Institute of International Bankers' Annual Conference
Callum McCarthy Chairman, FSA
Institute of International Bankers' Annual Conference, Washington
Monday 3 March 2008
It is a pleasure, as an old boy of the IIB, to have been asked again to speak at this annual event in Washington. To those of you – with whom I sympathise – who may feel that you have heard from me too often, I make one excuse and one promise. The excuse is that I am here as a result of your invitation, and the blame should therefore lie with Larry Uhlick, the originator of that repeated invitation. The promise is that this is the last time I'll address you, as I step down as FSA chairman in September. There will be a fresh face and a fresh voice in the FSA chair by the time of your next annual conference.
This afternoon I want to consider what you should expect to be the regulatory responses to the quite fundamental shock to financial businesses which has occurred over the last six months – a shock which it would be unwise to assume had worked its way through financial services. I think it prudent for all of us to plan on the basis that there may well be further shocks to come. It's only too easy to identify potential points of origin for this; there is no shortage of possible candidates: further declines in US residential property values, changes in the ratings of monolines, deterioration in commercial property values are three obvious ones.
There is little to be gained, I think, by rehearsing again how we have got to our present position. Indeed, it is not even obvious what our present position is: we know that the problems started with a set of acute liquidity problems; and that these have moved to problems of credit and capital availability (without, however, the liquidity issues having been totally resolved); there may be quite significant effects of restricted credit growth on the real economy still to come. So there are considerable uncertainties attached to plotting precisely where we are on this crisis map, and even more uncertainties in plotting where we may end up.
There is, however, one point which I would make about our present difficulties. The crisis in finance has not occurred because of some crisis in the real economy. Quite the contrary. The disruptions of liquidity last year, and the uncertainties as to valuation and credit which still persist, which have affected the financial sector so strongly and which may yet have significant effects on the real economy, have occurred at a time of continuing benign economic circumstances: the consensus market estimate of world economic growth in 2007 is for growth of 3.7 per cent; in the US, at least until recently, economic indicators showed problems largely confined to the housing and financial sectors; in the UK, the latest (Q3) data show domestic demand growing at its fastest rate for nearly a decade; Japan has been recovering from its economic doldrums. Banks and investment banks went into 2007 on the back of some five years of high profitability and with strong capital positions. Our present difficulties are not caused by faltering economic growth, nor by extended pressure on bank profits (in the UK we are even now in – towards the end of – the cycle of preliminary announcements of banks' 2007 results which have been for the most part reassuring, even after writing down of sub-prime assets). Rather the threat is that a set of problems which originated in financial institutions and financial instruments will invade and damage the wider economy.
The last decade has seen a very marked growth in financial activities relative to non financial activities. Many uncertainties which previously had to be left as uncertainties can now be hedged against by using financial instruments. This has brought all sorts of advantages, from cheaper mortgages to means of insuring against one of the world's oldest and still most damaging phenomena, the ravages of weather and climate. But the increasing dependence on financial solutions means that it is all the more important that the engineering and architecture of financial instruments and systems are robust. Since recent events have shown substantial vulnerabilities in instruments and systems, we – you as practitioners, we as regulators or supervisors – need to address them as a matter of urgency.
So this afternoon I want to list some of the issues which practitioners will be expected to deal with, and those issues which you must expect supervisors to deal with. It's important that we identify as clearly as we can who will be responsible for what; and that we recognise what each side can usefully do – where we can be constructive and add value. It's also important that we (particularly the authorities) recognise what we cannot do – where action will be more apparent than real, with the moral hazard of a semblance of protection without the reality; or where action is so hastily undertaken that it leads at best to unintended consequences, and quite possibly to downright harmful results. The history of rapid legislative response to financial crises or regulatory failure is not encouraging.
With those cautionary remarks, let me turn to what practitioners must do. I'll confine my suggestions to four for banks, two of a long term nature, two to deal with more immediate concerns.
First, it is clear that banks have to improve risk management. The US and various EU authorities, including the FSA, have examined the risk management practices over the period since last summer in some dozen institutions. It has shown very marked differences in the way in which risk was managed, and very significant differences in the success with which risk was managed. The best firms succeeded in integrating risk management – credit, market, operations; they avoided dealing in silos; risk management went to the top of those firms. We need to find means of ensuring that those risk practices are spread more widely. It's not that people don't know what constitutes good practice. The industry itself has identified that – through, for example, the work of the Counterparty Risk Management Group which Gerry Corrigan so ably chaired a couple of years ago, and whose recommendations, if properly and fully adopted generally, would have avoided some of the worst of recent incidents.
Second, there is a need for the financial sector as a whole to reconsider the incentive structure which it has adopted. The present bonus system places emphasis on the short term performance of individual parts of an organisation; and it encourages the taking of trading positions whose immediate profitability is rewarded, and whose eventual riskiness is not properly disincentivised. This is a problem which traditional banks have long recognised, and to a substantial extent managed. I suspect that, irrespective of the behavioural aspects of the present bonus arrangements, there will also be wider questions to answer. Shareholders in banks who have seen the value of their investment fall by many tens of percentage points are likely to question a bonus pool which remains flat or even increases. So a second long term issue is to find an incentive system which promotes behaviour which achieves a better balance both between risk and reward and between shareholder and employee.
Let me turn to the two (linked) actions which banks should undertake now. The first is to carry out the valuations of the instruments they hold with complete realism; and the second is to make public announcements of those positions with as much clarity as possible. There may be some who argue for a degree of smoothing of results, through the use of valuation methodologies which are less demanding, rather than immediate and full recognition of what has occurred. But this would be a mistake, as it would add to uncertainty, and result in doubts about the position of any institution adopting such an approach. There are some unavoidable uncertainties about valuations, since no-one can predict what will in fact happen in the US housing market. It is important that these uncertainties are not added to by doubts about the credibility of the valuation methodology adopted. Equally, banks must also show that they are making full disclosure. I think there is great advantage, both for the institution reporting results and for financial stability as a whole, in the reports making as much clear as possible: the purpose should be to allow a bank's counterparties and analysts to understand – both qualitatively and quantitatively – the impact of the financial turbulence on its financial position and its prospects. So, it is sensible for banks to give information on write downs (as most have done) on ABS and CDO assets, with analysis of asset quality and of tranche structure. It is also sensible for banks to give information on any important SPVs, and associated write downs. I would encourage banks to go further: and to be clear about valuation methodology; to be clear about the liquidity implications of these.
Let me turn to another part of the financial structure which has been found wanting, namely the credit rating agencies. The central importance of ratings, both for investors and for banks, is evident: many – too many – investment decisions have been made on the basis that a particular instrument is AAA rated (often the only category trustees are able to invest in, either for legal reasons or from custom and usage); ratings play a central part under Basel II in determining bank capital requirements. The issues associated with the ratings agencies are many: conflicts of interest; methodologies; the melding of advice and actual rating; transparency. I am neither persuaded that all of these are real problems, nor that for all there are in fact solutions: I see, for example, no practical means of avoiding the rating agencies being paid by the issuers; this conflict of interest – like many in financial services – needs to be managed since it cannot be eliminated. But two issues particularly concern me: the first is how to make sure the CRAs do not overtrade; the second is the need to move beyond the position that CRAs are not auditors to establish a better data underpinning for their work. On the first point, the growth in the scale of ratings of structured instruments issued by the CRAs over the last few years clearly outstripped the resources of the CRAs: politely, they became overextended; bluntly, they overtraded. They need to demonstrate the measures they will introduce to prevent that happening again. Second, a principal cause of the sub prime problems was that a serious degradation in the quality of data occurred as more and more sub prime mortgages were originated by essentially unregulated brokers, yet those data were treated by the CRAs as having equal validity with earlier and more reliable data. If they are not to be accused of applying sophisticated risk analysis to data of quality they should have been sceptical about – what bluntly might be regarded as an example of garbage in: garbage out – they have to make changes. The CRAs have to demonstrate a much greater concern with the data they use, rather than retreating to the position of not auditing data. The present position is unacceptable.
Last, let me deal with actions for regulators and supervisors. I'll specify just two which seem to me particularly important.
First, we need to review the regulatory capital regime. Recent events have shown all too clearly failings in Basel I, particularly its treatment of off balance sheet vehicles – something which Basel II will improve. But we need to consider whether there are failings, and if so what they are, in Basel II, and correct them. There are both specific issues, like the capital charge for trading book credit loss, and the more general issue of how we use ratings, which are central to Basel II, and where the problems in ratings (particularly of structured instruments) should make us thoughtful.
Second, we as supervisors need to pay more attention to, and overhaul, our liquidity regimes. The present troubles started with liquidity pressures, and evidently the present liquidity regimes are not up to the demands put upon them. That is why in the UK the FSA in December set out for consultation a series of measures designed to improve the UK's liquidity regime. I know that international banks, like those here today, would like to manage their liquidity globally, subject to one global, not several national, set of rules. But, unless there is a step change in the speed with which the Basel Committee progresses international agreement, we will be forced to deal with this on a national level. That is what we plan to do in the UK. I am of course very keen that the Basel Committee should actively consider whether it can develop a resilient approach to the cross-border management of liquidity for banking groups, which meets the most compelling requirements of regulators and industry alike.
There are other regulatory improvements which are needed: the desirability of finding ways of taking regulatory or central bank action which does not stigmatise or destabilise the bank concerned is one; the desirability of establishing better means of co operation between different national authorities when dealing with major international banks is a second. The UK authorities in January published for consultation our proposals to deal with the first; I commend "Financial stability and depositor insurance: strengthening the framework" to all interested – as anyone banking in the UK should be. On the latter, the FSA has been in the fore, with in particular the Swiss and US authorities, in developing practical solutions via the development of colleges of regulators. I have set out to the IIB on a previous occasion the FSA's views on how these solutions should be extended.
You will see that I regard recent events, and what is still to come, as having exposed vulnerabilities in the architecture and construction of modern financial systems and instruments. I have indicated some of the main actions which I believe are needed to repair these failings, many of which fall to you, the banks, to implement, and some of which fall to regulators and central banks. There are heavy responsibilities on all of us.