On one side, a physician keeps track of his patient's health. On the other, a police officer watches for and punishes illegal behavior. That's more or less a description of how "twin peaks" works, the Australian model of capital market regulation which is currently popular among international authorities. While one regulator seeks to maintain the liquidity of financial institutions and control systemic risks, another monitors the behavior of the players. If the "twin towers" of the World Trade Center represent a cruel attack on America’s vision of the world, then the "twin peaks" have been pointed out as a possible solution to well-established regulation systems such as the one in the U.S.. Already enforced in the Netherlands and Canada (see box on page 48), the regime may also be adopted in Spain, Portugal, the United Kingdom and Hong Kong.

The twin peaks model gained the spotlight last year after being praised in a report by the Group of 30, an organization which gathers academics and former finance ministers from several countries. The Report on the Structure of Financial Supervision, released in October 2008, mentioned Australia as the best-regulated jurisdiction in the world. The document was signed by Paul Volcker, former president of the Federal Reserve and current economic advisor to Barack Obama.

One of the lessons taught by the financial crisis was that regulatory structures failed by favoring problem remediation, instead of preventing the problems' causes. Consequently, several regulators have been discussing reforms to their manner of action more than the creation of new rules. In Australia, the strong presence of the Australian Prudential Regulation Authority (Apra) is seen as one of the reasons for the local economy not having taken such a blow from the subprime crisis. No Australian banks crumbled in the financial earthquake.

"We had been warning our market about the risks of American mortgage bonds for a long time", says John Laker, chairman of Apra. Therefore, fearing a bubble, the agency sought to repress the potential damage from subprime loans. In early 2008, one of the initiatives installed to curb the market's appetite for high-risk bonds was requiring mortgage brokers to use the same credit analysis standards as the original creditors, the banks. The measure led to lower default rates for financial institutions. While Apra was busy doing this, the Australian Securities and Investments Commission (Asic) was free to repress more day-to-day corporate irregularities.

SEPARATE HATS — One of the benefits of the twin peaks model is that it eliminates the conflicts between two types of approach. The case of Northern Rock Bank, the first in the United Kingdom to report losses from American junk bonds, shows this clearly. In September 2007, the lack of liquidity generated by the subprime crisis led Northern Rock's clients to stampede to their branch offices to withdraw money. The British central bank had to come to the institution's rescue to guarantee its deposits. In February 2008, Northern Rock was nationalized after failing to find any interested private buyers. The following month, the Financial Services Authority (FSA), the UK's capital market and financial system regulator, admitted that it focused much more on consumer protection than on preventing the bank’s bankruptcy.

In June this year, the British Parliament's committee on economic affairs published a report in which it assessed the need for a regulatory reform in the country. According to the document, the emphasis given by the FSA to market conduct was a natural consequence of the organization's characteristics. Given that prudential supervision is a behind-the-scenes operation by nature – the inquiries posed to financial institutions are confidential – its political effect is low as compared to conduct enforcement, which is marked by public disclosure and repercussion. "It's natural that a regulator in charge of both tasks will end up giving priority to the one with greater immediate political impact. Consumers don't usually call the FSA to complain that a certain bank is engaging in risky operations; they do it to complain that the bank treated them badly", says the parliamentary report.

The Australian system has supporters in Brazil. Lawyer and former chairman of the Brazilian Securities and Exchange Commission (CVM) Marcelo Trindade is one of the most vehement. He defends the existence of a single prudential regulator to take charge of preventing risks in the capital, banking, insurance and pension fund markets; and a different regulator to supervise the market behavior of these same players. According to Trindade, the most appropriate entity to perform the prudential part of the job would be the Central Bank. "It has the highest availability of resources and human capital to assume this role", is his opinion.

For conduct supervision, on the other hand, the lawyer believes that the most appropriate entity would be the CVM. From that perspective, the supervisory attributions of entities such as the Private Insurance Superintendence (Susep), in the insurance industry, and of the Supplementary Pension Bureau (SPC), in the pension funds segment, would be "swallowed up" by the capital market watchdog. "It's natural that this conjugation of regulators should take place under the CVM's leadership, due to its size."

LESS IMBALANCE — In addition to enabling a greater focus on each task, the twin peaks system tends to reduce the chances of "regulatory arbitration". This happens when the choice of a given regulatory environment is based on the "advantages" it offers – usually, less stringent requirements. This practice brings negative consequence to investors, such as a lack of information.

According to the current rules, anyone can put his or her money in a "swap" operation involving CDBs without knowing the associated risks. The reason why is that banks are not forced to provide this information to investors. On the other hand, derivatives traded on organized markets carry a large informational cost. The difference is due to the fact that CDBs are regulated by the Central Bank, whereas derivatives are regulated by the CVM. "This imbalance would not be allowed if there were a single conduct regulator, since the same requirements would apply to the sale of both products", says Trindade.

Another example mentioned by Trindade is the leasing notes created in October 2008, whose offering does not require registration with the CVM. Provisional Measure 448 exempted them from that procedure. "(Registration)...will make market opportunities, which in the market often last only a few days, be easily lost if the issuer has not yet issued the securities or, at least, acquired CVM authorization to issue them", reads the Provisional Measure. It became clear that the exemption from registration was only permitted in order to reduce costs for issuers, at the cost of transparency. If lease notes were subject to a conduct regulator such as the CVM, it’s possible that this regulatory "cutting of slack" would not exist.

Ary Oswaldo Mattos Filho, a law professor at Fundação Getulio Vargas (GV Law) and a former CVM chairman, is skeptical regarding the implementation of the twin peaks model in Brazil. For Mattos Filho, there is a risk of certain segments getting less attention from the regulating agencies. "The Central Bank didn't really pay the capital market much thought when that market was part of its supervisory attributions", he recalls. Up until 1976, when the CVM was created, the Brazilian Central Bank (Bacen) was in charge of supervising both the financial system and the capital market. "As prudential regulator, isn't it possible that the Central Bank would favor the financial system, which has the highest potential of causing systemic damage?", he asks.

In the current Brazilian model, each regulator takes care of the prudential and conduct-related aspects of their respective fields of activity – the CVM for the securities market; the Bacen for the financial system; the Susep for insurance; and the SPC for pension funds. Despite acknowledging that the CVM's supervisory actions pertain mostly to conduct issues, CVM director Marcos Barbosa Pinto states that the agency's prudential approaches have been effective. An example of this are the risk-mitigating rules applicable to investment funds, such as those that define limits for the assets in their portfolios. "Creating clear, effective rules is one of the greatest expressions of a good prudential approach", Barbosa Pinto says. "In Brazil, a scandal such as the Madoff incident would be very unlikely to happen."

Aside from the discussion on whether the twin peaks model fits the Brazilian reality, CVM director Otavio Yazbek argues that this model already exists in Brazil, in theory. He argues that the Bacen-CVM agreement signed in 2002 gave a twin peaks-like outline to the Brazilian regulatory system. In that agreement, the Bacen took on the role of prudential regulator, undertaking to position itself in advance in relation to the autarchy's prudential rules – related to derivatives markets, exchanges, investment funds and foreign funds. Yazbek argues that the system needs only be formalized. "As our twin peaks system is not 100% official, it's also not 100% efficient."