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    Financial Services Firms: Governance, Regulations, Valuations, Mergers, and Acquisitions
    Financial Services Firms: Governance, Regulations, Valuations, Mergers, and Acquisitions
    Financial Services Firms: Governance, Regulations, Valuations, Mergers, and Acquisitions
    Ebook1,195 pages13 hours

    Financial Services Firms: Governance, Regulations, Valuations, Mergers, and Acquisitions

    By Zabihollah Rezaee

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    About this ebook

    Indispensable coverage of new federal regulatory reforms and federal financial issues

    An essential guide covering new federal regulatory reforms and federal financial issues

    Financial Institutions, Valuations, Mergers and Acquisitions, Third Edition presents a new regulatory framework for financial institutions in the post-bailout era.

    • Provides valuable guidance to assess risks, measure performance and conduct valuations processes to create shareholder value
    • Covers the protection of other stakeholders, including customers, regulators, government, and consumers
    • Offers an up-to-date understanding of financial institutions, their challenges, and their opportunities in the post-Sarbanes-Oxley era

    Over the past decade, substantial changes have taken place in the structure and range of products and services provided by the financial services industry. Get current coverage of these changes that have transformed both traditional organizations such as banks, thrifts, and insurance companies, as well as securities providers, asset management companies and financial holding companies with the up-to-the-minute coverage found in Financial Institutions, Valuations, Mergers and Acquisitions, Third Edition.

    LanguageEnglish
    PublisherWiley
    Release dateJun 9, 2011
    ISBN9781118098530
    Financial Services Firms: Governance, Regulations, Valuations, Mergers, and Acquisitions

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      Book preview

      Financial Services Firms - Zabihollah Rezaee

      To the loving memory of my mother,

      Fatemeh Rezaee.

      Preface

      Traditionally, customers have had their checking and savings accounts at a bank, their mortgage at the savings and loan association, their insurance services with insurance companies, and their investment activities with investing companies, mutual funds, and brokerage firms. This conventional model of providing and receiving financial services has disappeared in the years after the Gramm-Leach-Bliley Financial Services Modernization Act of 1999. The recent wave of consolidations in the financial services industry has resulted in fewer but bigger financial institutions, and they are often perceived as too big to fail (TBTF). The distinctions among financial services and products of banks, insurance companies, mutual funds, and brokerage firms are now becoming less noticeable. The principal focus of this book is on banks, but many issues discussed throughout all chapters are relevant for all firms in the financial services industry, such as mutual and hedge funds and investment and insurance companies. Although it is not the purpose or this book to evaluate the relative importance of factors that contributed to the 2007–2009 financial crisis, their consequences and regulatory responses are discussed. As this book was going through production, the Financial Crisis Inquiry Commission issued a report that suggests the 2007–2009 financial crisis could have been avoided and was caused by inadequate and ineffective regulations to ensure the safety and soundness of the financial system. Other factors which contributed to the crisis range from lax oversight of derivatives to insufficient supervision by federal banking and securities regulators as well as greed, excessive risk taking, and mismanagement of executives of financial services firms.

      A new regulatory framework has been established for the financial services industry, including the Dodd-Frank Act of 2010 and its related regulations, Group of 20 summits, and Basel committee requirements. This new regulatory framework defines boundaries, guidance, and requirements within which banks and other financial services firms can effectively operate in generating sustainable performance. It normally is supplemented by best practices of vigilant boards of directors, risk assessment, and effective corporate governance. In an open market economy and the free enterprise system, the achievement of sustainable performance depends on cost-effective and efficient regulations as well as effective corporate governance, best practices, and competent and ethical culture. There should be a right balance between rules and regulations governing banks' operations and oversight functions of the board to engage in business strategy and overseeing managerial decisions.

      In summary, the new regulatory framework requires:

      Strengthening the quality and quantity of overall bank capital adequacy

      Assessing the market risk capital requirements

      Identifying systemically important financial institutions and measuring their sustainability, risks, and externalities to reduce the moral hazard of TBTF and risk to the global financial stability

      Stricter oversight of credit rating agencies

      Rationalizing the executive compensation program, which is linked to long-term performance and avoids incentives for undue risk taking

      Regulating over-the-counter derivatives and credit default swaps

      Enhancing the supervisory program for financial services firms

      Improving the corporate governance structure by increasing independence of directors and risk management functions

      Clearing banks' balance sheets of toxic assets by applying fair value in measuring, recognizing, and reporting assets

      Using the expected loss model instead of the current practice of incurred loss model for measuring credit losses

      Separating investment banks from commercial banks

      Developing more stringent prudential standards of enhanced capital and liquidity requirements

      Providing transparency and accountability for government bailout plans and stimulus programs

      Implementing close supervision and monitory of banks' debt, liabilities, and capital adequacy

      Maintaining ongoing and systematic assessment of banks' systemic risks

      This book presents these and other regulatory and corporate governance measures for the financial services industry.

      The past two decades have witnessed significant changes in the structure, characteristics, and types of products and services offered by financial services firms. The most significant changes were in four areas: consolidation, convergence, regulation, and competition. The modern financial services being offered by banks, insurance companies, and mutual funds, coupled with a new trend toward combinations between banks and financial services firms, make the subject matter of valuations and mergers and acquisitions (M&A) timely and relevant. It is expected that the steady global economic recovery and improved financial and credit market conditions in the postfinancial crisis period will lead to increased M&A across all industrial sectors particularly the financial services industry. The 2011 KPMG survey indicates that: (1) 2010 M&A activity increased significantly by 23 percent, and it is expected to continue to grow in 2011 as a result of a rebound in both the debt and equity markets; (2) two-thirds of respondents reported that they were currently more optimistic about the M&A deal environment than a year ago; (3) factors that contributed to the recent growth in M&A activities according to the survey are: a more stable economic environment (66 percent), an improvement in buyer confidence (52 percent), improved debt and equity markets (41 percent), the return of the private equity buyer (27 percent), and certainty surrounding tax legislation (27 percent); and (4) the three industries that will be more actively involved in M&A are banking, financial services, and health care. Strategic M&A transactions will be the key driver of business combinations in industries such as financial services, natural resources, pharmaceuticals, health care, and technology. M&A activities of the emerging markets, such as China, India, and Brazil, are expected to continue to increase significantly. Every day a significant number of business executives, business owners, accountants, attorneys, investment bankers, tax and regulatory authorities, and judges are involved in various stages of business valuation and the M&A process. Knowledgeable and experienced valuation specialists can play a vital role in this exciting, dynamic, and rewarding process.

      This book is intended to assist valuation and M&A practitioners in applying their knowledge and expertise in providing their services. No prior knowledge of financial institutions, valuations, or M&A is assumed in the third edition. The text presents current developments in the areas of valuations and M&A, which have progressed significantly since the first edition of the book in 1995 and the second edition in 2000. This third edition is designed primarily for business executives, banks, financial services organizations, attorneys, accountants, and appraisers interested in the valuation and M&A areas of the financial services industry. Throughout the book, every effort is made to integrate online, fair value valuation techniques into the due diligence process and practices for internal and external assessment purposes as well as M&A deals. The goals in preparing this edition are to:

      1. refine the style and clarity of presentations to maximize the effectiveness of the book as an authoritative guide and learning resource for users;

      2. refine the content and organization of the book to enhance its relevance and flexibility in accommodating new online valuation techniques for the financial services industry;

      3. provide comprehensive and integrated coverage of the latest developments in the environment, accounting standards, laws, regulations, and methodologies pertaining to the valuation process, as well as the due diligence practices for M&A deals; and

      4. present the emerging regulatory framework governing operations of financial services firms.

      The third edition is designed to provide a useful reference for anyone wishing to obtain understanding and knowledge of financial services firms and their regulation, governance, and valuation as well as the wave of M&A in the financial services industry. This edition presents a new regulatory framework for financial institutions in this postfinancial crisis era. It will provide valuable guidance to bank professionals, their advisors, and business appraisers to assess risks, measure performance, and conduct valuation processes to create shareholder value while simultaneously protecting interests of other stakeholders (e.g., customers, regulators, government, and society). This edition is a superior reference for all business professionals who need an up-to-date understanding of financial services firms, their challenges, and their opportunities in the Dodd-Frank Act era. The substantial changes in the third edition reflect the intent of the book.

      Highlights of Changes from the Second Edition

      These changes have been made in the third edition:

      Each chapter includes a conclusion.

      Emerging regulations for the industry financial services are discussed throughout the book.

      Bank valuation cases in the post–Sarbanes-Oxley (SOX) period are discussed.

      All chapters have been updated to address emerging initiatives affecting financial reporting and corporate governance and auditing functions (implementation rules of SOX and the Securities and Exchange Commission, auditing standards issued by the Public Company Accounting Oversight Board, technological advances, Dodd-Frank Act, Basel Committee, and globalization).

      Recent financial accounting standards, under U.S. generally accepted accounting principles and International Financial Reporting Standards on business combinations and fair value are incorporated throughout the book.

      Emerging initiatives on and models for the allowance for loan losses is incorporated into the related chapters.

      Risk management and assessment for bank loans and other major transactions is integrated into all chapters.

      Lending practices and overall health of financial institutions are addressed.

      Government efforts to influence bank rescues through the Trouble Asset Relief Program (TARP) are discussed.

      Bank credit markets, demands for commercial paper, and credit problems are examined.

      The misperception of too-big-to-fail banks is addressed.

      Derivatives risk and its regulatory oversight are examined.

      The emerging financial reporting and auditing initiatives, including the movement toward International Financial Reporting Standards as well as the use of Extensible Business Reporting Language (XBRL) reporting platform, are discussed.

      Government bailout of troubled financial institutions is covered.

      Capital allocation and performance measurement of the banking industry are discussed.

      Description of managing and assessing the value of financial institutions is presented.

      Corporate governance and executive compensation standards for the banking industry are discussed.

      Bank financial statement analysis and valuation assessments are covered.

      Financial and nonfinancial key performance indicators (KPIs) in the banking industry that affect the value of the bank are presented.

      Market performance, initial public offerings, and M&A transactions that affect the value of the bank are described.

      The Dodd-Frank Act of 2010 and recent Basel Committee requirements are presented.

      Integrated audit of both financial statements and internal control over financial reporting is incorporated into all related chapters.

      Bank sustainability performance and accountability reporting are examined.

      The role of new federal agencies to oversee Dodd-Frank regulations (Financial Stability Oversight Council, FSOC; Consumer Financial Protection Bureau, CFPB) is discussed.

      Risk management and assessment for bank major credit activities, loans, and other transactions is presented.

      Organization of the Book

      The organization of the third edition continues to provide maximum flexibility in choosing the amount and order of materials on regulation, corporate governance, valuations, and M&A for financial services firms. The entire valuation process is examined from an M&A perspective. Thus, in addition to valuation theory, concepts, methodology, and techniques, the M&A process, target bank analysis, applicable laws and regulations, and related accounting standards are thoroughly examined.

      The third edition is organized into five parts.

      The first part contains three chapters that constitute the foundation of the book. Chapters 1 and 2 discuss the major topics of the book, including the nature, role, operation, and the regulatory framework of financial services firms. Chapter 3 describes corporate governance measures of the financial services industry. Part II consists of Chapters 4 to 6. Chapter 4 discusses M&A in general and convergence in the financial services industry in particular. Chapters 5 and 6 present an overview of M&A and examine the regulatory environment and the financial reporting process of financial institutions.

      Part III, containing Chapters 7 through 10, addresses the fundamental issues related to valuation, including different types of value, approaches to measuring value, and the differences between tangible and intangible assets. The four chapters in Part III provide a thorough background on the basic principles needed to understand the calculation of the value of a bank.

      Part IV, comprising Chapters 11, 12, and 13, addresses the various types of research that likely will be undertaken as part of a proper valuation. A major portion of the discussion relates to the financial analysis of the banking company, but there is ample discussion of nonfinancial aspects of bank operations and organizations as well as the external market environment in which the bank operates. Taken together, the discussions in Parts III and IV provide a solid foundation for applying the principles of valuation to the calculation of a banking company's value.

      Part V contains Chapters 14 through 19, which focus on specific issues related to calculation of value for purposes of M&A. A description of the bank M&A process is provided as a background to put into context the role that valuation can play at various points in that process. Also covered are topics that are unique to banking, such as core deposits, branch acquisitions, unknown loan losses, derivatives, and accounting standards on M&A.

      The analyses in this book are described in order to be useful to both buyers and sellers. As a buyer, a banker must be able to assess the value of a target bank and gauge the underlying business that has created that value. As a seller, a banker should understand how the value of the institution will be assessed, whether a buy offer is fair, and possible strategies to enhance value. Where possible, examples are given from both the buyer's and seller's perspective. However, whether the reader is a buyer or seller (or a professional assisting either), the concepts, principles, and techniques described can assist in making the M&A process more successful.

      In one book, it is not possible to address the valuation of every type of subsidiary business a bank holding company may operate. Consequently, the focus is on what is commonly thought of as a commercial bank, often referring to the bank holding company legal structure that is common in U.S. banking. While the discussions that unfold generally focus on commercial banks and on those bank holding companies where the principal subsidiaries are commercial banks, the same valuation principles and techniques apply to nonbanking entities. Although the title of the book is Financial Services Firms: Governance, Regulations, Valuations, Mergers, and Acquisitions, and therefore the focus is on financial services firms, the issues of corporate governance, regulations, valuations, and M&A are relevant to all organizations in all industries. The first part of the book examines these issues in generic terms as they relate to all organizations. The other parts of the book discuss these issues as they pertain to financial services firms. Technical distinctions exist between mergers and acquisitions. Mergers often occur when two separate entities combine and both parties to the merger wind up with common stock in a single combined entity. In contrast, in an acquisition deal, the acquirer (bidding entity) buys the common stock or assets of the seller (target entity). However, in this book the terms mergers and acquisitions are used interchangeably to describe the method in which separate institutions are combined under the control of one entity. The vast majority of all business combinations are acquisitions rather than mergers.

      Acknowledgments

      This book has benefited from the assistance of numerous professionals and colleagues. I would like to thank specifically Tim Bell and Ram Menon for their invaluable review of earlier chapters of the book. I also thank the publishing team at John Wiley & Sons for their help, particularly John DeRemigis, Stacey Rivera, Natasha Andrews-Noel and Dexter Gasque in Hoboken, NJ. The assistance of my graduate students, Yue Zhang, Kyle Griffiths, Sudeshna Gunna, Mansi Gadi, and Amir Alimardani is greatly appreciated.

      The encouragement and support of my family and colleagues are also acknowledged. I am thankful for the love, patience, and support of my wife, Soheila, my son, Nick, and my daughter, Rose, in making it easier for me to focus on completing the third revision of this book.

      Part One

      Financial Services Industry: Its Markets, Regulations, and Governance

      Chapter One

      Fundamentals of the Financial Markets and Institutions

      Introduction

      More than half of all households (over 115 million) in the United States are now investing in the securities markets through private investments in company shares, mutual funds, and pension funds. Furthermore, due to the recent financial crisis, bank failures, the risks regarding Social Security, and the high-profile failure of some large pension funds, Americans are being forced to take responsibility for their financial future and retirement funds. The sustainability and financial health of public companies in general and financial services firms in particular is vital to keeping investor confidence high, and this sustainability requires public trust in the reliability of financial reports. Reliability of public financial information contributes to the efficiency, liquidity, and soundness of financial markets that may drive economic development and prosperity for the nation. This introductory chapter discusses the importance of our financial markets to the nation's economic prosperity, the promotion of the free enterprise system, the vital role of financial services firms in our society, and the importance of financial information as the lifeblood of financial markets.

      Financial Markets

      The efficiency, liquidity, and safety of the financial markets, both debt and capital markets, have been threatened by the recent financial crisis and resulting global economic meltdown. These threats have significantly increased the uncertainty and volatility in the markets, which adversely affected investor confidence worldwide. These crises prevent investors from receiving meaningful financial information to make savvy investment decisions. U.S. capital markets traditionally have been regarded as the deepest, safest, and most liquid in the world. For many decades, they have employed stringent regulatory measures to protect investors, which has also raised the profile and status of listed companies. However, the recent global financial crisis and the competitiveness of capital markets abroad have provided global companies with a variety of choices of where to list, possibly subject to less vigorous regulatory measures. As these markets abroad become better regulated, more liquid, and deeper, they enable companies worldwide to raise their capital needs under different jurisdictions. Investors now have a wide range of options to invest globally to secure their desired return on investment.

      To a significant extent, the global competitiveness of U.S. capital markets depends on the reliability of financial information in assisting investors to make sound investment decisions, cost-effective regulations that protect investors, and efficiency in attracting global investors and companies. The U.S. free enterprise system has transformed from a system in which public companies, including banks and other financial institutions, traditionally were owned and controlled by small groups of investors to a system in which businesses are owned by global investors. The United States has achieved this widespread participation by adopting sound regulations and by maintaining high-quality disclosure standards and enforcement procedures that protect the interests of global investors.¹

      Recent financial regulatory reforms—both the Sarbanes-Oxley Act of 2002 (SOX) and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank)—are intended to protect investors and consumers.²

      Financial Information and Capital Markets

      Reliability, transparency, and quality of financial information are the lifeblood of the capital markets. The efficiency of the markets depends on the reliability of that information which enables the markets to act as signaling mechanisms for proper capital allocation. Investor confidence in the same level playing field of all market participants has encouraged investors to own stock, and billions of shares trade hands to provide capital to businesses. Society, particularly the investing community, relies on the quality of corporate financial reports in making investment decisions. William McDonough, the former chairman of the Public Company Accounting Oversight Board (PCAOB), stated, Confidence in the accuracy of accounting statements is the bedrock of investors being willing to invest, in lenders to lend, and for employees knowing that their firm's obligations to them can be trusted.³ As investor confidence in financial information drives the willingness to invest, America's economic future is tied to how successfully companies respond to this call for greater transparency and reliability in financial information as well as cost efficiency and effectiveness of regulatory reforms of financial services firms.

      A greater number of people are now investing through retirement funds or are actively managing their portfolios and therefore are affected by financial information disseminated to the market. Reliable and transparent financial information contributes to the efficient functioning of the capital markets and the economy. In recent years, investment banks and major brokerage firms have grown rapidly and generated record revenue. Recently five major financial institutions have failed: Goldman Sachs Group, Bear Stearns Co., Morgan Stanley, Lehman Brothers Holdings, and Merrill Lynch & Co. The subsequent government bailout of some of these firms raises serious concerns about the value-adding activities of financial services firms, their ethics and governance, as well as the professional accountability of their board of directors, senior management, internal and external auditors, and other corporate governance participants. The lack of public trust and investor confidence in corporate America, Wall Street, and its financial dealings and reports has continued to adversely affect the vibrancy of the capital market. Bailed-out banks and their continuous excessive executive compensation schemes have left us with a legacy of mistrust. Policy makers and regulators have been challenged to establish and enforce more effective and efficient regulatory reforms; business leaders have been challenged to change their culture, behavior, and attitudes to restore confidence and trust in Wall Street.

      Financial Crisis and Financial Regulatory Reforms

      A historical perspective of the financial crisis in the United States indicates that real estate markets started to collapse in the second half of 2007, and investors began shorting real estate markets. Where shorting or short selling is defined as; borrowing an asset from a third party and selling it with a promise to buy back at a future point in time at a predetermined price. Collateralized debt obligations (CDOs) and mortgage-backed securities were written down, and financial panic continued into 2008, which caused major financial institutions to go bankrupt. The persistence of the financial panic in 2009 and lack of public trust and investor confidence in the financial system have caused the disappearance or reorganization of once-prominent Wall Street firms, some of which have changed their corporate structures and become bank holding companies. The U.S. financial crisis eventually affected global financial markets. Financial institutions worldwide have lost more than $1.5 trillion on mortgage-related losses. The failed financial institutions Bear Stearns, Lehman Brothers, AIG, and Merrill Lynch played important roles in the recent financial crisis by engaging in risky mortgage lending practices, credit derivatives, hedge funds, and corporate loans. The Federal Reserve responded by reducing interest rates and flooding the market with money, and the Treasury Department asked for a $700 billion package dubbed the Troubled Asset Relief Program (TARP) to buy toxic mortgages and other assets. The U.S. government responses to mitigate the financial panic were the TARP stimulus packages, temporary increases in deposit insurance coverage of $250,000 per person by the Federal Deposit Insurance Corporation (FDIC), and the Dodd-Frank Act of 2010.

      Recent financial reforms (Dodd-Frank), and corporate governance reforms, including SOX, convergence in regulatory reforms (from the Group of 20 [G-20]) worldwide, and TARP have shifted the power balance among shareholders, directors, and management of all entities, particularly banks. Shareholders including the U.S. government have been more proactive in monitoring and scrutinizing corporations. Directors are held more accountable in fulfilling their fiduciary duties by overseeing management's strategic plans, decisions, risk assessment, and performance. Management is expected to achieve sustainable shareholder value creation and enhancement and to enhance the reliability of financial reports through executive certifications of internal controls and financial statements. Some provisions of SOX that were not previously practiced by public companies and that are intended to benefit all companies include:⁴

      Creating the PCAOB to oversee audits of public companies and to improve the ineffective self-regulatory environment of the auditing profession.

      Improving corporate governance through more independent and vigilant boards of directors and responsible executives.

      Enhancing the quality, reliability, transparency, and timeliness of financial disclosures through executive certifications of both financial statements and internal controls.

      Prohibiting nine types of nonaudit services considered to adversely affect auditor independence and objectivity.

      Regulating the conduct of auditors, legal counsel, and analysts and their potential conflicts of interest.

      Increasing civil and criminal penalties for violations of security laws.

      Six provisions of SOX address the quality, reliability, transparency, and timeliness of public companies' financial reports:

      1. The board of directors should adopt a more active role in the oversight of financial reports.

      2. The audit committee is responsible for overseeing financial reports and related audits.

      3. Management (chief executive officer [CEO], chief financial officer [CFO]) must certify the completeness and accuracy of financial reports in conformity with generally accepted accounting principles (GAAP).

      4. Pro forma financial information must be presented in a manner that is not misleading and that is reconciled with GAAP items.

      5. All material correcting adjustments identified by the independent auditor must be discussed with the audit committee and reflected in any reports that contain financial statements.

      6. Management must assess the effectiveness of internal controls, audit of internal control over financial reporting (ICFR), communication of significant deficiencies to the audit committee, and public disclosure of material weaknesses in ICFR.

      The first summit of the 20 largest advanced and emerging countries, better known as the G-20, was held in Toronto in June 2010 to ensure international economic cooperation by addressing the global economic crisis, reforming and strengthening global financial systems, and promoting a full return to growth with quality jobs.⁵

      The 2010 G-20 agreed to:

      1. Reduce budget deficits by cutting the global deficit in half by 2013.

      2. Promote growth through global economic stimulus and more government spending.

      3. Full return to growth with quality jobs.

      4. Reform and strengthen financial systems.

      5. Create strong sustainable and balanced global growth.

      6. Reduce government debt–to–gross domestic product (GDP) ratios by 2016.

      The important provisions of the 2010 G-20 are discussed next.

      The Framework for Strong, Sustainable, and Balanced Growth assesses global policy actions and strengthens policy frameworks.

      Financial service reform establishes a more resilient financial system, improving risk assessment, promoting transparency, and reinforcing international cooperation.

      International financial institutions (IFIs) should develop as a global response to the financial and economic crisis and a platform for global cooperation including $750 billion by the International Monetary Fund (IMF) and $235 billion by the multilateral development banks (MDBs).

      Fighting Protectionism and Promoting Trade and Investment by refraining from raising barriers or imposing new barriers to investment or trade in goods and services at least until the end of 2013.

      Moving toward convergence in accounting standards by adopting a single set of high-quality globally accepted accounting standards.

      The most important declaration of the 2010 G-20 summit is the development of financial sector reform that encourages a systemic risk assessment, supports strong and stable global economic growth, requires prudential oversight, and promotes transparency and reinforces international cooperation. The G-20 financial sector reform consists of four pillars. The first pillar is a strong financial regulatory framework built on the progress of the Basel Committee on Banking Supervision. This regulatory framework would establish a new regime for bank capital and liquidity that will eventually raise levels of resilience for the global banking systems and enable banks to withstand the pressure of the recent financial crisis. This first pillar will come to fruition by the end of 2012 and is intended to strengthen financial market infrastructure by implementing effective measures to improve transparency and regulatory oversight of the over-the-counter (OTC) derivatives, credit rating agencies, and hedge funds.

      The second pillar is effective oversight and supervision of global financial institutions. The Financial Stability Board (FSB) in consultation with the International Monetary Fund (IMF) issued its report, in February 2011, entitled Progress in the Implementation of the G 20 Recommendations for Strengthening Financial Stability which makes recommendations to finance ministers and central bank governors to strengthen oversight and supervision while providing adequate resources and defining roles and responsibility of supervisors.⁶

      The third pillar is the development of a system that systematically restructures and resolves all types of financial institutions in crisis with no burden on taxpayers. This system would consist of policy framework, implication procedures, resolution tools, supervisory provisions, and core financial market infrastructures.

      The fourth pillar is robust and transparent international assessment and peer review of global financial institutions. This pillar demonstrates G-20's commitment to the IMF/World Bank Financial Sector Assessment Program to support transparent peer review through the FSB. The review process would address noncooperative jurisdictions based on effective assessment regarding the fight against money laundering, tax havens, and terrorist financing.

      The Basel Committee is intended to strengthen global capital and liquidity regulations to promote a more resilient banking sector with proper ability to absorb shocks arising from financial and economic stress and to improve risk management, governance, transparency, and disclosures. The Basel Committee addresses the market failures caused by the recent financial crisis and establishes measures to strengthen bank-level and micro-prudential regulation.

      On September 12, 2010, global bank regulators agreed to require banks to significantly increase their amount of top-quality capital in an attempt to prevent further international crisis.⁷ Basel III will require banks to maintain top-quality capital totaling 7 percent of their risk-bearing assets compared to the currently required 2 percent. Effective compliance with Basel III rules would require banks to raise substantial new capital over the next several years as the Tier 1 rule (4.5%) will take effect from January 2015 and the requirement for the capital conversation buffer (up to 10.5%) will be phased in between January 2016 and January 2019. The primary objective of Basel III rules is to strengthen global capital standards to ensure sustainable financial stability and growth for banks worldwide. The rules are intended to encourage banks to engage in appropriate risk business strategies to ensure their financial health and their ability to withstand financial shocks without government bailout supports. The increased capital requirement, however, could reduce the amount of funds available to lend out to customers.

      Specifically, Basel III will require banks to: (1) maintain top-quality capital (tier 1 capital, consisting or equity and retained earnings) up to 4.5 percent of their assets; (2) hold a new separate capital conservation buffer of common equity worth at least 2.5 percent of their assets; and (3) build a separate countercyclical buffer of up to 2.5 percent when their credit markets are booming. The tier 1 rule will take effect from January 2015 and the requirement for the capital conservation buffer will be phased in between January 2016 and January 2019.

      Other rules of Basel III include: (1) provisions for reducing risk-taking by banks, (2) requirements for liquid banks' assets, (3) promotion of financial stability, and (4) improvements in risk management, governance, banks' transparency and disclosures,

      Eleven important provisions of Basel III are listed next.

      1. Basel III rules are more robust than those of Basel II in the sense that they require higher capital standards (more than triple that required by Basel II) to withstand future financial crisis.

      2. The effective implementation or Basel III is undermined by several potential pitfalls during the eight-transition period.

      3. The new capital conservation buffer (2.5 percent) will not be effective until January 2019.

      4. The total capital requirement of 7 percent is expected to become a norm or standard floor for banks in order to avoid curbs on their payouts such as dividends, bonuses, or share buybacks.

      5. Basel III rules along with global liquidity standards that will become effective January 2015 will make banks build up reserves of cashlike assets and more capital than Basel II rules.

      6. Financial institutions may reconsider financial market trading in light of the new tougher capital requirements.

      7. Big financial institutions may build up more capital than Basel III rules to mitigate the negative effects of the perception of too big to fail (TBTF).

      8. Regulators may require excess countercyclical buffer.

      9. Banks may attempt to adopt Basel III capital requirements prior to the dates specified in Basel rules to demonstrate their commitment to a sound banking system and proper risk assessment. Investors will perceive early adoption of Basel III rules as positive steps toward a more sustainable, liquid, and sound banking sector.

      10. It is also expected that large banks will adopt Basel III rules earlier than the required timetable because they have more resources and incentives to do so to rule out the perception of TBTF.

      11. A relatively long transition period may put banks that delay adoption at a competitive advantage over early adopters.

      On July 21, 2010, President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which is called the most sweeping financial reform since the Great Depression. Dodd-Frank is named after Senate Banking Committee chairman Christopher Dodd (D-CT) and House Financial Services Committee chairman Barney Frank (D-MA). Its provisions pertain to banks, hedge funds, credit rating agencies, and the derivatives market. Dodd-Frank authorizes the establishment of an oversight council to monitor systemic risk of financial institutions and the creation of a consumer protection bureau within the Federal Reserve. Dodd-Frank requires the development of over 240 new rules by the Securities and Exchange Commission (SEC), the Government Accountability Office (GAO), and the Federal Reserve to implement its provisions over a five-year period.

      Many provisions of Dodd-Frank are considered to be positive and useful in protecting consumers and investors, including the establishment of a consumer protection bureau and a systemic risk regulator and provisions requiring derivatives to be put on clearinghouses/exchanges. The new Consumer Financial Products Commission will make rules for most retail products offered by banks, such as certificates of deposit and consumer loans. Dodd-Frank requires managers of hedge funds (but not the funds themselves) with more than $150 million in assets to register with the SEC.

      Some provisions are subject to study and further regulatory actions by regulators, including the so-called Volcker rule. Dodd-Frank fails to address the misconception of TBTF financial institutions, the main cause of the financial crisis, inefficiencies in Fannie Mae, Freddie Mac, and the housing agencies and the excessive use of market-based short-term funding by financial services firms.

      Provisions of the Dodd-Frank Act of 2010 are summarized next.

      1. Broadening the supervisory and oversight role of the Federal Reserve to include all entities that own an insured depository institution and other large and nonbank financial services firms that could threaten the nation's financial system.

      2. Establishing a new Financial Services Oversight Council to identify and address existing and emerging systemic risks threatening the health of financial services firms.

      3. Developing new processes to liquidate failed financial services firms.

      4. Establishing an independent Consumer Financial Protection Bureau to oversee consumer and investor financial regulations and their enforcement.

      5. Creating rules to regulate OTC derivatives.

      6. Coordinating and harmonizing the supervision, setting, and regulatory authorities of the SEC and the Commodities Futures Trading Commission.

      7. Mandating registration of advisors of private funds and disclosures of certain information of those funds.

      8. Empowering shareholders with a say on pay of nonbonding votes by shareholders approving executive compensation.

      9. Increasing accountability and transparency for credit rating agencies.

      10. Creating a Federal Insurance Office within the Treasury Department.

      11. Restricting and limiting some activities of financial firms, including limiting bank proprietary investing and trading in hedge funds and private equity funds as well as limiting bank swaps activities.

      12. Providing cooperation and consistency with international financial and banking standards.

      13. Making permanent the exemption from its Section 404(b) requirement for nonaccelerated filers (those with less than $75 million in market capitalization).

      14. Requiring auditors of all broker-dealers to register with the PCAOB and giving the PCAOB rulemaking power to require a program of inspection for those auditors.

      15. Empowering the Financial Stability Oversight Council to monitor domestic and international financial regulatory proposals and developments in order to strengthen the integrity, efficiency, competitiveness, and stability of the U.S. financial markets.

      16. Making it easier for the SEC to prosecute aiders and abettors of those who commit securities fraud under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940 by lowering the legal standard from knowing to knowing or reckless.

      17. Directing the SEC to issue rules requiring companies to disclose in the proxy statement why they have separated, or combined, the positions of chairman and CEO.

      The effective implementation provision of Dodd-Frank requires more than 60 studies to be conducted and more than 200 rules and regulations to be established within the next several years (2010–2015). Dodd-Frank is organized in 16 title provisions of the Act, as shown in Exhibit 1.1.

      Exhibit 1.1 Summary of Provisions of the Dodd-Frank Act of 2010

      Technological advances and global competition and regulatory reforms have enabled companies and their investors to largely meet in the jurisdiction of their choosing . . .[they] have choices about where to invest, where to raise capital and where secondary trading is to occur.⁸ Thus, companies can choose the regulatory regime they desire to operate under, and investors have a choice of safeguards and protections provided under different regulatory reforms. An effective regulatory reform creates an environment under which companies can operate in achieving their performance targets, being held accountable for their activities, and providing protections for their investors. Regulatory reforms in terms of their effectiveness and context can be classified into three concepts: (1) a race to the bottom; (2) a race to optimality; (3) a race to the top. The race to the bottom concept suggests that global securities regulators, in an effort to attract issuers, deregulate to the points that provide issuers with maximum flexibility for their operations at the expense of not providing adequate protections for investors. The race to the top concept suggests that global securities regulators provide maximum protection for investors through rigid regulations and highly scrutinized enforcements at the expense of putting companies in the global competition at a disadvantage with non-cost-justified regulations. The race to optimality concept is a hybrid of the first two concepts, in which both issuers (companies) and investors prefer a regulatory regime and jurisdiction that provides cost-justified investor protection. In a real-world global competition, a combination of these three concepts may work best, as many provisions of SOX have been globally adopted.

      Many provisions of SOX, particularly those pertaining to strengthening auditor independence, assessment of internal control over financial reporting, the creation of an independent board to oversee the accounting profession, and the strengthening of audit committee requirements, have been effectively adopted in other countries. Dodd-Frank is one of the most comprehensive financial regulatory reforms intended to strengthen regulation and oversight of the U.S. financial system in order to reduce the likelihood of future financial crises. Dodd-Frank consists of 16 distinct titles addressing all aspects of financial institutions from financial stability to mortgage reforms. It requires more than 500 rules to be established, 60 studies to be conducted, and 90 reports to be prepared to ensure proper and effective implementation of its provisions over the next four years. Effective implementation of provisions of Dodd-Frank is expected to have significant impacts not only on financial services firms but also on credit rating agencies, banks and bank holding companies, insurance companies, hedge funds, private equity, broker-dealers, and large asset managers among others.

      Types and Roles of Financial Markets

      A vital financial system and reliable financial information is essential for economic development worldwide. The persistence of differences in global financial systems necessitates a move toward convergence in corporate governance measures and regulatory reforms. Emerging global corporate governance reforms are shaping capital market structure worldwide, their competitiveness and protection measures they provide to their investors in ensuring the desired return on investment (ROI). The financial markets typically are classified into debt and capital markets. In particular, financial markets can be classified into capital, bond, mortgage, equity, derivative, and international financial markets.

      Capital Markets

      Capital markets are intermediaries facilitating the exchange of securities where business enterprises, including companies and governments, can raise funds and money for long-term investments. Securities are comprised of both debt and equity. Hence, the capital market includes the stock and the bond markets, which are further regulated by the Securities Exchange Commission (SEC). The capital markets are further segregated into two types—primary and secondary markets. A new security—bond/stock—is issued for the first time through the process of underwriting in the primary market. The existing securities are traded to other investors in the secondary market on the organized securities exchanges or OTC.

      Bond Markets

      Bond markets, also known as debt markets, are a type of financial market where participants purchase and sell debt securities. According to statistical data from the Bank of International Settlements (BIS), the world bond market exceeds the security market almost by 100 percent. The total size of the U.S. bond market is estimated to be $34.2 trillion. Debt securities have different risk/return characteristics ranging from short-term government bonds to corporate bonds. The types of debt securities and their subsequent weights in a total current debt outstanding amount are illustrated in Exhibit 1.2.

      Exhibit 1.2 U.S. Bond Market Debt Outstanding

      Source: Securities Industry and Financial Markets Association, www.sifma.org/.

      The advantages of the debt market are that debt securities are highly liquid and are not subjected to the same form of credit risk, where principal and coupon rates are received in accordance with the contract. Traditionally when the volatility of the equity market is high, investors turn to safe havens (e.g., bond markets), which pay a guaranteed interest rate. Money market funds are considered to be the safest security currently, yielding on average 0.02 percent. The biggest disadvantage of money market funds⁹ is their sensitivity to interest rate hikes. If the bonds are bought for the speculative purposes and are not intended to be kept to maturity, then they become subject to the volatility of interest rates. The largest segment in the debt market is the mortgage-backed bond market, which accounts for at least 35 percent of the total debt market. Failure of financial instruments, coupled with loose risk assessment standards for the collateral portfolio of loans, caused one of the worst subprime mortgage crises in history.

      Mortgage Markets

      The mortgage markets, so-called secondary mortgage markets, offer a diverse number of products. The secondary mortgage market is the market for the sale of securities or bonds collateralized by the value of mortgage loans. The mortgage lender, commercial banks, or specialized firms often group together many loans and sell loan portfolios as securities called collateralized mortgage obligations (CMOs) in an attempt to reduce the risk of the individual loans. The CMOs sometimes are further grouped in other collateralized debt obligations. The most popular mortgage-backed securities are mortgage-backed bonds, mortgage pass-through securities, mortgage pay-through securities, and CMOs.

      The mechanism of the mortgage-backed bonds is similar to any other bond; the only difference is the pool of mortgages issued by the specialized lending institutions or banks acts as collateral. Mortgage-backed bonds have a higher yield than other types of bonds and are considered to have lower risk rate. The prepayment risk is the major risk that can affect the profitability of the security instrument. All the income generated by the pool of mortgages (part of interest and principal) is directly distributed to the mortgage pass-through securities investors (excluding the fee that intermediary collects). The mortgage pool can contain either residential property mortgages or commercial property mortgages.

      Mortgage pay-through securities are similar to the pass-through securities except pay-through securities act like an amortized fixed-income instruments rather than equity instrument. The amortized payments are made from the cash flow generated by the mortgage pool, and prepayment risk comes into play.

      CMOs are a type of pay-through security; the main difference is that CMOs separate the payments of the interest and principal on the pool into different revenue streams and as a result can offer different rates. CMOs combine features of both mortgage-backed bonds and pass-through securities. Unlike with pass-through securities, with CMOs, the investor assumes the prepayment risk. CMOs are very complex financial instruments that are designed specifically to meet an investor's financial criteria as they do not necessarily synchronize with the original pool payments. The payment schedule can be accelerated or decelerated depending on the investor's choice. Mortgage delinquencies, defaults, and decreased real estate values can make these collateralized debt obligations difficult to evaluate. The recent wave of foreclosures resulted in the highest rate of foreclosures and payment delinquencies in U.S. history. According to the Mortgage Bankers Association, more than 4.6 percent of homeowners were in foreclosure as of May 19, 2010, which a record high for the mortgage market.

      The Community Reinvestment Act of 1977¹⁰ encourages commercial banks and savings association to facilitate the lending process for low- to middle- income borrowers. A study conducted by Harvard University Joint Center¹¹ for housing studies suggest that secondary market mortgage investors have little knowledge of the complexity of the mortgage products they are investing in. As a result, the efficiency of the secondary mortgage market is questionable. The study also stated that the existing regulatory framework, which is intended to protect investors, is far from perfect.

      Equity Markets

      Equity or stock markets are public forums for the trading of public company stock and derivatives at an agreed price determined by demand and supply for these financial instruments. Equity markets comprise securities listed on a stock exchange as well as those only traded privately. Stocks are listed and traded on stock exchanges such as the New York Stock Exchange (NYSE) and Nasdaq in the United States, Euronext (European Union), MICEX (Russia), and Shanghai Stock Exchange (China). According to statistical data from the World Federation of the Exchanges, the total size of the U.S. equity $14,281trillion.¹² NYSE and Nasdaq are both the first and third largest exchanges in the world. Exhibit 1.3 shows capitalization of the exchanges in 2008 and 2009.

      Exhibit 1.3 Change in Capitalization of U.S. Exchanges in 2009

      Derivative Markets

      Derivatives are financial contracts that are designed to create market price exposure to changes in an underlying commodity, asset, or event. In general, derivatives do not involve the exchange or transfer of principal or title and are typically classified into futures, forwards, options and swaps, or some kind of hybrid of those described earlier.¹³ Derivatives can be traded on organized stock exchanges or OTC exchanges. The most famous organized stock exchanges where futures and options are traded are Chicago Mercantile Exchange and NYSE Euronext. The size of the market, according to BIS statistics, was getting close to $86 trillion at the beginning of 2008. OTC derivative markets are much larger and poorly regulated. OTC derivatives include: commodities forwards, options swaps, equity-linked forwards, options, swaps, foreign exchange forwards, swaps, currency swaps, currency options, interest rate swaps, forward rate agreements and swaps, gold contracts, and many others. The total notional amount of the outstanding positions was around $615 trillion as of May 11, 2010.¹⁴

      The recent financial crisis has underscored the lack of regulations for non-securities based derivatives contracts such as credit default swaps (CDS), which are primarily traded in the OTC markets. Unlike other derivative contracts (insurance, securities, commodities, futures), CDS are not regulated. Thus they are perceived as a form of legalized gambling. Proper regulations require transparent information on OTC transactions to restore investor confidence on speculative derivatives transactions (credit derivatives). Global regulators particularly in the United States and Europe have considered regulating CDS and other OTC derivatives by establishing clearinghouses to serve as a central counterparty for those derivatives.

      Prior to 2000, almost all derivatives were traded on regulated central exchanges overseen by the Commodity Futures Trading Commission. After 2002, the derivative markets became unregulated and exempt from all regulations, including state gambling laws. With no regulation scrutiny on derivative trades, the determination of the true value of those exotic instruments became subjective, manipulative, and complex. The Commodities Futures Modernization Act of 2000 was passed by U.S. Congress and allowed the deregulation of financial derivatives. This deregulation enabled insurance giant AIG to engage in CDS. When AIG as a major player in CDS collapsed, other banks, insurance companies, and investment funds suffered tremendous losses. Deregulation of the CDS derivatives promoted speculative activities at the expense of derivative hedging activities, which substantially increased the systemic risks of CDS. Regulation of OTC derivatives has gained considerable attention since the Lehman Brothers collapsed and the AIG debacle. Lack of transparency in OTC markets, the excessive use of CDS, along with improper market discipline and mechanisms and the perceived complexity and speculation encouraged global legislators to issue legislative proposals to regulate OTC derivatives and transfer them from bilateral to multilateral trading.

      Derivatives are important tools used by management for mitigating risks. The ever-increasing growth of derivatives suggests that market participants including management find derivatives useful tools for risk management. Credit derivatives can be useful to commercial banks to manage loan portfolio risks, to investment banks to manage risks of underwriting securities, and to asset managers or hedge funds to achieve the desired credit risk portfolio. Nonetheless, credit derivatives can create conflict of interest when a bank performs all three commercial, investment, and insurance activities. Credit derivatives enable banks to take additional risks or transfer risks of loans to another party.

      Derivative markets should be better regulated and scrutinized to prevent further financial crises. Inadequate, ineffective, and unenforced regulations, particularly regarding OTC financial derivatives, have enabled and contributed to excessive speculative behavior of the use of credit derivatives.¹⁵

      Global Financial Markets

      Investor confidence in the global capital markets is the key driver of global economic growth, prosperity, and financial stability. Global capital markets are classified into those with either an inside system or an outside system. In an inside system, in such countries as France, Germany, and Italy, there is a high level of ownership concentration, illiquid capital markets, and liberal regulation of capital markets. Conversely, in an outside system, in such countries as the United Kingdom and the United States, ownership is widely dispersed, capital markets are liquid, markets are active for corporate control, and capital markets are highly regulated. There are more than 50 stock exchanges worldwide that assist companies to conduct their initial public offerings (IPOs). Stock exchanges in India, Italy, and South Korea recently have attracted many domestic IPOs; and many state-owned enterprises in China and France have done their fundraising domestically and have listed their IPOs on their home exchanges. Companies have traditionally listed on their domestic stock exchanges, and only about 10 percent of companies have chosen to list abroad.¹⁶

      U.S. capital markets have traditionally been regarded as the deepest, safest, and most liquid in the world. For many decades they have required stringent regulatory measures in protecting investors, measures that also have raised the profile and status of their listed companies.¹⁷ The U.S. financial markets are important sector of the nation's economy.¹⁸

      1. The U.S. financial services industry's GDP in 2009 exceeded $800 billion, accounting for 6 percent of the U.S. GDP.

      2. The securities industry accounted for more than $175 billion, about 17 percent of the total for financial markets.

      3. The financial services sector employed about 6 million workers in the United States in 2008, accounting for 6 percent of the total private sector employment.

      However, recent competitiveness of capital markets abroad has provided global companies with a variety of choices of where to list and possibly subject to less vigorous regulatory measures. As these markets abroad become better regulated, more liquid, and deeper, they provide companies worldwide opportunities to raise their capital needs under different jurisdictions. High compliance costs of SOX have prompted companies to think about whether their capital financing should come from U.S. capital markets or from capital markets abroad, which may be less strictness and have looser

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