Ceep Opinion on the Report Delivered by the High-Level Group on Financial Supervision In

REMARKS ON THE CONSULTATION LAUNCHED BY DGMARKT ON THE REPORT DELIVERED BY THE HIGH-LEVEL GROUP ON FINANCIAL SUPERVISION IN THE EU (25.02.2009)

Submitted by

Juan Pedro Marín Arrese

As a EU citizen may I welcome the opportunity offered by DGMARKT and COM to deliver my opinion on such a vital topic. My views are purely personal and do not reflect any other interest than contributing to the open discussion for financial regulatory reform, a vital issue to ensure a stable framework for economic activity. I will only touch on aspects of the Report that raise some doubts as praise for its balanced delivery has been widely emphasized, a view I broadly share.

ABSTRACT

I believe the Report to have the following main shortcomings:

• It addresses the new regulatory framework within EU in a too realistic and downgraded way, the praise received by financial community on that account moving to caution. The step by step approach towards a more coherent and unified EU financial authority, is likely to trim implementation only to its first stage. COM should press for a firm commitment by European Council to undertake its full implementation now that crisis puts some pressure on Governments.
• While most of its proposals on regulatory upgrading are useful and common sense (one wonders why they were not in place before) there is a certain bias towards a simplistic view that raising significantly capital requirement will deliver banking stability. Nothing is said about the costs to be borne by real economy (customers and borrowers) which might turn into a hurdle for recovery.
• Still worse, solvency is only approached on a “more regulatory capital” basis, disregarding the fact that the crisis was mainly due to gross failure by banks and regulators to perform a proper risk assessment on trading assets. Would we have avoided the crisis should capital ratio being let’s say 12% or 15%? That’s the key question and the answer is NO, especially if we are illustrated by BIS that many banks run a capital ratio as thin as 0,1% - 0,4% for structured securities in the false believe they could run to the emergency door when needed. The collective rush to that door turned into a deadly trap, showing that most of those products traded between banks like a ping-pong ball lacked an organized market and were illiquid. Such disaster showed that on top of intrinsic risk evaluated by bankers, there was a systemic one that should have been identified by supervisors.
• Moves in the regulatory framework should be made on an extensive basis and yet they need to be coupled with a more active stance by supervisors. Stringent rules might create regulatory arbitrage and prove useless unless buttressed by due monitoring and discretionary action by supervisors. We should avoid regulatory “overshooting” a temptation for supervisors wanting to redress their records now after their failure to act in due time (at least from mid-2007 where odd questions were raised on sub-primes and the use of OTC derivatives linked to CDS). Supervisors witnessed the huge escalation of banking balance-sheets, indebtedness and rocketing trading books, without raising any question. They bear a huge responsibility in the ensuing disaster and yet they seem unaccountable.
• The Report is oddly low-key on banking bail-outs. Talking about moral hazard and the difficulty of a common approach is all too easy. But it skips the real issue: how to address the competition distortions stemming from public funds being channelled to restructure ailing banks while not imposing compensatory measure so that more prudential and cautious banks are not unduly hit. Up to now Commission Communications, as well as practice, have been highly disappointing. Why does it accept that banking bail-outs be coupled with requirements to use public money to conduct normal (“permissive”) lending policy thus putting an onus on non-aided banks? The example of a British subsidiary (Abbey) recapitalised by private funds and having to undergo an unfair competition from hugely supported banks, should make the COM reflect. If it accepts that UK Government imposes a free-ride on lending for the banks it has bailed-out, that would be a serious breach to State aid rules and set a precedent with far reaching consequences on restructuring aid. I wonder if that line of conduct, if verified, could not amount to a failure by the COM to perform its duties with potential extra-contractual responsibilities according to the Treaty. The Report remains silent on this vital Community issue.
• On accounting the Report misses the point by firing at the mark-to-market principle. It should be reminded that only about 1/5 of average banking assets are subject to that principle (banking assets like lending using the traditional way). The problem lies in trading assets and any inner modelling or proxy might turn to be more pro-cyclical than sticking to market prices. Furthermore, moving away from such principle and extending the historical book value method would distort balance-sheets, thus affecting shareholders, investors and creditors, as well as providing an overoptimistic outlook in downturns leading to greater than warranted growth in banking expansion. It might even encroach on fair principle to assess the proper capital requirement.
• Shadow banking, insurance or CDS are treated on the basis of more regulation. That’s helpful but insufficient. A more clear signal should be given to providing a single financial authority the task to monitor all these entities and instruments to avoid inconsistencies in day-to-day practice and redress swiftly any attempt to benefit from regulatory arbitrage and loop-holes. Measures should aim at ring-fencing normal banking or insurance activities from highly volatile businesslike hedging, CDS and other highly structured securities.

Being an individual citizen, putting my case forward might prove of a very limited interest. Therefore I only develop the core issues concerning regulatory overhaul.

On Reforming key issues of current regulatory framework (Chapter II Title III)

a) The Basel 2 framework

Proposals under Recommendation 1 are not fully in line with the real weaknesses that have shaken the financial system. We will review them to support this claim.

Basel 2 amounts to Basel 1 on average capital requirement

As a preliminary remark, it is worthwhile noting that little attention is paid to the fact that Basel 2, for all its merits, was based on a broad understanding to keep unchanged the average capital requirement for banks in relation to Basel 1. The crude calibration factor of 1.06 is there to prove it.

Basel 2 does not address the real problemsin risk exposure

It is true that Basel 2 is less crude than Basel1 in valuating risks. Basel 1 flat 50% risk reduction for mortgage lending was certainly was of the factors that led to drive appetite for high yielding securities to mortgage-backed assets, fuelling the ensuing crisis. But Basel 2 embedded a highly pro-cyclical stance, by mirroring the performance of the last 12 months, giving the wrong impression in the upturn that any increase in lending could be accommodated with ease. This delusion proved fatal when things went wrong.

On top of that, it only dealt with inner risk perception of banks, disregarding the systemic effect of a collective move to get to the emergency door to get rid of securities in-locked in the banking system and lacking an open and broad market to trade them. This was the main cause of the collapse, and little is said about it in the Report.

The real issue is how to value such a systemic risk, a matter to be dealt with by supervisors, as only them are in a position to have an overall picture of a potential systemic-risk spiralling. Basel 2 rules need to address this issue providing extra-powers to supervisors to closely monitor VaR of each individual entity both in terms of its inner risk as well as taking into account its sensitiveness to systemic risk, and to impose a line of conduct for risk assessment if necessary.

IRB approach needs to be coupled with a longer along-the-cycle reference to reduce pro-cyclicality. Special treatment for trading assets should be considered taking into account its potential illiquidity in times of serious instability. Above all, some ring-fencing against reckless investment policies in highly volatile securities lacking a proper market buffer, should be introduced. Delusion on guarantees provided by CDS should be prevented and the corresponding systemic risk should be duly included in VaR.

A more vigilant and pro-active stance by supervisors is vital, as any rule without a watchdog performing its duty turns into mere wishful thinking.

Raising capital requirements should be carefully assessed

While valuing risk is the key issue, the Report supports a flat and supposedly high increase in capital requirement. It is a costly solution for the real economy as such move would entail higher fees and costs for costumers and borrowers. Some claim that raising solvency might reduce the banking indebtedness cost, but this conclusion seem less plausible than a hike in tariffs and more demanding borrowing conditions, thus transferring the cost to others.

Failure by supervisors to curb past problems should not lead to a face-saving regulatory “overshooting”, based on simplistic assumption.The crisis was not fuelled by having less capital than required but by driving recklessly such a risk exposure that dwarfed any capital in place.

Taking into account the crisis lessons, it might be better to draw a distinction between banking and trading activities. The only clear case would be for a rise in capital requirement linked to trading assets and/or a more strict evaluation of the risks associated to these assets.

Reducing pro-cyclicality is welcome

As referred before, Basel 2 provides for a very short reference (12 months) to risk assessment. It provides therefore a too optimistic view on risk in the upturn and this issue should be properly addressed. First of all, VaR should be assessed all along the cycle, taking into account stress conditions.

A longer perspective could be envisaged, like the provisioning mechanism used by the Bank of Spain taking into account the profits and losses made on a 10-year period. But this provisioning could prove less efficient than a proper IRB over the cycle under severely stressed conditions.

Ideas to implement a supplementary “buffer” reserve based on macroeconomic perspectives and fixed discretionary by supervisors, should be regarded with some reluctance, as no one can assure that supervisors are in a position to take swift action before the tide turns. Past experience on discretionary general measures do not warrant such an approach. Problems stem from very specific wrongdoing by individual banks, regardless of the macroeconomic conditions, and redressing such individual conduct should run paramount in supervisory policy.

Reducing systemic risk exposure is a must

But any of these measures would have proved inefficient to curb the crisis. In the absence of mandatory rules to duly take into account the systemic risks of AAA-tagged securities, covered by collaterals and derivatives providing false comfort to holders, any anti-cyclical measure would prove its limits. It is thus essential to avoid systemic risk from building and fostering secondary markets for this kind of asset-backed securities so to provide a market-reference and a better chance to sell them in case of need.

I believe that this issue tackled under 61 of the Report (measuring and limiting liquidity risk) is not duly developed in the Recommendations, given the importance it has, especially in view of its role in triggering the crisis. Neither does it provide a clear signal on ways to tackle this problem. I believe that trading activities should be subject to stringent checks to ensure their risk exposure is duly assessed. The illiquidity problem should also be addressed by curtailing the possibility of a build-up of such assets. A special leverage ratio might be useful and, eventually, higher capital requirement for these balance- sheet items.

The case for a gross leverage ratio

The Report does not take into consideration the potential introduction of a gross leverage ratio thus providing some extra control to avoid excessive build-up of trading books. Some other countries like US have this tool and others like Switzerland has introduced it. While it does not add up any substantial value to a proper IRB exercise and an adequate capital requirement, once VaR is properly assessed, it could prove a helpful instrument for supervisors in curbing excessive balance-sheet growth. Some discussion on this topic would have been welcome in the Report, especially on a special leverage ratio for trading assets referred to core capital.

c) Mark-to-market principle

Much too emphasis is given to the mark-to-market accounting rule. It should be noted that on average it is applied only to one fifth of banks assets. The normal banking book activities (loans and so on) are entered at fair value and their value is subsequently impaired in case of evidence of incurred losses. Only in trading book activities, the principle applied is to value them at the price that could be achieved if sold (mark-to-market or modelling to estimate the equivalent market price if such price is unavailable).

The Report seems to reason as if all operations were entered according to mark-to-market principles and this is clearly misguiding. Furthermore, the proposal to move away from such principles should be taken cautiously. In principle, there is no better way to value a security than its market price. Should proxies be used, undue value could emerge thus providing a false statement of value for shareholders, investors and creditors.

While there may a case for pro-cyclicality in mark-to-market, should historical values be taken as a general rule, except for short-term investments, it could lead to underestimate provisions for losses and increase the capital base of banks thus fuelling unwarranted increase of balance-sheets.

Moving away from mark-to-market principle in the trading book should be avoided, as a general principle. The Report does not consider the mismatch problems that could emerge from deviating from market prices and turning to historical book values inmedium and longterm security investments due to the inherent dangers to underestimate provisions for losses and giving a blurred picture of the banks situation. Regulatory rules might even be impaired by the accounting policy proposed by the Report.

As an ancillary issue, it might be pointed that the proposal to reduce use of ratings in financial regulation might convey the wrong impression that ratings as such are inaccurate, where the real problem lies in an inappropriate use of them. The small letter of such ratings usually warn about its use under strained liquidity situations or severe stress. Internal modelling as a proxy might prove more pro-cyclical and instable that the use of ratings.

d) Insurance

While there is a clear need to address the credit default swaps and monoline activities to avoid collapses like the AIG one, the best way to do it would be to ring-fence and split such activities from the core insurance business.

Failure of AIG was caused by widening of credit spreads which turned its CDS portfolio estimated at 500 billion dollars to a loss making machine. As its credit rate was downgraded this fact triggered a contractual obligation to provide collaterals on call. The inability to find liquidity to meet such calls and the reluctance by other insurance subsidiaries to provide money to the troubled Financial Products branch of the conglomerate, authorities stepped-in to provide 85 billions. But AIG also invested in ABS,raising cash from repo counterparties. When credit conditions worsened the counterparties started unwinding their positions thus leaving a hole of about 60 billion to fill. But at that time there was no market for the ABS and Government footed a 150 billion liquidity bill.

This shows the need to effectively ring-fencing normal insurance business from highly speculative business in CDS, and the best way to do it would be to split-up activities and undertake a thorough monitoring by regulators to avoid unpalatable surprises.

The proposal to “harmonise insurance guarantee schemes” is not developed in the text of the Report. The debate on regulating such products as CDS is welcome and yet it not clear that this should either be possible or effective. We are talking about a huge market (estimated at 60 trillion dollars) which allows banks to hedge risk in long credit positions. It should also be reminded that US withdrew draft legislation to ensure that only parties holding an insurable interest might enter this market.

On the other hand, it is true that CDS are strongly pro-cyclical and can bemuse banks to enter into longer than warranted positions, making them highly vulnerable to a change in market conditions or even rumours. But, it seems more prudent to further pursue examination of this issue without such a clear cut harmonisation proposal. Co-operation with US seems vital on this issue to ensure viability of such activities which bring benefits, if properly used, to reduce risk exposure.