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Gadziala Details Challenges Facing International Financial Institutions

The proliferation of complex new products, such as credit derivatives, creates challenges to financial institutions on many levels, including risk management and clearing and settlement, according to Mary Ann Gadziala, the associate director of the SEC's Office of Compliance Inspections and Examinations. Referencing the recent interagency statement on complex financial transactions and an earlier paper on sound practices, she discussed the risks facing international financial institutions at a seminar hosted by the Institute of International Bankers.

Gadziala believes that it is important for financial institutions to maintain effective compliance and risk management systems. For example, given the dynamic markets where new products are proliferating, firms should ensure that back office operations and compliance keep pace with sales and marketing of all new products, she said. A particular area of focus is assignments and confirmations with respect to the credit derivatives market.

The International Swaps and Derivatives Association reports that the credit derivatives market has more than doubled in the past year to approximately $26 trillion in notional terms. Any market of that size, she said, should be very carefully risk managed. In addition, the credit derivatives market is relatively new and has not been tested in a severe stress environment. She said that processing issues related to equity derivatives, collateralized mortgage obligations and asset-backed securities should also be monitored.

Another area that requires constant vigilance is anti-money laundering compliance, Gadziala said. This is not only because of its critical importance in combating terrorist financing and illegal money laundering, but because compliance must try to stay one step ahead of clever criminals, she said.

As financial derivatives and asset-backed securities have gone from somewhat esoteric instruments to a central feature of the markets, the SEC and the federal banking regulators have developed guidance for banks and securities firms that engage in complex structured transactions. The agencies recently issued revised interagency guidance on managing the risk of derivatives and other instruments issued in connection with the complex transactions. Broadly, the SEC and the banking agencies continue to believe that it is important for financial institutions engaged in complex structured transactions to design procedures effectively managing the associated risks.

Gadziala noted that the interagency statement describes the types of risk management principles the SEC and banking agencies believe may help a financial institution to identify complex structured finance transactions that may pose heightened legal or reputational risks to the institution and to evaluate and manage these risks within the institution's internal control framework. The main areas covered are due diligence, documentation, general business ethics, monitoring compliance, audit and reporting.

The statement covers U.S. branches and agencies of foreign banks supervised by U.S. bank regulators. Gadziala advised foreign branches and agencies to coordinate their policies with the foreign bank's group-wide policies developed in accordance with the rules of the foreign bank's home country regulators.

The statement also recognizes that a financial institution operating in foreign jurisdictions may tailor its policies and procedures, as appropriate, to account for, and comply with, the laws and regulations of those foreign jurisdictions. The comment period on the proposed revised statement has expired, and the SEC and banking agencies are considering whether any additional revisions may be necessary in light of the comments, she said.

The earlier sound practices white paper contains specific guidance with respect to significant domestic and international firms for identifying clearing and settlement activities in support of critical financial markets and maintaining sufficiently geographically dispersed resources to meet recovery and resumption objectives. The white paper also lists basic business continuity objectives applicable to all firms.

While the sound practices white paper does not address the recovery or resumption of trading operations or retail financial services, Gadziala noted, in 2003 the SEC issued a policy statement on business continuity planning stating that SROs and ECNs should prepare for the timely resumption of trading in the event of wide-scale disruptions. The agency also specified principles to be applied for business continuity planning.

The SEC also stated that the establishment of a next-business day resumption goal for the SROs and the ECNs should serve as a useful resumption benchmark for securities firms as well, recognizing that this is essentially a matter of business judgment. In Gadziala's view, this highlights the fact that business continuity planning remains one of the most critical aspects of risk management.