sie ts all' approac. ACCAagrees wit te suggestion tat tere sould be a orm o'sstemic risk surcarge' or certain institutions, requiringtem to old more capital against risks. Te Turner and deLarosiere reports, amongst oters, argue tat tere iscurrentl no adequate wa o regulating LCFIs. ACCAsupports te concept o some orm o segmentedregulation, similar to te GlassSteagall principles oseparating investment banking rom deposit taking, wilerecognising te practical diculties o establising acomplete barrier between te two unctions.

Te GlassSteagall principles are sound because teensure clarit o purpose on wat banking regulation issupposed to acieve. Given te severit o te collapse incondence in nancial institutions, it is essential tat tepublic is reassured tat consumer protection is at teeart o te regulator sstem. A clear separation odeposit-taking rom investment banking must be te aim.Efective and ecient compensation scemes must bepart o te sstem, wile te regulators sould be urged togive more priorit to increasing public 'nancial awareness'as part o consumer protection. It is also important tatconsumers and teir representative organisations areengaged in te regulator process as ar as possible.

Th is in t b nt sint is-tin ssit with xts.

PETR KRIz, PWC CzECh REPUBLIC

Wile tis paper does not seek to make recommendationson te specics o capital adequac, ACCA agrees tatBasel 2 needs reorm b re-weigting te comparative

liquidit risks wit market and credit risks and beingsimplied so as to allow better practical application. Witregulators, as mentioned b de Larosiere, seeking toreduce te problem o pro-cclicalit in te eisting capital(and accounting) rules, we are attracted b te Bank oSpain's polic o careull scrutinising banks' internalprovisioning models or imposing its own dnamicprovisioning model. Te aim is to allow an accumilation oa general cusion in good times, to be released in badears as specic provisions or loan losses need to bemade. Tis is te sort o measure tat could be useullmade in te sort term, wile allowing properconsideration to be given to an longer-term structural

canges.


8/36

6

A sensible model was put orward b te de Larosierecommittee, wic proposed a European Sstemic RiskCouncil to bring togeter representatives rom all tecentral banks and nancial regulators in Europe and or abinding mecanism to be set up to ensure tat sucgreater macro-prudential ndings are ollowed troug bmicro-supervisors in te various EU states. PilippeDanjou,2 a ormer director o te Frenc securitiesregulator, te Autorit des Marcs Financiers, andcurrentl a member o te International AccountingStandards Board (IASB), believed tis was a muc moreattractive approac tan tring or a 'European SEC'. Wileregulations and standards can be agreed at a regionallevel, practical supervision and enorcement need to be

carried out at a national level. Danjou said te secret ogood supervision was to be close to te institutions beingregulated, using te analog o a good police ocerknowing is or er 'beat'.

An issue tat arises ere, toug, is tat o 'wo pas?'wen tere is a crisis. As we saw wit Leman Broters, itwas not 'colleges o supervisors' wo discussed te issueover te crucial weekend, but nance ministers. Politiciansave a ke role to pla ere in upolding agreements,rater tan undermining tem as we ave seen in te eldo accounting standards, wit banks in bot te US andEurope successull lobbing teir own governments to

secure concessions to 'mark to market' rules rom teInternational Accounting Standards Board (IASB), wic ismeant to be an independent bod. Suc sort-termpolitical loss o nerve can onl damage te prospects oglobal accounting standards at a cost o long-term damageto business and does not bode well or wider nancialregulation.

It is essential tat te new bod, te Financial StabilitBoard (FSB) agreed at te G20 meeting works well witte International Monetar Fund to spot developing risks inte world's nancial sstem and to provide earl warningo emerging problems. Te board as alread madepronouncements about te uture supervision o edge

unds and credit rating agencies and, it appears, te FSBwill also review te eisting standards-setters suc as teIASB and te Basel committee. It is essential tat te dotis wit te long-term interests o te world econom inmind.

2. Danjou is speaking in a personal capacit and not on beal o teIASB or its staf.

ACCA believes tat better micro-regulation b regulators inareas suc as tis could ave prevented te ugeincreases in leverage in te banking sectors. In 20034,ater te easing o te GlassSteagall Act in te US (and apossible delaed reaction to te dot-com cras o 2000)banks' ratios o capital to debt increased rom 1:12 to upto 1:40. It is ard to dispute tat keeping a closer ee onindividual banks would ave been wortwile ere.

ACCA supports te Dubai Financial Services Autorit'ssubmission to tis paper, wic like tat o otersignicant institutions, igligted te need orsstemicall important products and instruments to beregulated. Te DFSA gave te analog o ow new medical

products are eamined b te Federal Drugs Agenc toensure teir impacts are understood. Tis is an idea worturter consideration.

INTerNaTIoNal coordINaTIoN

Te diculties o regulating LCFIs would be immense eveni te were purel national rms, but te dept o teproblem was sown most starkl b te cras o teso-called 'global in lie, national in deat' rm LemanBroters. Tis let administrators in various countriesdealing wit ver diferent insolvenc rules, wic cannotbe sustainable.

It is essential tat tere is greater cooperation andcoordination between national governments andregulators, altoug te G20 summit understandablstopped sort o calling or a single global regulator, givenbot te principles o subsidiarit and te realit tatnational sovereignt demands tat national regulatorscarr out da-to-da activit in eac countr. It can bereasonabl argued tat a global regulator could onlunction i tere were a global government.

ennt st b i t t

ntin . rts sh bs t ths bin t.

PhILIPPE DANJOU, Ex-DIRECTOR, AUTORIT DESMARChS FINANCIERS


9/36


Given also tat te efects o problems in te internationalnancial sstem ave te potential to eert an immediateand lasting efect on all countries, an new internationalstructures to be establised sould be trul global andsould allow te voice o te developing world to be eard.

ACCA rml agrees wit UNCTAD and te World Bank tatte developing countries must be given a saet net in anrevised global sstem o regulation. Te emergingeconomies in Arica, Asia, Latin America and Central &Eastern Europe ave a uge role to pla in boosting teworld econom and it is essential tat teir interests areull recognised. One concrete wa o doing tis is bundertaking a review o te international bodies

temselves, suc as IMF and te World Bank, wic wereset up in te post-war era and wose membersip reectste needs o tat era. Just as te G7 as become te G20,all suc bodies need to adjust to modern realities.

compeTITIoN o IdeaS

Altoug ACCA believes tat greater coordination andlearning between regulators is important, it is essentialtat improved cooperation does not eclude competitiono ideas. We ave alread made reerence to te Bank oSpain's current work on provisioning, wic oter nationalregulators sould eamine or applicabilit to teir own

domestic markets. Regulator arbitrage must beprevented, but it is vital tat regulators continue tooriginate solutions and ideas. In te US, aving onedominant accountanc bod did not prevent te Enronaccounting debacle, wile te bailed-out mortgageproviders Freddie Mac and Fannie Mae efectivel ad teirown regulator. healt regulator competition can preventte risks o complacenc.

Te G20 leaders also committed temselves to acievingiger levels o cooperation between autorities in teirdiferent countries and consistenc in regulator practices.ACCA believes tat te regulation o te nancial sectorwill be enanced i coordination in matters o controls andstandards can be acieved in practice. Learning rom bestpractice is one wa to acieve tis. Man o tose spokento in te compilation o tis report called or more regularormal and inormal orums were national regulatorscould discuss issues o common interest, particularl atregional level were tere ma be common culturalunderstandings.

Th sss n t i isth biit t tt in instsb n nitb n-isst hns.

US FINANCIAL REGULATOR

Te regulation o te nancial sstem sould certainl aimto reect te sstem's global caracter but it sould at tesame time respect te act tat diferent countries and

regions are at diferent stages o market development. Andit must also be understood tat te imposition oregulator rules on a standardised basis in all marketsma be not onl unrealistic but undesirable. For eample,in relation to regulator strictures or compan boards toappoint a minimum number o non-eecutive directors,tere ma not alwas be an adequate pool o individualswo are sucientl qualied and eperienced to perormtat role efectivel. And i all countries imposed uniormregulator standards, and we subsequentl eperiencedanoter major crisis, all countries would sufer in eactlte same wa.

In pursuing a strateg o coordination, it sould be bornein mind tat te impact o regulation depends to a greatetent on te efectiveness wit wic regulatorautorities carr out teir responsibilities: tis aspect will,as ever, call or adequate levels o resources to be madeavailable. It seems likel tat te international communitwill need to address not onl te issue o acievingcoordination o standards but also te implications oresources or consistenc o application.


10/36

8

INTerNaTIoNal BaNkINg

Te internationalised and interconnected nature o temodern banking sstem makes it essential tat wateversteps are taken to enance te efectiveness o teregulation o te sector, te are coordinated as ar as ispractical. Te big retail and investment banks operate on aglobal basis and teir successes and ailures aveconsequences or economies across te world. It souldollow tat te sstems and practices adopted or tepurpose o regulating suc entities sould aspire to adoptand enorce common standards, albeit wit provisionmade or signicant variations in market conditions indiferent countries and regions.

It is also important tat autorities recognise te cross-border realities o banking business. Te president oGerman's Bundesbank3 as argued tat te EuropeanCommission's touger rules on state aid or banks,introduced as a response to te nancial crisis, will avete side-efect o making lenders witdraw rom cross-border markets and become more nationall ocused.Regulation sould not ocus on sort-term problems at teepense o damaging business in te long term.

Heavy or 'lIgHT-ToucH' regulaTIoN?

It is understandable tat some o tose we contacted inte preparation o tis paper argued tat te time oreavier regulation ad come. Edgar zi, RBS's CFO inSangai, said tat te relativel minor damage suferedb Cinese banks sowed tat 'an interventionist andands-on approac would be more efective in regulatingte current nancial services industr, especiall orderivatives and creative products. A igl leveragedbalance seet sould not come under ligt toucregulation metods.'

In Joannesburg, tere are tose wo argue tat SoutArica as been well insulated rom te world economiccrisis b stricter credit regulation. Raj Maabeer, CFO,

Auditor General's Oce, Sout Arica, believes tat 'teworld needs a igl regulated banking sector, wicsould be rules-based. An transgression sould bepenalised arsl, including imprisonment o certainleaders and sareolders. Suc additional regulation willresult in better control o our economies and tepromotion o real growt'.

3. Ael Weber in an interview wit Financial Times, 22 April 2009.

And in Europe, Danjou pointed to te relative lack oeposure o Frenc banks to riskier activit compared witte UK as a possible indication tat eavier regulation,suc as tigter rules on bank capitalisation tan wasrequired b international standards, ad proved efectivein avoiding te worst o te trouble. he accepted, owever,tat tis was not proo o a causal link, and it can certainlbe argued tat te traditional caution o Frenc banks inlending to omebuers and oter borrowers was equallsignicant. Danjou also argued tat it was essential tatregulation sould cover 'sadow banking' activities andtat all assets and liabilities were brougt back onto banks'balance seets.

assitin 'iht-th' tin with'inis-bs' n intsi snitin with s-bs isisin. Ths ts ntt xsi.

DUBAI FINANCIAL SERVICES AUThORITy

Oter eperts consulted in te compilation o tis reportbelieved tat te risks associated wit of-balance seeteposures were not alwas clearl understood, and teirramications not alwas evident. One o te Big Four rmsin Dubai said tat 'in man cases wat was perceived to bean of-balance seet activit turned out to be an on-balance seet one, or became one, or eample implicitsupport provided b te banks to service te CDOtrances in order to protect temselves against tereputational damage at te time o deault'. ACCA wouldagree tat institutions suc as edge unds and privateequit rms must also be regulated i quasi-bankingactivit is appening it sould be regulated, no matterwat te name o te institution.

Detailed rules-based regulation ma ave anunderstandable attraction or politicians in te ligt o tecrisis, but it can be convincingl argued tat te problemin te banking sector was not lack o regulation o wictere was no sortage but a lack o efective supervision.Too oten regulators sufer rom an insucient number oskilled and eperienced staf to supervise compleinstitutions properl. Adequate unding o te newregulator sstem is essential i it is to make a realdiference.


11/36


Altoug tere will alwas be a remuneration gap betweenregulators and banks, te UK's FSA is making eforts tobridge te gap b providing more attractive packages. Asenior FSA representative said te regulator was recruitingeperienced staf as it enanced its supervisor approacand applied te increasingl intrusive stle, as outlined inte Turner Review. Tis additional recruitment ad alsoenabled te FSA to increase its 'signicant inuence'unction reviews, wic ave led several individuals towitdraw applications to take up senior Cit positions. TeFSA said, owever, tat it ad 'to be mindul not to stieinnovation. We do not want to regulate rms out oeistence'. Striking te rigt balance is te ke.

Ricard Sun, a PricewaterouseCoopers (PwC) auditpartner in hong Kong SAR, argued tat it was essentialtat regulators made ever efort to understand teirmarkets and commit teir staf to keeping up to date.Edgar zi also said tat regulators were 'oten academicsand rom government bodies rater tan banking and solagged too ar beind te advanced banking beavioursand products'. More ands-on eperience was essential.Several o our respondents pointed to te growing skillsgap between te regulators and tose regulated.

Ths s ti b thts n Neds is tht th t th bnin inst.

EDGAR zhI, CFO, RBS BANK, ShANGhAI

Even or tose regulators wit sucient resources andknowledge, are tere still inevitable limitations as to watte can acieve in terms o risk assessment?. Sun said ebelieved tat risk management ad risen sarpl up teagenda in Cina, wit companies tpicall aving separaterisk-management committees.

yet te late Lord (Eddie) George, ormer Governor o teBank o England, said in a lecture in September 2008: 'Idon't know o anone wo saw te sudden reeing up ote wolesale markets coming as it did, and I don't seeow one can realisticall epect te regulator to oreseewat appened wen te nancial eperts operating in temarketplace didn't.' 4

4. Annual lecture to Te Worsipul Compan o Cartered Accountants,Cass Business Scool (3 September 2008).

Is tis a reasonable statement o realit or an attempt todeect blame rom regulator ailure? Regulators adefectivel given teir blessing to diversication and tespreading o risks via securitisation. Man managementteams and boards considered te were ollowing te newbest practice and managing risk efectivel b transerringte risk o mortgage deault to te buers o te securities especiall given tat te were usuall AAA rated.

Is it inevitable tat regulators will alwas be one stepbeind tose wo are determined to nd te loopoles inan sstem and pus te rules to teir limits? ACCAbelieves we must recognise tat te spirit o enterpriseencompasses innovation and pusing o boundaries. We

cannot aford to crus tis spirit i we are to allowumankind to benet rom wealt creation and economicgrowt. So te callenge is to create a control rameworkwic is not a straitjacket: it could be argued SarbanesOle came close to tis and it is were over-centralistremedies could take us.

Te accountanc proession as muc to contribute interms o res tinking on nancial reporting and auditing,wic are ke parts o an nancial regulator sstem.Altoug some audit partners we spoke to insisted tatauditors were now asking more intrusive questions oclients tan ten ears ago PwC's Sun talked o te

'watcdog becoming a bloodound' oters believed tatepanding te scope o audit rom cecking nancialstatements to companies' risk strategies was te ke. TeDubai Financial Services Autorit also oated te idea oepanding te audit committee's mandate to include risk.


12/36

10

It must be remembered tat no regulator sstem iscost-ree. Te impact o compliance costs is alwasgreatest on smaller companies, wic will be te source omuc o te economic recover. A Big Four partner inDubai warned tat adoption o a rules-based approac,wile elping in areas suc as capital and liquiditmanagement, ran te risk o incurring a 'ig cost oregulator compliance resulting in an etra burdenafecting prots, and limiting necessar nancialinnovation especiall i tese rules are derived as areaction to te recent crises and written in aste'.

It is essential tat ligt-touc regulation, wic asbecome so disparaged in te political debate, is not

regarded as being snonmous wit a principles-basedapproac. As te DFSA as pointed out, suc anassumption is 'misleading'. ACCA believes tat a principles-based sstem, sucientl eible to be relevant in aast-paced business environment but wit strongerempasis on etical codes and practices, sould be tebedrock o te new approac. Wile recognising tecompleit o trading in global markets (and addressingte over-compleit o some o te nancial products,wic was a major cause o te problem) is essential,regulation sould noneteless be grounded in simplicit.

'aits t n t ssss w-in is intin n ntjst fnni sttnts. ants itnt bt t t.'

DAVID WU, PWC ASSURANCE PARTNER

ACCA believes instinctivel in market solutions rater tangovernment intervention, but we tink te nancial crisis issuc tat all parties must work togeter to re-establiscredibilit in nancial regulation. A recent McKinse reportpoints out tat 'regulation is about solving problems tatsociet or businesses cannot solve alone, as well asmaking trade-ofs among diferent objectives and teinterests o various stakeolders'.5

Tat report rigtl points out tat companies need to raiseteir sigts and tat lobbing against an regulation tatafects teir sector sould not be te deault position orresponsible businesses: 'In te coming new era oregulation, eecutives and regulators need, more tan ever,

to learn rom eac oter. Companies sould take astrategic view o regulation and strive or solutions tatbenet a wide range o stakeolders.'

Tis, ACCA believes, is te practical etical approac tatwas lacking in te boom up to mid-2007, and tat must bete basis o te new regulator era. As Adam Smit, teater o modern political econom, taugt te world,etics and trust are te basis o an econom. We would bewise to revisit Smit in te searc or te new regulatorregime.

5. The McKinsey Quarterly, December 2008: 'Managing regulation in anew era'.


13/36

11The FuTure oF Financial regulaTion 3. PrinciPleS oF Financial regulaTion

Te principles set out in te ollowing pages comprise a number o wat ACCA believes amount to core guiding aims orte regulation o business activit. Te cover not onl matters tat stand to be addressed and controlled b regulatorautorities but also tose tat call or action b business entities temselves. Te ave been inuenced b a number oconcerns tat ave come to ligt as a consequence o te banking crisis tat began in 2007 and are intended to applprimaril to te nancial sector. Te are, owever, ramed broadl enoug to be capable o application, wereappropriate, to te regulation o business activit more generall. Similarl, te principles are directed at te regulation olimited liabilit companies but ma well be capable o etension to oter tpes o entit, were tere is a strong publicinterest in te conduct o teir afairs.

Th h t tin

Regulator autorities sould aim undamentall toprovide assurance to te stakeolders o regulated entitiestat a responsible autorit is eercising te supervisionand control over tose entities tat te as stakeoldersare not in a position to do temselves, and to give temcondence tat tis is being done efectivel.

Regulator autorities sould ave a toroug understandingo te business sector tat te are supervising and souldaim to acquire a similar understanding o te operationalpractices o individual regulated entities.

An efective approac to regulation sould aim neiter to

be ostensibl 'ligt touc' wic would risk underminingcondence in te integrit o te sstem or ecessivelrules-based, an approac wic risks causing regulatedentities to lose sigt o te overall objective o teregulator process. Te more sustainable alternative is toadopt a principles-based approac, wic requiresregulated entities to ocus on te purpose and objectiveso te eercise. Rules will alwas be needed, but tevolume o te rules imposed on regulated entities, and televel o teir prescription, needs to be kept witin telimits o wat is necessar in te contet o te overallobjective. It is also crucial tat all rules imposed must becapable o supervision and enorcement.

Te etent o te supervision tat is appropriate in relationto particular tpes o entit and business activit will varaccording to te nature o te entities and activitiesconcerned and te risk posed to eac entit, itsstakeolders and te acievement o te overridingobjective. Recent eperience suggests, or eample, tatsome tpes o activit and product, suc as derivatives, docall or closer supervision tan oters. Te regulation oan large and eterogeneous sector sould not tereoreassume tat a uniorm approac will alwas be efective:an efective sstem o regulation needs to be sucientladaptable to be able to deal not onl wit diferent levels ocompleit but also wit canges in te marketplace. Wat

sould alwas underpin te sstem is a strongcommitment to principles, wit an empasis on eticalpractices.

3. pinis fnni tin

3.1 purpoSe o regulaTIoN

T vd pps t sdb t tt tmt bsss tvtyw pvd sds t tsts stkds d s mptt t mkt. 'Sds stkds' d:

dt d st mps mps xssvy skypts tt v t ptt t v

wd s m sqs,d

tv d spd ppptyd tvy w bs sdd ky t v dyd.


14/36

12

Compliance responsibilities sould be imposed on entitieson a proportionate basis and sould not ave te objectiveor efect o inibiting innovation and legitimate businessactivit unreasonabl. Individual complianceresponsibilities sould be commensurate wit teregulator's need to know and sould avoid imposingbureaucratic burdens tat lack regulator 'relevance'. Inorder to acilitate supervision, entities sould be requiredto maintain ull and accurate records detailing te actionste take to secure compliance wit teir variousobligations.

Regulation o te business environment, in wole or inpart, sould adopt a sstemic approac and aim to ensure

tat all actors wit a bearing on te acievement o teoverriding objective are addressed efectivel. Tissstemic approac sould take ull into account teimplications o wider macro-economic actors or teefectiveness o regulation in te nancial sector. In tecase o te banking sector, te regulator autorities andte central bank sould activel contribute to te goal oacieving stabilit in te nancial sstem. Depending onte area o business under review, relevant actors arelikel to include capital levels, risk management, nancialreporting, internal controls, eternal audit, corporategovernance arrangements, actuarial practice and creditrating activities. Specialised tpes o entit tat are

currentl outside te regulator net, but wose practicesma ave material or indirect economic consequences orstakeolders, ma need to be brougt witin its scope.

Supervisor procedures sould ensure tat entitiescontinue to compl wit teir responsibilities and enablete autorit concerned to identi quickl ailures andweaknesses tat ma call or epeditious regulatorintervention.

Regulator autorities sould aim to establis efectivecommunication links wit regulated entities. Tis isdesirable to acieve two outcomes. First, efectivecommunication is needed to promote understanding

among individual businesses o te purpose o teregulator process and o te regulator's epectations otem. Second, it is in te interests o regulator autoritiestat te encourage a positive attitude towards complianceon te part o te regulated communit. Te sould takepractical steps to conve to individual businesses tat teprocess o regulation is intended to be a genuine attemptto increase transparenc and to elp good businessessucceed in a competitive environment. Te intentionsould tus be tat tose subject to regulation souldtemselves benet rom te process in meaningul was.

etinssIt is essential tat an regulator autorit is and is seen tobe credible and efective, bot b tose wo are subject toits scrutin and b all interested stakeolders. Tis meanssupplementing necessar regulator requirements witefective supervision o entities' compliance wit toserequirements. Wit tis in mind, te requirements tat areimposed on regulated entities must in te rst instance becapable o being monitored and supervised b teautorit concerned. Efective monitoring, supervision andenorcement must ten appen in practice. To be in aposition to acieve tese ends, regulator autorities needindividuals wo ave skills, epertise and eperience in teeld being regulated and wo are capable o remaining

alert and responsive to developments in businesspractices. Tese actors will necessaril require autoritiesto ave access to sucient resources to allow tem toperorm teir role properl.

It is also essential tat autorities ave a clear, strong andpublic commitment to carring out teir regulatorresponsibilities. Tis commitment sould be promotedrom te top o te organisation and communicated to andadopted b staf at all levels.

As well as aving te rigt uman skills, efectiveregulation requires te autorit to establis te

procedures necessar to eert proper supervisor controland to be prepared to var and add to tose procedureswere developments in business practices render itnecessar. Te banking crisis as sown ow important itis tat regulator rameworks are designed and resourcedin suc a wa tat te are capable not onl o dealingwit increasingl comple structures, products andpractices but also o devising efective regulatorresponses to tem. Regulator procedures need to identite tpes o inormation tat are likel to be o materialsignicance to te regulator in carring out its unctionsand to ensure tat suc inormation is alwas available tote autorit and to an appropriate level o materialit,taking risk into account. At te eart o tese various

procedures sould be te goal o establising an etics-based culture among regulated entities.

Regulator sanctions sould be sucient to encouragecompliance in te rst place and to penaliseproportionatel in cases o proven breac. Regulatorautorities need to be prepared to make ull use o tepowers tat are available to tem.

antbiitRegulator autorities sould be independent o politicalcontrol but accountable to te democratic autorities orte eercise o teir unctions.


15/36


3.2 compeTITIoN

gvmts d t d tts sd d t pmt ty mptt t mkt p s t ptttvss t ty systms.

One o te issues tat needs to be addressed urgentl inte international response to te global banking crisis isweter governments and regulator sstems weterostensibl 'ligt' or 'eav' touc in nature ma avecontributed to te scale o te crisis b allowing entities tobecome ever larger and more powerul. Tis process,wereb some markets ave become dominated b ewerand ewer mega-entities, as led to questions aboutweter tese entities ave become too big to regulate.Are te now too big or governments to allow tem to ail?It seems clear tat te concentration o market power inte ands o a ew ver large entities as presentedsignicant callenges to regulators. It is also beond doubttat te economic importance o man suc entities as

caused governments around te world to take te viewtat on no account sould te be allowed to collapse,even i it means spending uge amounts o public moneto prevent it.

Te implications o tis continuing process oconsolidation or te efectiveness o regulation are suctat te need to be at te eart o te response to tecrisis. Regulator autorities sould see te promotion oealt competition as being a ke aspect o teirunctions. Most importantl, it sould not be consideredtat te scale o regulator activit must alwas be allowedto epand in proportion to te increasing sie o regulated

entities. Instead, tere needs to be an acknowledgementtat as an entit becomes larger and more comple, terewill be consequences or te efectiveness o regulatoractivities o all kinds: tese will include not onl activitiesconnected wit eternal regulation but also tose suc aseternal audit, internal controls and board-levelsupervision o management. Governments and regulatorautorities need tereore to consider weter te level omarket concentration tat as been allowed to develop isitsel an indicator o regulator ailure. Weter or not teagree tat tis is te case, te must address teundamental point tat te regulator autorit mustalwas be capable o understanding te regulated entitand eerting efective supervisor and regulator control

over it. I te consider tat te process o marketconcentration as gone so ar tat tis capabilit is beingundermined, te sould consider acting to recti tesituation.


16/36

14

It sould also be acknowledged, in te contet o owregulator autorities are likel to respond to issues omarket concentration, tat tere are wider implications orcompetition. Te instinctive reaction on te part oregulators ma be to impose on entities in, or eample,te nancial sector ver detailed compliance requirements,on te assumption tat tis is an appropriate risk-basedresponse or tem to make. It needs to be borne in mind,owever, tat etensive regulation can ave teeconomicall undesirable efect o discouragingparticipation in te market b smaller entities, tustending to inibit competition and lead to urterconcentration.

Te issue o ealt competition is also relevant toregulator sstems temselves. Te eperience o tebanking crisis suggests tat te regulator approacestat were adopted in certain countries, including Spain,Australia and Canada, ave elped to ensure tat tosecountries, and teir nancial institutions, ave avoided te

worst consequences o te crisis. Altoug tere souldcertainl be pooling o inormation, best practice andeperience among regulators, along te lines tat avebeen suggested b world leaders, it ma not be sae toconclude tat tere is an one best solution to te designo national regulator sstems tat sould be imposed onall countries, regardless o local market circumstances. Itmust also be borne in mind tat diferent regulatorobjectives are likel to be more appropriate or national,retail banks tan or global, wolesale banks in teormer, consumer protection will be ke wile, in te latter,te main driver is likel to be te need to acievetransparenc in te markets so as to enable participants tooperate at speed and on a large scale.

An new global ramework sould tereore allow ordivergent approaces to be ollowed were te autoritiesreasonabl consider suc approaces to be efective ormeeting te particular regulator objective, andappropriate or application in te market concerned.


17/36


3.3 STaNdardS o BuSINeSS coNducT

cmps sd b xptd ty t t tvts d wt stdds bsss dt.

Th th bA compan's board o directors is ultimatel responsible or ensuringtat te compan complies wit te requirements o te law, oregulator rules and o an codes o practice (or similar) tat itcooses or is obliged to ollow. Te board is also ultimatelresponsible or setting te tone or te various beavioural practicesundertaken in te name o te compan. Te board sould beepected to commit te compan to standards o business conducttat aim to ensure, as a minimum, tat te compan conducts itsbusiness afairs transparentl and treats airl all tose parties, botinside and outside te business, wit wom it deals. Suc actionsould involve, as a priorit, ensuring te active commitment o botte board and senior management to compan-wide policies andpractices on standards o responsible business conduct tat

collectivel amount to an etics-based culture.

Members o te board, and members o an special committees o teboard, ave a particular interest in ensuring tat all necessarinormation relating to te eercise o teir unctions, and tat isavailable witin te compan, is transmitted to tem. Members souldbe prepared to insist tat te management o te ow o inormationto tem is conducted in suc a wa as to ensure tat te areprovided wit all te inormation tat is or ma be material to teirdecision-making and governance responsibilities.

Te board sould ensure tat its policies and practices on businessstandards are observed b keeping teir application under regular review.

Th snsibiit iniisIndividual members o te board o directors (or equivalent) souldact not onl in accordance wit teir legal duties but wit duerecognition o te importance o ig standards o business conductor te long-term interests o teir compan. Individual emploeessould be epected to act in accordance wit te policies andpractices adopted b te compan.

Th th tRegulator autorities sould note and act upon te ollowingconclusion o te G20 meeting o April 2009:

'Strengtened regulation and supervision must promote propriet,

integrit and transparenc'.

Tis statement was intended to reer to te nancial sector alone, butte objectives identied are appropriate or application to all areas obusiness regulation. It sould be understood tat te credibilit, orregulator purposes, o an entit's actions, reports and statements willbe a unction o its compliance wit tese criteria.

A compan's written and actual commitment to standards o businessconduct sould be monitored b te regulator autorit and seen asan indicator o te etent to wic reliance can be placed on tecompan's various compliance assurances. Companies sould berequired to disclose, on an annual basis, te actions te ave takento establis and administer policies and practices on standards oconduct. Tose reports sould include details o an specic matters,eg regulator investigations and nes, tat could be viewed as avinga bearing on te compan's reputation.


18/36

16

3.4 STaNdardS o compeTeNce

cmps sd b xptd t vpppt sks d m ss t vs t bsss.

Th snsibiit bs n itsTe directors o a compan are ultimatel responsible ordirecting and supervising te activities o te business.Te sould tus be sucientl competent andeperienced to perorm teir role. Just like regulatorautorities, compan directors bot eecutives andnon-eecutives ave an obligation to acquire an efectiveunderstanding o te nature o teir compan's business,its management structure and its various operationalprocesses.

Te level o epertise and eperience appropriate orindividual directors sould be related to te nature, sieand compleit o te business and te particular role, i

an, tat an individual director ulls. Tose directors wosit on specialised committees o te board, or eampleaudit committees and remuneration committees, souldsimilarl be epected to ensure tat te are sucientlcompetent and eperienced to perorm tose particularroles. Were directors are entitled b law to delegateresponsibilities in dened matters to oter directors oremploees, te board sould still keep suc delegationsunder review and monitor teir operation so as to ensuretat te directors are able to eercise efective supervision.Boards sould ensure continuousl tat suitable training ismade available to directors in respect o mattersconcerning te business activities o te compan.

Te board is also responsible or ensuring tat tecompan, below board level, possesses adequate numberso staf wit te skills and eperience tat te companneeds to ull its business objectives.

Th th tIt is in te direct interests o te regulator autorit tatcompanies compl wit tis principle. Companies souldbe epected to satis te autorit, on a regular basis,tat te do so.


19/36


3.5 corporaTe goverNaNce

Bds, sds d stkdssd s mm dstd t pps d sp ptv.

In te spirit o tis principle, companies sould begoverned b te board wit te core aims o

(i) generating trust and condence in te compan, and

(ii) deending and promoting its long-term interests.

Boards need to acquire an efective understanding o teconcerns o teir sareolders, and were appropriateoter stakeolders, and take tese concerns into accountin te decision-making process. Sareolders sould beprepared, were practical, to pla an active role insupervising te board wile remembering tat teresponsibilit o te board is to secure te long-term

interests o te compan as a wole and not necessaril tosatis te sort-term interests o an individual or groupo investors.

Th th bTe board o a compan (and te equivalent governingbod in oter tpes o entit) is responsible or directingand controlling its afairs. It does tis or te primarpurpose o serving te interests o te compan's owners.Te board sould tereore establis approaces tat willelp it to ensure tat te compan's business is beingconducted successull and tat will allow it to accounttransparentl to sareolders (and, were appropriate,

regulator autorities) or its stewardsip. Tis will applregardless o te sie or te nature o te compan.

In man countries, guidance on optimal corporategovernance arrangements is te subject o legal rules,codes o practice and/or regulator rules. Corporategovernance rules and codes aim to maimise te qualit ote decision-making process witin a compan's board.Most do tis b tring to ensure tat, inter alia:

decision-making is not concentrated in te ands oone individual or small group

te board is 'reresed' b te addition o new

members on a regular basis

te board contains non-eecutive members, wo areepected to bring an attitude o independence andobjectivit to te decision-making process

matters tat are considered to be particularl sensitive,suc as te compan's nancial reporting proceduresand eecutive remuneration, are addressed b separatecommittees o te board, wic contain members woare considered to meet criteria o 'independence'.


20/36

18

Were an suc rules or codes appl, companies souldcompl wit teir requirements to te ullest practicaletent. Good corporate governance sould, owever,involve not solel compliance wit te writtenrequirements o rules but a genuine commitment tocompl wit te broader spirit o good corporategovernance. Merel aving te requisite proportion onon-eecutive directors on a board, or separating te roleso cairman and CEO, is not enoug in itsel: teundamental objective sould be to acieve a balancedboard and to avoid ecessive concentration o power. Oneo te lessons learned rom te banking crisis (andprevious corporate crises) is tat some companies tatcomplied wit te letter o corporate governance codes,

and considered temselves to ollow best practice, werenot in realit well governed at all. Accordingl, companiessould keep teir corporate governance arrangementsunder constant review and consider making cangeswere te are called or. To assist in tis, companies maconsider it elpul to appoint a separate corporategovernance committee o te board. Companies sould, inparticular, reect on eac case o governance ailure teave eperienced and consider w te board, orindividual directors, did not ask te questions or suggestand acieve te actions tat migt ave prevented tatailure rom appening.

In te same wa tat individual companies sould keepteir practices under review and re-address tem in teligt o ailures, accepted wisdom on wat amounts togood corporate governance practice sould also be keptunder review b te autorities. Te eperience o tebanking crisis suggests tat a review o tinking on tisissue is now opportune.

Even toug te appointment o non-eecutive directors tocompan boards as or man ears been widelconsidered to be an appropriate means o callenging andoverseeing te eecutive, te presence o non-eecutiveson te boards o banks and oter tpes o compan does not appear to ave succeeded in restraining

irresponsible and in some cases disastrous businesspractices. Te reasons or te cases o apparentinefectiveness need to be eplored and addressed. It mabe, or eample, tat ailures can be linked to inadequateinormation ow to non-eecutives, to lack o appropriatetraining or to lack o support, in wic case canges willneed to be made to corporate governance rules in severalrespects. Tere ma also be a case or ensuring tatnon-eecutives, and boards in general, receiveindependent assurance about te actions o managementin implementing te policies o te board, especiall inrespect o control matters.

ennt with shhs n th sthsWere a compan's directors are legall responsible oracting in te collective best interests o te sareolders,te sould ensure tat te understand wat toseinterests are and act accordingl. It is rigt tat tedirectors retain ultimate decision-making autorit witina compan, but taking active steps to engage efectivelwit tem on ke issues will elp tem to ensure tat terepresent te interests o teir sareolders.

Sareolders collectivel own te companies in wic teinvest. It is to tem tat te board is accountable and inwose name directors conduct te compan's afairs.Altoug te traditional Anglo-Saon model o sareolder

primac is increasingl being callenged, in te UK and inman oter countries, te membersip remains a keelement in te governance ramework o entities o allkinds.

Ecept in small businesses, owever, ew sareoldersactuall eercise teir rigts o participation: most investor teir own nancial reasons and, in normalcircumstances, sow little interest in monitoring temanagement. Altoug te large, institutional investorgroups do monitor and engage wit compan boards on aregular basis, te banking crisis as sown tat even at telisted compan level, organised sareolder groups oten

ail to engage wit boards to te etent tat te can eertbenecial inuence on tem and restrain tem romcourses o action tat, in retrospect at least, sould avebeen regarded as unwise and likel to be detrimental tosareolder interests.

Institutional investor groups oten own substantial oldingsin te largest companies. Altoug te powers available tosareolders will var rom countr to countr, institutionalgroups sould be prepared to use te autorit te ave,b virtue o teir oldings, to eert inuence on companboards werever circumstances make tis appropriate.Sareolder groups o watever kind sould not seek tointerere wit matters o da-to-da management.

Noneteless, it is reasonable, and elpul rom agovernance perspective, or institutional sareolders inparticular to become involved wit strategic and structuralissues and to establis efective working relationsips witcompan boards in relation to tose issues.

Investors also owe it to temselves and teir ownstakeolders to monitor te compan's actions and tocallenge tem were tis ma be appropriate.


21/36


It is not realistic to epect sareolders alwas to be ableto take efective action to protect te value o teirinvestments, but neiter is it realistic to epect tat, in allcases, eternal regulation will be able to do it or tem.Investors sould accept teir own responsibilit to evaluatecriticall plans and decisions wic are likel to afect teirinterests directl, and act accordingl.

As long as sareolders onl ave rigts to participate incompan afairs, rater tan responsibilities to do so, it willremain impractical to tink tat ig levels o memberengagement can be acieved in te case o largercompanies. Noneteless, i boards allow temselves tobecome disconnected rom teir sareolder bodies to te

etent tat te act in efective ignorance o members'concerns, te result ma be not onl a governancedsunction but also breac o teir legal duties b tedirectors.

Te role o a compan's bod o sareolders souldtereore be seen as an element o te governanceramework tat as te potential or eerting benecialinuence on board beaviour. In tis ligt, companboards sould be epected to eplore was o enancingboard-member communication wit a view to acilitatingactive interest in te wa tat compan afairs are beingdirected and controlled. For eample, te sould consider

weter te inormation tat is provided to memberscould be presented and communicated in diferent, moreaccessible was; weter te potential o narrativestatements suc as te Operating and Financial Review (orsimilar) could be better eploited so as to meet teinormation needs o sareolders and oters; andweter te compan's annual general meeting could bestructured more imaginativel. Regulator autoritiessould also consider was in wic members migt beactuall required to participate more in te governance oteir companies.

In te contet o encouraging greater levels o sareolderparticipation, owever, it must be remembered tat it is or

te compan's directors to make te decisions about watis ultimatel likel to be in te best interests o teircompan. Sareolders sould not epect to pressuriseboards into making decisions, especiall nancialdecisions, tat are motivated b teir own sort-terminterests, and directors or teir part need to be entitledand prepared to witstand suc pressures i te believete are not in te best interests o te compan.

Th th tIt is in te interests o te autorities tat sareolderspla teir part in te governance process b asking terigt questions and olding teir boards to account. Inassessing te compliance risk posed b individualcompanies, regulator autorities will wis to considerweter te are governed in a wa wic reects bestapplicable practice and wic serves to engender trustand condence on te part o teir sareolders and oterstakeolders. Were boards are required to take widerstakeolder interests into account in te wa tat tedirect te afairs o teir companies, te autorities souldalso consider tis aspect wen reviewing companies'governance arrangements.

Companies tat are epected to implement corporategovernance rules or codes o practice sould compl witan associated requirement or disclosure regarding teircompliance or oterwise. Compliance sould be efectivelmonitored and enorced. Tis sould etend not onl toan requirement to make a 'compl or eplain' statementbut to compliance wit te substance o te guidanceitsel: it is not reasonable to epect a compan'ssareolders to take action in respect o non-compliancewit guidance on tis issue.

As a matter o course, wen directors o regulated entities

leave teir positions, eiter b resignation or oterwise, teregulator autorit concerned sould considerconducting interviews wit tem wit te objective oidentiing an matters connected wit teir departurestat migt be o regulator interest.


22/36

20

3.6 accouNTaBIlITy

cmps sd b xptd t t t tvts tspty, tyd wt d d , s pppt, tdmds, ts d mt ds t stkds.

Th fnni tinInormation on companies' nancing and perormance willbe required to be prepared and disclosed in diferent wasand or diferent purposes. Weter te inormationconcerned is intended to satis te needs o sareolders,regulator autorities or oters, te preparation anddisclosure o accurate and credible nancial inormation isessential or te efective supervision o companies'activities.

Te specic requirements or te wa tat nancial andoter reports sould be ramed need to take account ote tpes o activit undertaken b te entit, its sie andcompleit, and te actual or perceived inormation needs

o te likel users o te reports. It sould ollow tat temore specialised and comple te business, and tegreater its degree o economic materialit and stakeolderimpact, te more etensive te disclosure and reportingrequirements will need to be, i onl because in sucbusinesses te inormation needs o a large and disparategroup o stakeolders will all need to be addressed witinte same report.

Te banking crisis as led to a number o criticisms aboutte role o nancial reporting standards. Te majorcriticism concerns te use, as mandated b teInternational Accounting Standards Board (IASB), o air

value accounting in te treatment o nancial instruments.Te argument concerns te act tat companies arerequired, under IASB rules, to value teir nancialinstruments at current market prices, rater tan at teiristoric cost values. Were current market values aresubstantiall lower tan te original cost o te assetsconcerned, entities ave to make large write-downs onteir balance seets. In te eceptional conditions we aveseen, 'market' values or particular assets ma simpl aveceased to eist, in wic case companies are orced toresort to 'mark to model' tecniques, based on te ewsales tat are taking place. It also means tat assets tatad originall been eld or trading purposes now ave tobe retained, wit an value now dependent on prospective

cas ows rom interest and repaments.

Were tis appens, as as appened on a large scaleduring te banking crisis, condence in te reportingcompanies will be damaged and tere can be massiveconsequences or teir capitalisation. Tus te situationunder air value rules is ver diferent rom wat appenswen assets are reported using te amortised costapproac, were tere is no need to report write-downsunless te value o epected uture cas ows is estimatedto be less tan istorical cost. Since banks will ordinarilave ver substantial oldings o nancial instruments, teadoption o air value rules as afected teir results muc

more tan it as oter entities.


23/36


Tere is no doubt tat air value accounting as adsignicant efects on companies' reported results duringtis period and it is rigt tat its urter application toclasses o assets oter tan tose currentl encompassedb te IASB rules be deerred until suc time as te ullramications o te approac can be digested. Tere arecertainl tecnical issues wit air value tat need to beaddressed. Te use o air value accounting as not,owever, been a direct cause o te crisis and itsapplication sould not be suspended. It remains te onlrealistic metod o accounting or derivatives and as tegreat virtue o transparenc it discloses te value tat anentit stands to gain b selling or settling te assetsconcerned at te balance seet date, i it cooses to do so.

It sould also be noted tat investor groups, woseinterests annual nancial statements are primarilintended to address, ave been strong supporters o teuse o air value accounting.

Anoter, related issue tat as been raised in te wake ote crisis is weter te rules governing annual nancialstatements sould, in uture, be ramed so as to beconsistent wit te epress inormation needs oregulator autorities, rater tan tose o te compan'ssareolders. Te meeting o te G20 countries in April2009 epressl called on te IASB and oter standard-setters to work wit regulator autorities on was to elp

ensure tat accounting standards serve te cause opromoting nancial stabilit in te wider econom. Gearingnancial statements so as to reect compliance oroterwise wit prudential and regulator requirementswould be a material departure and would require aundamental re-tink o te purpose o accounting.Financial statements, in teir traditional orm, are designedessentiall to enable directors to report on teirstewardsip o teir compan to teir sareolders, so asto elp tem make inormed decisions about teirinvestments in te compan.

It would not be elpul to make a undamental cange otis kind since te inormation needs o investors and

regulator autorities are diferent and sould beaddressed b diferent routes. I regulator autoritiesneed diferent or additional nancial inormation in orderto increase te efectiveness o teir own regulatorunctions, canges sould be made. An specicinormation needs tat te regulator autorities ave orteir purposes, and tat are not met b te generalpurpose nancial statements in teir current or anrevised orm, sould best be addressed b means oseparate and dedicated prudential reporting requirements.

Te ke contribution tat nancial reporting can make tonancial stabilit sould be seen as providing timel,

neutral and transparent inormation to investors andoters tat te can trust and rel on to report economic

events as te appen and describe teir impact oncompanies, teir perormance and nancial position. Tisprocess elps te cause o stabilit b elping to correctte natural pro-cclicalit o markets in over-estimatinglosses at times o great uncertaint, b providing te basisor more rational pricing decisions.

Tis is not to suggest tat te nancial reporting processwitin its eisting parameters cannot develop so as toenance te understanding o investors and oters o tenancial standing, perormance and prospects o reportingentities.

One pressing issue in tis area concerns te etent o loan

loss provision b banks. Accounting standards generallare built on te reporting o losses tat ave beenincurred, but it seems probable tat regulators in tebanking sector will in uture epect losses to be anticipatedb institutions, or else look to models adopted in Spainand elsewere. It is wort eploring te etent to wictose two approaces could be brougt togeter. Foreample, as te incurred loss model been too slow inallowing losses to be recognised as te economic ccleworsened? Is tere scope or going beond tis andrecognising epected losses troug te lie o loans?

It seems likel tat regulators, or prudential purposes, will

wis to go urter tan tis and develop models tatrequire reserves to be created in te good times or lossestat can be epected at worse times in te economic ccle.Sould tis materialise, ow sould suc reserves besown in nancial reports as a separate designatedreserve witin equit or as reductions in asset values, tuscreating losses (in te good times) and prots (in te badtimes)? Te rst o tese would be te better representationo economic realit. An additional regulator bufers o tiskind sould be disclosed in banks' accounts in a transparentwa, as te ma provide useul insigts or investorsregarding te longer-term risks o diferent areas o lending.

Anoter signicant issue concerns te efects o te

accumulation o legal and tecnical reporting rules or tesie and compleit o nancial statements, especialltose o banks. Tis situation is giving rise to questionsabout weter suc statements can still serve a coerentinormation purpose or an class o user (and contributeto te goal o member engagement discussed elsewere intis paper). Te UK and International AccountingStandards Boards are bot looking at tis issue and tisdevelopment is welcome.

Additionall, te proession needs to address a number oimportant tecnical questions concerning te same coreissue o ow to render accounting practices more

transparent and useul to users. Tese questions includete ollowing.


24/36

22

Wat sould be te ke purpose o accounts to reect

an accurate picture o wat as appened, inormabout te present, or predict te uture?

Are nancial statements currentl epected to do tooman tings, resulting in a lack o balance betweenunderstandabilit and transparenc?

how could accounts communicate more efectiveinormation on risk?

Does narrative reporting as it is currentl ramed servea useul purpose and i not, is tere a better wa ocommunicating non-nancial inormation?

Would it serve te interests o te various users oaccounts i te concept o materialit was epanded soas to require nancial inormation to be presented inranges o probabilit?

Tese, and oter ke questions are or te proession toaddress.

Th xtn itTe process o eternal audit is integral to te objective oprotecting te interests o a compan's members and anecessar component o regulation. First and oremost,

te audit process sould be, and sould be seen to be,objective and independent o management. Auditorssould ave all necessar powers available under te lawto allow tem to operate reel: to obtain te inormationte need and to carr out te procedures tat arenecessar or tem to orm teir opinion on te compan'snancial statements. Auditors must also be ree to rameteir audit report, in watever wa te eel appropriate(subject to teir conormit wit applicable auditingstandards) and to communicate an relevant concernste ave to te appropriate levels o management andgovernance witin te client compan.

Eternal audit evolves over time as auditing standards andpractices witin te audit proession cange and respondto developments in te business world. For eample, in tecurrent economic circumstances, auditors are likel to bespending more time on assessing a compan's 'goingconcern' status and management's strategies on risk.Noneteless, it is not just troug te audit o nancialstatements and associated disclosures tat auditors cancontribute to te efective regulation o companies. Givente investigative nature o auditing, te auditor acquiresknowledge o a compan's internal controls and itsbusiness practices, wic ma ave direct relevance to tework o a regulator autorit. One specic wa oarvesting tis, wic as alread been adopted in some

countries (UK auditors are currentl subject to aproessional dut in tis regard), is or te auditor to begiven te entitlement (and/or obligation) to communicatecertain inormation to te regulator autorit. Tis isinormation tat ma ave a direct relevance to teecient eercise o te autorit's supervisor unctionsand tat comes to te attention o te auditor as aconsequence o te audit. In some jurisdictions, and orcertain companies, suc as banks, regulators ma requiretat auditors eamine specic inormation in a compan'sreturn to te regulator.

Auditing itsel is increasingl carried out in accordance

wit International Standards o Auditing and, altoug teregulation o te nancial sstem sould aim to reecttat, tere is muc scope or regulators and te auditingproession to eplore te potential tat eternal audit asor adding new value to te regulator process, wetertroug canges in te nature o an audit or etensions toits scope. In te course o considering ow audit could beepanded, it will be essential to ensure tat legitimateconcerns eld b auditors about liabilit are satisactorilresolved.


25/36


3.7 INceNTIveS

rmt sms dts dmpys sd b ttd t mpy's stt ps d sd b t t dstt bv w db dtmt t t -tm tsts t mpy; pt, tvsms sd b kd, pmy, t tvmt -tm sdv by t mpy s w.

Th th bCompan boards sould ave te basic reedom to oferremuneration, pension and incentive packages tat, inteir opinion, te compan can aford, are set at tenancial level necessar to attract and retain individuals ote qualit required and tat provide bonus rewards tatare air and commensurate wit perormance. yet boardsalso need to recognise tat tere ma be oter relevantactors wit a bearing on tis issue.

First, te wa tat incentive scemes are structured maave beavioural consequences tat are not necessarilconsistent wit te best interests o te compan. As asbeen seen during te banking crisis, scemes tat promise

ig rewards or eceptional sort-term perormance maencourage a degree o risk-taking wic, unless tigtlmonitored and controlled, can ave adverse consequencesor te compan as a wole, its reputation and its long-term nancial stabilit.

Secondl, boards need to be aware tat, even were acompan's sareolders ave te legal rigt to review andcomment on its remuneration practices, te usuallcannot cange commitments tat ave alread beenentered into, owever muc te disapprove o tem.Were te compan's interests sufer as a direct result ote board's agreed scemes, tis could ave adverse

consequences or te uture relationsip between teboard and te members.

In te ligt o tis, boards could consider some or all o teollowing measures.

Remuneration scemes sould identi teacievement o longer-term sareolder value as teke measure o corporate success or te purpose odetermining entitlement to contractual or non-contractual bonuses.

Contractual bonus rewards sould be linked epresslto a combination o individual and corporate

perormance; bonuses tat are linked to te acievemento sort-term perormance targets sould not be paiduntil te cas ow in relation to wic te ave beendetermined as been recorded b te compan.

Guaranteed bonuses, irrespective o eiter individual orcorporate perormance, sould not be allowed.

Boards sould consult te compan's members aboutteir broad proposals or teir incentive and bonusscemes beore te are put into operation.

Wen considering eecutive remuneration, bonus and

pension levels, boards sould consider weter toselevels are reasonable given te compan's perormanceand nancial position and te corresponding levels tatare available to te compan's emploees generall.


26/36

24

Finance-based incentive scemes sould also be afectedb te adoption o a corporate-wide etics culture. Teaim sould be to ensure tat undue pressures are notimposed on directors or staf to meet nancial targets andat te same time tat directors and managers do not turna blind ee to ig-risk activities tat promise sort-termprots but tat are not sustainable. Companies sould alsoconsider, in te same contet, te possibilities or usingnon-nancial criteria in incentive scemes.

Th th tIn te main, decisions about remuneration polic souldrest wit te compan's board, wic will be in te bestposition to decide weter its plans are afordable and in

te compan's interests. Te levels o remuneration and

bonuses paid b a compan sould be a matter o concernto te regulator autorit onl to te etent tat te avean inerent potential to distort te business practices ote compan or an o its directors or emploees andtereb treaten te longer-term stabilit o te compan(and te interests o its sareolders and oterstakeolders). Te autorities sould also keep underreview te etent to wic teir own rules, suc asquarterl reporting requirements, ave a bearing onsort-termist pressures on remuneration. Te souldurter consider te pressures tat und managers andmarket analsts ma eert on companies in relation to tetime-scales linked to incentive awards, and weter sucpressures are detrimental to te acievement o regulator

objectives.


27/36


3.8 rISk maNagemeNT aNd INTerNal coNTrol

a mps sd st p skmmt d t ts dts sd b pb bbjtvy d by t bd,dpdty mmt.

Companies sould be epected to implement procedurestat enable tem to identi and manage te variousnancial and non-nancial risks tat te ace, tat elpensure te integrit o teir nancial sstems and tat tecan use to monitor wit condence te efectiveness oteir various corporate policies and practices. Teseprocedures will include tose relating to te stress testingo te compan's business models.

Th th bCompan boards are responsible or setting te compan'spolicies on risk management and internal controls and oreercising efective oversigt over teir practical operationb management. Te board sould also be aware o and

understand te design o an oter internal controlrequirements and sould ensure tat te efectiveness opolicies and practices can be monitored wit condence.

Boards are responsible or planning and directing tecompan's afairs in a wa wic takes ull into accountte various actors tat will ave a bearing on its businessperormance and te long-term interests o itssareolders. Te management o business risk sould bea concern or te board as wole. Te board sould ensuretat all material risks to te compan, and treats to itscompliance wit te law and regulator requirements, arebrougt to teir attention.

Intn itTe internal audit unction perorms a vital unction inlarge entities in tat it provides te board, and especiallte audit committee, wit epert advice on ow tecompan's controls are operating in practice. It isimportant, owever, tat te internal audit unction is botobjective and independent. To ensure its independence,te internal auditor sould not ave an line or managementresponsibilities and sould be clearl separate rom terisk management unction. Te scope o te internal auditunction sould include consideration o te riskmanagement unction and o te board's oversigt o risk.

To be able to perorm te role efectivel, te internalauditor sould ave a senior status witin te compan. Itsould also be clear tat te ead o internal audit is notsubject to management control in te eercise o teirunctions: te post-older sould report to te cairman ote audit committee (or equivalent) rater tan aneecutive manager. Boards, and regulator autorities,sould consider weter te independence o te internalauditor can be enanced b removing te costs o teinternal audit unction, including remuneration, rommanagement control and transerring tem to te directcontrol o te board.


28/36

26

ris nntRisk is a constant, toug constantl canging, eature ote business environment. Ever business, wenconsidering its business plans, is likel to see bot treatsand opportunities. Risk management involves takingappropriate deensive or evasive action in respect o tetreats identied and making considered judgementsabout ow to eploit opportunities witout over-eposingte compan to te risk o ailure.

Te banking crisis is evidence, owever, tat even incompanies tat appear to ave igl sopisticated riskmanagement sstems, major ailings can occur. It seemstat tose banks tat nanced teir businesses eavil in

te mortgage-backed securities tat uelled te sub-primecollapse did not understand te risks te were taking,made assumptions tat subsequentl proved to be unwise,or were prepared to take uge gambles.

No single ailing appears to ave been present but anumber o alternative eplanations suggest temselves.Te tools wit wic compan boards assessed teassociated risk ma not ave been appropriate; boards didnot devote sucient time or resources to assessing terisk, or did not ave sucient epertise to do so properl;companies ma ave convinced temselves tat since tesame practices were being carried out b oter market

participants an risk tat ad been identied could bedisregarded or downplaed. It was also te case tat manboards considered tat te were efectivel managing riskb transerring te risk o mortgage-backed securities tote buers o tose securities (wic were oten AAArated). It is air to acknowledge, rst, tat neiter centralbank regulators nor eperienced risk managers anticipatedte sudden reeing up o te wolesale markets tatoccurred and, secondl, tat eternal risk is arder topredict and mitigate tan internal risk.

Te eperience o te banking crisis sows ow importantit is tat a compan's risk management and controlpolicies and practices can be understood b te board as

a wole and can be callenged, independentl omanagement. It is important tat means are developed orboards to receive 360 assurance, independent omanagement, tat all te policies o te board are beingimplemented b management and tat tere are no majorrisks, known or unknown to management, tat afect tecompan in te uture. Strengtened, independent internalaudit unctions ave a substantial role to pla in acievingtis outcome.

Companies sould ensure tat te put in place internalprocedures to monitor and manage risk tat are sucientto give tis unction real inuence and autorit. Risk

sould remain ultimatel a matter or te board as awole, but larger companies sould consider appointing adirector wit specic responsibilit or risk andestablising a dedicated risk committee o te board.

TnsnFor boards and audit committees to perorm teirunctions efectivel, te need to ave access to allinormation tat is relevant and material to te decision-making process. In practice, tis issue is ver dicult tomanage: boards and committees ma not necessarilknow weter te need te inormation te are given, orweter tere is oter, and more accurate inormationavailable tat te do actuall need. Te are tus

dependent to a great etent on te management andinormation structures tat te set up, and on teindividuals working witin tose structures. Accordingl, aswell as establising te structures, boards sould also beprepared to insist tat te ow o inormation to tem isaccurate and complete (in te sense tat it does notdeliberatel omit or misrepresent relevant acts or possibleoutcomes). Boards sould epect tat management willperorm tis unction proessionall and eticall and witdue regard to te position o te directors. Steps must betaken, in particular, to avoid an situation were one or twoeecutives efectivel control te inormation ow to teboard.

Furter, companies sould adopt a practice o encouragingte communication o material inormation regarding teailure o controls to a specied individual or individualswitin te compan, suc

financial crises suggestions

Documents