The G7 finance ministers asked the FSF at their October 2007 meeting (statement) to analyze the underlying causes of the turbulence, which the FSF did in the first chapter of the report.

The G7 also asked the FSF to offer proposals for liquidity and risk management; accounting and valuation of financial derivatives, role of credit rating agencies in structured finance; supervision of banks and the treatment of off-balance sheet vehicles.

At their February 2008 meeting, they redefined the agenda of the FSF. They urged financial institutions (especially the banks) to disclose their losses. They called for a better liquidity risk management inside Basel-II and to address the problem of off-balance-sheet-vehicles. The G7 Finance Ministers said they were not hostile to a reform of the Basel II capital adequacy framework. They wanted to change the incentives of the originate-to-distribute-modell and address the conflict of interests in the credit rating agencies. They also called for a review of national and international supervisory mechanisms.

Prudential Oversight

Basel II and Minimum Capital Requirements

The report of the FSF calls for a timely implementation of the Basel-II-framework, despite its deficiencies. In 2006 in a response to a questionnaire by the FSI, 95 countries indicated plans to implement Basel II in their jurisdiction (for members of the European Union, Basel II is mandatory). National supervisors are called for evaluating the impact of Basel II and adjust minimum capital levels accordingly.

The BCBS is called to reform Basel II by increasing capital requirements for complex structured credit products such as Colleratlized Debt Obligations of asset-backed securities (ABSs). Together with IOSCO, the BCBS will propose regulation for a better representation of these structured credit products in the trading books of banks and securities firms. The BCBS also wants to strengthen the capital treatment for banks’ liquidity facilities to off-balance sheet asset-backed commercial papers (ABCPs).

On the national level, supervisors are called for to continue to develop the risk assessment framework inside Basel II and the compliance of the banks. One main debate in the financial world is whether the risk-based mininum capital requirements in Basel II encourages procyclicality and supervisors are called to address that.

The role of monoline insurers and financial guarantors is going to be assessed by the IAIS and regulation to be introduced to reflect their relation to structured credit products.

Liquidity risk and liquidity management

Regulators are urged to be more strict in enforcing adequate liquidity risk management. Supervisors and central banks are called to examine an internationally consistent liquidity approach for cross-border banks. Pillar 2 (supervision) is strengthened to avoid that banks build up excessive exposures to liquidity risk.

The BCBS together with national supervisors is going to reassess the use of internal risk-models to ensure comparability between financial institutions. One priority is the guidance relating firm-wide risks, including concentration risks. Again, this includes liquidity risk associated with off-balance-sheet-vehicles, securitisation business and exposure to leveraged counterparties (such as Hedge Funds). Institutional investors are urged to be more cautious when investing in structured products.

Regulators are also called to review compensation models to avoid giving incentives for inappropriately risky conduct of financial business and more focus on long-term, firm-wide profitability.

Over-the-Counter Derivatives

The FSF calls for Market participants to improve the standards for credit derivative trade documentation in accordance with the not yet implemented cash settlement protocol. Standards for the accuracy and time lineless of trade data submissions for OTC derivatives should be improved. The financial industry as a whole is urged to develop reliable operational infrastructure supporting OTC derivatives.

Transparency and Valuation

Accounting, Disclosure and Auditing

Financial institutions should disclose their risks aand supervisors should enforce risk disclosure requirements under Pillar 3 of Basel II (with the help of the BCBS). Financial institutions are encouraged to disclose their losses in their upcoming mid-year 2008 reports.

The IASB is asked to propose an international disclosure standard for off-balance sheet vehicles and strengthen the standards to achieve better disclosures about valuations, methodologies and the uncertainty associated with valuations. The IASB is also called to improve its guidance on valuing financial instruments when markets have dried up (an advisory panel will be set up for that). The BCBS is called to enhance the supervisory assessment of banks’ valuation processes and help supervisors reinforce sound practices.

The auditing of complex or illiquid financial products needs to be improved. Therefore the International Auditing and Assurance Standards Board (IAASB) and major national audit standard setters are required to rexamine the standards in that area.

Transparency in securitisation processes and markets

Securities market regulators and the securities need access to more information on securitised products and their underlying assets. Originators, arrangers, distributors, managers and Credit Rating Agency need to be more transparent at each stage of the securitisation chain by standardising information about assets underlying structured credit products. Securities market regulators will set up a comprehensive system for post-trade transparency of the prices and volumes traded in secondary markets for credit instruments.

Changes in the role and uses of credit ratings

Rating process

Credit Rating Agencies (CRAs) should improve the quality of the rating process and manage conflicts of interest in rating structured products. IOSCO will revise its Code of Conduct Fundamentals for Credit Rating Agencies and CRAs will revise the implementation of this code.

CRAs are called to differentiate ratings on structured finance from those on bonds, and expand the initial and ongoing information provided on the risk characteristics of structured products. They should expand the information on the risk characteristics of structured products.

CRAs should enhance their review of the quality of the data input and of the due diligence performed on underlying assets by originators, arrangers and issuers involved in structured products.

Uses of ratings by investors and regulators

The over-reliance on ratings by investors needs to be decreased. Ratings should not replace appropriate risk analysis and management on the part of investors.

Authorities will also review the use of ratings in the regulatory and supervisory framework. by checking the roles assigned to ratings in regulations and supervisory rules and their consistency with theobjectives of having investors make independent judgment of risks and perform their own due diligence.

Strengthening the authorities’ responsiveness to risks

Translating risk analysis into action

The FSF criticizes that Supervisors, regulators and central banks need to have adequate resources and expertise to oversee the risks associated with financial innovation and to ensure that firms they supervise have the capacity to understand and manage the risks. They should communicate to firms’ boards and senior management at an early stage their concerns about risk exposures and the quality of risk management and the need for firms to take responsive action.

The FSF will increase its own risk analysis and recommendations, both directly and through the actions of its members through a mechanism for regular interaction at senior level with private sector participants, including investors and CRAs, for prompting mitigating actions to identified risks and weaknesses.

The use of international colleges of supervisors will be expanded so that for each of the largest global financial institutions a college of supervisors exist.
To increase the speed of supervisory responsiveness to developments that have a common effect across a number of institutions, supervisory exchange of information and coordination in the development of best practice benchmarks needs be improved at both national and international levels.

To facilitate central bank mitigation of market liquidity strains, large banks will be required to share their liquidity contingency plans with relevant central banks.

International regulatory, supervisory and central bank committees will strengthen their prioritisation of issues and, for difficult to resolve issues, establish mechanisms for escalating them to a senior decision-making level. As part of this effort, they will establish timetables for required action and action plans for addressing delayed or difficult issues.

National supervisors will, as part of their regular supervision, take additional steps to check the implementation of guidance issued by international committees.

The FSF will encourage joint strategic reviews by standard-setting committees to better ensure policy development is coordinated and focused on priorities.

The FSF and IMF will intensify their cooperation on financial stability, with each complementing the other’s role. As part of this, the IMF will report the findings from its monitoring of financial stability risks to FSF meetings, and in turn will seek to incorporate relevant FSF’s conclusions into its own bilateral and multilateral surveillance work.

Robust arrangements for dealing with stress in the financial system

Central bank operations

Central bank operational frameworks should be sufficiently flexible in terms of potential frequency and maturity of operations, available instruments, and the range of counterparties and collateral, to deal with extraordinary situations. To meet an increased but uncertain demand for reserves, monetary policy operational frameworks should be capable of quickly and flexibly injecting substantial quantities of reserves without running the risk of driving overnight rates substantially below policy targets for significant periods of time.

Policy frameworks should include the capability to conduct frequent operations against a wide range of collateral, over a wide range of maturities and with a wide range of counterparties, which should prove especially useful in dealing with extraordinary situations.

To deal with stressed situations, central banks should consider establishing mechanisms designed for meeting frictional funding needs that are less subject to stigma.

Central banks should have the capacity to use a variety of instruments when illiquidity of institutions or markets threatens financial stability or the efficacy of monetary policy.

To deal with problems of liquidity in foreign currency, central banks should consider establishing standing swap lines among themselves. In addition, central banks should consider allowing in their own liquidity operations the use of collateral across borders and currencies.

Arrangements for dealing with weak banks

Authorities will clarify and strengthen national and cross-border arrangements for dealing with weak banks. Domestica authorities will review the division of responsibilities of different national authorities for dealing with weak and failing banks.

National authorities should agree a set of international principles for deposit insurance systems. National deposit insurance arrangements should be reviewed against these agreed international principles, and authorities should strengthen arrangements where needed.

For the largest cross-border financial firms, the most directly involved supervisors and central banks should establish a small group to address specific cross-border crisis management planning issues. Authorities should share international experiences and lessons about crisis management. These experiences should be used as the basis to extract some good practices of crisis management that are of wide international relevance.