Intermediary Internal Controls associated with Price Verification of Structured Finance Products and Regulatory Approaches to Liquidity Risk Management Final Report TECHNICAL COMMITTEE OF THE INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS FR02/11 FEBRUARY 2011 2 Contents Chapter Page Foreword 3 1 Background and Purpose of the Project 4 2 Internal Controls – Practice and Regulatory Arrangements 6 3 Liquidity Requirements 27 3 Foreword The Technical Committee of the International Organization of Securities Commissions (IOSCO) published a consultation report in July 2010 entitled: Intermediary Internal Controls Associated with Price Verification of Structured Finance Products and Regulatory Approaches to Liquidity Risk Management1. The comment period ended on 29 October 2010. The only entity to comment on the report was the International Capital Market Association (ICMA). Their letter, however, did not recommend any changes to the report. As a result, the IOSCO Technical Committee decided to publish the report as final with only technical edits. 1 Intermediary Internal Controls Associated with Price Verification of Structured Finance Products and Regulatory Approaches to Liquidity Risk Management - Report of the Technical Committee of IOSCO, July 2010 available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD331.pdf 4 Chapter 1 Background and Purpose of the Project In May 2008, the IOSCO Technical Committee (TC) published its Report on the Subprime Crisis (Subprime Report).2 The TC noted in the Subprime Report that, among other things, many institutional investors and investment banking firms had inadequate risk modelling and internal controls in place to understand and address the risks they were assuming when buying many types of structured finance products. The TC further noted the work of the Senior Supervisors Group (SSG) in analyzing this issue.3 As a result of its findings, the TC recommended that its Standing Committee on the Regulation of Market Intermediaries (TCSC3) ―undertake a study of the internal control systems of financial firms, including asset managers, in different IOSCO jurisdictions and develop principles to address any concerns identified.‖ The Subprime Report also addressed the critical importance of balance sheet liquidity for financial institutions. It observed that firms that proved more resilient during the market turmoil also appear to have more effectively managed their contingent liquidity needs. In some cases, this led firms to forego investments and business lines related to the subprime market because of the contingent liquidity risk they potentially posed. By contrast, firms that experienced greater difficulties tended to not align their treasury functions with their risk management processes, or may have based their contingency funding plans on incomplete or inaccurate information or faulty valuation practices. Indeed, the TC concluded that many institutional investors and investment banking firms had inadequate balance sheet liquidity, even when adequately capitalized. As a result, the Report recommended that TCSC3 also survey members on their experiences with regard to how firms they oversee managed liquidity risk, and with regard to current liquidity standards. This is intended to assist with and supplement the work currently being undertaken by the Basel Committee on Banking Supervision. As part of its study of internal controls, TCSC3 conducted a survey of both firms and regulators. The primary purpose of the survey to firms was to obtain information from major intermediaries that held certain structured finance products (SFPs) (as defined below), in or around 2006, concerning their internal controls as they relate to marking-to-market the value of these assets. The purpose of the survey to regulators was to obtain information from them concerning applicable regulatory requirements and their views as to the causes of the failure of certain firms to mark-to-market accurately the value of certain SFPs. The focus of both surveys was on internal controls and policies in effect at firms, and pertinent regulations, in 2 Report on the Subprime Crisis – Report of the Technical Committee of IOSCO, May 2008, available at: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD273.pdf. 3 The SSG published a report in March 2008, entitled Observations on Risk Management Practices during the Recent Market Turbulence. It is available at: http://www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_f