Mansion House speech
Speech by Callum McCarthy, Chairman, FSA
26 September 2006
My Lord Mayor, My Lords, Aldermen, Mr Recorder, Sheriffs, Ladies and Gentlemen. My Lord Mayor, I start as always by thanking you for organising this annual dinner and providing an opportunity for the FSA to address such a distinguished set of guests. But my – indeed all our – thanks go much wider than that, to you for your indefatigable, energetic and expert efforts in so many countries to promote the City of London in particular, and UK financial services – whether within the City or elsewhere within the UK – in general. We are all grateful to you and your colleagues for these efforts.
It was President Kennedy who observed that the right time to repair the roof is while the sun is shining, not when the weather has already turned. That pithy comment encapsulates what I want to say this evening. The world economy has enjoyed – and continues to enjoy – growth and relative stability of a nature which makes us unusually fortunate, and financial services have benefited accordingly from that benign state of affairs. But we know from past experience that the time when risks grow, but do not yet crystallise, is during benign circumstances – just as we know that when circumstances turn harsh, risks which were not even apparent materialise in only too evident a manner. As President Kennedy implied, it takes rain for us to appreciate the leaks in our roof, which too easily pass unnoticed in the sunshine.
I think we are all aware of the benign nature of recent years – characterised for the UK by Mr Governor as the NICE years of non inflationary consistent expansion. I wonder however if we realise quite how benign the global economic circumstances have been. I cannot think of a period of history where sustained economic growth – world GDP is forecast to grow at four per cent per annum over the decade 1998 to 2007 – has been accompanied by such low levels of both nominal and real interest rates. Economic historians of the future will debate the relative contributions of the expertise of central bankers on the one hand and of the supply side changes arising from the new position of China and others in the global manufacturing economy on the other; they will be united in remarking on the unprecedented nature of the combination of strong growth and low interest rates. But we would be imprudent in the extreme if we were to proceed on the basis that the present fortunate circumstances will persist. This is a time for thinking hard about, and working hard on, the repairs to our roof.
I do not want to suggest that the UK's financial services industry is other than in good heart and good shape. Our banks enjoy a return on equity as high as or higher than those of all their main overseas competitors, and capital ratios which remain significantly higher than regulation requires. The improvement in the capital position of the life companies on which I commented on this occasion a year ago has been consolidated. The general insurance and reinsurance market has weathered the demands placed upon it by Hurricane Katrina with a rapid rebuilding of capital, which has been assisted by a recognition that premiums will reflect the need for new capital. Asset management continues its growth. And the attractiveness of markets and exchanges based in the UK remains as strong as ever – both to new issuers who are increasingly choosing London as the market of choice, and to those who have aspirations to establish a more international network of exchanges. On all these measures, the UK's financial services industry demonstrates its robustness, founded not on protectionism or artificial support, but on the competitiveness of its markets, its openness to innovation, its openness to firms from outside the UK, its willingness to accept new entrants, and on the skills of its practitioners. Our concern at the FSA is to continue to encourage those qualities, in the belief that this is the best way of discharging our statutory duties. I am grateful to you, Lord Mayor, for your generous acknowledgment of how the FSA can help and has helped through the way we work.
These qualities should of course provide resilience during more adverse circumstances as well as exuberance – rational or otherwise – during benign times. There is however a natural human tendency to act as if good times will persist and therefore I hope it is both helpful as well as sobering to consider some of the issues which need addressing now. What, if I may pursue the roofing metaphor, are the tiles we would do well to replace today, on the basis that they will not withstand more stormy weather?
I want this evening to look at three issues, and to explain what we at the FSA are doing, and what we expect the industry itself to do, to ensure that we can respond robustly if the need arises.
The first is an eventuality of low probability in any short timescale, but of certainty over an indefinite period. It is the prospect of a pandemic, where avian flu is currently the most likely. Now, the correct response to events of low probability but very high impact is a difficult conundrum: it is easy to spend very large sums in a nugatory fashion. But I remain concerned that we may have not thought through with sufficient care the likely effects of a flu pandemic on the financial services industry. I find the experience of SARS in South East Asia in 2003 illuminating. We live in a world where more than 150,000 people die every day. SARS infected 8,000 people, of whom 800 died – an epidemic which was an almost unnoticeable addition to the statistics of world mortality. The total number who died from SARS is a fraction of the number who die of AIDS in Africa each day. And yet SARS had a major economic impact: East Asian GDP was reduced by an estimated 2 per cent, with the tourism and retail sectors being particularly badly affected. During the first month of the outbreak, Hong Kong equity prices fell by 12 per cent vis à vis global stock prices. An avian flu pandemic, were one to occur, is forecast to have immediate health effects far greater and far more long lasting than SARS: the UK government's contingency plans, set out on the Cabinet Office website, assume that as a base scenario 25 per cent are affected, and a mortality rate of 0.37 per cent. Understandably, and correctly, public authorities round the world have concentrated in the first instance on the implications of a pandemic for the health services. But there is a need for much fuller thought about how financial services would be affected: the availability of key staff, services and systems (for a pandemic would severely affect many of the basic components of a society's infrastructure – a problem at any time, and all the more so in the just in time world we now inhabit); the effect on liquidity; the effect on markets; the changes needed to internal processes if, as seems likely, a severe health threat resulted in widespread voluntary absenteeism. All require thinking through with a care and attention which matches the scale of the threat to financial systems, services and stability.
Because of the importance we attach to this issue, the FSA will be leading this autumn, starting on 13 October, a six week exercise to test the resilience of the British-based financial institutions – banks, securities houses, insurance companies, financial infrastructure providers, exchanges – to a pandemic. Some sixty organisations will respond to a scenario that simulates a pandemic flu outbreak and in particular the potential impact on the UK financial sector. Many participants – government departments, health agencies, service providers, foreign regulators and other experts – are working with us, both on design and response during the exercise. This builds on other work which, alongside the Bank of England and HM Treasury within the tripartite structure, we have done to test the ability of the financial services industry to respond to crises and to uncover issues needing attention. It differs from other, shorter term tests, by being an extended test, just as the circumstance for which we are preparing is likely to be an extended trial rather than a short term emergency. I am confident that we will all learn much from this test – as we need to do. It is an area we would neglect at our peril, and we are determined not to allow this to happen.
The second slate on my roof needing attention relates to a particular form of operational risk. The FSA has been much concerned over the last 18 months with the growing operational risk associated with confirmations for credit risk derivatives. In close and successful co operation with the US regulatory authorities, particularly the Federal Reserve Bank of New York, we have acted to repair this position, with satisfactory results. All the firms covered by our joint initiative have achieved their agreed target of reducing outstanding confirmations by 70 per cent; good progress has been made on developing electronic systems; the industry is well on its way to making much improved delivery times the norm. But the confirmation of credit risk derivatives is but one of a number of operational issues which need working on if we are to improve the resilience of the financial system to shocks. In the UK insurance market there is the need to bring the legal agreement and documentation of risk in line with the economic transfer of risk. In the credit risk derivative market there is the need to ensure that, in the event of default, there is a legally robust link between the derivative and the underlying bond. And in the equity derivative market there is a need to ensure that we do not find that the problems which have – with some effort – been solved in the credit derivative market do not simply migrate to their equity counterparts. In general, I think it fair to say that operational risk is more difficult to identify, measure and hence control than either market or credit risk. You should expect further regulatory help, on a transatlantic basis, to make sure that these operational issues are kept under control.
My third and last concern is more than a specific operational issue. It is the fundamental issue of how any organisation identifies the risks it is prepared to incur – the stresses against which it tests its risk appetite and risk systems; and the amount of risk it then assumes. Our concern at the FSA centres on the systems for identifying these risks. In benign times, it is harder to identify the stresses which may develop in less favourable times – and all the more important to do so rigorously. This is no easy judgment: there is no unique, intellectually robust, computationally testable answer to what assumptions should be included in stress tests. They differ in nature from the statistical analyses which underpin value at risk and internal ratings-based approaches. Those judgments are difficult, not because of the complexity of computation and the associated probability of computational error, but because of failure to identify correlations and second order effects. The events of spring 2005 when both Ford and GM bonds suffered reduction in their ratings showed that many who traded those bonds or derivatives of them had failed to identify or establish correlations correctly. More generally, and as John Tiner warned at the FSA's Annual Public Meeting in July, we all need to guard against the increased risk of sharp, and possibly coincident, corrections in a number of asset classes. The FSA is concerned that financial institutions test their resilience to such shocks, and implement realistic and tough stress testing as an integral part of their management practices. Only if they do this well can they have confidence in the amount of risk they choose to assume. We will encourage the firms we regulate to have appropriate systems. The choice of how much risk is theirs. We are examining, as part of our normal supervisory work, the rigour and the effectiveness of the stress testing adopted by our major institutions.
My Lord Mayor, I have set out three areas where we – the FSA and practitioners – need to use the opportunity of our present fortunate circumstances to prepare for less happy times. Time and effort spent now, in temperate climes, will save much anguish when the weather is rougher.
My Lord Mayor, it simply remains for me to express on behalf of all your guests our thanks – for the splendid hospitality you have extended to us this evening, and for your continuing work to explain the attractions of the UK's financial services to customers, actual or potential, in so many countries round the world. I ask my fellow guests to rise and join me in drinking to the health of the Lord Mayor and the Lady Mayoress.