The Implications of Globalised Financial Markets of Regulation
Speech by Callum McCarthy, Chairman, FSA
IIF 25th Anniversary Annual Membership Meeting: Washington
Saturday 20 October 2007
At the time Charles Dallara invited me to speak, I doubt if he thought that I would come as a witness of, and a protagonist in, an event in the UK – queues of depositors seeking to withdraw their deposits from a bank – which one has to go back many, many years to recall. It is not my intention today to speak in any detail about either the events which led to the present position in Northern Rock or about the UK regulatory system and practices. There will be other occasions for both of those.
What I do want to do is to consider what the events since August should make us reconsider in terms of our national and international regulatory policies.
First, let me sketch what I consider the events since August to comprise. First, there has been – a long overdue – repricing of risk, which will I hope bring greater discipline to markets which had for some time responded to world liquidity and the search for yield by compressing the spreads between low and high risk investments: the compression of spreads between investment and non investment grade corporate debt, or the very rapid growth in covenant lite LBO issuance earlier this year were perhaps the most obvious examples. Second, and more particularly, a specific set of problems in the US sub prime market has infected confidence across a very wide range of asset classes: CDOs, CLOs, ABCP, RMBS – and no doubt other initials as well. The root cause of this are two fold – and of very different nature. The first relates to doubts about the confidence that can be placed in the origination process for these mortgages – doubts about the data that borrowers had reported, and doubts about the care with which that data had been checked – (a lack of confidence which spread across asset backed securities); the second relates to the complexity of the investments which had been developed from income streams attached to mortgages, where many investors recognised belatedly that they did not understand sufficiently the true nature and characteristics of the complex instruments, and had placed excessive reliance on ratings from the credit rating agencies (this lack of confidence spread across many classes of complex instrument). The third set of events has been the action of many institutions faced with these problems to act to conserve liquidity – banks against the legal need or commercial wish to take back on balance sheet assets presently in conduits or SIVs, hedge funds or money market funds against the possibility of redemptions. The result of those three factors has been a large fall in CP activity, a marked rise in the spread of LIBOR over base rates, and a marked reduction in the maturity of funding. These strains are still apparent, even after the more acute liquidity problems of August have gradually improved.
As of today, the casualties of this process have been national rather than international institutions: two German regional banks, a British mortgage bank, the Canadian CP market, a small US bank. Although this set of liquidity problems is global, the consequences have had to be dealt with largely within countries. A national – US – cause had spread to become a global problem, with national consequences.
Let me set out briefly what I think are some of the lessons for regulators, for banks and for investors to be drawn from recent events – nationally and internationally.
Nationally, we in the UK will want to reconsider certain aspects of our arrangements. In particular, let me mention two aspects of international interest:
- We have accelerated the consideration which was already being given to the UK deposit guarantee scheme, to amend it to give greater certainty in terms of the size of its coverage, the proportion of deposits covered, and the practical arrangements for making payments and avoiding disruption including how quickly payments can be made. The British scheme covered 100 per cent of the first £2,000 of deposits, and 90 per cent of between £2,000 and £35,000, which meant that anyone with deposits over £2,000 faced the prospect of some loss. We have changed this to cover 100 per cent up to £35,000, something some non-FSA estimates consider will cover well over 90 per cent of bank depositors. The FSA was in the course of raising the industry funding for the deposit taking part of the financial compensation scheme from £2.6 billion to £4.0 billion, which will significantly deal with size issues. But there are other aspects of compensation and transitional arrangements for a failing bank – notably smooth arrangements for the transfer of accounts – which we need to deal with. Unless we can assure depositors and account users that there are arrangements for a rapid and smooth continuation of their banking services in the event of failure we cannot be confident that even a small perceived risk of potential failure will not result in a lack of confidence. The UK compensation scheme –and I suspect those of many other countries – was designed against a background of consumer protection and concerns of moral hazard (the original UK scheme had a 75 per cent limit). We – and others – have to consider the financial stability effects. We had started doing so earlier this year. We need to intensify this work.
- Second, much more attention needs to be given to individual firms' stress testing, in terms of both the nature and magnitude of the stresses applied and the attention paid to the results by managements. I do not think this is easy – either for regulators or for the banks. There is no arithmetic or formulaic approach to stress testing which makes sense. The search for and identification of stresses which are severe but plausible is not an easy task. It requires a full understanding of the bank's business model, and judgment about what can occur. There is no point in firms devising scenarios which are so extreme that they break the bank. The process of concentrating on severe but plausible scenarios will test both the management of banks and their regulators who need to be satisfied that stress tests provide a true reflection of firms' resilience. It is a focus of work for all of us.
Internationally, there are various strands of work which will need to be pursued. Let me mention just three:
- First, there is work on Basel II, where we need to check that the increased emphasis on ratings is not undermined by the limitations which recent events have shown in at least the use made of ratings and – less clearly – the reliability of ratings. I would add that one aspect of the present difficulties – the extensive use, particularly in the EU, of conduits by banks – should be dealt with better under Basel II which provides for a more realistic capital treatment than Basel I.
- Second, there will be a new impetus to tackle questions of liquidity. The problems we have encountered have essentially manifested themselves as liquidity problems, and it is entirely appropriate that we should intensify our work on liquidity – a notoriously difficult area. The Basel Committee, in work co chaired by Nigel Jenkinson of the Bank of England, is already working to establish a stocktaking of the various national approaches to liquidity. We need to go beyond this, to recognise the very strong – and entirely sensible – wish of major international banks to manage liquidity globally and not country by country or currency by currency; and to make progress rapidly. In the UK, the FSA will before the year end come forward with proposals on how we expect to make progress.
- Third, we need to reconsider what is the role of the credit rating agencies in recent events. It is fashionable at present to represent the rating agencies as malign participants in the present difficulties. I think we need to be careful about our response: there are clearly issues of potential conflicts of interests in those giving ratings being rewarded by the institutions rated; and there may be other specific issues. These are being examined, in the US (the home of the most important rating agencies) by the SEC, in the EU by CESR, globally by IOSCO. I do not want to prejudge their conclusions. I would observe that any regulatory response should be based, not on a general dissatisfaction about how ratings have been used or misused, but on both a clear identification of any market failure and a rigorous assessment of the likely net benefit of regulatory intervention.
Let me end with one further note of caution. What has happened is very sobering both for market participants and for regulators. Both need to learn from what has happened and then apply the lessons. In the UK, the FSA is committed to doing just that. But equally we must not succumb to a pressure to introduce new regulatory initiatives for the sake of demonstrating that we are taking action. Political and other pressures can create almost irresistible pressures to 'do something' and introduce measures precipitately. It is hard to think of an example from the past where this has not created problems. It is important that we stick to the policy making disciplines of identifying market failures and undertaking cost benefit analysis that have stood us in good stead in more stable times.