Responding with a code of conduct – IIF Interim Report 2008 on Best practices
The IIF (which is essentially the main political lobby organisation of the large, multinational commercial banks) has released a new report on markets best practices. It can be seen as the response of the banks to the regulatory efforts of the G7 Finance Ministers and the FSF.
In summary, Banks take the blame for the credit crisis by saying that lending standards declined, securities were not sufficiently underwritten, structured products not fully understood, liquidity risks (when markets dry out) not anticipated and because of poor management reputational risk (which result in the stock prices of bank going down) not foreseen for the banks.
The IIF suggests a code of conduct for the major financial institution. The motivation is twofold: such a code of conduct should send a signal to the regulators that the financial industry does not need new regulation. It is questionable though, whether regulators continue to rely on voluntary standards, such as the IOSCO Code of Conduct (2004) for Credit Rating Agencies or the Hedge Fund Code of Conducts (2007).
The second motivation is toward the markets: a code of conduct can be a signal to the markets that certain risks are being addressed. However, markets are more difficult to fool than regulators: if a code of conduct is simply a piece of paper which does not reflect the practices of financial institutions, then markets won’t take the bait.
One weakness of the proposal by the IIF is already included in the proposal: because of the diversity, there will be no single standard for the whole industry. The report says:
Because there are substantial differences in business models, mix of business, exposures,
regulatory oversight and culture, there is unlikely to be a single solution to any issue that would be optimal for all firms and all circumstances. Thus, “best practice” as used here is not a legal obligation but a high standard for firms to apply in developing solutions appropriate to their own situations.
The IIF report calls for improved standards in areas: risk-management governance; technical risk-management issues; and stress testing. They admit that questions have been raised about…
…the ability of certain Boards properly to oversee senior managements and to understand and monitor the business itself.
The report wants to establish a “risk culture” and “three lines of defense” (business management, risk management, audit and control functions). The problem however is not so much that the existing regulation did not already establish these mechanism. The problem is that often the management encouraged the taking of excessive risks claiming that their competitors did the same. This “herding” led to the problem of prudent banks such as the German Landesbanken or the IKB speculating heavily with products they did not fully understand.
In essence, it is doubtful if voluntary standards will satisfy the regulators, but the debate between regulators and industry surely has taken an interesting turn.
(Will be continued)
Topics of this post: code of conduct, finance ministers, fsf, g7, iif, regulation, Reports, risk management, subprime crisis