take home exam 4

Student No.: 2007160720 ／ 3035203297

Course Code & Course Name: LLAW/JDOC 6093 Regulation of Financial Markets

Research Title (if applicable):

Word Count (if applicable): 6993 words

2 Student number: 2007160720 / 3035203297 RFM Take-‐home examination

Question 1 Word count: 3495

Student number: 2007160720 / 3035203297 RFM Take-‐home examination

3

Part (i)

In this part, we aim to scrutinize the genesis of the global financial crisis. In this way, we will

derive the rationale of implementing Basel III, which involves a theoretical, practical and

empirical discussion on the main issues and problems this set of reform measures targets to

solve.

The genesis of the financial tsunami

Briefly speaking, prior to the 2008 crisis, a period of cheap credit created a flood of liquidity

in the economy. The easy-credit-environment led to overlending and overinvestment in US,

particularly in the mortgage-lending market. While qualified mortgagors were limited, banks

saw subprime mortgages as another gold mine. Subprime mortgages are loans granted to

people with poor repayment abilities. In other words, borrowers with no income or no assets

could be qualified. Shifting to the originate-and-distribute model, commercial banks sought

help from investment bankers, who then utilized their financial magic and repackaged these

loans into collateralized-debt-obligations (CDOs). Thus creating a big secondary market for

subprime mortgages. Empirical data has evidenced that Goldman Sachs, Merrill Lynch and

Lehman Brothers had leveraged up to 30-40 times of their initial investments to support these

activities; while Bank of England (2009) recorded that the subprime mortgages market has

grown, shockingly, from US$50 billion in 1997 to US$600 billion in 2005 (table (i)).1

table (i)

Nevertheless, when homeownership had reached a peak at 70% and the interest rate rose to

5.25%, it came to the turning point – Home prices started to fall, subprime borrowers could

1 Francesco Cannata and Mario Quagliariello, ‘Basel III and Beyond – A guide to Banking Regulation after the

Crisis’, 1st ed, Risk Books, 2011, page 16.


not afford the high interest payment and started defaulting. Investors are economically

sensitive. Flight to quality occurred and those CDOs were no longer welcomed. This marked

the beginning of the credit crisis, which ultimately evolved to become a financial crisis. In

2007, HSBC has reported severe write-downs of US$10.5 billion in its subprime-mortgage

portfolio.2 And by mid-2008, ten of the worlds’ largest financial institutions have shown a

subprime loss of US$490 billion.3 Without sufficient liquidity and by relying heavily on

leverage tricks, Northern Rock approached the Bank of England for assistance.

Issues and Problems:

Based on the above, we have broadly summarized the issues and problems Basel III tries to

tackle into 4 categories – (1) Deficiencies of the capital requirements; (2) excessive leverage;

(3) inadequate liquidity requirements and (4) systemic risks posed by certain financial

intermediaries.

Basel II required banks to maintain 8% total capital against its risk-weighted assets. To

illustrate, we hypothetically compare home mortgages to mortgage-backed-securities (MBS),

which the former is given a 50% risk-weight and the latter is given a 20% risk-weight. For

every US$1000 home mortgages, banks are required to put $40 aside ($1000x8%x50%),

while for every US$1000 MBS, banks are only required to hold $16 capital

($1000x8%x20%). Consequently, smart bankers tried to circumvent the capital requirements

by utilizing risk-transfer mechanisms such as securitisations, which is how they repacked the

subprime mortgages into CDOs. In doing so, banks were able to reduce their capital charges

by moving risky assets into the trading book and the capital freed up could be used to make

additional loans. This is probably why the trading book was criticised as one of the most

powerful devices for regulatory arbitrage. The significance of these activities can be proven

by recent empirical researches – Haldane, Brenna and Madouros (2010) reveals that the total

trading assets (the size of trading book) has grown from 20% in 2000 to approximately 45%

in 2008 (table (ii));4 the IMF (2009) also echoed this by suggesting that the yearly issuances

of securitisations have evolved from 1.5 trillion to 4.7 trillion US dollars in 2000 and 2006

2 Ibid, page 22. 3 Ibid, page 23. 4 Ibid, page 11.


5

respectively (table (iii)).5 In recent years, big banks are even allowed to determine risk-

weights themselves by adopting internal ratings-based models. This may further incentivize

them to attribute lower risk-weights and thus generate more profit. By underestimating the

true risk and falling below the intended capital requirements, banks may not be capable to

withstand shocks during recession.

table (ii) table (iii)

Secondly, excessive leverage by banks is one of the key issues that might have contributed to

the financial crisis. In essence, leverage is the amount of debt used to finance the assets and is

at the heart of banking (investment) business. To elucidate, a potential homeowner with

US$100 may persuade a finance institution to loan him 9-times his original amount, making a

sum of US$1000 ($100+$900) to invest in properties. This happens not only to homebuyers,

but also to financial intermediaries. The problem of over-leveraging is caused by various

factors – As stated in the genesis part, firstly, the decline of the interest rates enhanced the

affordability of debts; secondly, companies prefer debt financing when compared to equity

financing because the interest expenses arose are tax-deductible; finally, as banks granted

more and more subprime mortgages, the market has sent out a wrong message – increased

indebtedness was no-worries. Thereupon, it is suggested statistically by Sevcan Yesiltas

5 Ibid, page 10.


(2011) that most investments banks were leveraged up to 30x to 50x.6 Therefore, during

recession, highly leverage companies find it hard to pay their debts with no additional

financing available.

The third issue that immediately catches our eyes is liquidity. Liquidity is the degree of

readiness to which an asset could be converted into cash without losing value. It comes as no

surprise that investors commonly favour highly liquid assets as they can easily sell them in

case of emergency. From what we have discussed so far, the bursting of the housing-bubble

in conjunction with the leverage problem may significantly reduce banks’ access to funding,

resulting in a credit crunch. Bear Stearns’s decision of closing two hedge funds, which

revealed a huge loss on MBS, in some way demonstrated this situation. Investors became

alert and they questioned to what extent the financial institutions knew the true value of their

books. Becoming more risk averse, investors began to avoid mortgage-related investments

altogether. The hard-to-value securities soon spread over and the investors are unwilling to

provide further liquidity in the marketplace. Having relied too much on short-term

borrowings, banks have put the maturity transformation practice into an extreme. Without

any loss-absorbing capital for redemptions, banks can only conduct quick sales. The

substantial reduction of asset values put banks into great financial difficulties. As a result, in

September 2007, Northern Rock (UK) and Countrywide (US), with no other resort, required

rapid assistance from Bank of England and the Fed respectively.7

Last but not least, systemic risk is another major contributory factor to the financial crisis.

There are some intermediaries in the financial market that are ‘too-big-to-fail’.8 For instance,

the American International Group (AIG), as the world’s biggest conventional insurance

6 Sevcan Yesiltas, ‘Leverage Across Firms, Bank and Countries’, Johns Hopkins University, 2011, available at

https://www.google.com.hk/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CB0QFjAA&url=https%3

A%2F%2Fwww.aeaweb.org%2Faea%2F2012conference%2Fprogram%2Fretrieve.php%3Fpdfid%3D93&ei=S

pB9VPLqJMa7mgWbqYCICA&usg=AFQjCNFlCLFD6rDM4WqCR2Ncl_4Hv2wv5g&sig2=UPfUBkikl_NE

Y5loyRWh6Q. page 40. 7 Francesco Cannata and Mario Quagliariello, ‘Basel III and Beyond – A guide to Banking Regulation after the

Crisis’, 1st ed, Risk Books, 2011, page 24. 8 Ben S. Bernake, ‘Causes of the Recent Financial and Economic Crisis’, the Financial Crisis Inquiry

Commission, Washington, 2010, available at:

http://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm.


7

provider and has made up a substantial part of the economy, sold many credit-default-swap

(CDS) during the financial crisis. A CDS works as an insurance bond which guarantees buyer

for the lender’s default. As a result, AIG built a close tie with other financial institutions

including a lot of banks. When the house bubbles burst, the close linkage of the interbank

system, so-called the ‘domino effect’ spreads the systemic risk out to other banks.9 This left

AIG with only half of the total assets and was in nowhere near the full CDS amount owed

(table (iv)). Eventually, the U.S government decided to bail AIG out with $180 million in

order to prevent AIG from bankruptcy, which if happens would cause other financial

institutions to collapse too.

table (iv)

9 Ibid.


Part (ii)

As a result, Basel III is introduced so as to tackle the issues we raised above. The key

elements of Basel III are – (1) Capital requirements; (2) Leverage ratio, and (3) Liquidity

requirements.

Capital requirements:

In principle, regulatory capital should be the first shield against losses, as they ensure banks

to be able to withstand negative shocks. Ideally, the ratio of capital to risk-weighted assets

must be correctly designed – capital should be able to absorb losses and risk-weights should

truly reflect the riskiness of the underlying assets. However, financial engineering techniques

were adopted by banks to disguise the public with sufficient capital standards that turned out

to be untrue. Therefore, after the Lehman crisis, a new round of negotiation of capital

adequacy has started and more stringent requirements are being introduced.

equation (i)

Basically, Basel III aims to increase the amount of capital that should be set aside. While

Basel II required banks to hold 2% of their common equity in reserve, Basel III raised it to

4.5%.10 In addition to that is the new requirement of capital conversation buffer of 2.5%.11

This measure aims to minimize procyclicality, which means slowing down the credit growth

during a boom, and at the same time provides banks the capacity to recover during a

10 DavisPolk, ‘U.S. Basel III Final Rule: Visual Memorandum’, Davis Polk & Wandell LLP, 2013, available at:

http://www.google.com.hk/url?sa=t&rct=j&q=&esrc=s&source=web&cd=20&cad=rja&uact=8&ved=0CFMQF

jAJOAo&url=http%3A%2F%2Fwww.davispolk.com%2Fdownload.php%3Ffile%3Dsites%2Fdefault%2Ffiles

%2Ffiles%2FPublication%2F3e28c060-fd34-42c0-9b75-

003fe1c4ea5c%2FPreview%2FPublicationAttachment%2F937e4d31-4e86-4a00-a48b-

00629c05ca4f%2FU.S.Basel.III.Final.Rule.Visual.Memo.pdf&ei=7CCPVI7EH8TKmwXB1IL4BA&usg=AFQj

CNEjsU-na3FXGf7Ta0r71FDcUTdFPQ&sig2=B6uU5-8DsanWQ5xNlo3UvA. 11 Ibid.


9

downturn. Overall, this brings the total common equity requirement to 7% (4.5%+2.5%).12 It

has also been suggested that the total capital requirement for bank should be increased from

the original 8% to 10.5%.13

Besides raising the minimum capital requirement, the capital ratio can be increased indirectly

by increasing the quality of capital. In this regard, the Basel III has defined the Common

Equity Tier 1 (CET1) comprehensively in order to ensure loss absorbency, flexibility of

payments and permanence by setting 14 criteria.14 Core equity capital with no loss-absorption

capacity will not be taken into account. This includes minority interests or Deferred Tax

Assets. Hybrid Tier 1 component, for instance, innovative/SPV-issued Tier 1 instruments are

gradually phase-out.15 With more stringent criteria on the sources of fund, this new definition

of regulatory capital is composed of elements that can fully reveal the solvency status of the

financial institutions. These microprudential measures aim to encourage banks to be more

alert when they allocate equity to support risky business. Other than revising firm-specific

requirements, Basel III also aims to mitigate systemic risks. As such, banks that are

designated by Financial Stability Board as systematically important are subject to a surcharge

as high as 2.5%.

Leverage ratio:

From the above, we have explored that banks may still be vulnerable even if they adhere to

the capital ratio. For instance, holdings of sovereign debt in some countries, for instance, the

Italian banks, might not be bound by capital requirements and liquidity limitations, but still

they represent a huge portion of risks. In this case, even the banks can satisfy the capital

adequacy ratios, this does not guarantee the banks’ balance sheet are sufficiently liquid and

can meet outstanding short-term and long-term obligations. Therefore, leverage ratio is

designed as a metric to limit the size of the balance sheet.

12 Ibid. 13 Ibid. 14 Ibid. 15 Ibid.


equation (ii)

The Basel III introduced a ‘simple, transparent, non-risk based leverage ratio’ to act as a

supplementary measure to the ‘risk-based capital requirements’.16 It aims to restrict the build-

up of leverage in the broader financial system and provides a non-risk-based ‘back-stop’,17

irrespective of the assets’ quality. The leverage ratio is likely to be 3%.18 It means that a bank

would not be allowed to hold assets representing more than 33 times of its equity. Going to

the left side of the equation (ii), Tier 1 capital is now specified – It consists of Common

Equity Tier 1 and Additional Tier 1.19 To be a Tier 1 capital, it has to be perpetual in nature,

able to bear loss and fully paid up without any funding.20 Examples include common stock

and retained earning. On the denominator part, the credible leverage ratio introduced by

Basel III adequately captures both on and off balance sheet leverage of banks. Under the old

Basel rules, the capital ratio applies only to risk-weighted assets but not to total assets.

Further, big banks have been permitted to rely on their own calculation models to assess the

‘risk-weights’. Consequently, they are often tempted to attribute very low risk weights to the

assets so as to increase leverage and generate more profit. Basel III tries to introduce this

leverage cap that takes ‘the total quantity of asset as its capital’. Thus, despite the capital

ratios is largely criticized as ‘easy-to-manipulate’, the leverage ratio, which takes into

account all kind of assets, is much more difficult to manipulate.

Liquidity:

As we have seen in part (i), where Bear Stearns performed badly in the two hedge funds and

the money markets froze, banks sought assistance from the central banks or government for

liquidity support. Likewise, in the 2012 European sovereign crisis, banks obtained term 16 Georges Ugeux, ‘International Finance Regulation’, 1st edn, John Wiley & Sons Inc, 2014, page 82. 17 Ibid. 18 Ibid. 19 Ibid. 20 Ibid.


11

funding from the European Central Bank. In order to prevent the repetition of liquidity-

shortage, Basel III announced two new liquidity ratios to enhance liquidity and self-

sufficiency of banks. They are the Liquidity Coverage Ratio (LCR) and the Net Stable

Funding Ratio. It is evidential that the funding of assets by deposits has dropped sharply

while other forms of funding have replaced this traditional liability.21 Consequently, one of

the overarching aims of Basel III is to turn the track back to relationship-based retail deposit

funding from short-term wholesale market funding.

equation (iii)

The LCR ensures that banks keep adequate stocks of ‘unencumbered high-quality liquid

assets’ that can be turned into cash immediately to meet their liquidity needs ‘for a 30

calendar day liquidity stress scenario’.22 The aim of this measure is to reduce banks’ reliance

on short-term and fragile sources, for instance, ‘unsecured inter-bank deposits with tenors

below 30 days’.23 Banks have to maintain the ratio at or above 100%. In other words, banks

can still manage to take liquidity risk, but if they choose to do so, they should have ensured

themselves with ‘sufficient liquidity risk bearing capacity to weather short-term liquidity

shocks’.24 Thereupon, high quality liquid assets on the numerator demonstrate assets with

high credit quality and high market liquidity. These may include central bank money,

government bonds or covered bonds.

equation (iv)

21 Ashok Vir Bhatia, ‘New Landscape, New Challenges: Structural Change and Regulation in the U.S. Financial

Sector’, IMF working paper, 2007, available at: https://www.imf.org/external/pubs/ft/wp/2007/wp07195.pdf,

page 3. 22 Georges Ugeux, ‘International Finance Regulation’, 1st edn, John Wiley & Sons Inc, 2014, page 81. 23 Stephan W. Schmitz, ‘The Impact of the Liquidity Coverage Ratio (LCR) on the Implementation of Monetary

Policy’, in Economic Notes, Vol 42, Issue 2, 2013, page 135. 24 Ibid.


For long term holding, the banks will then be required to hold ‘a net stable funding ratio’ to

meet its liquidity requirement ‘over a period of 12 months’.25 Similar to the LCR mechanism,

the gist for this measure is simply to impose a cushion by using long-term debt to cover some

of the long-term assets in the banks’ portfolio.

25 Ibid.


13

Part (iii)

Regulatory arbitrage

As we know, nothing is ever completely one-sided. Basel III, on one hand, may enhance

financial stability and bank liquidity by adopting a tight money conservative approach, on the

other hand, it may lead to severe impacts and freeze the growth of the societies – This is

particularly obvious for banks in developing countries. With the new liquidity and leverage

ratios, banks will be forced to reduce credit since maintaining additional capital significantly

reduces the amount of money available to be lent out. Derivatively, low supply raises lending

cost and banks will be less generous to extend loans to individuals. For instance, traditional

mode of financing, say, Letter of Credit, will be more expensive. Ultimately, it comes back to

the society again – individuals or corporates will then find it hard to advance their families or

businesses economically. Nevertheless, Basel III itself opens up a loophole – it has omitted to

bring non-banking financing companies under their ambit.

Shadow bank is described as a bank-like institution with activities structure outside the

regular-banking system. From the above scenario we can observe that when most of the

banks are still under the deleveraging process, shadow-banking system can act as a ‘bank-like’

credit intermediation that are not subject to the same regulatory constraints as banks. Thus,

banks themselves may rely on the shadow banking entities to build up leverage and bypass

the capital or liquidity requirements. This can be seen where banks often substitute asset-

backed financing for regular lending facilities since the capital requirements for the former is

much lower. From the experiences of the financial crisis, it can generally be inferred that the

higher the capital/leverage/liquidity ratio, the more likely that regulatory arbitrage will be

exploited. They are directly proportionate. Thus, Basel III itself aggravates this problem.

How should the shadow banking system be regulated

From the above inference we can see that regulatory arbitrage increased when traditional

banks are subjected to stringent regulations. Since the end of the 2008 crisis, perhaps, the best

way is to regulate shadow-banking systems more, especially when there is no sound reason to

lessen the requirement imposed on traditional bank by Basel III. In this section, we will


explain how shadow banks can be regulated by direct and indirect regulatory framework and

critically analyse whether these are effective.

Indirect regulation forbids the counterparty to deal with the entities without complying with

certain rules. For instance, the Dodd-Frank Act (DFA), similar to Basel III, imposes

regulations on non-bank institutions. In order to enhance better screening and transparency

from the shadow banks, the DFA imposes an improved disclosure framework and introduces

the ‘skin in the game’ regime – by retaining a substantial share of the asset, it incentivise both

the originators or the SPVs to conduct better risk assessments. Nonetheless, we should be

cautious against these indirect regulations since a more stringent requirement for banks, again,

increases the tendency of exploiting regulatory arbitrage. Where there are two different

regulatory regimes (traditional and shadow banks) with no switching costs, it is foreseeable

that more activities will be diverted to the shadow banking system. Therefore, it has been

suggested that direct interventions are more preferred.

Direct regulation addresses risks that stem from shadow banking entities/ instruments. For

instance, the DFA has introduced a new calculation method for the capital, leverage and

liquidity ratio so managers are now easier to monitor the securities lending. Besides, hedge

funds must now register with the Securities and Exchange Commission (SEC), while all

‘systematically important institutions’ are caught under the new regime set up by Federal

Reserve. This aims to break the linkage between traditional banks and shadow banks, block

the transmission of risks and limit the impact of failures. The Solvency II Framework

Directive (2009) requires insurances to take into account credit risks. If Basel III or the

indirect regulation in a roundabout way brings back the systemic risk, a stricter and direct

regulation is necessary to reduce regulatory arbitrage or systemic risk. Nevertheless, given

that different non-bank entities may carry out different functions, it is not possible for

regulators to easily spot out non-bank entities that should be subject to regulations. One may

argue that imposing requirements to all the non-bank entities can solve the problem, but we

would contend that this burden outweighed the costs of implementation. Thus, despite direct

regulation may be more favourable than the indirect one, without an efficient enforcement

regime it is still yet to say that this is the key.


15

Overall, as shadow banking involves various activities and entities, it may not be possible for

a single regulatory approach to deal with all circumstances. Provided that shadow banking

has a fundamental role in the whole financial system by providing sources of funding and

diverting risks, the best regulation we would hereby suggest is a balancing test in minimizing

their risks but at the same time preserving their efficiencies. Accordingly, the regulatory

framework should include a case-by-case balance to deal with all potential costs and benefits

of the interventions. Alternatively, one may try to regulate the systemic risk by utilizing

insurance. Long-term insurance policies can arguably pacify the fluctuations faced by the

shadow bankers. However, we would contend that this simply moves the systemic risk

between two different sectors. Thus, regulations only help, but not heal. Ultimately, a good

regulation framework should imply flexibility and adaptability that may take into account any

adjustment the financial institutions may have made after the enactment of the Basel III (as

what they did after Basel I & II). This will now all fall to the Financial Stability Oversight

Council, who is given the discretion to recommend any necessary regulatory changes in order

to maintain financial stability. After all, there is no fast-route and we still have to admit none

of the above solution is a panacea.


Question 2 Word count: 3498


17

Part (i)

A security firm is a financial intermediary that conducts activities such as dealing and

advising on securities and futures, and assisting in mergers and acquisitions. Briefly

speaking, securities firms can perform several functions. For example, with the help of

securities firms like investment banks, companies can issue securities to public or to private

investors through placements to obtain extra financing. On the other hand, firms like

securities brokers and dealers provide channels for investors to trade shares in the secondary

market.

To outline the importance of an effective internal system in a securities firm, we will, in this

part, identify three main governance issues (i.e. separation of ownership and control,

transparency and resources allocation) in order to explain precisely what is the corresponding

importance of an effective internal system.

Importance (1) – Separation of ownership and control

Generally speaking, shareholders can gain from entrepreneurial ventures by supplying

capital, ‘even though they lack management skills’;26 conversely, managers earn from

‘profitable business opportunity’ despite they lack personal wealth.27 However, problem

arises as the interests of the shareholders and managers are always diverted. For instance,

while managers cannot capture all the benefits even if their decisions are extraordinarily

successful, or they do not need to bear extra loss even the venture diminishes; they tend to

consume leisure instead of dedicating to wealth maximization.28 Therefore, it is alleged that

managers, who serve as agents, have engaged in self-serving behavior that is detrimental to

26 Fischel Engle, ‘Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United

Kingdom Inflation’, Econometrica, 50, 1982, page 1262. 27 Ibid. 28 Ibid.


the company’s wealth maximization.29 From the perspective of shareholders, it is important

to ensure that they can get an appropriate return for their financial investments.30

Thus, it is important for an effective internal system to exist, which outlines a board of

independent directors, who occupies a central role in entrepreneurial decision-making and is

located squarely between the shareholders and managers. The enhancement of board

independence can prevent corporate controllers from diverging their attention to personal

interests and thus it is effective in protecting shareholders’ interests. To elucidate, board

independence is particularly important in high-performing securities firms. In these firms, the

CEO may have high status and power and thus gives them a high degree of entrenchment.

This may encourage the CEO to incentivize in his/her own empire building and pursuing

higher bonuses even in regression. Notably, Mitton (2002) suggested that ‘shareholder

expropriation’ was severer during financial crisis where the expected return drops

significantly.31 Oppositely, independent boards have proven to be of greater contribution to

the firm value.32 An empirical research by Musteen (2010) has shown that firms with a

greater proportion of ‘outsider directors’ (i.e. independent non-executive directors) generally

have a better reputation than firms with a high proportion of ‘insider directors’ (i.e. executive

directors)33. Following the introduction of Sarbanes-Oxley Act (SOX), the New York Stock

Exchange had proposed rules that clearly suggested that a majority of the board of directors

of a listed company should be ‘independent’.34

Importance (2) – Transparency

The problem of asymmetric information exists in all imperfect markets. Needless to say,

parties that possess more information are in a better position to make informed decisions and

29 E.F. Fama, ‘Agency problems and the theory of the firm’, Journal of Political Economy 88, 1980, page 288-

307. 30 A. Shleifer, and R. Vishny, ‘A survey of corporate governance’, Journal of Finance, 52, 1997, page 737-783. 31 T. Mitton, ‘A cross-firm analysis of the impact of corporate governance on the East Asian financial crisis’,

Journal of Financial Economics 64(2): 215-41. 32 M.Musteen, D.K. Datta and B.Kemmerer, ‘Corporate reputation: do board characteristics matter?’, British

Journal of Management 21(2): 498-510. 33 Ibid. 34 Ibid.


19

in turn, maximize their interests. When applying such concept to a large securities firm, small

shareholders, who are seldom engaged in running the business on a day-to-day basis, may not

possess sufficient information to monitor the company’s performance and assess whether the

returns received from their investments in the company are considered reasonable. Due to the

lack of access to internal information, shareholders can merely rely on publicly published

information to base their decisions. Without a proper internal system, there are possibilities

that managers will take advantage of their positions to misuse the company’s resources for

personal benefits without being noticed. Senior management may then conceal their acts by

creating fraudulent records, thereby nullifying the accuracy and usefulness of those financial

reports. Shareholders may make wrong judgments if they refer to the erroneous information.

To avoid the occurrence of such situations, a reliable financial reporting system

complemented with an independent internal audit function should be established to ensure the

entity operates in an efficient and orderly manner. It is worth mentioning that reliable

financial statements also increase investors’ confidence in the companies concerned as they

can get a clearer picture of the entities’ financial standing and future prospects, thereby

reducing the firms’ cost of capital and increase profit margin. Shareholders will then be able

to receive a higher return accordingly.

Other than shareholders, directors also benefit from the implementation of an effective

internal system as such system helps them to discharge the fiduciary duty, and duty of care

and skill owed to the company. For example, directors in Hong Kong are expected to avoid

actual and potential conflicts of interests. Owing to the nature of business, it is not surprising

that large securities firms often enter into countless deals every day. Some of those

transactions may be very complex attributable to the involvement of numerous counterparties

that are inter-linked to each other, by that causing the identification of potential conflict of

interests a daunting task. With the help of an effective internal reporting mechanism,

directors can easily avoid breaching the aforementioned duty as all business transactions are

properly recorded and monitored. Facing a complicated organizational structure with sizable

operations, it is also almost impossible for directors of large securities firms to properly

exercise the duty of care, skill and diligence unless the relevant internal frameworks are in

place to capture all risks to which the companies and their clients are exposed.


Importance (3) – Resources allocation

In order to maximize profit, it is crucial for managers and directors to direct limited resources

such as labour and capital to proper use and an effective internal system can help to achieve

this result. For instance, clear reporting lines as well as well-defined roles and responsibilities

can ensure employers are working in an efficient and systematic manner, thereby avoiding

duplication of effort. Comprehensive policies and procedures outlining authority and

approval limits can expedite the execution of projects or transactions, by that ensuring the

firms can secure all good business opportunities. An appropriate risk management system

makes sure the firm only engages in businesses that are both within its risk appetite and

capacity. Presence of operational controls not only assures the business to run in a smooth

way, it also helps the firm to comply with legal and regulatory requirements. This can all be

done by continuously exercising effective control, monitoring and risk assessments.

Overall

To sum up, having an effective internal system can significantly enhance the firm’s

performance. For instance, it can encourage the parties to achieve their objective in a more

structured and effective way; it can boost public confidence by preventing fraud and

providing more reliable financial disclosures; it can also avoid any damage to the company’s

reputation by making sure it complies with relevant laws and regulations.

However, there are certain loopholes that may not be remedied by an internal system no

matter how effective it is. In no doubt an effective internal system can provides clearer

information and feedbacks, which may assist in strategic planning or achieving objectives, it

has no legal enforcement regime that can guarantee the implementation. Therefore, we

should be obliged to consider the broader picture by looking further to a legislative and

regulative framework.


21

Part (ii)

While we have already seen a sound internal system could encourage efficient and orderly

market, prevent fraud and encourage law compliance, it could be argued that this is not

enough. Added to that, a sound legislative and regulatory framework can ease the public with

better understanding on the securities industry. Another gist of these regulatory regimes is to

maintain Hong Kong’s overall financial stability and to prevent market misconduct. Looking

back to histories, we can see that economic crises often stem from ineffective or inadequate

regulations of financial markets. For instance, the broke down of the under-regulated

securities market in the US devastated the economy and led to the Great Depression in 1930.

Therefore, in this part we aim to analyze how a robust legislative and regulatory framework

provides us a safe and sound financial environment.

Importance (1) – Executive remuneration and incentives

In the 1980s, executive compensation soared due to the rapid economic growth and rising

inflation rate. It was alleged that several executives received hugely excessive payouts. For

instance, Michael Eisner (Disney) received a ‘stock option’ of 920 million35 while Sandy

Weille (Citigroup) got approximately a 980 million stock option.36 By 2006, the paychecks

received by CEOs in America were approximately four-hundred-times more than average

workers. This can be evidenced by the table below, which indicated that CEOs’ remuneration

package have grown significantly in the past decades. More absurdly, the executives of

Barclays were paid million pounds albeit a significant fall in its share price; while in Scotland,

senior management in a renowned security firm earned a huge sum despite over 1000

employees lost their job.37

35 David Larcker & Brian Tayan, ‘Corporate Governance Matters’, 1st edn, Pearson Education, 2011, page 239. 36 Ibid. 37 http://www.nytimes.com/2012/01/23/business/in-britain-a-rising-outcry-over-lavish-executive-pay.html?_r=0.


These unreasonably high remunerations are heavily criticized by the public and are widely

discussed these days. Researchers have revealed that ‘the correlation between’ performance

and executive pay is ‘very weak’.38 P.Jacquart (2013) even suggested that high payment

renders worse performance – it demotivated the CEOs, encourages them to omit the

stakeholders and neglect to make any long-term decisions for the stakeholders. 39 To

exemplify, the excessive compensations may lead to the emergence of self-serving behavior

and thus shorten the CEOs’ long term vision; while CEOs are generally offered to purchase

stock options, they may be tempted to buy the shares at a low price and by falsely reporting

profitability, they can resell those shares at a much higher price and reap huge profit at the

expense of the investors. This can be echoed from the Enron scandal (2001), where the

executives’ remuneration was not taken out from the net profit thus representing a false

profitability statement. Furthermore, an excessive compensation demoralizes employees. As

shown above, how can an employee be satisfied if their boss (i.e. the CEO) earns four-

hundred-times more than them? Even if the CEO is incredibly smart, it is the workforce who

executes and implements his or her decisions. Without those labour, the company cannot

even function properly.

As a result, in order to safeguard the interests of other stakeholders, a legislative and

regulatory framework is a must. To effectively regulated the above problem, or from a

regulatory and supervision viewpoint, the practice can include policies that govern the

38 A.J. Vogl, ‘Vexing questions. Across the Board’, ABI/INFORM Global database, 1994, page 18. 39 Philippe Jacquart and J.Scott Armstrong, ‘Are Top Executives Paid Enough? An Evidence-Based Review’,

Interfaces, Forthcoming, 2013, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2207600.


23

execution and termination of the contract, an ad hoc disclosure that includes any share

transactions, or how the remuneration-related policy is affected by the annual voting regime.

For instance, in Hong Kong, the SFC requires institutions to include a remuneration

committee in the firm’s organizational chart in order to review ‘the level and structure’ of the

remuneration scheme.40 Besides, it also lists out the CEO’s role and responsibilities,41 which

includes but not limited to regularly report the strategic objectives to the board so that it

inhibits the CEO from manipulating the business plans for personal goals. 42 In the

international aspect, for instance in the US, section 953 of the Dodd-Frank Act (DFA)

proposes that the ‘pay-for-performance’ and the ‘ratio between the CEO’s compensation’ and

‘the median of other employee’s compensation’ should be disclosed. 43 Similarly, the

Australian Securities and Investment Commission requests financial services companies to

disclose their executives’ compensation schemes.

Another issue relating to executive’s compensation is the golden parachute clause and golden

handshake clause. Golden parachute is a clause that entitles the senior executives to a

lucrative compensation if the company is being taken over and the executives loss the job as

a result of such event. On the other hand, if a golden handshake clause is included in the

employment contract, executives can get a significant severance package once he or she loses

the job. Although golden parachute and golden handshake arrangements can help to retain

high-quality CEOs, it may also bring about moral hazards. These terms may act as a catalyst

for the executives to act for their own interest but not the shareholders. Beware that anyhow

the gist of the fiduciary duties is to act for the best interest of the company,44 the reason for

an extra compensation seems to be meaningless. To ensure the investors and shareholders

have access to this piece of material information, s951 of the DFA outlines that the golden

parachutes should now be disclosed. Likewise, the Director’s Remuneration Report

Regulation 2002 requires annual accounts to show all payment details to directors. Swiss

40 SFC, ‘Code of Conduct of Persons Licensed by or Registered with the Securities and Futures Commission’

Securities and Futures Commission, 2013, available at: http://en-

rules.sfc.hk/net_file_store/new_rulebooks/h/k/HKSFC3527_1868_VER30.pdf. 41 Ibid. 42 Ibid. 43 Section 953, Dodd-Frank Act, available at http://www.dodd-frank-

act.us/Dodd_Frank_Act_Text_Section_953.html. 44 Bristol and West Building Society v Mothew [1998] EWCA Civ 533.


referendum even requires votes on executive pay to be binding and they restrict the golden

parachutes. All those legislative and regulatory frameworks somehow help to protect the

integrity of the securities market.

Arguments like executive remuneration can encourage short-term profit and risk-taking and

thus partially contributed to the financial crisis can be seen everywhere. With the above

legislative and regulatory responses, employees’ productivity may increase as they are no

longer antagonistic about the ridiculously high-paid of their leader. Except this, we would put

more concerns on whether these frameworks may effectively help the companies to stay

competitive and allocate the right amount of risk and remuneration respectively. While no

one will argue that it is extremely hard to regulate executive remuneration, at least, with the

frameworks, the remuneration scheme has moved from arbitrary to regulatory.

Importance (2) – Whistleblowing

Whistleblowing is an act of reporting any illegal, harmful, irregular, unethical or corrupt

matters. Generally, the whistle is blown on behalf of the public interest. Despite employers

are usually the party who spot those problems, they are often reluctant to expose them. The

possibilities of getting fired, harassed or even reprimanded deter employees from disclosing

the fraudulent activities. Empirical data has shown that such fear was reasonable – A recent

survey provided that among the surveyors (whistleblowers), 62% was made redundant, 18%

were transferred and 11% had a reduction in salaries.45 Consequently, without an effective

whistleblowing system, corporate fraud is covered by veil. Stakeholders’ interests are thus

jeopardized. Even with an effective internal system, this system can still be defeated by

employees’ conspiracy. For instance, in the Enron scandal, Sherron Watkins wrote an email

to the CEO addressing the misstatements in the financial reports,46 but this report was not

published until five months later.47 Similarly, Cynthia Cooper, who worked for WorldCom,

was the first one who noticed the accounting fraud but her boss delayed her findings.48 45 http://ethics.csc.ncsu.edu/old/12_00/basics/whistle/rst/wstlblo_policy.html. 46 Geoffrey Christopher Rapp, ‘Beyond Protection: Invigorating incentives for Sarbane-Oxley Corporate and

Securities Fraud Whistleblowers’, Boston University Review, Vol 87:91, 2013, available at:

http://128.197.26.34/law/central/jd/organizations/journals/bulr/volume87n1/documents/RAPPv.2.pdf. 47 Ibid. 48 Ibid.


25

Therefore, whistleblowing is important to overcome such conspiracy and bring the

information of fraud to the regulators’ attention.

Thereupon, many countries have legislative and regulatory framework to govern the

whistleblowing activities in order to suppress malpractices. For instance, in Hong Kong, the

SFC Code of Conduct now expressly commands that any licensed entities who have

suspicions on whether their clients breach the market misconduct provision in SFO are

required to report to the authority.49 From the international aspect, the Sarbanes-Oxley Act

(SOX) (2002) includes a whistle blowing section and stating, albeit indirectly, that it is

essential to maintain an effective and proper governance structure: Firstly, section 806(a) of

the SOX outlines the ‘anti-retaliation’ provision. Employees who face wrongful dismissal can

now claim for damages. Secondly, SOX suggests the establishment of a ‘standardized

channel’ to report misconduct internally within the corporation.50

These provisions aim to deter the company from reprimanding the whistleblower and

compensate the whistleblowers for any negative impact he or she may suffer at the same time

encourage employees to participate in monitoring the corporation and thus enhance good

governance practice.

Importance (3) Adequate disclosures

The major problem here arose from asymmetric information as we have already noted in part

(i) – transparency is one of the fundamental concepts that can give shareholders and investors

better access to the information required and thus assist them to make better judgments.

However, a mere effective internal system may not be enough – a good disclosure regime is

not only beneficially internally, it can aid the public to understand the structure and

operations of the company, and subsequently analyze whether they should invest in the

company.

Thus, there remains a need for legislative and regulatory framework to step in. To

demonstrate, in Hong Kong, the regulatory structure for selling investment products issued

49 Supra note 15. 50 Section 301, Sarbanes-Oxley Act 2002.


by SFC requires parties to disclose sufficient information in the product documents so that a

person can be free to make an informed decision. Besides, the SFC also requires the

securities firm to make sure themselves to consider whether the product is suitable before

they recommend them to any particular investors.51 Under Securities and Futures Ordinance

Part XV,52 it requires individuals or corporations who have 5% or more voting shares to

disclose any of their interests or changes in interest; Directors and chief executives that

worked in a listed corporation are also catch by the disclosure regime. Section 336 of the

same ordinance expressly requires every listed corporation keeps ‘a register of the [disclosed]

interests and short positions’.53 Analogically, same disclosure requirement applies to the

directors and executives.54 These can be echoed internationally, where in the EU, Article

19(5) of the MiFID provides that all the EU members have to ensure securities firm to

provide knowledge of investment according to their professions and give clients appropriate

advice for their specific product.55 Furthermore, the OECD in 1999 published a legislative

and regulatory framework that aims to ensure that the company makes ‘timely and accurate

disclosure’ regarding to matters like ‘financial situation, performance, ownership and

governance’. 56 In the US, under the SOX, companies are now required to disclose

information related to systems and procedures of financial reporting process. Section 404

expressly underlines that the auditor and management has to publish information about the

company’s internal control framework pertaining to financial reporting and assess whether

such system is adequate or not.

All these disclosure provisions not only foster market confidence and promotes the

development of the financial market, it also assists the regulatory bodies to perform the

supervisory duties as early warning signals can be identified from the information disclosed.

After all, the investors will always have most confidence when no insider information is

concealed or if the financial reports are highly reliable. Indeed, a failure to disclose now can

subject the party to heavy penalty. To illustrate, Deutsche Bank’s failures of disclosing its

51 Supra note 15. 52 Supra note 15. 53 Section 336, Securities and Futures Ordinance. 54 Ibid, Section 352. 55 Article 19(5), Markets in Financial Instruments Directive 56 Hong Kong Society of Accountants, ‘Corporate Governance Disclosure in Annual Reports’, 2001, page 5,

available at http://app1.hkicpa.org.hk/publications/corporategovernanceguides/p1-54.pdf.


27

interests in an energy investment company to Stock Exchange of Hong Kong Limited within

the required timeframe triggered SFC to conduct an investigation on the institution’s relevant

internal controls. As a result, SFC identified certain deficiencies in the institution’s position

monitoring system and a public announcement was issued in May 2014, reprimanding

Deutsche Bank and demanded a fine of HK$1.6million from the institution.57

Conclusion:

Overall, an excessive executive remuneration scheme may reduce the scope and efficiency in

the financial system, as the executive is brainwashed by short-term or even self-objectives

instead of long-term fiduciary achievement. A weak whistleblowing system and an unreliable

disclosure regime deceased public confidence as fraud may be concealed. Without sufficient

information, shareholders may be incapable to make a proper valuation of sharing prices.

Combining all these factors, the adverse impact turns back to the society – economic growth

may slow down; financial crisis may occur etc. Therefore, while internal policies may not

always be updated to reflect the current frameworks, a robust legislative and regulative

framework sounds a better cure, albeit it is admittedly not the final cure. Nevertheless, this is,

at least, what the society need most now.

57 SFC, ‘SFC reprimands and fines Deutsche Bank Aktiengesellschaft $1.6 million for regulatory breaches’,

Securities and Futures Commission news announcements, 2014, available at:

http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=14PR59.


Bibliography


29

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Legislation:

Companies Ordinance

Dodd-Frank Act

Markets in Financial Instruments Directive

Sabanes-Oxley Act

Securities and Futures Ordinance

Website:

http://ethics.csc.ncsu.edu/old/12_00/basics/whistle/rst/wstlblo_policy.html.

http://www.nytimes.com/2012/01/23/business/in-britain-a-rising-outcry-over-lavish-

executive-pay.html?_r=0.

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