Author: | Published: 30 Sep 2004
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Keith Clark is managing director and international general counsel of Morgan Stanley. He has responsibility for the firm's Institutional Securities Law groups in Europe and Asia, and generally oversees legal matters outside the US.

Clark joined Morgan Stanley early in 2002 from Clifford Chance, where, as the firm's chairman, he oversaw its groundbreaking merger with Rogers & Wells in the US and Pünder Volhard Weber & Axter in Germany. Prior to that Clark spent periods as senior partner, head of the banking division and partner responsible for business development at the firm.

European lawmakers should talk more with the industry and take a closer look at the costs of new legislation. That is the message from Keith Clark, Morgan Stanley's international general counsel.

In the face of the change visited upon bankers by the Financial Services Action Plan, there is little point in quibbling over details, he says. Europe's directives are a step towards the global integration of capital markets and will benefit both issuers and intermediaries. But the pace of transformation is too quick. And arguments over the details of proposed legislation could be avoided with more thorough consultation. Here Clark talks to IFLR about how his firm is handling the pressures of such rapid reform.

Rob Mannix: Can you begin by telling us which regulatory issues you are focussing your attention on most?

Keith Clark: On one hand, we are required to react to initiatives taken by the regulators, such as the Spitzer enquiries in the US. On the other, there is a proactive agenda, particularly in Europe, which is in the act of creating a complete new infrastructure for the financial markets. So our work with the regulators falls into two streams: the first, responding to requests for information, and the second, cooperating on a whole range of different initiatives that are aimed at changing the way that the financial markets operate in Europe and globally.

Are there specific parts of Europe's Financial Services Action Plan that you would identify as especially critical?

It is difficult to ascribe different levels of importance to different directives because they all interrelate. You start with the harmonization of accounting principles, which is absolutely fundamental to the ability to operate a single transparent marketplace. The benefits of that are carried into how firms go out to solicit investment in new products under the Prospectus Directive. Then you have the Transparency Directive covering how you update information to investors on a regular basis.

The way the financial markets operate overall is essentially addressed by the Markets in Financial Instruments Directive (Mifid), which is requiring a large amount of attention right now. The Financial Conglomerates Directive is a huge issue, and will bring in Basel requirements across the whole of our business in a way that has not been the case to date. For us as a firm the Financial Conglomerates Directive, Basel and the Capital Adequacy Directive are massive issues. The strength and depth of the change that this brings for an organization such as Morgan Stanley in a relatively short space of time is breathtaking.

What is your opinion of the legislative approach taken by Brussels?

One of the big issues is deciding what the right level of detail should be in legislation. Should you rely on fairly high-level principles and then leave the implementation to the local regulator? Or is it more important to get absolute harmony between the member states and therefore to set more prescriptive measures at the level of the Committee of European Securities Regulators (Cesr). I think within our organization we feel that the detail has gone too far. We would prefer the balance to be struck more in favour of high-level policy.

Can you give some examples of the practical problems that very detailed rules can cause?

You have to ask whether it is right to have a detailed conflict policy for all your wholesale customers and to have to communicate that to 250,000 highly professional investors. Should you have to get them to sit down and sign up to an agreement in the same way that might be appropriate for smaller companies or retail investors? What you need for the retail sector does not necessarily make sense in a large wholesale professional marketplace.

How has Morgan Stanley changed the way it does business as a result of the regulatory focus on conflicts both in the US and Europe?

Morgan Stanley has always gone about trying to do first class business in a first class way. The recognition of the importance of managing conflicts is ingrained at the centre of how we have always operated.

For example, during the whole intensive investigation in the US in relation to the independence of equity analysts, not a single instance was found in relation to Morgan Stanley analysts where any of our analysts published anything other than their own strongly held personal views. But some of this is about restoring trust and about industry taking a lead in demonstrating it aspires to the highest standards. For example, we have sought to bring requirements into fixed income research similar to those in equity research.

What has been the effect on the industry of the Spitzer settlement in the US relating to conflicts in equity research?

Clearly the Spitzer requirements were very detailed about creating demarcation lines between investment banking and equity research. If you talk to people in the marketplace, the chill effect of those requirements has shown that the imposition of detailed rules can lead to an exaggerated response. There are a lot of 'I's being dotted and 'T's being crossed to evidence the distinction between research and investment banking. In some areas, this has led to the severing of quite innocent and quite helpful communications. I think over time it will be recognized that it may be sensible to reengage some of the interaction between investment banking and equity research.

There has been much controversy over trade transparency requirements in the Markets in Financial Instruments Directive. What is your view on these?

Article 27 of Mifid, which deals with pre-trade transparency, is a political compromise driven by all the worst elements of European lawmaking. It is quite difficult to reconcile the requirements of France and Italy, which have historically had difficulties with off-exchange trading, with the internalization approach that has worked well in the US and which we would have preferred to have been the model in Europe.

The consultation coming out in the next few weeks on Level 2 implementing measures for Mifid is going to be a critical phase. There are exemptions built into Article 27, such as price improvement exemptions, to facilitate wholesale markets. If those get pushed in the wrong direction it will be problematic. If they get clarified in a helpful way we will be pleased.

Some of the people on the opposite side of the fence from us really do want to reintroduce the concentration rules, so they won't be happy with anything that achieves less than that.

How will the Prospectus Directive affect your business?

Whenever you have requirements under either the Prospectus Directive or the Transparency Directive to put information out, you have potential liability. You have to work on the assumption that investors will base investment decisions on that information. The potential liability regimes in the different European member states differ. There is not clarity as to what rules operate with regard to potential liability.

But it has to be good that you can use a single form of prospectus to carry out issues of securities and that it is clear which regulatory authority will address the appropriateness of that document. Given that Cesr is working pretty effectively, there is some hope of greater coordination between the regulators as to how they will approach the approval of prospectuses.

What are the long-term benefits for the industry?

There is more to be done, and some of that depends on how the regulators carry out those functions. But you can reasonably hope that the Prospectus Directive will simplify the issue of shares, which is a major achievement. You can carp about the division between equity issues and debt issues. But if you stand back I think the broad thrust of what has happened with the Prospectus Directive is extremely helpful for the European capital markets.

It puts us one stage closer to the goal of trying to synchronize the US and European markets. It would be so much better for a company seeking to raise capital to be able to access the US and European capital markets at the same time using the same methodology and documentation. The costs of raising capital would be reduced dramatically. Achieving single methods of operating throughout Europe is an important initial step towards getting that convergence between the US and European capital markets. That is why we welcome the working arrangements that have recently been set up by the SEC and Cesr.

What do you think of the compromise brokered in the Prospectus Directive to protect the wholesale Eurobond market?

We were very aware with the Prospectus Directive of the irony of the Eurobond market being dismantled to achieve something better perhaps for the equity markets. We strongly backed the UK government's stance to get exemptions on the bond side because it was silly to dismantle something that was already an effectively functioning and efficient single market.

Brussels came up with this document without consulting and if they had bothered to check with the markets they could have come up with a far better first draft. Instead it turned into a battlefield with the UK yet again painted as being the awkward customer of Europe.

Does Brussels consult enough on new legislation?

There are two principles that the UK's Financial Services Authority (FSA) has been extremely able in laying down as foundations for its work. These are in the process of being taken up in Brussels and we would like them to be taken up and totally endorsed there. The first is consulting with the industry before developing any proposals in any detail, and the second is carrying out a cost benefit analysis. It doesn't make any sense to bring forward an agenda for change if the benefits are swamped by the costs of doing it. I think the FSA has been quite scrupulous in following those two lines of action, which have been very helpful for London over the past few years. Brussels has certainly improved in terms of consultation, but there is considerably more that can be done in terms of cost benefit analysis.

How will the Market Abuse Directive affect your business?

Parts of the Market Abuse Directive, such as the requirement to maintain detailed lists of insiders, are difficult to tie up with the realities of how things actually happen. People are also unsure what the consequences of getting rid of the regular user test in the UK will be. The industry fought long and hard in the UK to get that type of objectivity built into the regime only for it to be superseded by new European requirements. It is a bit like getting a new pair of shoes and getting comfortable in them only to be told you have to take those of and put Wellington boots on. You are not quite sure how it's going to feel but you know it's going to feel different.

For us it means training, training and retraining. We trained off the back of the English regime. Getting people to get their heads around the differences with the new regime is going to take up a lot of time and a lot of effort.

You mentioned earlier that Basel II is changing the way you work. Are you happy with the Accord?

Basel I was basically designed for the money centre banks. It was successful. But it was a relatively blunt instrument, certainly blunt in terms of different types of credit risks. Basel II has fine-tuned a lot of these credit risk weightings to make the allocation of capital against risk more accurate. The desire is to apply that across all different financial institutions including the investment houses.

But Basel II has been formulated by a committee that still reflects the interests and needs of money centre banks. The SEC, for example, is not part of the Basel Committee group. The extension and maintenance of credit off the back of investment bank business is different from money centre banking business. The length of time that your risk is outstanding is usually much shorter. The collateral that you have in relation to that risk is very different.

We feel that changes need to be brought in to the Basel II Accord. It is overly draconian in terms of the capital allocations for some of the risks in investment banking. A joint working party between the International Organization of Securities Commissions (Iosco) and the Basel Committee that was established earlier this year is addressing these issues. I think there is agreement that amendments are needed but exactly how those will be identified and the timetable for bringing that into the operation of Basel II is still unclear.

How are you preparing to deal with the capital adequacy requirements for operational risk in Basel II?

Because the fine tuning of the capital allocations in Basel II has meant a decrease in the overall capital to be allocated based on credit risk, the Basel Committee's objective was to retain similar amounts of overall capital within the system and so the need to back operational risk with a capital allocation. You may ask why. An operational glitch will tend to lead people to look at that glitch and remedy it. The incentive to resolve the defect is born out of the defect itself.

Whatever the philosophical rights and wrongs, the Basel Accord has set up requirements to allocate capital against operational risk. In any event it has to be helpful to the industry to set up sophisticated methodologies to identify, manage and control operational risk. In a few years the science of operational risk management will have been developed in similar ways to the science of managing market risk and credit risk.

Lastly, what issues do you expect to dominate your attention for the next two to five years?

First of all, this year we have begun to see a real upsurge in economic and business activity. Secondly, we see market unification and convergence continuing, both within Europe and in Asia. We hope also to see convergence between the major international markets in the practice of capital raising.

And thirdly there will be continuing work to deal with regulatory investigations. A lot has been done already by the industry participating with regulators both in the US and Europe to look at business practices. There is another year or two of that still in the pipeline.

The way organizations such as ours operate, behave and make decisions is changing. The market in which we operate is changing a lot. And the pace of change is very fast. If you stand back and ask whether it should take longer, then yes it should. But it is understandable that things are put on concentrated timetables because politically you have to try and make a substantial change rapidly.

There was originally a consensus not to bring forward major new legislative change until the Financial Services Action Plan was in place. But another reasonably large agenda for change has emerged, whether in the area of corporate governance, investment management, the potential supervision of hedge funds or the supervision of credit rating agencies. There are still many issues on the legislative table.