Mansion House Speech
Speech by Callum McCarthy, Chairman, FSA
20 September 2007
My Lord Mayor, My Lords, Aldermen, Sheriffs, Ladies and Gentlemen. I am grateful, My Lord Mayor, for your acknowledgment of the work of John Tiner, and your welcome to his successor, Hector Sants. As you will understand, these are times when good wishes are indeed appreciated.
On an annual occasion, such as this, comparison of one year with another is both inevitable and proper. That would be the case in any year. This year comparison is particularly called for, since the change from 2006 to 2007 has been so marked. The climate has clearly changed – literally and metaphorically: literally as the summer of 2006, the warmest and the driest since meteorological records began in 1659, has given way to what has possibly been the wettest summer for nearly a century; and metaphorically as the benign financial markets of 2006 have given way to the volatility and strains of this August and September – and the queues of last weekend which have filled television screens. I think that there are good reasons to believe that neither year should be regarded as the norm – rather both represent extreme positions in terms both of climate and of finance.
The last week has been sobering for all of us, and we need to reflect and then act to prevent repetition of anxieties and concerns which I recognise and with which I sympathise. I am conscious that those who queued last weekend will have questions about what happened, and why, which need to be answered. But this evening I want to raise my eyes from the justified concern with particular issues which have occupied so much time – and public attention – over the past few days and to consider what has changed over the last year and what our responses to those changes should be. I should start however by setting out some elements which have not changed – consistent factors which are only too easily overlooked.
First, my Lord Mayor, there is continuity between your own efforts and those of your distinguished predecessors in the work you do round the world to promote the financial services sector of the UK in general, and of the City in particular. The City remains the world's capital market centre of choice, thanks to the practitioner skills represented here tonight. The FSA's contribution is to provide a sensible, risk‑based – I stress risk‑based, not "light touch" – regulatory regime for practitioners to work in – one that allows innovation, and which encompasses, rather than denies, risk. My Lord Mayor, the City of London and the UK as a whole have benefited greatly from the work you do in setting out the facts about our financial services with such clarity and energy in so many countries round the world. Our thanks go to you for this.
Second, it is important to remind ourselves that our present problems of liquidity and – crucially - confidence, the severity of which we all recognise, are occurring against an economic background which remains benign. The world economy has been strong over the last decade, with four per cent annual growth. The UK economy has grown steadily for an extended period. There are two points I would emphasise from this. First, as the Governor pointed out last week, our present problems do not have their source in the state of the world economy – a source of some consolation, as well as indicating where solutions do and do not lie. Second, as I said on this occasion last year, our financial institutions have benefited from the decade of growth. Our main banks are well capitalised. They have capital ratios which remain significantly higher than regulation requires; their return on equity is at levels which many competitors envy; while they may be subject to liquidity pressures, they have, with a single notable exception, coped well with these pressures to date. Hence, banks start from a good position to withstand the pressures to which they will be subject as what are global, not exclusively UK, issues are worked through.
So, it is important not to assume that all has changed. There are some continuing features which provide stability and which we overlook at cost to our confidence – which is itself a valuable asset.
Nor – difficult though it is – should we regard all that has changed as change for the worse. It is incontrovertible that over the last three months there has been a change in risk appetite and that risk premiums have risen. Much of the comment on this has understandably concentrated on the pressures which have developed. But the fundamental change that has occurred – an increase in the premiums which investors require to take risk – is probably a healthy development on the whole, as these premiums have been exceptionally low for some time. For some time, as Chairman Bernanke, the Governor and the FSA have all pointed out, important classes of risk have been mispriced. Let me give just two examples:
- the spreads between investment grade and non-investment grade corporate debt have been at historically low levels – for example, on 29 May 2007 the spread between AAA and BBB securities was as low as 64bps;
- the growth of leverage buy-out financing has been rapid and subject to declining credit quality – for example leveraged loan issuance grew by 65 per cent between the first quarter of 2006 and 2007. In May 2007 US$47 billion of covenant-lite transactions came to market – representing twice the level of issuance in the whole of 2006.
Pricing of risk of this nature could and should not be continued. It was as unnatural as the drought of 2006.
It is evident, of course, that not all aspects of the correction in risk appetite have been sensible or desirable. To some extent, this is to be expected. Markets rarely correct in a smooth or tidy way; reactions are often overreactions. We have undoubtedly seen that in the last weeks as the uncertainties associated with the US subprime market have spread so widely and had such direct impact on the UK high street. We have moved from one abnormal state of affairs – too little risk aversion – to another abnormal state – too much risk aversion. There has been a flight to quality – a sharply increased demand for gilts, treasuries and other government issues; a flight to shorter maturities; and a flight to simplicity – a continuing demand for single name investment grade commercial paper or corporate bonds, but a retreat from more complex instruments. As a consequence, asset classes which were widely accepted are no longer freely traded.
These developments have occurred in a world which remains characterised by large savings and very significant amounts of capital seeking investment opportunities. It is hard to argue that there is a lack of global aggregate liquidity. But it is clear that this liquidity is not being distributed efficiently within the financial system. The question we need to address is what steps we can collectively take to ensure that the liquidity that exists both globally and within well-capitalised major banks is spread.
At present, there is a concerning lack of discrimination between different asset classes, and different institutions, which has led to the impact of the US subprime mortgage market being greater than should be the case. This needs to improve.
I would hope – and expect – that there will be increasing discrimination in the approach of those extending credit: discrimination between asset classes, so that it is recognised that there are asset backed securities which are wholly untainted by any association with the US subprime mortgage market; discrimination within the mortgage backed securities market, based on more informed assessment of the quality of the underlying assets; and discrimination between possible short-term profit reductions and the fundamental ongoing credit worthiness of those institutions which, although their profitability may be reduced, remain well capitalised and good credit risks. It is clear that in recent weeks the process of discrimination between and within asset classes has not functioned very efficiently and price discovery has suffered – and, I would point out, as a consequence there must now be significant investment opportunities for investors with the ability to draw distinctions which are there to be discerned and acted on.
I would hope that those who are seeking either credit or investment will assist this process by being clear about their exposure to particular asset classes. It is in everyone's interest – including their own – that this should happen: that firms indicate their exposure, direct or indirect, to the subprime market; and specify the nature and scale of their investment in complex instruments, whose valuations I fear may remain subject to uncertainty for some time to come. This will clearly involve some pain: reductions in profitability for financial services firms, and in some cases the winding-up of investment vehicles. But clarity as to the scale of the problem will enable decisions to be made, whereas continuing uncertainty will prolong the process of adjustment. It will, of course, be important that investors and lenders react intelligently to the information that is revealed and use the data to make informed decisions. I confess to some disappointment that reports of a very small exposure to either the US subprime market or to CDOs as an asset class have sometimes concentrated more on the unsurprising fact of any exposure at all rather than the more relevant statement of the limited quantity of that exposure. Clearer information needs to be accompanied by clearer analysis if we are to make the market more fluid.
I have described the process of adjustment we can expect, and which we will seek to encourage. But the UK authorities – Treasury, Bank of England, FSA – will also be concerned to assist in other ways. Adjustments can be painful, and can affect innocent bystanders as well as those whose actions have contributed to creating the problem. That is why there has always been a recognition of the need for a central bank to act as lender of last resort for solvent institutions which face liquidity problems, and where there is wider public interest of a type which justifies intervention to protect that wider public interest. In the UK, the arrangements for this are clearly established under the Memorandum of Understanding between Treasury, Bank of England and FSA. In a world of legal obligations on publicly quoted companies to make disclosure to shareholders and bondholders the opportunities for confidential assistance are limited – and, as the queues of last weekend evidenced, public recognition of assistance can lead to a lack of confidence which was only overcome by explicit Government guarantee. There are long‑standing components of these arrangements which need re‑examination, notably the compensation scheme arrangements for depositors, as the Governor made clear in his evidence this morning to the Treasury Select Committee. In relation to Northern Rock, we now have in place a guarantee which should preserve the confidence of existing depositors, whether retail or wholesale, as of Treasury's formal statement today. The Chancellor has made it clear he will act in a comparable manner in comparable circumstances. It is important that there should be a usable tool of this nature in the authorities' tool bag. If we can limit the wider danger of individual failure, we should more comfortably be able to encourage the wider process of adjustment which I described earlier.
A further development has been the Bank of England's announcement yesterday of its plans to conduct an auction in which it will provide funds at a three‑month maturity against a wide range of collateral, including mortgage collateral. Details of this will be announced tomorrow. It could contribute to alleviating some of the problems of valuation and liquidity in important asset classes which I discussed earlier. I hope that, once eligible banks have gained access to funds which the Bank of England has made clear are being made available to alleviate the strains in longer‑maturity money markets, they will deploy them accordingly. We need to improve liquidity at longer maturities. You, the practitioners, have an opportunity to do so, which I hope will be used.
My Lord Mayor, these are not easy times. But it is a source of reassurance to see you presiding over this occasion, a reminder that the City has seen and has seen through other times of turbulence, and a source of the confidence which we need to reinforce in present circumstances. Fellow guests, please join me in a toast to the Lord Mayor and the Lady Mayoress.