(The article featured below is a selection from International Securities and Financial Reporting Update, which is available to subscribers of that publication.)

Financial Stability Forum Sets Out Broad Reform of Financial Regulation

The Financial Stability Forum ("FSF") has proposed a sweeping overhaul of financial regulation centered on strengthened risk management, enhanced disclosure, and the reform of valuation and credit rating for complex structured products. At the heart of the FSF's plan is the broad reform of the entire securitization process. Originators, arrangers, distributors, managers and credit ratings agencies are all called upon to strengthen transparency at each stage of the securitization chain, such as by enhancing and standardizing information on an initial and ongoing basis about the pools of assets underlying structured credit products.

The FSF also urged standard setters to improve and converge financial reporting standards for off-balance sheet vehicles and develop guidance on valuations when markets are no longer active. The Forum calls for a college of regulators to be put in place by the end of 2008 for each of the largest global financial institutions. The report's conclusions and recommendations are consistent with those of the President's Working Group on Financial Markets, but on a global scale.

The FSF recommendations, while primarily aimed at filling regulatory gaps, also include suggestions that could enhance market conditions. These include, for example, encouraging stronger mid-2008 financial reporting, enhanced transparency for off-balance sheet entities, and fair value estimates for complex securities. According to the FSF, firms need to strengthen their risk management practices, liquidity buffers and capital. The Basel Committee also should raise capital requirements for complex securities and off-balance sheet vehicles. In addition, regulators need to issue revised liquidity risk management guidelines by July 2008, enhance monitoring, and require more stress testing. Firms also need to fully disclose their risk exposures.

The FSF also calls on the credit rating agencies to implement the revised IOSCO Code of Conduct, due out in mid-2008, to manage conflicts of interest in rating structured products and improve the quality of the rating process. The agencies should also differentiate ratings on structured credit products from those on bonds and expand the information they provide.

As part of the rating process, underwriters should be required to provide representations about the level and scope of due diligence that they have performed on the underlying assets. Rating agencies should adopt reasonable measures to ensure that the information they use is of sufficient quality to support a credible rating. Importantly, the agencies should also establish an independent function to review the feasibility of providing a credit rating for new products materially different from those currently rated.

The rating agencies should refrain from rating a complex securitized product when complexity or the lack of robust data about underlying assets raises a serious question about whether a credit rating could even be determined. Finally, rating agencies should take into account the information on the portion of underlying asserts held by originators when rating securitized products.

For their part, investors are asked to reconsider how they use credit ratings in their investment guidelines. Ratings should not replace appropriate risk analysis and management on the part of investors. Rather, investors should conduct risk analysis commensurate with the complexity of the structured product and the materiality of their holding, or refrain from such investments.

The report also urges the IASB to examine its principles for disclosures about the valuation of financial instruments to identify areas for enhancement in light of lessons learned from the market turmoil. This effort will assess disclosures in year-end 2007 annual reports and draw on the views of investors, firms, auditors, and regulators about the quality of valuation disclosure practices.

The IASB will form an expert advisory panel to assist it in reviewing best practices in the area of valuation techniques and formulating sound practice guidance on valuation methods for financial instruments and related disclosures when markets are no longer active. This panel will comprise experts representing both preparers and users of financial statements, as well as regulators and auditors. The group should have a broad perspective of expertise encompassing risk modeling, valuation and auditing.

The FSF also asks market participants to act promptly to ensure that the settlement, legal and operational infrastructure underlying OTC derivatives markets is sound. In this regard, market participants should amend standard credit derivative trade documentation in accordance with the terms of the cash settlement protocol that has been developed, but not yet incorporated into standard documentation. They should also automate trade innovations and set rigorous standards for the accuracy and timeliness of trade data submissions and the timeliness of resolutions of trade matching errors for OTC derivatives. More broadly, the financial industry should develop a longer-term plan for a reliable operational infrastructure supporting OTC derivatives.

In the FSF's view, market turmoil and illiquidity have only served to highlight the importance of enhanced risk disclosure by market participants. What is needed is enhanced disclosures by financial firms of more meaningful and consistent quantitative and qualitative information about risk exposures, valuations, off-balance sheet entities and related policies. The FSF strongly encourages financial institutions to make robust risk disclosures at the time of their upcoming mid-year 2008 reports.

Moreover, going forward, financial industry representatives and auditors should work together to provide risk disclosures that are most relevant to the market conditions at the time of the disclosure. The Basel Committee will issue by 2009 further guidance to strengthen disclosure requirements under Pillar 3 of Basel II for securitization exposures, sponsorship of off-balance sheet vehicles, liquidity commitments to conduits, and valuations.