IIF Releases Interim Report

The Institute of International Finance has announced:

A report embracing the critical issues in today’s financial markets has been published by the Institute of International Finance (IIF), the global association of financial institutions. “The leadership of our industry recognizes its own responsibility to restore confidence in the financial markets, solve the problems that have arisen and prevent those problems from recurring in the future. We are fully committed to raising standards and improving best practices in the financial services industry,” stated Dr. Josef Ackermann, Chairman of the Board of Directors of the Institute of International Finance (IIF) and Chairman of the Management Board and the Group Executive Committee of Deutsche Bank AG, speaking on behalf of the IIF’s Board of Directors.

Some of the recommendations are priceless:

The suggestion has been made that some firms would find it useful to have at least as a portion of members of the risk committee of the Board (or equivalent) individuals with technical financial sophistication in risk disciplines, or with solid business experience giving clear perspectives on risk issues, consistently with the overall need for the Board to have the skills necessary to conduct meaningful review of management’s actions to manage risk, as to manage other aspects of the business.

Even more basically – but this did not exist at all firms – Boards need to understand the firm’s business strategy from a forward-looking perspective, not just to review current risk issues and audit reports. It should be the duty of senior management to review with the Board how that strategy is evolving over time, and when and to what extent the firm is deviating from that strategy (e.g., when a strategy morphed into heavy dependence on conduits or on structured products).

… whereas some recommendations, to the extent that they have any meaning at all, are dangerous:

Taking the view that consistent achievement of high standards requires a shared sense of norms and yardsticks to help avoid backsliding, the IIF will recommend a suite of best practices to be embraced voluntarily, perhaps in the context of a “code of conduct” to which the world’s leading financial institutions could subscribe. 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.

As usually discussed, and as is ideal, “best practice” can mean “Don’t be afraid to learn from others”. Those who have any experience in the matter will know that “best practice” really means “tick these boxes and don’t you dare think about what you’re doing”.

There are a number of recommendations dealing with the issue of managers not talking to each other, which echoes the finding of the International Report on Risk Management Supervision.

The IIF continues to highlight the problem of pro-cyclicity:

Basel II can make a substantial difference to the stability of regulated institutions. One of its main strengths is sensitivity to risk. However, it is important to recognize that as currently structured, the Accord will have procyclical effects, especially as banks reduce internal ratings and adjust models for current events. Therefore, further consideration will be needed as how to mitigate these effects, including broadening the use of through-the-cycle rating methodologies.

They make a formal genuflection to the cause celebre du jour:

52. There is a strong sense that externally mandated compensation policies would be at odds with the need to forge competitive, efficient firms that serve the interests of consumer and corporate clients. While recognizing that compensation policies should remain subject to the discretion of the CEO and the oversight of the Board, there is strong support for the view that the incentive compensation model should be closely related by deferrals or other means to shareholders’ interests and long-term, firmwide profitability. Focus on the longer term implies that compensation programs ought as a general matter to take better into account cost of capital, not just revenues. Consideration should be given to ways through which the financial targets against which compensation is assessed can be measured on a risk-adjusted basis. The principle of making the compensation model consistent with shareholders’ interests is well established in some contexts but has been unevenly applied across the industry, especially with respect to compensation of sales and trading functions.

53. Severance pay packages should be tied to performance, consistently with the general principle of alignment with the long-term interests of shareholders.

54. Transparency and proper disclosure to shareholders of compensation policies and criteria, including appropriate alignment of such policies with the firm’s business strategy, is important. Due to competitive issues, disclosure should be focused on principles and process.

There is also some recognition that bank-sponsored conduits are not as off-balance-sheet as might be desired:

Recent events highlight the need for firms to address the proper assessment of nonlegal reputational risk of off-balance sheet vehicles and other potential exposures. Such analysis should include consideration of whether risk of reputation damage could lead a firm to take exposures back onto its balance sheet with adverse liquidity and capital implications. Senior management must be confident that such return of assets would not happen if these exposures are treated as off-balance sheet for regulatory purposes, and Boards should assure themselves that management is properly attentive to this issue. And, on the other hand, supervisors should not take firms’ internal assessment of such risk as necessary grounds to require consolidation for accounting or capital purposes.

The next one’s really going to annoy the Internuts, who are already up in arms about Level 3 “Mark to Make-Believe” accounting … in times like this, when for many instruments there is nothing – nothing! – to be marked to, the Committee seems sympathetic to what will shortly be dubbed Level 4 valuation “Mark to What Looks Good”:

For these reasons, the Committee believes that broad thinking is needed on how to address such consequences, whether through means to switch to modified valuation techniques in thin markets, or ways to implement some form of “circuit breaker” in the process that could cut short damaging feedback effects while remaining consistent with the basics of fair-value accounting. And, while there is no desire to move away from the fundamentals of fair-value accounting, the Committee feels that it is nonetheless essential to consider promptly whether there are viable sound proposals that could limit the destabilizing downward spiral of forced liquidations, writedowns and higher risk and liquidity premia. The Committee is developing specific proposals for consideration in a timely fashion.

My reaction to recommendation #86 is mixed in the extreme!

86. Many investors relied on the rating when making credit decisions. More sophisticated investors were able to make their own assessments to a degree but many less sophisticated investing institutions relied on investment mandates where the rating was the paramount feature. The Committee finds that though rating agencies make their models available to investors, without detailed underlying loan-back data from the banks, additional information on stress testing and the underlying assumptions of the model, it is not possible for investors to verify the accuracy of the ratings models. It would in any case also be beyond the capacity of many investors to validate independently the rating agency models. More detailed loan data needs to be made more readily available and more information on stress testing particularly from a credit perspective will be released by the rating agencies, but for many investors the ratings models will remain a black box. Given this, ratings models should be subject to standards of independent review and external validation (akin to those in Basel II for Internal Ratings-Based Models).

OK … so I like the bit about making more data available. But I don’t really care about whether or not it’s beyond the capacity of many investors to validate independently the rating agency models … if it’s beyond their capacity, they should get competent advice. And I really dislike the idea of subjecting ratings models to independent review and external validation.

Credit ratings are investment opinions, dammit! Take it, leave it, get other independent advice … but don’t get the government or agency thereof involved in validating and reviewing investment advice. That’s a road to ruin if ever I saw one.

Recommendation #88 is full of helpful little hints for investors to abnegate responsibility for their investments and ensure that credit ratings don’t need to be understood as long as all the little boxes are ticked. Recommendation #89 contains such an absolutely priceless phrase that I’m going to quote it without further comment:

For example, the Market Best Practices might suggest that investors, making use of enhanced disclosures suggested elsewhere in this paper:
• Understand vehicles clearly, including the position of rated tranches and cash flows in the structure.

And as we proceed to #91, I’m so highly amused I can barely type:

91. Key issues that need attention at the level of the structured product include:
a. Quality of information provided in offer documents for structured products varies significantly based on the originating firm, country of origination and type of product. Offer documents can range from five pages to more than fifty pages and sometimes are difficult to read.

Awwww … the offer documents are sometimes difficult to read, are they? Awwww. Holy smokes, it should have become apparent by now that what the banks behind the IIF really want is a world of plain vanilla investments that banks can flog for high fees without anybody taking any risk.

All in all, a report more notable for its entertainment value than its contribution to debate.

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