CASS/IEA Lecture Series in Financial Regulation
CITY UNIVERSITY, 26 FEBRUARY 2003
Howard Davies
Chairman, Financial Services Authority.

Introduction

My term as Chairman of the Financial Services Authority is now approaching its end, but I still have a few months left to serve. So it would be tempting fate to suggest that my time has been thankfully free of financial crises.

Indeed some might regard that as an odd claim to make, in any event. Policy holders in Equitable Life, or investors in split capital investment trusts may, with some reason, consider that their financial affairs have been thrown into crisis by the failings or failure of individual financial firms. Indeed, at present, anyone with a sizeable stock market investment, whether direct or indirect, is aware that financial markets are going through an extremely difficult period.

However, on the definition I will use this evening, there has not been a financial crisis in recent years. When I talk of a crisis, I mean a situation in which confidence in financial institutions or markets generally is lost, where there is an actual, or a serious risk of collapse in the whole financial system, which generates collateral damage even for savers and investors who are not directly linked to the institution or institutions which are the source of the crisis.

On that definition, it is some time since we experienced a full blown financial crisis in the United Kingdom. Neither the collapse of BCCI, nor of Barings, damaged confidence in the banking system as a whole. The secondary banking crisis of the early 1990s was perhaps a more direct, though little apprehended threat to the stability of the system at the time. But there has been no need for the UK authorities to intervene on any substantial scale for some decades, and the losses to the various safety net protection schemes – the Deposit Protection Scheme etc. – have been extremely modest.

But I do not say this in order to suggest that we should be complacent, or that "it could not happen here". Indeed very much the reverse. Many people, when the term financial crisis is used, conjure up scenes of demonstrations by housewives banging saucepans in Argentina, hyperinflation in Brazil or Turkey and wholesale bank failures in Russia.

But the Scandinavian banking crisis of the late 1980s/early 1990s, Japan’s decade long slow-burn financial sector melt-down and especially the late-1990s failure of Long Term Capital Management, which caused the Federal Reserve Bank of New York to promote a market- financed bail-out on the grounds of possible systemic threat, remind us all that financial crises are not confined to emerging markets. The LTCM case also alerted us to the possibility that a systemic crisis might emerge from outside the banking system. I am increasingly persuaded that crises can arise in non-banks, which is a powerful argument for an integrated approach to financial regulation.

So my aim this evening is to reflect a little on recent crises and, in particular, to draw some conclusions for how regulators should behave both before, during and after a crisis. I will, first, offer a few thoughts on what can be done in the area of crisis prevention, and on managing crises once they have crystallised. Then I will say a little about the kinds of changes that have been implemented internationally in order to improve our ability to handle crises. Finally, I will suggest one or two additional steps that might be taken, and which I believe could be both helpful and politically feasible.

Preventing Financial Crises

The first point to note is that we cannot hope to eliminate international financial crises entirely. That might seem a depressing conclusion, but it is a realistic one. Liberalised global financial markets and the free flow of capital across borders bring with them the risks of overshooting, greater volatility and imbalances which can exacerbate or amplify poor policy decisions. The result may be a currency crisis, a banking crisis, or, worst of all, both. Reducing currency volatility by a return to fixed exchange rates, or even a gold standard, as advocated by some, and tighter control of cross-border financial flows, might reduce the incidence of international financial crises. Domestic crises could, however, still arise from poor fiscal and monetary decisions and such crisis reduction would be at the cost of access to external finance and ultimately to economic growth.

Should we conclude from this that the answer is to turn one’s back on open global capital markets? I do not think so. Financial liberalisation does certainly mean that, if you throw a rock in the global financial pond, the ripples spread more quickly than they would need to: the viscosity of the water has reduced. But the upside is that the pond is larger, the opportunities for risk-sharing are greater, and enhanced transparency makes it harder for countries to persist in imprudent policies: the bubble is now pricked sooner. But whatever the regime, I take as a given that we will never entirely eliminate international financial crises.

There is an analogy here with our insistence at the FSA that we are not running a "no-failure" regime. Failure is an inherent part of a flexible, competitive, innovative capitalist system. We should not aim to oversee a race in which all shall win prizes. Eliminating the possibility of failure would distort incentives and in effect, penalise success. That is not, however, to say that we should not attempt to reduce the number of failures, or deal properly with their consequences. Quite the contrary. We devote considerable supervisory resources to attempting to reduce the number of firm failures, and on mitigating the consequences of failure when it occurs, all in the full knowledge that companies which follow inappropriate business strategies, suffer from management incompetence or the lack of effective internal controls will and should fail – despite our best efforts.

So too for financial crises. While we cannot eliminate them, we can attempt to reduce their number, duration and spread, and to mitigate the immediate consequences, particularly for innocent bystanders. In this task we have four principal tools at our disposal: i) international macro-economic surveillance; ii) market discipline; iii) corporate governance; and iv) prudential supervision. We might think of macro-economic surveillance and market discipline operating at the macro level, while corporate governance and firm-specific prudential supervision operate at the micro level. But such distinctions are hardly waterproof and, properly used, each individual tool reinforces the others.

International Macro-Economic Surveillance

The Asian financial crisis of 1997-98 exposed some serious gaps in our global system of macro-economic surveillance. How could a group of "tigers" with good growth rates and relatively solid public finances suddenly fall like flies to financial speculators?

We now know that a combination of fixed foreign exchange rates, imprudent unhedged short-term dollar borrowing and long-term domestic currency lending (largely on real estate during a burgeoning asset bubble); combined with weak prudential oversight and corruption/cronyism produced a lethal brew. How did the institutions tasked with international economic surveillance miss this explosive concoction?

I am sure this question will continue to be a fruitful source of PhD theses – many of them at the LSE – for some time to come. So far, the preliminary analysis suggests that, for one thing, macro-surveillance overlooked the possibility that structural vulnerabilities like poor regulatory structures could provoke or aggravate nascent financial crises. Institutions such as the IMF, while always very strong on high-level macro-economic analysis, lacked both market and regulatory expertise. Partly as a result, they failed to spot the pressures and imbalances that ultimately produced the Asian crisis. This failure provoked a considerable amount of soul-searching on the part of the Fund and the World Bank, in particular, which has generated some significant action.

Two institutional responses are worth highlighting. First, the G7 political leadership realised there were gaps in our global surveillance structure. Following a report drafted by Hans Tietmeyer, formerly head of Germany’s Bundesbank, they established the Financial Stability Forum which brings together high-level financial ministry officials, central bankers and regulators with a remit to identify risk and vulnerabilities in the international financial system and set out mitigation strategies. The inclusion of regulators was a significant step, recognising the role of regulation in maintaining financial stability. The FSF is still, perhaps, finding its feet in the international financial architecture, but we in the UK have put a lot of effort into making it work, and the signs are positive.

Second, the IMF, recognising its own lacunae, has set out to improve its market and regulatory expertise. It has established a new Capital Markets Department under a former commercial banker - Gerd Häusler of Dresdner - and has begun publishing a Global Financial Stability Review. I commend that useful publication to you. It has a significant influence on our own assessment of financial market risks. In addition, through its exhaustive Financial Sector Assessment Program (FSAP), the IMF is gaining a knowledge of regulatory standards and structures which will be disseminated throughout the rest of the organisation.

The FSAP team carries out reviews of the financial sectors of individual member countries of the IMF, and indeed of some Offshore centres as well. The aim is to assess the extent to which each country is meeting international best practice standards of regulation and financial management. I can speak with some authority about the rigour of this process. A team of twenty or so experts descended on the FSA three times last year to carry out the UK review, whose results will be published in the next week or two. I cannot foreshadow the assessment this evening, but I can tell you that it was a thorough and sharp pencilled process. I hope and believe that the same is true elsewhere.

I should note that financial stability is also now on the European agenda, with heightened awareness of the linkages between financial firms and markets and developments in the real economy. Some have argued that the EU needs its own version of the FSF. The institutional structures are still being discussed. The outcome remains in doubt, partly because national arrangements for handling these issues remain very diverse. It is a challenge to create appropriate representative bodies at the EU level which accommodate this regulatory biodiversity. Something concrete will no doubt emerge in due course, but exactly with what participants and with what scope, role and influence, remains unclear. In my view there is a gap which should be filled.

Market Discipline

It would be wrong to think, however, that the regulators or the IFIs are the front line of defence against crisis. In reality, markets are usually their own best regulators. This remains true despite their tendency to over-react and overshoot. To perform this regulatory role, however, markets and market participants need timely and accurate information. Here we enter the complex realm of accounting standards, transparency and disclosure standards, effective implementation and enforcement mechanisms.

Accounting remains the foundation upon which our entire financial system rests. If we cannot get our accounting and auditing standards right, then transparency and good quality disclosure are meaningless (and indeed supervision is also seriously challenged). Internationally we are struggling towards internationally accepted norms, through the work of the International Accounting Standards Board, chaired by David Tweedie. The European Commission have already agreed that International Accounting Standards should be adopted by all listed European corporations by 2005. We hope, through trans-Atlantic convergence with American GAAP, that ultimately we will have an agreed basis upon which to assess companies, regardless of the location of their headquarters, or of where their stock is traded. There are some fundamental disagreements, often between national agencies, on key issues such as the use of fair value accounting and expensing stock options, but I am cautiously optimistic that this work will eventually produce an acceptable result.

More generally, there has been considerable work internationally on developing, refining and implementing the various codes and standards that markets, ideally, will use to assess firms and countries. The Financial Stability Forum has blessed a core list of 12 key Codes and Standards which stretch across banking, securities, insurance, fiscal transparency, payments systems, money laundering and off-shore centres, etc. The sectoral standards-setters have increasingly realised that the key issue is not the standard-making but rather its effective implementation. So in organisations such as the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), effort is focussing on methodologies to help members implement good practices in their countries.

In the end, however, little will be gained if market participants themselves do not actively use the internationally agreed standards in their day-to-day judgements. Here we face the difficulty of transforming a qualitative standard into a useful quantitative reference point. The IMF has recognised this challenge and, assisted by the Bank of England and ourselves, has embarked on a programme to ensure that codes and standards are increasingly "user friendly".

Corporate Governance

As for markets, so too for firms. There is much overlap in the development of codes and standards for markets and standards which firms should use in their internal control systems. The recent scandals in the USA, in particular, have exposed some serious gaps in areas such as auditor oversight and independence, the role of boards in overseeing management, corporate disclosure, conflicts of interest, etc. The controversial Sarbanes-Oxley Act in the USA is meant to address some of these shortcomings. On this side of the Atlantic, we continue to stress the responsibilities of senior management for the correct and timely disclosure of pertinent information and the necessity of establishing robust internal control systems to ensure that problems are caught before they become unmanageable, with possible catastrophic effects for the firms, its employees, investors and perhaps the larger financial system.

Internationally, the OECD is currently working on a revision of its Guidelines for Corporate Governance which, although only guidelines, spell out basic acceptable norms. Corporate governance issues do have a particular political resonance, especially in light of some of the salary excesses and performance failures exposed by recent scandals. I therefore expect to see corporate governance issues figure quite prominently in this year’s Economic Summit process as our political leaders seek to regain investor and consumer confidence.

Prudential Supervision

But in spite of the emphasis I place on the role of market discipline, robust prudential supervision of both firms and markets is essential. Here I would make two points, based on my experience at the FSA. First, supervision must be risk-based, that is to say resources, which are always finite, must be allocated to those areas of the greatest risk and the greatest impact. This approach has implications for both investors and consumers, the most basic of which is investors and consumers must take greater responsibility for their financial decisions. I have said that we do not attempt to run a "no failure" regime. Our risk-based approach means attention is, or should be focussed on those key institutions or interfaces that have the most impact. We cannot hope to cover everything. This requires smart and educated consumers and investors, and consumer education is an area where we are investing considerably more resources than most of our regulatory counterparts, though both the US and Australian regulators have already done a lot to raise consumer understanding of financial issues.

And second, we are an integrated regulator covering banking, insurance and securities. In a world of accelerating cross-sector, cross-border financial innovation, universal banks, bulge-bracket investment banks and insurance company-owned banks, we believe this is the right place to be. It allows us, almost naturally, to practice consolidated supervision, i.e. a comprehensive approach to the firms we regulate and all their sub-entities.

In theory, and increasingly in practice as we develop our integrated approach, we are able to get a better handle on the interaction between different types of risk in different sectors of the market. We can better understand the overall risk dynamics of complex diversified institutions. One of the key tasks which all our line supervisors are required to undertake in relation to the larger firms within our care is to assess the potential impact of the failure of that institution on other firms, on its customers and on the markets more generally. This impact assessment could not be carried out effectively by the previous sector based regulators.

In all these ways, I think it fair to say that the regulatory community has made some progress in understanding the sources of financial instability and in setting up mechanisms to allow that information to be more effectively shared across borders.

But problems will slip through the net, inevitably. So it is appropriate also to ask whether corresponding progress has been made in our ability to manage crises when they arise.

Managing Financial Crises

I suspect the honest answer is that is we are still better at identifying financial crises, especially when they are about to burst upon us, than managing them, both in terms of intensity and duration. Indeed some say that the regulators are now likely to forecast a dozen of the next 3 crises. We may, however, be on the verge of seeing evidence that some progress has been made.

If the current Argentinean debt default had occurred five years ago I would hazard that the contagion effects on Argentina’s neighbours and global financial markets would have been much greater. To a degree this reflects better risk management by the major international banks. They saw an unsustainable position and lowered their exposure. But it also, to some degree, reflects improvements in the "plumbing" of the international financial system. This may not be much comfort to the man on the street in Buenos Aires but greater sophistication and differentiation between markets has led to implicit "tiering" by investors which will reduce contagion at the cost of making it harder to those with a poor policy mix to borrow money on global capital markets.

Still, the management of financial crises is a chaotic and painful business. My sense is that we can, and should, do better. The Mexican, Asian, Russian and Brazilian experiences of the late 1990s have provoked a series of reform proposals which range from a supranational World Financial Authority to making the IMF the global lender of last resort, or transforming it into the overseer of an international bankruptcy court modelled on USA-style Chapter 11 proceedings.

The arguments behind some of these suggestions are at times persuasive but, to date at least, they all lack one essential ingredient – political feasibility. For the moment, or at least until the next major international crisis, national governments will remain unwilling to cede even greater powers to international institutions. We are therefore stuck, for better or worse, with the post-Asian crisis institutional structure and division of responsibilities. The debate over some form of international bankruptcy process is not yet concluded and may yet produce something new, but the grander schemes are unlikely to get the political support necessary to take them forward.

This reality check should not, however, be interpreted as saying that nothing can be done to improve our ability to manage financial crises after they have broken out. And some meaningful improvements have been made in recent years.

Steps Taken To Date

It is fashionable to argue that the international response to the Asian financial crisis has been woefully inadequate, and indeed that the reaction to the gaps highlighted by the Enron and WorldCom scandals has been slow and insufficient. I do not take such a pessimistic view.

At the institutional level the Financial Stability Forum is now actively engaged in vulnerability, risk, gap and underlap identification and increasingly in developing strategies for risk mitigation. The IMF and BIS have attempted to counter the perception of Eurocentrism by establishing offices in Tokyo (IMF) and Hong Kong and Mexico (BIS) respectively. The IMF, through the creation of the Capital Markets Department has consciously set out to improve its market and regulatory capabilities. Better co-ordination between international financial institutions, another flaw underscored by the Asian crisis, is now on everyone’s agenda.

In terms of policy, crawling currency pegs are largely discredited. One of the understandings to emerge out of the Asian crisis is the need for well thought out sequencing of reforms intended to liberalise financial flows, and that those reforms in turn must be combined with solid regulatory structures. More recently, the latest bout of chaos in Argentina has demonstrated that even currency boards cannot hold back speculators if policy choices are fundamentally flawed.

At a less exalted level, but probably more importantly, we are cleaning up, or flushing out, a lot of our international financial plumbing. A few examples will have to suffice. At the international committee level, following the collapse of Enron, IOSCO was quick off the mark in proposing new principles on auditor independence and oversight and corporate transparency which are likely to become the global standards. We at the FSA have just published a consultation paper on financial market conflicts of interest and the UK Listing Authority, now a division of the FSA, will be looking at various corporate governance issues as part of its current review of the UK listing rules.

As an integrated regulator, we are particularly cognisant of the increasing complexity innovation has brought to the financial sector. Recent advances in debt securitisation and risk transfer, particularly between the banking and insurance sectors, has raised the linked questions of where certain risks are lodged and whether they have been correctly priced. As issues like credit risk transfer appear on our radar screen, we work both directly with the financial industry, and through appropriate international committees such as the FSF and the IAIS, to get a better handle on the extent of any possible problems. So far, there are signs that credit risk transfer has, overall, been a stabilising factor, but there are concerns about whether some of the buyers of risk have properly assessed what they have taken on.

Similarly, recent financial developments have resulted in the creation of very large, very complex financial firms, known in the trade as LCFIs, which are not necessarily all American. A regulator’s nightmare is if ever one of these firms got into serious trouble and had to be unwound. My devout wish is that this never happens, but to prepare for any eventuality we and other regulators have expended considerable effort improving our understanding of LCFIs, their structures and risk management and control systems. This is still very much "work in progress" but at a minimum, I believe we have a better understanding of the challenges we regulators would face if things were to go wrong and we were to be obliged to attempt an orderly run-down. In this game there are no simple, neat answers.

The European Financial Groups Directive will bring a measure of consolidated supervision to all financial conglomerates operating in Europe when it is implemented in 2005 and I have already mentioned Europe’s commitment to implementing International Accounting Standards during the same year. The conclusion of the Basel Committee negotiations on capital adequacy, which will be transmuted into European law through a new capital adequacy directive, will introduce a greater risk-based element to the calculation of bank capital. Through its FSAPs and its Off-shore Centre assessments, the IMF is both assessing jurisdictions against minimum standards and gaining for itself a much more refined view of where structural pressures could manifest themselves. IOSCO and the Committee on Clearing and Payments Systems have just published a useful joint study on where problems could arise in the international payments system.

Is this enough? Has the international community responded adequately to the challenges, or is there more to do? We will not be able to give wholly convincing answers to those questions until the next crisis presents itself, at which point it will be too late.

Looking Ahead: What More Can Be Done?

So the jury is still out on the effectiveness of the most recent spate of reform in the following the Enron and Argentina crises. Some useful steps have been taken in response to the exposure of corporate excesses or tensions within the international financial system. More time, however, is needed to determine if they will be fully effective. For their part, the French have made it clear that socially responsible markets, corporate governance and excessive volatility will be a central part of the agenda for their presidency of the 2003 G7/G8 Economic Summit process. This year, regulatory issues will be highlighted as never before by both heads of government and finance ministers at the Evian Summit.

But what useful outcomes could there be, if one accepts that there is no political consensus for any significant new international institutions or even for any significant increase in the powers of existing institutions?

My view is that even within those constraints more can be done to reduce the occurrence of financial crises, lessen their impact and speed up their resolution. First and foremost, I believe that we have to push forward convergence on a single set of international accounting standards. There are some difficult problems to be addressed including issues such as the treatment of financial instruments, the expensing of stock options and the disclosure of pension fund deficits. These are knotty questions that have bedevilled national standard setters for years and will be even more difficult to agree on internationally. And yet, recent events which suggest that US standard-setters have no monopoly of wisdom, have created an environment where real progress can be made towards a single set of standards which would allow cross-border comparisons. There is a new willingness in the US to consider compromises. I believe that we must seize this opportunity. I hope that the G7 finance ministers and leaders unanimously and enthusiastically give this a push at this year’s summit. Political support for the process is required.

There are other actions which would help manage financial crises. One example is the inclusion of Collective Action Clauses (CACs) in all sovereign bond contracts, which would prevent a rump of disaffected investors from holding up debt restructuring. We already do this in London for 30% of the sovereign bond market and it seems a pity that extension globally is delayed because of post-Depression attitudes enshrined in US domestic bankruptcy legislation. More work also needs to be done on options for international debt restructuring, including standstill arrangements that would contribute to orderly dispute resolution. In addition, recent work on financial stability indicators has begun to bear fruit. Such devices could provide both national governments and international agencies a useful early warning before pressures build up to the explosion point. I am encouraged that last weekend’s G7 Finance Ministers meeting in Paris encouraged both private and public sector interests to adopt effective Collective Action Clauses at an early date.

On the policy front, we need to go further on both crisis prevention and crisis management. Those organisation such as the FSF and IMF that have been tasked with surveillance responsibilities should be willing to speak out on vulnerability issues and on mitigation strategies. Only then will they meet their full potential. In this vein, greater clarity in the mandates of international organisations identifying vulnerabilities, setting standards and assessing and, if necessary, enforcing standard implementation needs to be fostered. Institutions and their national members have to be willing to transform their judgments into concrete actions. Work towards this end is progressing in IOSCO, IAIS and elsewhere, but it has to be still further encouraged.

Work on upgrading and implementing internationally agreed Codes and Standards will continue. What is required, however, is a far greater emphasis on effective implementation. As noted above, for this to happen, our various standards must be made more market user friendly. Wearing my regulator’s hat, I would even go one step further. The IMF is gathering a mass of information and experience on how these standards are being implemented through its FSAP and Off-shore Centre assessment programs. To date, these programs remain entirely voluntary and, for the moment, are not supposed to influence either the IMF’s or the private sector’s lending decisions. To change this is sensitive and controversial, especially for emerging markets, but somehow a means must be found to draw on information related to adherence to internationally agreed codes and standards to influence both public and private lending practices. It is not unreasonable to expect that jurisdictions participating in and benefiting from global financial flows meet and continue to adhere to minimum financial sector standards and, ideally, best practice. As a first step, the FSAP country assessments should routinely be published. The UK will shortly set an example and make the full IMF assessment public. Publication will help market participants draw their own conclusions about financial stability, and the integrity of the financial sector, which could itself enhance market discipline.

Conclusion

My conclusion will be brief. A stable international financial system is merely a means to an end. That end is sustainable economic growth and rising prosperity. Stable domestic and international financial markets are therefore necessary but not sufficient conditions for continued sustainable growth. Recent financial crises have starkly shown the damage that poor regulatory structures and oversight can do to countries with ostensible positive growth rates.

We have come a long way since Mexico in 1995, the first of the "new round" of financial crises. We still, however, have a way to go before we have in place the systems, institutions, policies and levers that will minimise the number, duration, fall-out and complexity of financial crises. Elimination of financial crises is beyond our reach; but we can realistically aim to do a better job of preventing and managing them in the future.

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