What’s up, Doc? Asian regulation in the Chinese Year of the Rabbit

By Alan Ewins, Partner, Allen & Overy, Hong Kong (01/03/2011)

As the Year of the Tiger prowls off into the distance and becomes the Year of the Rabbit, it is important that the swirl of international financial regulation does not become a rabbit stew. Driven by the powerhouses of the US and Europe, there has been a significant move in the international financial community towards heavier and stricter prudential regulation. The banks have become subject to the groundwork for Basel III, to build up capital buffers and liquidity; shadow banking has started to come into the light with the emergence of the SIFI concept, covering systemically important financial institutions to be carefully monitored and controlled.

The alternative fund management industry now has to get to grips with a more settled form of fund manager legislation for Europe, and Dodd Frank in the US is in the midst of the mammoth rule making process which will be the true measure of its worth. Mandatory derivatives clearing is one of the highly significant changes being made under that legislation, and broadly mirrored in Europe. And what else? The Foreign Corrupt Practices Act is being ever more enthusiastically enforced, and the UK Bribery Act with its even tougher strict liability corporate offence for allowing bribery to happen on the corporate’s watch is set to cause serious day-to-day concern in the board rooms of corporations in April, when it is due to go live.

Coupled with all of these things has been a desire in the G20 and other international fora for countries and regulators to be seen to be tough on breaches of regulation and on the causes of breaches of regulation. There is a clear global political momentum to be seen to be doing the right thing, or at least supporting or being seen to support that it is done. The right thing, of course, means many different things for many of the Western jurisdictions.

Ultimately, there is a need for the international changes in regulation to be implemented in ways that not only accord with the overall consensus but also work for the purposes of local domestic and regional requirements. This is where there is some difficulty in the global model. All of the major changes referred to above, and they do amount to huge changes in the way that markets will be operated and will co-exist going forward, can very much be viewed as addressing what are principally Western problems, created out of the rolling crises of sub-prime, credit crunch and sovereign fragility.

Asia had its crises at the end of the last century (in the imaginatively named Asian Financial Crisis, and then SARS in the early 2000s), and clearly learned from the problems, including the high capital maintained by most Asian banks and their relatively strict lending policies. No major banks, brokers or clearers failed in Asia during the Global Financial Crisis, and that can be traced to a great extent to the developments from those earlier crises.

The Asian part of the GFC has principally been in the context of mis-selling of structured products, ie, the aftermath of Lehmans. That has generated a wave of substantial reforms of sales regimes for those types of product, including the introduction of a shortform summary document requirement in Hong Kong, and similar developments in Singapore and Malaysia; Korea has also followed the product regulation path, and the other major Asian jurisdictions have tightened up their respective regimes. The Europeans are now grappling with a similar concept (KIDs), in many respects mirroring the Asian developments.

So how does and will the various swathes of changed and changing regulation affect Asia? The product sales regulations are now becoming more settled after the initial flurry of major concern and indeed, particularly in Hong Kong, novelty.

But there are two main sets of the international regulatory regime changes that will have major impacts on Asia, firstly those which the Asian jurisdictions are adopting as a result of the drive for cooperation and consistency (and the threat of being viewed, otherwise, as a maverick state). This includes the regulation of credit rating agencies (Hong Kong – a new regulated activity); bankers’ pay in Hong Kong (banking regulator pronouncements), Singapore (via the corporate governance requirements), China (including Draconian clawback provisions); and hedge fund monitoring and increased regulation. The implementation of the Basel III requirements for banks is another form of international harmonisation, notwithstanding that there are arguments that from an Asian perspective it will make little difference.

The second category is the increased extra-territoriality of certain types of Western legislation. That includes the cross-border effect of the FCPA and Bribery Act reaching out into Asia, potentially affecting activities in Asian jurisdictions with only a limited connection with the US or the UK. Also, the Dodd Frank requirements in relation to mandatory clearing of derivatives come into play in respect of Asian jurisdictions. Early movers have been Singapore and Japan in the race to secure market share for those jurisdictions in relation to central counterparties; Hong Kong is set to follow, and China and India have taken steps in the direction of clearing of, in particular, interest rate swaps. It is the more complex derivative products such as credit default swaps which pose the greatest challenges in this space.

The regional markets are wrestling with these concepts, in the same way as their Western counterparts, with the potential under Dodd Frank for the structures essentially to need blessing under the US regime before players in those markets would be effectively recognised for US purposes. With CCPs comes the need for inter-operability among those markets to provide a degree of utility for multi-national market participants.

As an overlay to all of the above is the increased level of supervision and enforcement, including a distinct gearing up of cross-border cooperation between regulators. Indeed, 97 per cent of IOSCO members have formally agreed to cooperate more actively with each other in relation to pursuing rogue market participants. There has been a distinct change in tone among the regulators, and in Asia it has become clear that the main jurisdictions have by no means lagged behind in aggressively attacking market misconduct. The Hong Kong SFC’s successes in relation to market misconduct have been a prime example of this.

Heavier regulation, stronger supervision and more hard-line enforcement activity have been evident in Asia, and have been indicative of a truly global phenomenon. In the coming year, we can expect to see more of the same, particularly as the pieces of Dodd Frank take further shape, the UK Bribery Act takes up station and the other regulatory developments continue to work through the G20 and beyond.

Financial institutions in Asia need to be mindful of the international developments which will push into the local markets and shape the international regime going forward. Asia will need to take a firm position as part of the overall global process to ensure that it has one voice with which to influence the nature and speed of change, rather than a collection of local voices, which would carry significantly less weight.

Staying for a moment with the Rabbit metaphor, the carrot of more cohesive international financial regulation beckons.