Testing times for bankers and regulators
Speech by Callum McCarthy, Chairman, FSA
Institute of International Bankers Annual Breakfast Dialogue, Washington
22 October 2007
These are testing, and fast-moving, times for both bankers and those who regulate and supervise banks. They are testing times because we are dealing with the effects of a much needed and in many ways overdue correction in the pricing of risk, which has imposed strains on a number of business models and which has raised questions about the effectiveness of bank regulation and supervision in countries round the world. This correction, like many market corrections, has in many respects been an over-correction: the drying-up of market liquidity especially for asset backed securities, and the absence of price discrimination which lies behind the unwillingness of many market players to trade, have spread much wider than objective analysis would regard as reasonable. There are (many) asset backed securities which have no sub-prime components; not all complex instruments incorporate incomprehensible complexity. They are fast-moving times because, only six months ago, many of us were concerned about excess global liquidity, which manifested itself in too much savings chasing too few investment opportunities, with the resulting compression of credit spreads, erosion of credit standards, and the various features often marshalled under the general title of the "search for yield". From flood to drought in six months has been an experience to test all of us. The test has been severe, but banks – so far at least – are coming through the test quite well.
In these circumstances, there is a temptation to argue for a fresh start: to abandon the principles of management or regulation adopted in the past, and to strike out boldly with new regulatory initiatives. I believe strongly this would be a mistake. The history of rapid and bold regulatory response to a crisis should give us pause for thought. I think that there are relatively few who would argue that Sarbanes-Oxley was a well-judged reaction to the manifest abuses of Worldcom or Enron, and I am not even sure whether many would now seek to argue that Glass:Steagall was the correct policy response to the acute problems of the financial crisis of the 1920s. We need to make sure we understand what has happened before we diagnose cures; and in prescribing cures we need – as always – to make sure the cure is not more damaging than the disease.
What I do think recent events have made clear is the need for us to advance further, and faster, on a number of journeys on which we have already started. Many – most – of them involve international cooperation, and it is these that I want to identify today.
The first requirement is to build on the existing quite well-developed cooperation which already exists between national supervisors, and which recent events have strengthened. These arrangements have been put in place over time; they have proved their worth in difficult circumstances. We have for some time been developing regulatory arrangements which enable the regulatory and supervising authorities in the most important markets for some of the most important global firms to pool knowledge – and, it should be recognised, any concerns. This needs to be done in normal as well as volatile times. These arrangements have been convened by the home supervisor, and include the most significant host supervisors. An example of this is the EBK which has, for many years, organised meetings involving the FSA and the Federal Reserve Bank of New York to discuss the business of UBS and Credit Suisse; likewise, the FSA has organised meetings with a range of supervisors to discuss Standard Chartered, or HSBC. At the very least this reduces duplicative information demands on the banks. In practice, it goes much beyond this, in that it allows national regulators to take a common view on what are the main issues for a particular institution. At any time this is a useful initiative. It has been particularly valuable during a period of acute stresses, where we have been able to exchange information and understanding about the financial institutions at the centre of the financial system effectively and rapidly. I would add that a particular development which has proved timely has been the arrangements arising from the introduction by the SEC of the consolidated supervised entity (CSE) regime for the large US broker-dealers – partly in response to the requirement in the EU that all third country groups should be subject to consolidated supervision. Under these arrangements the SEC conducts consolidated supervision for these groups which includes their operations in the EU. The FSA in particular is the EU coordinator for these broker-dealer groups, and we have worked closely and productively with the SEC during the recent troubles. Given the scale of the operations in the UK of these large broker-dealers, this represented an important contribution to financial stability. So my first, general, point is that the arrangements for cooperation between national regulators have performed well, and have been strengthened by the tests that have been encountered – and to which they are still subject.
As a footnote on the subject of international cooperation between supervisors, I would note that an initiative from the Federal Reserve Bank of New York two years ago to require action on credit risk derivatives settlement has proved its worth. This led to a highly effective pincer movement between the New York Fed and the FSA to require collective action. Without it, the surge in volume of transactions which we have seen in recent months would have resulted in far greater backlogs – all of which would have caused greater uncertainty than we now have. The present backlogs are uncomfortable. But for the action taken they would have been dangerous.
There are also more specific international initiatives which we need to advance. The recent troubles, whatever their causes, have manifested themselves as an acute liquidity problem, and we need to make progress on liquidity standards. Given that global firms aspire – justifiably – to manage their liquidity on a group-wide basis, it is clearly preferable that we agree on new internationally agreed standards rather than develop separate national regimes. There should be no illusion about how difficult this will be. Different countries have different approaches; there is a strong link, which has to be recognised, to monetary operations by the central bank. The recent troubles have thrown into sharp relief issues which need greater attention than they have sometimes been given. I think, for example, that the wish of global entities to reduce the scope of separate liquidity regimes of subsidiaries implies stronger and more effective guarantees of those subsidiaries by the group. The freezing of the FX swaps market which occurred must make both treasurers and supervisors look again at currency liquidity. And I am thoughtful about whether we yet know enough about the impact of internet banking or the assumptions about the inertia normally ascribed to retail deposits. So resolving these issues will be demanding. Given these complexities, stress testing will assume a particularly important role. Striking the right balance between tests that are rigorous enough to demonstrate the firm's resilience while also being realistic will be a particular challenge. I should add that liquidity and stress testing are both essentially principles-based approaches. The renewed emphasis on stress testing which I see will provide a further boost to the principles-based approach towards regulation favoured by the FSA.
Work has been done in the Basel Committee on reviewing sound practices for managing liquidity in banks. It is a measure of the complexity of the issues that this review of present good practice, which will conclude this year, is the development of work which started in the year 2000. I think we will need to advance from review to conclusions at a much faster rate.
The second feature of the present troubles worth commenting on is the way in which banks have decided to re-accept, for either legal or commercial reasons, some responsibility for conduits or structured investment vehicles (SIVs), and where these obligations have not been properly recognised under the capital requirements of Basel I (though I should recognise that US regulatory practice was better than that in the EU – which may have been a factor in the growth of European SIVs). Basel II will provide a more realistic capital assessment of the impact of conduits. An area for regulators will undoubtedly be, given the commercial incentives which have led some banks to stand behind SIVs, to understand better the reality, as distinct from simply the legal position, of separation of sponsor from SIV. I would expect this to be an area of increased attention under Pillar Two work within Basel II. More generally, we will need to review our implementation of Basel II to take account of what we are learning from events as they develop.
Third, there will clearly be examination in Europe within CESR, in the US by the SEC, and globally within IOSCO of the work of the rating agencies. I think there is need for greater clarity in what is the objective. It should not be simply a call for undefined "regulation". I think we should recognise that no realistic alternative to the credit rating agencies has been identified to the important task of providing independent assessments of credit risk for proper use by investors. The questions should centre on the independence and quality of the rating agencies' work, and the use to which that work has been put by investors. If the various examinations produce a better understanding of what ratings seek to do and – as importantly – what they do not claim to do, this would be a major advance. The estimate of default probability is not, and should not be seen as, a statement about liquidity – and yet at least some comment has confused the two. There are real questions about the use to which ratings have been put, but these questions need to be answered by the investors who used ratings as much as they need answering by the ratings agencies themselves.
In addition to these international initiatives I expect all national regulators to take stock of how well their own systems and practices have stood up to the stresses – how well did we monitor the risks that were mounting but had not yet crystallised in the period until the problems became acute in August; and how well have we coped since then. I hope that all banks will do the same. At the FSA, we are committed to doing this very seriously. But that is a subject for another discussion.