Address to the Basel Comittee on Banking Supervision Industry Outreach Meeting
Speech by Callum McCarthy, Chairman, FSA
Basel Committee on Banking Supervision luncheon
28 January 2008
This is a gathering of both senior banking practitioners and of those, in central banks or regulatory organisations, charged with the supervision of financial services. For all of us, these are anxious times, as we seek to establish what are the features of the financial landscape which we recognise and can rely on; what are the changes we can identify; and what can we do to estimate the effects of events and trends that may occur or develop. What has happened – and what is still in train – is deeply sobering for all of us.
I don’t want today to set out yet another potted history of how we have got to our present position, nor even to speculate on what our present position is in the three act play of liquidity, credit and capital pressures and real economy effects. There have been plenty of occasions on which that has been done already – and I suspect there will be many more occasions to come. I will however make one observation designed to make us all more conscious of the responsibilities we carry. It is – or should be – a particular concern for the financial industry – practitioners, central bankers and regulators – that the enormous disruptions to liquidity last year and the uncertainties as to valuation and credit which still persist, which have had such powerful impact on the financial sector and which may yet exacerbate developments in the real economy, have occurred at a time of generally extremely benign economic conditions: consensus market estimates put world economic growth in 2007 at 3.7 per cent; in the US, until recently, economic indicators showed problems largely to be confined to the housing and financial sectors; in the UK, to be parochial, the Q3 economic data, which you may or may not choose to believe, showed GDP growth of 0.7 per cent quarter on quarter, and domestic demand growing at its fastest rate for nearly a decade. Banks and investment banks went into 2007 on the back of some five years of high profitability and with strong capital positions. This was not a problem of economic growth faltering – nor the result of extended pressure on bank profits. And yet we have a position of the present grave nature which originates in the financial sector. The responsibility on us to sort this is all the greater.
It is clear that sorting this will require action by both practitioners and by the authorities. Central to a successful resolution of our task is a recognition of what each of us can usefully do – where we can be constructive and add value – and equally (and this particularly applies to the authorities) what is it that, tempting though it may be to show that action is being taken, is inappropriate – action that is more apparent than real, with all the moral hazard which this can produce, or action which, because hastily or incompletely considered, has unintended and harmful consequences.
Very many of the actions required to sort our problems are actions best undertaken by the industry themselves. I welcome the work done now some two years ago by the Counter Party Risk Management Group under Gerry Corrigan's leadership as a particular and very productive example of this – and rather hope that, once the dust has settled on our present circumstances, we will be able to have that work rerun. And I also welcome the work now being done by the IIF special committee on market best practice, whose members met this morning with the FSF working group under Mario Draghi's chairmanship looking at the present problems. Many of the things that have created the problems the effects of which we are now trying to cope with lie directly in the industry: underwriting practices at the start of the origination and distribution chain; effective – ie usable because comprehensible – disclosure in report and accounts; real use of stress tests; appropriate use of credit ratings. There is a heavy onus on the industry to come up with answers, and there is also a strong incentive: the more concrete and convincing these answers, the less likely it is that there will be inappropriate regulatory initiatives. For all our sakes, I therefore hope that the industry's response will continue to show the seriousness and urgency needed.
I should express one concern about the way in which this work is weighted, which is heavily towards the sell side of financial services – the originators, the distributors, the CRAs – with less attention paid to what went wrong on the buy side. But much of what went wrong was due to buy side failings: a basic error of purchasing products which were not properly understood, and where a credit rating label was used as a substitute – and an inadequate and misguided substitute – for real understanding. There is of course a need for the sell side to recognise fully its responsibilities in terms of know your customer and of promoting products in a way that is fair, true and not misleading – something which I suspect future litigation will make clear. But it is also important for the buy side to face its responsibilities: caveat emptor must not become an empty concept.
With that strong encouragement for practitioner action, let me set out my list of actions for the authorities – appropriate areas for regulatory initiatives. I will confine myself to four.
First, it is clear that the regulatory measurement of capital under Basel I has been inadequate, particularly in its treatment of off balance sheet vehicles – something which had long been recognised and which Basel II will improve. But we need to review whether recent events have indicated other failings in our regulatory capital regime, and if so correct them. A particular area is the use of ratings, a central feature of Basel II, where the problems in ratings revealed by recent events should make us all thoughtful.
Second, there are a range of questions associated with liquidity, which we have always found more difficult to answer than those relating to capital, as is evidenced by the relatively slow progress on liquidity questions within the Basel Committee. I am very conscious of how difficult liquidity issues are: they involve judgements about the stresses which have to be withstood rather than the more statistical analyses which underpin capital; and they also depend on understanding the attitude of the relevant central bank or banks as the ultimate providers of liquidity towards the eligible collateral they will accept, when policy manifestly differs between central banks, and is not necessarily clear to market participants in advance. I know that large international banks – those here today – would like a uniform and internationally agreed policy on liquidity. Given the urgency of dealing better with liquidity issues – after all, it was a set of liquidity problems which started the present turmoil – I don't see national authorities will be able to wait for international agreement unless there is a step change in the speed of progress on liquidity issues within the Basel Committee. In the UK, we have already started to review and change our liquidity regime, with the paper published by the FSA last month.
Third, the authorities have to find means of avoiding any intervention on our part stigmatising the bank which is the object of that intervention. There are many lessons to be drawn from the events surrounding Northern Rock in the UK, but one of the most concerning is that a weapon that has been recognised as an important component of the armoury of central banks since the time of Bagehot – provision of liquidity to a solvent bank – when used proved not only ineffective but actually counterproductive, by triggering a lack of confidence which its use was designed to avoid. This was the most extreme, but not the only, example of the problem of stigma, and it is a problem that the authorities have to recognise and solve. In the UK we will this week be publishing for consultation proposals of a quite far reaching nature designed to improve both our deposit insurance regime and our powers to deal with failing institutions. But I don't believe it is uniquely a British problem. It is an important task for the authorities in each country.
Fourth, the authorities need to be able to take more effective international action. Up to now, we have been fortunate in that the institution–specific problems have been capable of being dealt with on a country by country basis, without the informal links between central banks and regulators which are so important being strained. But I have no doubt that those informal arrangements need strengthening. The FSA has on a number of occasions put forward suggestions on how to do this. We are working, with others, to do so in practice for the major institutions in which we have an interest, as either home or host regulator. But we need to improve the framework more generally.
You will see why I believe why all here today – practitioners, central bankers, supervisors, have heavy responsibilities.