Facing uncertainty from a position of strength
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Speech by Thomas Huertas, Director, Wholesale Firms Division and Banking Sector Leader, FSA
Standard & Poor's Global Bank Conference, London
16 November 2006
I see that the organisers have attempted to cast this regulator to type, but I shall refrain from too much talk about removingpunch bowls. Instead, let me focus on the problem at hand –facing uncertainty from a position of strength – whilst you enjoy your champagne.
That times are uncertain is beyond dispute. Actual and potential political problems abound. Economic imbalances persist. I need not recount them here – you are very familiar with the list.
That banks are in a position of strength is also beyond dispute. Across the world, banks are churning out record profits and they are brimming with capital. The rating agencies are responding with upgrades, or thinking about doing so.
The global economy is strong – indeed the last five years have seen some of most rapid and sustained economic growth on record. Inflation is by and large under control, and liquidity is abundant.
What should firms do? The opportunity cost of scaling back too early is high – ask anyone who got out of the stock market in 1999 after Greenspan's first comments about irrational exuberance -- but so is the cost of scaling back too late – ask anyone who still held those once hot internet IPO's in 2003.
For those of us endowed with perfect foresight, there is an obvious solution – ride the boom up to last minute, convert to cash at the peak, invest in Treasuries whilst the market crashes and go long again once the market hits bottom. For the really confident holders of perfect foresight, one could spice up the strategy by selling the market short shortly before the crash.
For those of us whose foresight is less than perfect -- and that certainly includes regulators – the solution is less obvious. We have no way of knowing when the next downturn will occur, what will cause it, how deep it will be, how long it will last or what sectors it will affect. All we foresight-challenged individuals know is that there is a probability – perhaps a significant probability – that the good times will not last forever, that somewhere, somehow something will go wrong and that losses – perhaps significant losses - will occur.
What can banks do in such a situation? The answer, we are told, runs along the lines of originate, underwrite, but above all do not hold, debt issued by ever more highly leveraged borrowers, be they firms that are the targets of private equity investors or homeowners willing to pledge ever higher multiples of their annual salary in order to buy their dream house. If and when the downturn comes, it will be investors, not the banks, who wind up holding the bag.
The "originate, underwrite and distribute" model is fine in theory. It is a perfectly acceptable model, indeed a very efficient model. It diversifies risk and it could make banks more resilient. But to execute such an "originate, underwrite and distribute" strategy banks will have to meet three challenges: the investor challenge, the risk management challenge and the resiliency challenge. Let me say a few words about each in turn.
The investor challenge
The success of the "originate, underwrite and distribute" model depends on investors. Can the bank find investors and keep finding investors? Without investors who are ready, willing and able to buy the instruments that the banks originate, the "distribute" element of banks' strategy fails, and the entire strategy stalls. From the regulator's perspective, a key question is "are banks treating investors appropriately?" Specifically, are banks selling products that are suitable to customers' requirements, and are banks providing adequate disclosure to investors?
As products become more complex, this task is likely to become more difficult. Take derivatives as an example. These instruments are increasingly being tailored to a client's specific situation. This places a premium on the bank's understanding the nature of its counterparty, determining the ability of the counterparty to understand the complexity of what the bank is selling and ascertaining the suitability of the product for the client, not only at the time of sale, but over the life of the product.
As a case in point, take the constant proportion debt obligation or CPDO. In the words of the FT the CPDO represents, "a leveraged bet on the credit quality of a bunch of US and European investment grade companies". Is such a leveraged instrument really suitable for all investors? Do the investors have the ability to understand the risks involved? Does the prospectus contain adequate disclosure?
The risk management challenge
The success of the "originate, underwrite and distribute" model may also depend on financing the investors who buy the instruments originated by the banks. Hedge funds are a good example. They frequently buy instruments originated by the banks and then pledge these same instruments back to a bank as collateral for a loan from the bank.
In prime brokerage, repos, derivatives and various other activities central to modern banking, collateral management is a key component, perhaps the key component, of risk management. Time after time we as supervisors hear the words, "don't worry, it's collateralised".
Well, regulators do worry. That's our job. Accordingly, regulators have initiated discussions with leading banks regarding the strength of their collateral management systems and controls. The FSA is currently piloting some thematic work on collateral management and will be rolling this out to a number of large investment banks during the fourth quarter. We anticipate feeding the results of this study back to the industry during the course of 2007, perhaps in the form of a statement of good practices. We will coordinate this work with that of other regulators.
We will be asking firms the following type of questions:
- do banks have sound collateral agreements in place?
- do banks value collateral correctly and impose appropriate haircuts?
- do banks review the correlation between collateral and the value of the underlying exposure to the counterparty, both in normal and in stressed environments?
- can banks realise collateral quickly, if they have to do so?
- can banks get their collateral back quickly, if they extinguish their underlying obligation to the counterparty?
These are complex questions, particularly in a world where collateral is pledged on a cross-border basis, where collateral pledged can continue to be traded; where collateral pledged by Bank A to Bank B can be re-hypothecated by Bank B to Bank C; and where cross-margining agreements allow counterparties to post collateral to a central pool against exposures in multiple jurisdictions.
Will all this work, and will it work in a stressed environment? That is the key question.
The resiliency challenge
That brings me to the third challenge facing banks: how to assure resiliency under stress, even severe stress.
Stress testing can point banks in the right direction. This entails imagining what the insurance industry calls realistic disaster scenarios and, more importantly, planning what the firm would do in the event that such a scenario occurs. In some cases, the firm will find that it is well prepared; in others, that it would come up short – either in terms of available staff, or technology, or capital or liquidity. In such cases, the firm will need to consider what it should do today in order not to be caught out, should a disaster occur.
Stress testing is up to each individual firm, and we recently wrote to the CEOs of supervised firms to remind them that stress testing formed an essential part of sound systems and controls, as well as to pass on our observations about what constituted good practice in this area and what did not. One observation particularly worth noting today was that firms were reluctant to test scenarios that really caused a significant level of pain – few firms tested scenarios that caused them even to think about passing a dividend, much less having to raise new capital or face a liquidity crunch. Mild disruptions may be a scenario, but it is in our view neither a disaster nor realistic.
Think back for a moment to 2002 and 2003. Records show that several globally active firms had to take measures to preserve their ratings, including raising new capital, if they were not to lose their ability to compete in the wholesale banking and/or insurance markets. The combination of antecedent events was 9/11, the popping of the internet bubble, an economic recession, the collapse in investment banking revenues and floods in various countries. Murphy's Law at work.
In our view neither the business cycle nor Murphy's Law has been repealed. Nor has the threat of terrorism been eliminated. Nor has a cure for pandemic flu been discovered, much less tested. Bad things do happen.
The question facing today's management of a strong bank is whether they wish their bank to remain strong when times turn bad. Or does management wish to run the risk that, come a crisis, regulators, rating agencies and investors will be discussing - most likely with the successors to today's management - how to turn the bank around or how to plug the holes in its balance sheet.