What is meant by “governance” in the context of a financial institution (FI)? [1] Corporate governance is traditionally defined as the system by which companies are directed and controlled. The OECD Principles of Corporate Governance (2004) defines corporate governance as involving

“a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.” [2]

In the case of financial institutions, chief among the other stakeholders are supervisors and regulators charged with ensuring safety, soundness, and ethical operation of the financial system for the public good. They have a major stake in, and can make an important contribution to, effective governance.

Good corporate governance requires checks and balances on the power and rights accorded to shareholders, stakeholders, and society overall. Without checks, we see the behaviors that lead to disaster. But governance is not a fixed set of guidelines and procedures; rather, it is an ongoing process by which the choices and decisions of FIs are scrutinized, management and oversight are strengthened and streamlined, appropriate cultures are established and reinforced, and FI leaders are supported and assessed.

…continue reading: Toward Effective Governance of Financial Institutions

The past three years have been a period of enormous change and challenge for the SEC. The aftermath of the financial crisis, the passage of legislation that imposes extensive new responsibilities on the agency, and the growth in the size and complexity of the financial markets have demanded that the SEC become more efficient, creative and productive to achieve its mission. While we have made significant progress in many areas, much work remains to be done. My testimony today will highlight a number of the actions we have taken over the past three years to reform and improve SEC operations. In addition, I will describe our progress on implementation of financial reform legislation, upcoming challenges, and the agency’s FY13 appropriations request.

Operational Improvements and Recent Accomplishments

As you know, the SEC has responsibility for approximately 35,000 entities, including direct oversight of about 12,600 investment advisers, 9,900 mutual funds and exchange traded funds (ETFs), and over 4,500 broker-dealers with more than 160,000 branch offices. We have responsibility for reviewing the disclosures and financial statements of more than 9,100 reporting companies and also oversee approximately 450 transfer agents, 15 national securities exchanges, eight active clearing agencies, and nine nationally recognized statistical rating organizations (NRSROs), as well as the Public Company Accounting Oversight Board (PCAOB), Financial Industry Regulatory Authority (FINRA), Municipal Securities Rulemaking Board (MSRB), and the Securities Investor Protection Corporation (SIPC). Due to recent changes in the law, smaller investment advisers will transition from SEC to state oversight during 2012, but with the corresponding addition of advisers to private funds, we estimate that the agency will still oversee approximately 10,000 investment advisers with about $48 trillion in assets under management. During FY 2012 and FY 2013, we also expect to fully implement our new oversight responsibilities with respect to municipal advisors and entities registering with us in connection with the security-based swap regulatory regime.

…continue reading: Changes and Challenges at the SEC

Regulation is the most important factor influencing strategic change at financial institutions and is the second largest threat – after economic uncertainty – to growth prospects, according to PwC’s Annual Global CEO Survey [1]. The survey, which is in its fifteenth consecutive year, canvassed CEOs at over 250 financial institutions in 42 countries late last year and provides a good barometer on market sentiment. The significance of regulation as a change driver in the financial sector has grown steadily since the recent crisis. Based on PwC’s face-to-face interviews with CEOs of some of the world’s largest financial institutions, it is clear, though, that it is not simply regulatory change, but regulatory complexity and uncertainty that are really dampening confidence in growth.

Upgrading the European Union (EU) prudential regime for banks in line with the Basel III proposals is an excellent example of both regulatory complexity and uncertainty. In July 2011, the European Commission [2] released two proposals to introduce the new regime. The bulk of the existing EU prudential regime, with the amendments necessary to introduce Basel III, is recast into a regulation – the Capital Requirements Regulation (CRR) – amongst other things to support the parallel EU goal of harmonising and deepening the internal market through a single rule book. In addition, a Directive – Capital Requirements Directive IV (CRD IV) – sets out requirements in a limited number of areas where Member State discretion is still necessary, for example in relation to corporate governance.

…continue reading: Regulatory Complexity and Uncertainty: The Capital Requirements Directive IV

On April 18, 2012, the CFTC and SEC adopted final rules [1] to further define the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.” [2] The rules initially establish the threshold for the de minimis exclusion from SD registration requirements at $8 billion for swaps connected with dealing activity effected in a 12-month period for CFTC-regulated swaps and all credit default swaps and $400 million for other SBS. [3] Importantly, the rules also exclude from the scope of dealing activity swaps between majority-owned affiliates. The Commission also excluded certain hedging activity from the SD registration analysis.

The Commissions generally declined to adopt exclusions from the definition of SD and MSP for categories of persons, including for sovereign wealth funds, agricultural cooperatives and employee benefit plans. Furthermore, the Commissions confirmed that absent a limited purpose designation, an SD registration applies to the entire legal entity and to all of such person’s swaps or SBS, whether or not such swaps or SBS are entered into in a dealing capacity. The final rules do not address the extraterritorial application of Title VII, including whether a limited designation would be available for a U.S. branch of a foreign bank or to separate U.S.-facing activities from non-U.S.-facing activities; instead, the Commissions stated that they will address such issues in future releases.

With the adoption of these rules, there remains one step – the issuance of final swap product definition rules – before the start of the countdown for swap dealer and MSP provisional registration. The swap entity definition rules will be effective 60 days after they are published in the Federal Register, which is expected to occur shortly. For further information regarding the CFTC’s expected compliance timetable, see the last section of this memorandum.

…continue reading: CFTC and SEC Adopt Final Definitions for Swap Participants

In the paper, Board Structure and Monitoring: New Evidence from CEO Turnover, which was recently made publicly available on SSRN, we provide new evidence on the potential benefits of SOX and ensuing new exchange listing rules and the effectiveness of monitoring by independent directors. Although many researchers, regulators and investors believe that increasing the representation of independent directors on corporate boards can improve quality of board oversight, empirical evidence has been mixed and inconclusive. Recent research even raises doubt about the effectiveness of independent directors in monitoring CEOs.

Using the change in NYSE and Nasdaq listing rules following the passage of the Sarbanes-Oxley Act as a source of exogenous variation, we provide the first statistically convincing evidence on a causal relation between board (committee) independence and the sensitivity of forced CEO turnover to firm performance. Specifically, we find that firms that after SOX moved to a majority of independent directors or to a fully independent nominating committee experience increased sensitivity of forced CEO turnover to performance. This evidence suggests that quality of board monitoring is positively related to board independence and nominating committee independence and the causation goes from board structure to quality of board monitoring.

…continue reading: Board Structure and Monitoring

In March, the Public Company Accounting Oversight Board held hearings about whether to require public companies to change — or “rotate” — their external auditor periodically. Meanwhile, the European Union is proposing to require mandatory rotation every six or 12 years, and the lower house of the Dutch Parliament recently voted to require auditor rotation every eight years.

At the PCAOB hearings, various investor advocates and pension funds argued in favor of mandatory rotation. They found fault with the lengthy relationships between many auditors and the companies they audit — the auditors of almost 36% of all companies in the Russell 1000 have held that position for 21 years or more. According to the supporters of auditor rotation, this coziness creates a potential conflict of interest: an auditor’s desire to maintain a good relationship with its client could conflict with its duty to rigorously question the client’s financial statements.

Mandatory auditor rotation could reduce this conflict. Since auditors would know that their engagement would come to an end after a fixed period, they would have less incentive to curry favor with management. At the same time, mandatory rotation could encourage existing auditors to perform more thorough audits, because the firm would fear that a new auditor would expose any previous errors or omissions.

…continue reading: Search for Auditors; Don’t Rotate

The Federal Reserve issued a statement last week clarifying that it will interpret the Volcker Rule to afford banking entities the full two-year period provided by the statute to conform their activities and investments to the Rule’s prohibitions and restrictions. The financial services industry should welcome this alternative to curtailing trading and investment activities earlier than the statute on its face would have required, but inevitably some questions remain. The Federal Reserve still has not given any indication whether it may extend this period. As compliance activities progress and we gain greater insight into the effect of the Rule on the economy, the public may seek even clearer guidance on this aspect of the Federal Reserve’s discretion.

Statute

The Volcker Rule added a new section 13 (“Section 13”) to the Bank Holding Company Act of 1956 imposing prohibitions and requirements on a banking entity that engages in proprietary trading and has investments in or certain relationships with a hedge fund or private equity fund. [1] The Rule also provides that a non-bank financial company supervised by the Federal Reserve that engages in proprietary trading or makes hedge fund investments must comply with certain other requirements, including supplemental capital requirements or quantitative limitations. [2] The Rule takes effect on the earlier of two years after the date of its enactment, July 21, 2012, or 12 months after the date of issuance of rules implementing that section. Because the Agencies did not issue implementing rules by July 21, 2011, the effective date will be July 21, 2012.

…continue reading: Federal Reserve Clarifies Deadline for Volcker Rule Compliance

Thank you for permitting me to testify before you today on cost-benefit analysis conducted by the Securities Exchange Commission (SEC). I am speaking today on behalf of the Committee on Capital Markets Regulation (Committee), of which I am the Executive Director for Research. The Committee has, since its 2006 Interim Report, [1] strongly supported improved cost-benefit analysis by both the SEC and other agencies. Today, the need for improved cost-benefit analysis is particularly evident in the agencies’ respective rulemakings under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). We are deeply concerned that the inadequate cost-benefit analysis in the vast majority of rulemakings under Dodd-Frank could expose these rules to judicial challenge, prevent important rules from taking effect, and contribute to uncertainty in our markets over their fate.

The broad scope of new regulation under Dodd-Frank, issued by agencies including the SEC, Commodity Futures Trading Commission (CFTC) and others, will result in fundamental changes across the financial industry. Sound cost-benefit analysis must be a part of this process, to ensure that in each case, the proposed rule is optimal among all reasonable alternatives. In light of the ruling last July by the U.S. Court of Appeals for the D.C. Circuit in Business Roundtable v. Securities and Exchange Commission, [2] and a current lawsuit seeking to strike down the CFTC’s recently promulgated position limits rule, [3] we believe many of the rules under Dodd-Frank could be subject to successful challenge in court. It would be an unfortunate outcome if, after the Dodd-Frank rulemaking process has run its course for several years, important rules are invalidated because of inadequate analysis. Even if such rules are not eventually invalidated, prolonged uncertainty around their fate threatens to hamper economic activity.

…continue reading: The Need for Improved Cost-Benefit Analysis of Dodd-Frank Rulemaking

On April 3, 2012 the Financial Stability Oversight Council issued its final rule and interpretive guidance governing its process for designating a nonbank financial company as a systemically important financial institution under the Dodd-Frank Act. The adoption of the Final Rule marks the completion of the highly anticipated standards for designating SIFIs, a process that first began in October 2010. While there have been changes made to the process, much remains to be understood how the FSOC will use its authority to determine whether a nonbank financial company should be supervised and subject to prudential standards. It is widely anticipated that designations of some SIFIs will be made before year-end, making us wonder whether the designation process has been underway without final rules being in place.

The Statute

Section 113 of the Dodd-Frank Act [1] authorizes the Financial Stability Oversight Council (“FSOC”) to designate a nonbank financial company to be supervised by the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and be subject to prudential standards. [2] The FSOC will make a designation after determining that material financial distress at the company or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company could pose a threat to the financial stability of the United States.

…continue reading: Final Rule Issued on Systemically Important Firms, Many Unknowns Remain

The Public Company Accounting Oversight Board is proposing a new auditing standard that relates to the auditor’s evaluation of a company’s relationships and transactions with related parties, and amendments to existing auditing standards that relate to significant unusual transactions and financial relationships and transactions by a company with its executive officers (including incentive compensation arrangements). The new and amended standards are intended to focus auditors’ efforts on areas that may pose an increased risk of material misstatement to a company’s financial statements.

The PCAOB’s proposals largely build upon and enhance existing requirements in these areas, primarily by providing greater specificity around the procedures that must be employed and inquiries that must be made. While the proposals would not directly impact the non-financial-statement disclosure (such as proxy disclosure) relating to related party transactions and executive compensation under SEC rules, companies should anticipate greater auditor focus and additional audit procedures on the financial statement impact of these areas if these proposals are adopted.

Subject to SEC approval, the new and amended standards would be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012. The deadline for public comment is May 15, 2012.

…continue reading: New PCAOB Auditing Standards