For the last third of 2007, global markets grappled with an unprecedented credit crunch that appears far from over. There is still uncertainty over just how serious the trouble is, how it happened, who is to blame and what needs to change as a result. It’s also clear that unravelling these questions will be a primary challenge for regulators in the year ahead.

The scope and scale of the problems revealing themselves amidst the ongoing turmoil in credit markets is such that Susan Wolburgh-Jenah, president and CEO of the Investment Dealers Association of Canada, believes it’s likely that this event is going to be “a huge preoccupation for the industry and regulators” throughout much of 2008.

In Canada, the credit disruption has been felt most acutely in the non-bank asset-backed commercial paper market, and the financial services industry has come together to try to resolve the immediate crisis. But, Wolburgh-Jenah says, solution or not, the impact of the entire episode will go much deeper.

“People will be looking at what lessons can be learned,” she says. “What are the underlying causes and what — if anything — needs to be done.”

The credit issue is a big one; it upends so much conventional wisdom about the recent development of financial markets while revealing so many industry failings. Those failings originate with some shady practices at the retail banking level, particularly in the U.S. subprime mortgage business. The negative consequences were then amplified and spread throughout world financial markets by the repackaging of loans into exponentially more complex and opaque structured products. All of this was topped off by an apparent lack of diligence from investors — both institutional and retail — and their advisors, as they bought these products without understanding them or their risks.

Before the markets stumbled, this trend to securitization boosted market liquidity and made credit seem cheap and plentiful. Now, much of that is being unwound — perhaps permanently. That shift is altering the face of financial markets and, by extension, having an impact on the global economy. The long-run economic effect of all of this is certainly a concern for central bankers, but there’s also plenty for regulators, both market and prudential authorities, to fret over, too.

At the macro level, the spreading of the turmoil from one fairly obscure sector of the global financial market to seemingly unrelated sectors reveals that contagion is a bigger risk than was commonly thought. Indeed, it was assumed that globalization mitigated risk by spreading it more widely. It turns out that the dispersion of risk has actually stoked uncertainty, as the effects of the market turmoil rebound in unpredictable ways. This questions the adequacy of market transparency, particularly of the derivatives and structured products that financial engineers have been constructing in recent years.

As David Dodge explained in his final public speech as governor of the Bank of Canada in mid-December, the lack of transparency is delaying markets’ ability to reprice credit risk and is continuing to disrupt the global interbank market.

This has left the owners of complex structured products needing more transparency regarding their assets. Similarly, shareholders are looking for greater insight into companies’ exposure to these products and how they are being accounted for on companies’ books — particularly at the world’s large banks and brokers. As Dodge says: “Uncertainty remains about the extent to which banks are holding these securities, how much they may be required to take onto their balance sheets and what value to place on them.”

While the banks may have understood the risks they were taking with these products, other supposedly sophisticated investors clearly did not. That raises other regulatory concerns. The fact that investors were buying products they didn’t understand suggests that they were getting inadequate if not incompetent advice. Moreover, they may have taken false comfort in the high credit ratings that some of these very complex structured products carried.

In other words, there’s plenty for regulators to worry about. Former U.S. Securities and Exchange Com-mission chairman Arthur Levitt likens this chapter to the last big corporate crisis — the collapse of Enron Corp. and WorldCom Inc. amid a cascade of dubious accounting practices and corporate governance failures.

“The scope of this crisis is not the only similarity to the Enron-era scandals,” Levitt told a lunchtime audience at the Ontario Securities Commission’s annual conference in late November. “They also share root causes that include conflicts of interest, a lack of accountability and limited transparency, leavened with a healthy dose of naive greed.

@page_break@“Indeed, the subprime meltdown — which is still roiling the markets and the economic health of the world — is yet another example of what happens when independence and accountability are compromised among key market actors,” he adds, “[and] of what happens when trust breaks down.”

Enhancing independence, accountability and transparency will probably be at the root of regulators’ efforts to grapple with the credit market disruption. In November, the International Organization of Securities Commi-ssi-ons created a task force to consider whether regulatory action is required. It will focus on risk management by firms that trade in structured products, transparency of the products themselves, valuation and accounting issues, and the role played by credit-rating agencies.

These are not easy issues, and the challenge for policy-makers is compounded by the fact that they are so far-reaching and diverse. That means an international perspective is probably needed for a full understanding of the problems.

For now, Canadian regulators appear content to let IOSCO take the lead. The OSC is publicly supporting IOSCO’s approach. And Doug Hyndman, chairman of the B.C. Securities Commission, is also behind it, saying that the IOSCO effort appears to cover the ABCP issues “pretty well.”

The IOSCO task force is due to report at the organization’s next annual meeting in May and the results will probably give regulators a direction to follow in their own jurisdictions. Wolburgh-Jenah finds it hard to believe that IOSCO will have all the answers by then. More likely, it will come up with some high-level principles for market players to follow, and regulators can then adapt them to their local circumstances.

But that does not necessarily mean that regulators will be jumping to impose new rules. Speaking at the same conference as Levitt, OSC chairman David Wilson expressed support for the IOSCO effort, noting that regulators pursuing a global response to the credit crisis are not going to overreact: “Precipitous change tends only to create additional problems and unnecessary new burdens.”

Indeed, one lesson the Enron crisis imparted is that regulators should resist the urge to rush out with new rules in response to market calamities. In this case, it will probably take some time for regulatory responses to emerge.

Policy-makers are, however, already working through potential approaches. For example, the latest issue of the Bank of Canada’s Financial Stability Review concludes that increased regulation of the credit-rating agencies isn’t justified. Instead, it suggests, markets will probably be most effective at improving the ratings process; regulators may be able to help the market exercise discipline by encouraging more disclosure about that process, it adds. It proposes that regulators focus investors’ attention on ratings transparency by publicly evaluating the agencies’ compliance with the IOSCO code of conduct for the industry.

Similarly, Dodge has suggested regulators should be doing more to demand transparency from structured-product issuers. He contrasts the lack of disclosure requirements for products sold in the exempt market with the detailed disclosure obligations that accompany ordinary retail issues. “It seems to me that some very basic disclosure is needed in every market,” Dodge maintains.

One alternative he proposes would be requiring issuers to disclose the information they provide to credit-rating agencies.

He also suggests the securitization process may need some regulatory intervention to ensure that loan originators are at least somewhat interested in the creditworthiness of their borrowers. That could include branding asset-backed securities to encourage due diligence by lenders before the loan is securitized, or requiring lenders to keep a substantial portion of their riskiest products on their own books.

In the financial services industry history books, 2007 will probably be remembered as the year of the global credit crunch. The year ahead, and beyond, will be marked by the regulators’ efforts to deal with the market failures that occurred. IE