Problems in the reform of financial market regulation are compounding systemic risks, writes RICHARD BRANDWEINER, board member of the CFA Society of Sydney.

At the recent CFA Australia Investment Conference in Sydney, Matt Moran, vice president of the Chicago Board Options Exchange, highlighted the use of their volatility index, the VIX, in providing negatively correlated returns to risk assets in very weak markets. Then, right on cue in the first two weeks of August, the VIX index hit 48, its highest level since the collapse of Lehmann in late 2008 when it broke through 80. To put this into context, the VIX has averaged about 20 with a standard deviation of about 8 since 1990. The volatility was a reminder of the challenges of late 2008 and of the regulatory reform being enacted around the world to deal with the problems the GFC had highlighted in our financial system. In February 2009, the CFA Institute Centre for Financial Market Integrity, together with the Council of Institutional Investors in the US, formed the Investors’ Working Group (IWG). This was an independent, non-partisan panel formed to provide an investor perspective on ways to specifically improve the regulation of US financial markets. Up until this point, US regulatory talk of reform largely ignored investor considerations.

The working group’s report, with recommendations for US financial regulatory reform, was published in July 2009 and is available from the CFA Institute website. In July 2010, however, the Dodd- Frank Wall Street Reform and Consumer Protection Act became law. Deloitte notes that, “the Act arguably is the most sweeping change to financial regulation in the United States since the changes that followed the Great Depression”. While there is a raft of reforms, three stand out: − The creation of the Financial Stability and Oversight Council (FSOC), which has a mandate for identifying risks and responding to emerging threats to financial stability. − The “Volcker Rule”, which aims to prohibit banks from proprietary trading. − The development of centralised clearing and exchange trading for standard OTC derivatives, as part of a new regulatory regime which is intended to increase transparency, liquidity and efficiency in derivatives, and to mitigate systemic risk which was cited repeatedly in the fallout from the GFC.

The FSOC recently released its first annual report. Jim Allen, head of capital markets policy for CFA Institute, and a contributor to the Investors’ Working Group report, believes the report is not so much a forum for uncovering emerging systemic problems as a means of shifting blame for regulatory failure. One of the main reasons for this is the make-up of the FSOC. The Investors’ Working Group advocated heavily for the creation of an oversight entity that would be separate from the banking and market regulators. However, the FSOC is anything but independent. Other than only one independent member, it’s made up of all the main regulators in the US – Tim Geithner is the Chair and he is joined by the Fed, SEC and FDIC. The problem IWG members saw with this type of arrangement was that the same regulators who oversaw the industry’s problems would then sit in judgment of their own decisions.

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