Financial Services Firms E-Book

Zabihollah Rezaee

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Corporate F&A
• Sprache: Englisch

Seitenzahl: 1129

Veröffentlichungsjahr: 2011

Beschreibung

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.

Leseprobe

Contents

Cover

Title Page

Copyright

Dedication

Preface

Highlights of Changes from the Second Edition

Organization of the Book

Acknowledgments

Part I: Financial Services Industry: Its Markets, Regulations, and Governance

Chapter 1: Fundamentals of the Financial Markets and Institutions

Introduction

Financial Markets

Financial Information and Capital Markets

Financial Crisis and Financial Regulatory Reforms

Types and Roles of Financial Markets

Financial Services Firms

Conclusion

Chapter 2: Introduction to Financial Institutions

Introduction

Landscape of the Financial Services Industry

Structural Changes in the Financial Services Industry

Historical Perspective of American Banking

Current Trends in the Financial Services Banking Industry

Regulatory Reforms

Valuation Process

Conclusion

Chapter 3: Corporate Governance

Introduction

Corporate Governance Effectiveness

Global Regulatory Reforms

Sarbanes-Oxley Act of 2002

Dodd-Frank Act

Corporate Governance Functions

Board of Directors and Its Committees

Audit Committee Roles and Responsibilities

Executive Compensation

Conclusion

Part II: The Foundation: Financial Institutions, Valuations, Mergers, Acquisitions, and Regulatory and Accounting Environment

Chapter 4: Overview of the Valuation Process

Introduction

Valuation Services

Valuation Profession

Valuation of the Business

Attracting Valuation Clients

Accepting a Client

Pricing Valuation Services

Importance of the Engagement Letter

Planning an Appraisal Engagement

General Planning

Appraiser's Traits

Appraiser's Due Diligence Process

Risk Assessment

Conclusion

Chapter 5: Overview of Mergers and Acquisitions

Introduction

Historical Perspective of Mergers and Acquisitions

Recent Trends in Mergers and Acquisitions

Regulations of Bank Mergers

Players in Mergers and Acquisitions

Motives for Business Combinations

Determinants of Mergers and Acquisitions

Perceived Shortcomings of Mergers and Acquisitions

Studies on Mergers and Acquisitions

Leveraged Buyout

Post Mergers and Acquisitions Performance

Shareholder Wealth and Effect of Mergers and Acquisitions

Joint Ventures and Strategic Alliances

Ethics in Mergers and Acquisitions

Governance in Mergers and Acquisitions

Mergers and Acquisitions Process

Conclusion

Chapter 6: Regulatory Environment and Financial Reporting Process of Financial Institutions

Introduction

Consolidation

Regulatory Environment

Bank Supervision

Financial Modernization: The Gramm-Leach-Bliley Act

Financial Reporting Process of Financial Institutions

Statement of Financial Accounting Standards No. 115

Auditing Proper Classifications of Marketable Securities

Tax Consideration of Fair Value

Recent Development of Fair Value Accounting

Financial Reporting Requirements of Financial Institutions

Corporate Governance of Financial Institutions

Conclusion

Part III: Fundamentals of Valuations: Concepts, Standards, and Techniques

Chapter 7: Value and Valuation: A Conceptual Foundation

Asset-Liability Management

Investment Management

Lending Management

Liquidity Management

Nature of Value

Twelve Concepts of Value

Types of Property that Can Be Valued

Relationship among Different Types of Value

Principles of Valuation Theory

Pricing Value versus Reporting Value

Limitations of the Valuation Process

Conclusion

Chapter 8: Approaches to Measuring Value

Overview of the Valuation Process

Cost Approach to Valuation

Market Approach to Valuation

Income Approach to Valuation

Special Topics—Approches to Intangible Asset Valuation

Special Topics—Business Valuation

Valuation and Business Concentrations

Special Topics—Closely Held Stock

Special Topics—Valuing Widely Traded Companies

Conclusion

Chapter 9: Valuations for Tax and Accounting Purposes

Tax Aspects of Mergers and Acquisitions

Typical Tax-Oriented Valuations

Accounting Aspects of Mergers and Acquisitions

Typical Accounting-Oriented Valuations

Acquisition Method

Presentation, Disclosure, and Transition Requirements of Business Combinations

Convergence in Accounting Standards on Mergers and Acquisitions

Conclusion

Chapter 10: Intangible Asset Valuation

Nature and Types of Intangible Assets

Amortizable versus Nonamortizable Intangible Assets

Measuring the Useful Life of an Intangible Asset

Establishing Value of Intangible Assets

Amortization Methods

Supporting Intangible Asset Valuation and Amortization

Goodwill Impairment

Conclusion

Part IV: Assessment of Financial Institutions

Chapter 11: Financial Analysis of Banks and Bank Holding Companies

Types and Sources of Financial Data

Overview of Financial Statements

Composition of Bank Assets

Composition of Bank Liabilities

Off–Balance Sheet Items

Composition of Bank Capital

Regulatory Capital Components

Risk-Based Capital

Value-at-Risk Models

Composition of Bank Income

Composition of Bank Expenses

Balance Sheet Analysis Illustration

Income Statement and Profitability Analysis Illustration

Loan Risk Analysis Illustration

Liquidity and Investment Portfolio Analysis Illustration

Portfolio Equities Analysis (REALM Model)

Special Bank Holding Company Considerations

Liability Management

Conclusion

Chapter 12: Internal Characteristics Assessment

Objectives and Benefits of an Internal Characteristics Assessment

Ten P Factor Framework

Shareholder Value Creation

Conclusion

Chapter 13: External Environment Assessment

Impact of External Environment on Value

Political Analysis

Economic Analysis

Social Analysis

Technological Analysis

Other Analysis

Conclusion

Part V: Valuation of Mergers and Acquisitions

Chapter 14: Bank Merger and Acquisition Process

Strategy Phase

Negotiation and Investigation Phase

Finalization and Integration Phase

Other Considerations

Conclusion

Chapter 15: Valuing a Bank as a Business Enterprise

Business Enterprise versus a Collection of Assets

Concept of the Banking Franchise

Difference between Strategic and Tactical Valuations

Why the Cost Approach Is Not Used for Strategic Bank Valuations

Application of the Market Approach to Valuing a Bank

Application of the Income Approach to Valuing a Bank

Sensitivity of Value Estimate to Assumption Changes

Value-Creation Opportunities and the Acquisition Price

Valuation Methods for Mergers and Acquisitions

Sophisticated Valuation Techniques for Mergers and Acquisitions

Relation between Price and Value and Effect on Stockholders

Conclusion

Chapter 16: Valuation of Tangible Bank Assets

Tangible Physical Assets

Tangible Financial Assets

Tangible Assets in Bank Mergers and Acquisitions

Intangible Assets in Bank Mergers and Acquisitions

Conclusion

Chapter 17: Core Deposits as a Special Type of Intangible Asset Valuation

Concept of Core Deposit Base as an Intangible Asset

Internal Revenue Service Position on Core Deposits

Important Core Deposit Tax Court Cases

Deposits to Be Included in Valuation

Alternative Approaches to Valuing a Core Deposit Base

Core Deposit Base Life Estimation

Application of the Cost Savings Approach

Application of the Future Income Approach

Systemically Important Financial Institutions

Conclusion

Chapter 18: Derivative Financial Instruments

Authoritative Guidelines on Derivatives

Derivative Markets

Derivatives Risk Management

Derivatives Risk Management Policy

Accounting for Derivatives

Tax Considerations of Derivatives

Audit of Derivative Transactions

Sources of Information on Derivatives

Derivatives Valuation Models

Derivatives under the Dodd-Frank Act of 2010

Conclusion

Chapter 19: Real-World Bank Valuation Complications

Banks Experiencing Recent Losses

Banks with Low Equity Capital

Banks with Uncertain Future Loan Loss Exposure

Preferred and Common Stock

Highly Leveraged Banks

Branch Acquisitions

European Banking Model

Initial Public Offering

Islamic Banking System

Emerging Issues in the Financial Services Industry

Conclusion

About the Author

Index

Copyright © 2001, 2011 by John Wiley & Sons, Inc. All rights reserved. Second edition 2001

Third edition 2011

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Rezaee, Zabihollah, 1953-

Financial services firms: governance, regulations, valuations, mergers, and acquisitions/Zabihollah Rezaee.—3rd ed.

p. cm.

Rev. ed. of: Financial institutions, valuations, mergers, and acquisitions. 2nd ed. New York:

J. Wiley, c2001.

Includes index.

ISBN 978-0-470-60447-2 (hardback); 978-1-118-09851-6 (ebk); 978-1-118-09852-3 (ebk); 978-1-118-09853-0 (ebk)

1. Banks and banking–Valuation–United States. 2. Bank mergers–United States. 3. Sale of banks–United States. 4. Financial institutions–Valuation–United States. 5. Financial institutions–Mergers–United States. 6. Financial institutions–Purchasing–United

States. 7. Consolidation and merger of corporations–Law and legislation–United

States. I. Rezaee, Zabihollah, 1953- Financial institutions, valuations, mergers, and acquisitions. II. Title.

HG1707.7.R49 2011

332.1′6–dc22

2011012029

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 adequacyAssessing the market risk capital requirementsIdentifying systemically important financial institutions and measuring their sustainability, risks, and externalities to reduce the moral hazard of TBTF and risk to the global financial stabilityStricter oversight of credit rating agenciesRationalizing the executive compensation program, which is linked to long-term performance and avoids incentives for undue risk takingRegulating over-the-counter derivatives and credit default swapsEnhancing the supervisory program for financial services firmsImproving the corporate governance structure by increasing independence of directors and risk management functionsClearing banks' balance sheets of toxic assets by applying fair value in measuring, recognizing, and reporting assetsUsing the expected loss model instead of the current practice of incurred loss model for measuring credit lossesSeparating investment banks from commercial banksDeveloping more stringent prudential standards of enhanced capital and liquidity requirementsProviding transparency and accountability for government bailout plans and stimulus programsImplementing close supervision and monitory of banks' debt, liabilities, and capital adequacyMaintaining 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.

PartSubjectChaptersIFinancial Services Industry: Its Markets, Regulations, and Governance1–3IIThe Foundation: Financial Institutions, Valuations, Mergers, Acquisitions, and Regulatory and Accounting Environment4–6IIIFundamentals of Valuations: Concepts, Standards, and Techniques7–10IVAssessment of Financial Institutions11–13VValuation of Mergers and Acquisitions14–19

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

TitleHeadingDescriptionIFinancial StabilityCreating a Financial Stability Oversight Council to identify users and respond to existing and emerging systemic risk of bank holding companies and large nonbank financial companies. The Council is composed of ten voting members chaired by the head of the Treasury Department.IIOrderly Liquidation AuthorityProvides recommendations for receivership that may be made by the secretary of the Treasury or Federal Reserve and Federal Deposit Insurance Corporation (FDIC) or Securities and Exchange Commission (SEC) for the financial companies in default. Secretary will petition U.S. district court for an order to appoint the FDIC as receiver if a failing financial company does not consent to it. The liquidation process requires that: unsecured creditors bear losses; shareholders do not receive payment until all claims are fully paid; management and directors responsible for the failure are removed; any funds the FDIC borrows from Treasury to facilitate a liquidation be repaid through asset sales and risk-based assessments; no taxpayer funds to be used to prevent or pay for a liquidation.IIITransfer of Powers to the OCC, FDIC, and the Federal ReserveAbolishes the Office of Thrift Supervision; preserves the thrift charter. Allocates supervisory and rule-making authority for all thrift holding companies and their nondepositary institution subsidiaries to the Federal Reserve. All rule-making authorities for thrifts will be transferred to the Office of the Comptroller of the Currency (OCC). The OCC will be redefined as a bureau within the Department of Treasury. Imposes a number of deposit insurance reforms to: redefine the assessment base to reflect assets; requires the reserve ratio to reach 1.35% of estimated insured deposits; permanently increases deposit insurance coverage to $250,000; fully covers non-interest bearing transaction accounts through 2012.IVRegulation of Advisers to Hedge FundsEliminates the private advisor exemption and requires the investment advisor to maintain certain records and reports. Provides exemptions from the registration requirements for: advisors solely to venture capital funds; foreign private advisors with fewer than 15 U.S clients and less than $25 million in assets under management; family offices as defined by SEC. Requires the General Accountability Office (GAO) to study and report on appropriate criteria for determining the financial thresholds.VInsuranceMonitors the insurance industry and identifies issues contributing to system risk. Determines if the state insurance measures are preempted by certain international insurance agreements. Requires modernization and improvements of the U.S system of insurance regulation. Submits a report to Congress on the global reinsurance market.VIImprovements to Regulation of Bank and Savings Association Holding Companies and Depository InstitutionsGAO conducts a study of elimination of exceptions as amended, for thrifts, loan companies and credit banks, etc. Modifies regulations related to transactions with affiliates, charter conversions, and SEC's elective investment bank that holds company framework and also requires the Federal Reserve to examine nondepositary institution subsidiaries engaged in activities as banks. Provides rules such as: banking entities to be prohibited from engaging in trading or investing funds; insured depositary institution not including an institution that functions solely in a trust or fiduciary capacity. Banking entities must bring their activities and investments into compliance within two years after the rules become effective. Includes activities such as transactions in U.S government obligations or in connection with activities related to market making to meet demand of clients/customers or risk mitigating hedging activities. Transactions will be prohibited if they have conflict of interest between clients or customers; or if they are prone to high-risk assets or trading strategies or even if they pose a threat to the safety of bank.VIIWall Street Transparency and AccountabilitySEC and Commodity Futures Trading Commission (CFTC) will share authority for regulation of OTC's swaps that actually are required to be submitted for clearing must also be traded on or through exchange or swap execution facility. (The dealers and participants must register with SEC/CFTC.) An exemption is provided for end users who use derivatives to hedge against risks such as fuel prices and interest rates.VIIIClearing and Settlement SupervisionCouncil to design financial market utilities and payment; the Federal Reserve to prescribe uniform risk management standards for the payment and settlement activities. Requires conducting examinations to evaluate compliance with risk management and conduct standards besides the market utilities getting access to Federal Reserve's discount window under few restrictions. Requires that financial institutions not include swap data repositories, security exchanges, and the financial market utility not include the above not a broker, dealer or agent as well.IXInvestors Protections and Improvements to Regulation of SecuritiesAs per the Investors Protections, SEC is granted authority to promulgate rules to establish fiduciary duty. SEC must study and give suggestions within six months of enactment of care for brokers-dealers or persons associated while advising customers; study enhancing investment advisor examinations, mutual fund advertising, etc. Credit rating agencies to be established within SEC to administer the commission's rules with respect to nationally recognized statistical rating organizations (NRSROs) that in turn will be examined annually by SEC as its employees (of NRSRO) are covered by the whistleblower protections. Asset-backed securities would be required to retain economic interest and risk retention requirements for commercial mortgages to be determined by federal banking agencies and the SEC. Executive compensation to be provided as prerequisite for listing shares on an exchange. Create municipal securities; its dealers and advisors are to register with the SEC.XBureau of Consumer Financial ProtectionEstablish a bureau that comprises of the consumer protection functions (Federal Reserve, OCC, OTC, FDIC and NCUA) to be resident within the Federal Reserve and to be funded by Federal Reserve system. Grants authority to the bureau to regulate any person engaged in offering or providing a consumer financial product or service. Banks and credit unions with total assets of $10 billion or less would be subject to examination and enforcement of their compliance with federal consumer laws. Exclusions to be provided for some persons including SEC/CFTC regulated entities; real estate brokers; home retailers; accountants, tax preparers; auto dealers. Bureau to take action against covered persons and service providers to stop unfair, deceptive, and abusive acts and practices. Additional offices to be established under the bureau including the Office of Fair Lending, Financial Literacy, Service Member Affairs, and Financial Protection for Older Americans. Interchange fees for electronic debit transactions to be required to be reasonable and proportional.XIFederal Reserve System ProvisionsFederal Reserve to establish policies and procedures to ensure that a program is used to provide liquidity to the financial system. GAO to audit Federal Reserve loans and other financial assistance and to audit Federal Reserve Bank governance, including consideration of the selection and appointment of directors and conflicts of interest.XIIImproving Access to Mainstream Financial InstitutionsEstablish grants to promote initiatives that enable low- and moderate-income individuals access to financial products that meet their needs. Establish multiyear programs to provide low-cost alternatives to small-dollar loans.XIIIPay It Back ActReduce authorization of the Troubled Asset Relief Program and requiring to proceed from the sale of Fannie Mae, Freddie Mac debt purchased under Treasury's emergency authority.XIVMortgage Reform and Anti-Predatory Lending ActTo create laws/rules requiring mortgage originators to be qualified, registered, and licensed; to set a minimum standard that mortgage originators make a reasonable and good-faith determination while prohibiting steering where no mortgage originator may receive compensation, directly or indirectly based on terms of loans; to limit prepayment penalties. To increase protection for consumers by redefining high-cost mortgages with smaller spreads over the prime offer rate than currently used and by adding requirements regarding escrow accounts and appraisal standards.XVMiscellaneous ProvisionsRequires the GAO to report to Congress in a year on relative independence, effectiveness, and expertise of appointed inspectors general and designated federal entities. Requires the FDIC to evaluate the definitions of core deposits and brokered deposits and their impact on the economy.XISection 1256 ContractsAdds a new provision to the Internal Revenue Code providing an exception for any securities future contact and any interest rate swap, currency swap, basis swap, interest rate cap, commodity swap, equity swap, or similar agreement.

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/.

$6,927.80U.S. Treasury (marketable securities out of a total debt of $12 trillion, $7.5 of which is public)2,972.4Agencies of the United States2,726.8State and municipal6,778.4Corporate3,430.3Money market8,948.7Mortgage backed2,533.6Asset backed$34,318.0Total

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.