Financial Crisis: Dealing with Systemic Risks
13 May 2008
Summary of comments by Graham Bishop to the ALDE/PSE seminar by the co-Rapporteurs on ECON’s own-initiative report on “Lamfalussy follow-up: future structure of supervision”
Disputing Ackerman of Deutsche Bank’s celebrated comments, the market will heal itself, but perhaps only up to a point. So a wise response by the public authorities should build on this natural evolution – and perhaps push it further. Open and competitive financial markets remain essential to channel the rising tide of aging Europeans’ retirement savings into productive investments around the globe.
Background
o Size of problem: The IMF reports that $300bn of sub-prime mortgages in the US (versus $3800bn of prime) is likely to lead to $1000bn of write-offs and write-downs, though other observers such as the OECD expect the damage to be about half this level. Remarkably, nearly half the losses expected by the IMF will be borne by non-US financial firms. Problems in the EU mortgage market appear to be of a different order of severity so far – the UK’s Northern Rock had published loan loss ratios about half the level of its rivals when it ran into liquidity problems that have precipitated a dramatic review of UK bank regulatory arrangements.
o US: So the first question to answer is how did the US system allow these “toxic” loans flow into the bottom of the financial system’s “food chain”? The working paper (WP) correctly points out that these loans had to flow through the purview of lawyers, accountants and rating agencies before reaching the investment banks that structured the products that were then purchased by investors (including the banks themselves). Apart from the initial origination of the mortgages, all the participants were subject to various forms of regulation/oversight by public authorities, especially in the US.
o Ethics: Many of the participants at the bottom of the chain must have realised that they were exposing a significant portion of theses mortgagees to the probability of personal ruin. Correspondingly, they must have known that the probability of the projected cash-flows was debatable. As the products flowed up the chain, an increasingly highly-educated group of finance professionals should have realised the potential problems inherent in the products they were distributing. Why did their ethical values allow them to shut their eyes – at best – to this? The answers will have profound implications for their willingness to accept the letter (let alone the spirit) of any regulatory changes that ensue.
o Remuneration: ECB President Trichet recently commented powerfully about “some financial agents’ incentives that were aligned against prudent practices”. The key problem to emerge is the lop-sided balance of risks to the banks and rewards to the executives where there is no mechanism to claw these rewards back if the products turn out not to produce the forecast flow of profits. An individual bank cannot impose new principles on its employees without risking an exodus. So public policy may need to respond – but correspondingly that can only work if applied across all major financial centres.
o Regulators’ staffing: How can public regulators keep up with the turnover of their best staff attracted to the other side of the fence by high salaries? As the EU moves toward colleges of international supervisors for the biggest and most complex groups, the regulatory skills of the college members will be enormously valuable to the firms they regulate, so the incentives to switch sides will be tempting! Perhaps the senior regulatory staff should be on a 2-3 year contract so they know at the outset that they must stay for that period but would then be free if they wished to move.
o Speed of legislative reaction: Commissioner McCreevy has talked of the need to avoid a “knee jerk” reaction, but has then proposed timetables for action that seem risky and based only on the timetable for the current Parliament and Commission to complete measures. The essence of the Lamfalussy Process is to consult stakeholders at the pre-legislative stage and then all the way through the process to ensure that all players accept the societal legitimacy of the resulting rules. First, that should minimise the risk of the “law of unintended consequences” emerging later. Second, it will raise the chances that ethically-minded participants will respect the spirit of the new rules, rather than just seeking to game them and by-pass the intent.
Specific comments
- Accounting standards: The valuation of illiquid assets is at the heart of these problems and is probably insoluble in the context of marking to a market price when there is not one for the very simple reason that dealers do not have the reliable information necessary to try to find the price where knowledgeable buyers and sellers will meet. The alternative of reverting to a system where the bank’s directors simply announce a value is unlikely to command public support. But perhaps they could be allowed to do that temporarily when the valuation is accompanied by sufficient detail to allow outside observers to judge the adequacy of the valuation – and impose a market discipline on those banks that were felt to be in denial. But that discipline could well take the form of a run on the bank, so there must be adequate measures to handle such risks.
- Extra capital: The knee-jerk reaction of demanding ever-higher levels of bank capital may actually compound the problem in the long run. Someone has to remunerate that capital: either by lower deposit rates to savers or higher charges to borrowers. Either way, the natural response will be for citizens to seek to dis-intermediate an expensive banking system and shift into some sort of un-regulated system.
- Shadow banking sector: What does this term really mean? To the extent that greater regulatory burdens are placed on banks, key staff members can shift into say hedge fund management where the rewards are potentially enormous precisely because the fee structures are skewed to participate in rewards but not losses – or even to claw back previous rewards
- Early warning system: Ministers and others are fond of proposing such ideas but they are really only needed once every decade or two. In reality, the financial markets themselves are the most sensitive indicator and many public bodies e.g. the IMF have looked at the problems and concluded that it was manageable. Moreover, many central banks publish Financial Stability reports and have warned about the potential risks but no policy actions were taken – by them or the actual regulators of financial firms.
- Maturity mismatches: It was startling to find that SIVs did not always have back-up credit lines that match the maturity of the assets. It seems that lines were often only for 364 days as that attracted a much more favourable capital requirement, yet these vehicles were funding very long –dates assets that might not be capable of a rapid sale at ordinary prices.
- Cross-default clauses: The too-connected-to-fail analysis is rapidly gaining in credibility as the old-fashioned model of a bank that held marketable assets has been replaced with one that consists of a dense web of financial contracts that cannot be wound down quickly – if at all. So a mechanism needs to be found that gives the regulators the credible option of liquidating a major institution without inflicting massive collateral damage on the remainder of the financial system whilst ensuring that the shareholders and all the collective senior management bear the full consequences of their behaviour.
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