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Financial Crisis Series: Long-Term Implications
Practical Law Article 9-384-0311 (Approx. 8 pages)
Financial Crisis Series: Long-Term Implications
by PLC Corporate & Securities and PLC Finance
| Published on 13 Feb 2009 • USA (National/Federal) |
This Article is part of a series on the causes and impact of the financial crisis and looks at the likely long-term implications of the financial crisis for banks and markets.
Financial Crisis Series
This Article is part of a series on the causes and impact of the financial crisis. The other practice notes in the series are:
What are the Long-Term Implications of the Financial Crisis for Banks and Markets?
In the long term, the financial crisis will lead to increased domestic and international regulation of the financial sector to reduce systemic risks and increase transparency.
To address regulatory failings, the federal regulatory bodies themselves will be reformed and, in some instances, supplemented or replaced. Regulators and central banks around the world have already taken unprecedented coordinated action in response to the crisis. They will face increased pressure to work together and this may ultimately lead to the creation of new supra-national supervisory structures. The crisis has already prompted consolidation in the financial sector and changes in the way that businesses in the financial sector organize themselves. Further consolidation is likely to follow.
On December 30, 2008, the Securities and Exchange Commission (SEC) delivered a report to Congress recommending against the suspension of the fair value or mark-to-market accounting standards. The report was mandated by the Emergency Economic Stabilization Act of 2008. In its examination of the application of fair value accounting, the SEC found that investors believe the accounting standards forced companies to provide more reliable and comparable financial information on their investments, and that the accounting method was not a primary cause of bank failures in 2008 (see Legal Update, SEC Recommends Improving Rather than Suspending Fair Value Accounting Standards).
The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have formed a joint advisory group to review reporting issues coming out of the financial crisis.
More widely, the financial crisis has shifted the balance of power between the state and the market. Government bailouts of the financial sector, and the government's new role as an equityholder in some of the US's largest financial institutions, will have a lasting impact both in the financial sector and beyond. As a result, checks have already been imposed on executive compensation and bonuses at institutions participating in the bailout.
On a practical level, the financial crisis has led market participants to reassess the allocation of risk in transactions.
The first and most obvious signs of this have emerged in relation to finance transactions, where lenders are looking at terms to give them greater protection when the markets are disrupted and greater control (through tighter covenants) when borrowers run into financial difficulties. However, the financial crisis is also having an impact on all kinds of business arrangements from simple commercial agreements to complex business combinations. These changes are likely to be long-lasting.
The expected wave of securities litigation will have significant implications for all market participants and is also likely to lead to lasting changes in market practice. In addition, commercial litigation in relation to matters such as reverse break-up fees and material adverse change provisions will change the way parties negotiate and document corporate transactions generally.
Broad Changes to Regulatory System
The multiple failures of oversight leading up to the current financial crisis convinced many observers that the federal financial regulatory system needs reform.
The Emergency Economic Stabilization Act (EESA) requires the delivery of several reports to evaluate aspects of the current regulatory system and recommend changes. Both the Congressional Oversight Panel and Treasury Department are to report on the efficacy of broad-based regulatory reform in 2009.
In March 2008, the Treasury Department made extensive recommendations to overhaul the federal regulatory structures overseeing the financial industry in its Blueprint for a Modernized Financial Regulatory Structure (Treasury Blueprint) (Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure).
Given the deepening of the financial crisis since the Treasury Blueprint was published, it may serve as the model both for the Treasury's report due in April 2009 and future legislation.
The Treasury Blueprint recommends:
- Establishing a Mortgage Origination Commission to set up and monitor licensing and qualification standards for state mortgage originators (that is, the mortgage brokers and lenders). A bill to establish this commission was introduced in the US Senate on September 25, 2008 (S. 3581: Mortgage Origination Commission Act of 2008 (GovTrack.us)).
- Consolidating regulation of state-chartered banks under the Federal Reserve or the Federal Deposit Insurance Corporation. The current regulatory structure is thought to be needlessly complicated, with five different federal agencies overseeing depository institutions.
- Merging the SEC and the Commodities and Futures Trading Commission.
- Eventually consolidating all the regulatory agencies of the financial industry into three agencies focused on:
- Market stability;
- Market safety and soundness; and
- Business conduct.
The global financial crisis is likely to prompt regulatory overhaul around the world. It may also lead to some form of international regulation or supervision of the sector, to avoid "regulatory arbitrage" arising from loopholes between different regulatory regimes.
International political agreement on a single, global financial regulator or lender of last resort is unlikely. However, more modest and realistic possibilities include:
- A "college of supervisors" to oversee the biggest financial firms, through which national regulators could act in concert.
- A set of international high-level principles establishing what national regulators should regulate and how.
- Reforming the International Monetary Fund (IMF) to give it the power it would need to support today's global financial markets.
- Systemizing the Federal Reserve's emergency swap lines with other central banks.
Increased Regulation of the Financial Sector
The financial crisis prompted immediate but piecemeal new regulation of certain activities in the financial sector, including short selling and credit default swaps (see Article, Financial Crisis Series: Impact on Capital Markets).
Some of the measures are designed to be temporary; permanent solutions are likely to be put in place over the course of 2009 and are unlikely to involve a lower level of regulation than the original quick fixes. If anything, more extensive regulation is likely to be put in place.
In addition, reform of the regulatory system will bring with it sweeping and significant changes in regulation.
One key area where increased regulation is likely is in relation to the use of leverage in the financial sector. Under EESA, the Comptroller General is to report on methods of monitoring and regulating leverage in the financial sector on June 1, 2009.
There is also likely to be wide support for regulations increasing market transparency, including greater disclosure and new margin requirements and leverage limitations for hedge funds.
It is likely that regulators will pay more attention to the adequacy of the internal risk models in the future. The use of complex computer software to create models that predict cash flows from securities with the aim of controlling risk in a variety of market conditions has been shown to be generally inadequate: among other things, this kind of risk modeling did not take into account the risk of widespread collapse of liquidity in many assets.
Alongside formal regulation, the federal government's response to the financial crisis has given it a new role as an equityholder in the US's largest financial institutions; a role that will have a lasting impact on the activities of the entities affected.
The mere fact of a government bailout changes the market dynamic and the government's role in relation to the entities it bails out is devilled by conflicts. These conflicts will multiply if, as has already been seen, bailouts extend beyond the financial sector.
Having determined that certain companies are too important to fail, the government finds itself walking a difficult line between defending the taxpayer investment and taking more direct action for what it perceives as the wider good. For example, after taking Fannie Mae into conservatorship, the government directed it both to borrow less (to protect taxpayer investment) and also to buy more mortgages (to keep lending lines open for borrowers).
The conflicts are particularly acute when it comes to questions of moral hazard (that is, the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk). It is for political, rather than economic, reasons that participants in the Troubled Asset Relief Program (TARP) have been required to curb bonus payments. In addition, questions of principle will arise. For example, to what extent can entities that the government partly owns legitimately engage in tax planning activity?
Regulation of Credit Rating Agencies
In a series of related actions in June and July 2008, the SEC proposed rule amendments aimed at minimizing conflicts of interest and increasing transparency for Nationally Recognized Statistical Rating Organizations (NRSROs) (SEC Release No. 34-57967; Proposed Rules for Nationally Recognized Statistical Rating Organizations).
The principal proposals:
- Require NRSROs to disclose substantially all of the information provided by an issuer used to determine an initial credit rating. This information could then be used by other NRSROs to provide competing ratings of the security.
- Require NRSROs to disclose and manage conflicts of interest, and prohibit some conflicts entirely.
- Require increased reporting and record retention by NRSROs.
Additional proposed rules would have required NRSROs to differentiate the ratings assigned to structured products from those assigned to bonds and were intended to reduce undue reliance by investors on credit ratings used in SEC rules.
On December 3, 2008, the SEC voted to adopt rules imposing disclosure, recordkeeping and other obligations on NRSROs and proposed additional rules for comment addressing transparency in the practices of credit rating agencies and competition among credit rating agencies. The SEC did not take action on its previously proposed rules on the use of ratings in SEC rules and rating differentiation for structured products. See Legal Update, SEC Publishes Final Amended and Reproposed Rules for Nationally Recognized Statistical Rating Organizations.
Increased Congressional attention may result in further regulation. One suggestion is for market participants jointly to sponsor a new non-profit ratings entity established by Congressional charter and funded by buyer-paid fees.
Financial Sector Consolidation and Restructuring
In practical terms, the financial crisis has led to dramatic and sudden consolidation in the financial sector.
As a result of the financial crisis:
- JPMorgan bought Bear Stearns.
- Bank of America bought Merrill Lynch.
- Lehman Brothers declared bankruptcy, with most of its US assets going to Barclays Bank.
The sheer number of distressed or failing financial institutions is likely to drive further consolidation in the industry. Institutions with stronger balance sheets should be able to acquire distressed banks at heavily discounted prices.
The Treasury Department decision to inject capital directly into financial institutions under TARP is also expected to drive bank mergers and acquisitions. Since there is no requirement for institutions receiving TARP funds to increase lending, participants may instead use the money to acquire struggling banks.
One indication of this trend may be PNC's $5.58 billion merger agreement with National City Corporation. PNC simultaneously announced the National City deal and its decision to accept $7.7 billion in federal investment under TARP on October 24, 2008. This prompted a suggestion that the Treasury should be given power to strike down any proposed mergers that would be financed with money from TARP.
Another consequence of the crisis is that major investment companies (most notably Goldman Sachs and Morgan Stanley) have restructured themselves as bank (and then financial) holding companies (see Article, Investment Banks Become Financial Holding Companies: What Does It Mean in Practice?).
Scrutiny of Mark-to-Market Accounting
Some commentators have blamed mark-to-market accounting for exacerbating the financial crisis by forcing owners of mortgage-related securities to write down severe losses on those securities when the market for them froze (even though the securities were not in default and the owners were not being forced to sell them and realize actual losses).
Estimating value based on a few distressed trades occurring in a frozen market can yield a distorted low price. For this reason, on September 30, 2008, FASB and the Chief Accountant to the SEC issued a joint press release clarifying the mark-to-market rules, emphasizing that the price of "disorderly" trades in a thin or distressed market is not determinative of fair market value (Joint SEC and FASB Press Release: Clarifications on Fair Value Accounting, September 30, 2008, subsequently expanded by FASB Staff Position Paper No. FAS 157-3). The clarification also noted that estimates of fair value should include consideration of future cash flows and multiple inputs from different relevant sources.
The SEC has explicit authority under EESA to suspend mark-to-market accounting rules when it deems necessary. On December 30, 2008, however, the SEC delivered its EESA-mandated report to Congress recommending against the suspension of the fair value accounting standards. In its examination of the application of fair value accounting, the SEC found that investors believe the accounting standards increased transparency, and that the accounting method was not a primary cause of bank failures in 2008 (see Legal Update, SEC Recommends Improving Rather than Suspending Fair Value Accounting Standards).
The Financial Accounting Foundation, which oversees FASB, has criticized EESA provisions relating to mark-to-market accounting and has urged that any changes to financial reporting standards should be made through FASB.
To this end, FASB established, with the IASB, the Financial Crisis Advisory Group (FCAG) comprising regulators, preparers, auditors, investors and other users of financial statements to help ensure that reporting issues arising from the global economic crisis are considered in an internationally coordinated manner. The FCAG will be jointly chaired by a former SEC Commissioner and the Chairman of the Netherlands Authority for the Financial Markets.
FASB and the IASB were already working towards convergence of US and international generally accepted accounting principles and, as in a regulatory context, the global nature of the financial crisis points toward global solutions.
Limits on Executive Compensation and Bonuses
Anger over excessive bonuses paid to some executives of struggling or failing institutions, and concerns that bonus-based compensation structures encouraged staff to make risky investments, has fueled popular demand for government action to limit executive compensation and bonuses.
The immediate result was that, under EESA, institutions participating in TARP are subject to limitations on executive pay including mandatory clawback provisions and caps on "golden parachute" payments.
In the long term, further legislation in this area is likely. Possible measures include:
- "Say on Pay" laws. These would require stockholders to vote annually on executive compensation arrangements.
- Limiting deductions. A reduction in the $1 million limit on a publicly-traded company's tax deduction for compensation paid to certain employees in a single year (Section 162(m), IRC).
The effectiveness of limits on executive compensation has been questioned as previous legislative action in this area has been ineffective in practice.
Executive recruitment is a global exercise and many companies fear the loss of talent to international rivals not bound by similar limitations. In addition, companies have traditionally found creative ways around government attempts to limit executive pay.
On February 4, 2009, the Treasury Department announced new executive compensation restrictions for companies receiving government bailout funds. These restrictions are in addition to previous executive pay guidelines. For more information executive compensation restrictions, see Legal Updates, New Executive Compensation Restrictions for Companies Receiving Government Assistance and Additional Executive Compensation Rules Issued Under TARP.
What are the Wider Long-Term Implications of the Financial Crisis?
More widely, the financial crisis has led market participants to reassess the allocation of risk in transactions.
The first and most obvious signs of this have emerged in relation to finance transactions, where lenders are looking at terms to give them greater protection when the markets are disrupted and greater control (through tighter covenants) when borrowers run into financial difficulties (see Article, Financial Crisis Series: Impact on Loans and Credit Markets).
However, the impact is not limited to finance agreements. The financial crisis is having an impact on all kinds of business arrangements from simple commercial agreements to complex business combinations. These changes are likely to be long-lasting.
The expected wave of securities litigation will have significant implications for all market participants and is likely to lead to lasting changes in market practice (see Article, Financial Crisis Series: Causes and Effects: What litigation is going to come out of the financial crisis?).
In addition, commercial litigation in relation to matters such as reverse break-up fees and material adverse change provisions will change the way parties negotiate and document corporate transactions generally (see Article, Financial Crisis Series: Impact on M&A and Private Equity, Article, Financial Crisis Series: Impact on Companies and Practice Note, In Dispute).