• FSA Library
  • Communication documents
    • Speeches

Speech by Thomas Huertas, Director, Banking Sector, FSA
Euro 50 Group, London
21 April 2008

Nuclear energy can create catastrophe or contribute to prosperity. Controls make the difference between Chernobyl and efficient energy. Whether nuclear energy has a future depends critically on whether controls can be effective.

So does the future of securitisation and of the so-called "originate and distribute" model. The past year has been the financial and economic equivalent of Chernobyl. Failures in risk management at major financial institutions have resulted in hundreds of billions of dollars of losses, posed the risk of financial meltdown, and forced extensive intervention by the authorities. The Bank of England's refinancing scheme announced this morning is only the most recent example.

As do the physicists who promote nuclear energy, those bankers who promote securitisation and the originate-and-distribute model stress that these financial innovations can benefit society. Indeed, some of the bankers who do the promoting are trained physicists and the models that they use to make their case borrow from science some very advanced mathematics.

And, the theory is right. But the practice has turned out horribly wrong.

What will bankers and their regulators need to do if securitisation and the originate-and- distribute model is to be resurrected?

First, they must rebuild credibility with investors, for without investors neither securitisation nor the originate-and-distribute model will work. That requires making available to investors relevant information about the risks inherent in the securitisation structures as well as information about the performance of the assets underlying the securitisation. Although rating agencies may endeavour to resurrect the role that they had previously had as validators and evaluators of such information, I suspect that investors will move much more to a "do-it-yourself" model and expect much more in the way of due diligence and ongoing information provision from the investment banks that underwrite new securitisation issues. And, investment banks will need to think about how they warrant what they sell.

Back to top

Second, banks will need to reform their own risk management practices. The most significant problems over the past year have been associated with banks that originated but did not distribute. For example, some banks thought that it paid to keep vast quantities of super senior tranches of securitisation deals on their own books – quantities that amounted to several decades of daily trading volume in such securities. Those sure-fire super senior tranches become the financial equivalent of hula hoops piled up in the warehouse of a defunct retailer. Other banks thought it was wise to warehouse extensive amounts of mortgages, pending securitisation, so that they could save on underwriting fees. Such banks effectively took massive amounts of liquidity risk. They simply did not distribute quickly enough. Effectively, banks were taking inventory risk – and they either ran out of funding or they found that investors did not share their assumptions about the value of the merchandise that they had elected to stockpile. Whatever model the banks were following, it was not "originate-and-distribute".

In reforming their risk management practices, banks will need above all to get two things right: first, build in the risk that really adverse events can occur and, second, take measures to protect themselves against these realistic disaster scenarios. Banks will have to recognise that their own actions, including their policies with respect to remuneration, can have a material influence on whether they will or will not be subject to really adverse events. And, banks should actually trade regularly the assets that they keep in their trading book.

These and other actions (as outlined by the FSF and/or the IIF) are for banks themselves to take. But public authorities will also need to act.

Back to top

The broad public appears to expect the authorities to prevent the failure of major banks or, at the very least, to prevent the failure of banks from having significantly adverse consequences on the economy.  Some pundits characterise this as the authorities' having written a gigantic put option which permits banks to privatise profits and socialise losses. Others rightly point to moral hazard.

Whatever the status of this debate, it seems clear that the authorities should move to keep this so-called put option clearly out of the money. That spells above all three things:

1. Assuring that banks keep adequate capital and better quality capital. Supervisors are already engaged in discussions with banks on this, and international forums such as the EU and the Basel Committee are reviewing the rules with respect to own funds.
2. Assuring that banks keep adequate liquidity. Again, supervisors are already engaged in discussions with banks on this, and international forums such as CEBS and the Basel Committee are reviewing the rules with respect to liquidity.
3. Intervening promptly when banks veer toward failing to meet these threshold conditions. If need be, governments should move, as the UK government has indicated it will do, to reform legislation to strengthen the ability of the authorities to make such interventions.

In sum, both securitisation and the originate-and-distribute model should have a future. How bright that future will be depends on actions that banks and the authorities take to implement that model better.

Back to top