The Future of Financial Regulation

Howard Davies

The last quarter of 2007 was a very good time not to be a financial regulator. And I suspect that the first quarter of 2008 will not be much easier. The turmoil in global financial markets, which as recently as last July was a cloud no bigger than a man’s hand, has spread from the wilder shores of the subprime mortgage business in trailer parks in central Florida, to the heart of the London interbank market. It is not surprising that US mortgage lenders, and the investment banks who securitised their loans and traded them extensively, have run into problems. But so have German and Geordie banks. What began as a house price correction transmuted into a general widening of spreads on risky assets, then a liquidity squeeze and now looks well on the way to becom- ing a full scale credit crunch. Martin Wolf, Chief Economics Commentator of the Financial Times, has talked of a “revulsion” in capital markets, as investors in all types of asset-backed securities have rushed to the exit. In the central banks it has been all hands to the pump to supply liquidity which the markets themselves are unwilling to provide. They came to the task with varying degrees of enthusiasm. Yet in spite of this massive assistance the crisis seems far from over, and looks highly likely to have a significant impact on the real economy, certainly in the United States, and probably in Europe as well. As a result, politicians and others have raised serious questions about the adequacy of market regulation. Could the crisis not have been pre- vented? Were the regulators asleep at the wheel?—a common cliché which is proudly trotted out by politicians at these times, as if freshly minted.

Sir Howard Davies is Director of the London School of Economics and Political Science. The article is an edited version of the speech he gave at Oxford University on January 15, 2008 at a seminar organised by OXONIA, The Oxford Institute for Economic Policy.

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 11 Howard Davies

In the regulatory bodies themselves, the loudest sound is that of stable doors being slammed shut. But there are also countless reviews under way, both domestically and internationally, to try to understand what went wrong and what might be done to strengthen our defences in the future. In this article I shall try to parse some of the so far rather inchoate criti- cisms of the performance of the regulatory system and to give a prelimi- nary assessment of where there is a case for a change. But first let me provide one simple conclusion from my new book with David Green, who was head of international affairs at the UK’s Financial Services Authority (FSA).1 The global regulatory system is rather complex. Figure 1 shows the heavily simplified version. It has grown up like topsy and committees have proliferated extravagantly. New committees rarely die. That is especially true in the European Union, where it is given to few to understand how things are supposed to work (Figure 2). There is a powerful case for simplification. (How this might be done is described in the book.)

Figure 1: Global committee structure—a regulator’s view

G-7 (Governments) IMF World Bank OECD (Governments) WTO (Governments)

FATF (money laundering) IASB IASC Financial Stability Forum IAASB Monitoring Bank for (Audit) PIOB International Group Settlements (Central banks)

G-10 Basel IOSCO IAIS IFIAR (Central banks) (Banking) (Securities) (Insurance) (Audit)

CGFS CPSS Joint Forum

Source: Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007

1 Global Financial Regulation: The Essential Guide. Howard Davies and David Green. Polity Press, March 2008.

12 WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 The Future of Financial Regulation Audit AURC EGAOB of Audit Regulatory Committee European Group Oversight Bodies European Parliament IWCFC EFCC Financial Committee Committee on Conglomerates Interim Working Conglomerates European Financial CEBS EBC European Commission Supervisors Banking European Committee of Committee European Banking CEIOPS 3L3 Committee EIOPC Pension Supervisors and Occupational Committee of European European Insurance Pensions Committee Insurance and Occupational Council of Ministers (ECOFIN) Banking of the ECB Committee Supervision CoRePer ARC Ambassadors (legislative) Regulatory Committee Accounting EFC ECB ESC CESR European Securities Economic and Committee Supervisors Committee of Financial Committee European Securities Council (legislative) FSC Working Groups Working Committee Financial Services Government level (Finance Ministries and observers from regulatory level) Regulatory level (Competent authorities) Central Bank level Outside Commission Committee framework Figure 2: European committee structure Source: Adapted with permission from a chart originally devised by John Sloan

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 13 Howard Davies

A health warning

Before I begin parsing, I should enter a health warning. It is always dangerous to devise regulatory policy in the midst of a crisis. As I have argued elsewhere, financial regulation in the UK, and indeed elsewhere, can best be explained as a series of Dangerous Dog Acts. Legislation is often con- ceived in haste in response to a particular example of excess. In the United States, the Sarbanes–Oxley Act is clearly in this category.2 It may well have some merits, but almost all observers would acknowledge its inflexibility and unintended consequences. It was certainly legislated in haste and American markets have now been repenting for a while. So it is quite important not to be seduced into new regulations and controls by market panic, controls which might in the long run be very costly and deliver insufficient benefits. But even with that health warning in mind, we must acknowledge that the last six months have raised some interesting and difficult questions for central banks and regulators, whether unified or separated. I identify seven, as follows: Question 1 is about the causes of the crisis. Did the Federal Reserve itself inflate the bubble by pushing interest rates down too far in the aftermath of the collapse of the dot com boom and 9/11? Were other central banks accessories after the fact? Question 2 is, in some ways, more fundamental. Does this crisis show that liberalisation in financial markets has gone too far, and that there are fundamental flaws in what people, especially the French, call the Anglo- Saxon model? Question 3 relates to the origin of the crisis last summer in the US subprime mortgage market. Is there a fatal flaw in that market, which was pos- itively encouraged by the Ancien Régime in the Fed on the essentially political grounds that home ownership was thereby expanded? Question 4 relates to the Credit Ratings Agencies. Did they fall down on the job, and was their failure attributable to fundamental conflicts of interest in their business model which need to be corrected?

2 The Sarbanes–Oxley Act was passed in July 2002 and was a direct reaction by the US Congress to address the accounting scandals of 2001 and early 2002 including the Enron debacle. The Act’s stated purpose is “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes”.

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Question 5 relates to liquidity. Can we be happy that central banks have had to inject liquidity on such a massive scale? Do bank regulators need an entirely different approach to liquidity? Question 6 relates specifically to the UK: Does the Northern Rock problem demonstrate a fundamental flaw in the UK arrangements, whether in the Tripartite system itself or in the separation of banking supervision from the Bank of England? Question 7 relates to global financial regulation, the subject matter of my book with David Green. Does the response to the crisis show that there are gaps in the global regulatory system which need to be filled? Is there a leadership problem within the complex network I illustrated in Figure 1? I shall attempt to answer these seven questions in the remainder of this article.

Q1. Did the Fed cause the problem?

This is the one of my seven questions on which I am proposing to enter an open verdict. My excuse is that it is essentially a macroeconomic question, rather than an issue of financial regulation. It was almost universally acknowledged that the markets were awash with liquidity and that real interest rates were very low, indeed often neg- ative. So credit expanded extravagantly. Were central banks focused on the wrong indicators, fiddling while New York burned? In focusing exclusively on the use of interest rates to target inflation (and stabilize output) are we shifting volatility to other markets? The case for the prosecution has been trenchantly argued by Steve Roach of Morgan Stanley. In a piece in Fortune magazine unambiguously entitled “The Great Failure of Central Banking” he argues that “central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset dependent economy”.3 Roach maintains that “the current financial crisis is a wake up call for modern day central banking” and that “the art and science of central banking is in desperate need of a major overhaul”. His principal concrete recommendation is that monetary authorities need to take the state of asset markets into explicit

3 ‘The Great Failure of Central Banking,’ Stephen Roach. Fortune, August 2007.

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 15 Howard Davies

consideration when framing policy options and that “failure to recognise the interplay between the state of asset markets and the real economy is an egregious error”. This is a powerful critique, and even more powerful today than it was last August. But Roach’s concrete recommendation is one fraught with complexity. Which asset markets? Since CPI measured inflation has remained low, what would a tighter monetary policy in the last few years have meant for the overall price level and for the behaviour of the real economy? These are questions which go well beyond the subject of this article, though I plan to reflect on them further this year as I work on another book about the political economy of central banking. I am quite sure that central banks themselves are thinking hard about the problem, about how they take account of balance sheet issues in setting monetary policy, and about the way in which their financial stability responsibilities interface with monetary policy.

Q2. Is this a broader crisis of Anglo-Saxon capital markets?

The essence of the second question is whether the nature of this crisis reveals fundamental flaws in the Anglo-Saxon capital market structure, based on securitisation, risk transfer and the trading of almost anything. Are we witnessing the twilight of the masters of the universe? It is all over for the originate and distribute markets? Will Hutton is in no doubt.4 He is clear that what we are seeing is “testimony to the exhaustion of the conservative free market world view”. The new interconnectedness of global markets, which has been trum- peted as a success for London in particular, means that the world’s financial authorities have “lost control”. As a result, the US and UK governments “will have to devise new forms of regulation and control”, as yet undefined but clearly draconian. Martin Wolf is not far behind Hutton in his assessment. The credit crunch is, as he sees it, “a huge blow to the credibility of the Anglo-Saxon model of transactions-orientated financial capitalism”. What has gone wrong is an example of both “crony capitalism and gross incompetence”.5

4 ‘The Worst Crisis I’ve Been In 30 Years,’ Will Hutton. Observer, 4 November 2007. 5 ‘The Helicopters Start to Drop Money,’ Martin Wolf, Financial Times, 12 December 2007.

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He notes that the principal argument in favour of securitisation and risk transfer, which has been at the heart of the market dysfunction, is that, as a result, it is possible to shift term-transformation risk to those best able to bear it. But instead, he argues, through securitised investment vehicles and complex credit risk transfers, risk has gone not to those best able to bear it but “to those least able to understand it”. The result is what he terms a “market revulsion”, and a dramatic widening of spreads. The fact that AA asset backed commercial paper moved from 30 basis points above treasuries in the summer of 2007 to 270 basis points above in December suggests a degree of volatility and mispricing which points to serious market malfunction. Is this a commonly held view? Well, commonly perhaps, but not universally. The Financial Times, in a leading article, took a very different line.6 (The Leader conference which preceded it must have been an interesting discussion.) The FT lists all the great benefits which have come from financial liberalisation, which led to “a surge of competition and innovation, cheaper financial intermediation and a more complete and efficient set of markets. Not only has capital been allocated more effi- ciently as a result, but foreign investment has been a channel for the transfer of technology and management skills, and so increased growth”. Even some of the failures have a thick silver lining: “A system of bank rescues in which shareholders lose all their money creates the right incentives” and “subprime mortgages made home ownership possible for hundreds of thousands of people who would otherwise have been tenants”. So there is no case for a dramatic response: “financial regulation, especially on bank liquidity and consumer lending, should be tweaked in response to the credit squeeze. But its liberal direction, which has brought great benefits, must remain”. Who is right, Martin Wolf or his tweaking editor? On the specifics of the subprime mortgage market I believe the Hutton/ Wolf tendency has the better of the argument, but is it indeed a sign of a more fundamental market malfunction? This question is not capable of a definitive answer. It is hard to draw up a balance sheet of the costs and benefits of financial liberalisation.

6 Leading article, Financial Times, 30 December 2007.

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 17 Howard Davies

My own view on the broader issue would tend towards the Financial Times leader. I see nothing sinister in securitisation. It is generally correct to argue, as a matter of principle, that securitisation allows risk to be spread around the market. Indeed it is notable that in spite of the turbulence of the last few months, there have been relatively few failures of banks or other financial institutions. The losses, so far, and they have been considerable, have been widely spread around the market. Hedge Funds, insurers and reinsurers who are active in the securitisation market have in practice acted as shock absorbers, which has been generally beneficial. On the other hand, there is, as Martin Wolf argues, a problem of complexity. Part of the origin of the liquidity crisis is that counterparts are not sure where the risks originating in the subprime mortgage now lie, because of the highly complicated nature of the securitisation process which investment banks have undertaken. So they have been reluctant to lend to anyone. It is in fact a version of the ‘market for lemons’ problem. Alan Greenspan, in a conversation with me at the London School of Economics in October, acknowledged also that securitisation had meant that the crucial link between borrowers and lenders had now been broken. No one was very interested in the quality of the underlying credit, and many market participants relied on ratings almost exclusively. This has turned out to be an unwise approach, as I shall explain in a moment. Now, of course, the holders of these complex instruments are very interested indeed in the dynamics of the underlying credits, but that interest has emerged rather late in the day. What is the appropriate regulatory response? I suggest that in the short to medium term the market will resolve much of the problem itself. There is not likely to be much in the way of new issues of super senior AAA mezzanine tranches of subprime mortgage securitisations driven out of the BBB tranche of the original mortgage pool. Could regulators ban securitisation or make it so costly in terms of its capital treatment that the market dried up? This would, I believe, be an overreaction and would be costly for many ultimate borrowers, with adverse consequences for the real economy. This is not to say that nothing should be done. Fundamental reforms in the US mortgage market are necessary, and there are clearly issues in relation to rating agencies. I suggest, too, that the accounting and regulatory treatment of liquidity and of off balance sheet vehicles needs to be

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readdressed. (Basel 2 should help here.)7 The International Accounting Standards Board (IASB) will soon be making proposals on the first point. But the cost of reintermediating all these securitised risks would be very high, and I do not believe it would be justified. So on this broad question my overall view is that it has been a very embarrassing episode, especially for investment banks and rating agencies, but though there is more trouble to come I suspect it is not the beginning of the end of Anglo–American capital markets. Will Hutton will have to wait a little longer for this con- summation for which he so devoutly wishes. The short-term economic consequences may be severe, however, as Kenneth Rogoff and Carmen Reinhart argued at the recent American Economic Association conference in New Orleans.8 Comparable past episodes have resulted in a significant contraction of GDP. That may now be happening in the US.

Q3. Is there a fundamental problem in the subprime mortgage market in the United States?

It is generally acknowledged that the origin of the crisis lies in the subprime mortgage market. Clearly there are other dimensions, and perhaps more fundamentally one might say that the underlying problem was one of a general mispricing of risk. Indeed Alan Greenspan pointed to this phenomenon, and the risks of unwinding, in his final Jackson Hole speech in 2005, when he said that history had not dealt kindly with the aftermath of periods of severe narrowing of spreads and mispricing of credit risk.9 But what about the subprime market itself? The market grew, very rapidly, in the early years of this century (see Figure 3). In 2001, subprime mortgages represented only 7½ percent of the total of mortgage origination in the US. By 2006, subprime mortgages

7 The original Basel Accord was agreed in 1988 by the Basel Committee on Banking Supervision to help strengthen the soundness and stability of the international banking system as a result of the higher capital ratios that it required. Basel 2, initially published in June 2004, is a revision of the existing framework, which aims to make it more risk sensitive and representative of modern banks’ risk management practices. Its purpose is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks they face. Advocates of Basel 2 believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. 8 ‘Is the 2007 Sub-Prime Financial Crisis So Different? An International Historic Companion,’ Carmen Reinhart and Kenneth Rogoff, AEA Conference, January 2007. 9 ‘Reflections on Central Banking,’ Alan Greenspan, Jackson Hole Conference, August 2005.

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 19 Howard Davies

Figure 3: Mortgage origination by product (%)

100

60 Prime % 50 Subprime 40 Alt-A 30

0 2001 2002 2003 2004 2005 2006 9m 2007

Notes: 1. Total mortgage origination excludes seconds and home equity lines of credit. 2. For relative growth versus 2001, 2007 annualized based on 9 months of data.

accounted for 23% of the total. In the subprime sector credit quality is low, leverage is high and documentation is very modest. Most borrowers certify their own income, etc. It is quite clear from these figures that the nature of the subprime market changed during that period. Lenders were drawing into house pur- chase many borrowers who would not have been considered for a mortgage earlier. (If you want a good explanation of the way the American housing market works, go to see Glengarry Glen Ross on Shaftesbury Avenue—a play by David Mamet, in which estate agents in Florida sell plots in swamps to people they meet by chance in Chinese restaurants.) Also, during this period, it became clear that the original credit quality of the borrower was of little or no interest. As house prices rose, loans were simply refinanced when the borrower could not pay. Indeed, in many cases it seems that borrowers borrowed significantly more than the value of the house in order to make the first few payments, long enough for the lending bank to securitise the mortgage while it was still being serviced. In retrospect, one can see that this was a classic bubble, fuelled by irra- tional exuberance and a dose or two of fraud.

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Where did it all go wrong? Well, in the first place, house prices began to fall in the Autumn of 2005 (Figure 4). And this fall, even though modest at first, was sufficient to create a serious problem, since refinancing was the route out of trouble for most distressed borrowers, and that was no longer possible in a falling market. The other point that is important to understand is the nature of the securitisation. Typically, mortgage pools were divided into separate tranches with ratings from triple A to equity (see Figure 5). Principal repayments were made from the triple A tranche downwards, while the losses proceed from the equity tranche upwards. The equity tranche bears the first 7% or so of the losses, whichever 7% of the mortgages in the pool turn out to default. More significantly, though, CDOs were generated from the Triple B tranche, with the underlying vol- umes multiplied 30 or so times. And some of these mezzanine CDOs, as they are known, are further divided into super senior tranches rated triple A and the rest. But in fact the so-called super senior tranches begin to lose capital value when default rates, or projected default rates, exceed 9% or so (see Figure 6).

Figure 4: Historical US home prices

S&P/Case-Shiller Composite-10 Home Price Index (1991–2007) 250

200

150

Index value 100

0 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Source: Standards and Poor’s

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 21 Howard Davies

Figure 5: Subprime mortgage pool securitization

Capital structure containing subprime loans Principal 100% Losses payments Mortgage pool Principal losses are payments are allocated made sequentially sequentially from from the top of the the bottom of the capital structure capital structure to the bottom to the top AAA

28% AA 20% A 11% BBB 7% Residual/Equity 0%

Note: Ratings are Rating Agency defined

How do we know what the default rates on these recent mortgage pools will be? We do not know with any accuracy, but an estimate can be devised from the percentage of loans which are delinquent, in other words where interest payments are more than two months late. The escalation of those delinquencies rates for the more recent mortgage pools is dramatic, and shows no signs of levelling off. That is not wholly surprising given the resets, in other words the number of loans which are what we would call low start mortgages, with interest rates discounted for the first 12 months, but where the monthly payments may almost double at the moment of the reset. The best proxy for the value of these bonds is something called the ABX index, which fell from 100 cents in the dollar in January last year to around 30 cents in December (Figure 7). In other words the triple B tranches lost around 70% of their value during the year, and some of those losses occurred in CDOs rated triple A. This is what we regulators used to call, in technical lan- guage, a complete shambles.

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Figure 6: ABS CDO securitization

Capital structure containing Subprime mezzanine CDO subprime loans containing BBB subprime bonds

100% 11% 100%

Super senior

AAA

Cumulative AAA losses

8.6% 40% AAA 28% AA AA 20% A A 11% 11% BBB 7% BBB 7% Residual/Equity Equity 0% 7% 0%

Figure 7: Recent ABX BBB price history (2007)

120 2H 05 BBB 1H 06 BBB 100 2H 06 BBB 1H 07 BBB 80

60 Price

0 19 Jan 16 Feb 19 Mar 16 Apr 14 May 13 Jun 12 Jul 9 Aug 7 Sep 5 Oct 5 Nov 5 Dec

Source: Markit Partners Note: ABX BBB – Standardised basket of 20 home equity; ABS reference loans from home equity deals (issued within 6 months prior to index issue date)

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 23 Howard Davies

Underlying this market is, of course, a lot of human misery, with many dispossessed families now homeless. But it may be argued that there are nonetheless more people with homes, who have benefited from rapid house price escalation over the last 6 or 7 years. Indeed, Alan Greenspan in his book argues that the social benefit of this market place is net positive.10 He maintains that the expansion of home owning democracy was a very positive political development in the United States. He does not think, therefore, that regulatory intervention would have been appropriate or justified. Not surprisingly, perhaps, Paul Krugman takes a very different view. He points out that home ownership rates have now fallen back to where they were in the middle of 2003 and that they may well fall back below where they were at the beginning of the Bush presidency as a result of this dramatic market unwinding. He sees this as a classic case of over reliance on market disciplines which prove to be fundamentally flawed.11 Indeed, he says, “it is hard to imagine a more graphic demonstration of what is wrong with the Republicans’ economic beliefs”. And the critics are not just oper- ating with the benefit of hindsight. Ned Gramlich, a former Fed governor who died recently, made all these points over 3 years ago.12 The Federal Reserve has now decided on a significant restructuring of mortgage regulation in the United States.13 They have proposed changes which would outlaw no documentation or low documentation mortgages and would require more explicit disclosure of teaser rates and the effect on repayments when those rates are reset. Most of their proposals would work on the lenders rather than the brokers and have been described by the Chairman of the Senate Banking Committee, Chris Dodd, as “deeply dis- appointing”.14 It is possible that Congress will legislate something more restrictive and which bites more directly on the broking community. This is an extremely difficult area, but it is hard to avoid the conclusion that the US would benefit from the imposition of a regime of mortgage broker regulation such as the one introduced in the UK about 3 years ago. On the whole the market has welcomed that regime, which has tightened

10 The Age of Turbulence: Adventures in a New World. Alan Greenspan. Penguin Press, 2007. 11 ‘A Catastrophe Foretold,’ Paul Krugman, New York Times, 26 October 2007. 12 ‘Subprime Mortgage Lending: Benefits, Costs and Challenges,’ Edward Gramlich. Financial Services Roundtable Annual Housing Policy Meeting, Chicago, 21 May 2007. 13 ‘Proposed Changes to Regulation Z,’ Federal Reserve, 18 December 2007. 14 Statement by Sen. Christopher Dodd, 18 December 2007.

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up lending practices and improved ethical standards among brokers. So in this area I answer firmly yes to the question of whether regulatory changes are required.

Q4. Is there a fundamental problem with the ratings agencies?

The fourth area of concern is the ratings agencies. The very rapid down- grading of securities rated triple A has focused attention very sharply onto their procedures. Indeed it has become open season on the rating agencies and all their works. One of the sharpest shooters has been Willem Buiter, Professor of European Political Economy at the LSE. He argued in front of the Treasury Select Committee that there are fundamental problems in the business model of the ratings agencies who are paid by the issuers of the securities they rate. In Willem Buiter’s view that practice should stop. The ratings agencies should sell nothing but ratings and the critical role of the rating agencies in Basel 2 should be abandoned.15 Buiter’s analysis of the potential conflict of interest which rating agencies face is clearly correct. Issuers have an incentive to achieve the highest possible rating, to maximise their chances of getting the security away at a good price. But what is the alternative? If agencies are paid by investors in securities, there is a similar but opposite potential conflict in that investors have an incentive to see a lower rating, so that they pay a low price and secure a high yield. It is also technically rather difficult to see how investors, especially secondary investors, can be made to pay for ratings, without regulatory intervention of some kind. And regulatory intervention of that sort may imply greater official sanction for ratings that is justified. So I suspect that, while there is a potential conflict, it must be managed, just as conflicts of interest within banks or investment banks must be managed. But whether or not the rating agencies have been managing these conflicts well, they have clearly not convinced the market that they do so. Many believe that agencies have been prepared to negotiate ratings with issuers of securities in a process of iteration, where the agencies explain what is needed in terms of adjustments to the structure of securitisation to achieve its desired double or triple A status. Of course it makes no sense

15 ‘Basel 2 Back to the Drawing Board,’ Professor Willem Buiter, LSE. Maverecon.blogspot.com

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 25 Howard Davies to prevent agencies from holding discussions with clients, but they must be within a transparent framework. Furthermore, there need to be checks and balances in place within the agencies, perhaps with some regulatory oversight, to ensure that ratings are objective, that rating agency staff are not remunerated in relation to the profitability of the enterprise, or in relation to the number of ratings they deliver. The broader issues, and in the long term the more important ones, relate to the way in which ratings are used by investors, and indeed to the regulatory status of both the agencies and their ratings. On the first point, it would seem that many investors have substituted ratings for thought. They appear to have taken little interest in the behaviour of the underlying credits, and simply invested on the basis of the rating. I suspect that the dramatic losses suffered in the CDO market will change that behaviour. There is also a specific problem in the way ratings are used in the securitisation market which needs to be addressed. The agencies may well argue, as indeed they do, that such statistical evidence as they had about the behaviour of these credits suggested that the ratings they gave them were equivalent to those which they gave comparable plain vanilla corporate debt. But it is equally clear that in turbulent markets they can behave very differently, and the default rate on securitisations graded AAA in conditions of liquidity stress has been dramatically different. The agencies need to consider whether the same ratings scale is appropriate for these instruments, or whether a separate scale, or some kind of “starred” arrangement indicating that the securities may behave differently in certain circumstances, ought to be adopted. This would in turn facilitate a better understanding in the market place of the nature of the risks investors take on when they invest in these structured products. This could be the response to one of a number of recommendations which the Bank of England made last year (Box 1). The others are worth considering, too. As for the regulatory environment surrounding ratings agencies, they are registered in the United States, and indeed last year a new Act was put in place which gave the Securities and Exchange Commission (SEC) a greater oversight role. There is no similar regime in the European Union, though under pressure from the European Parliament regulators and the Commission are investigating whether a similar regime should be introduced in the UK. There is significant political pressure to do so.

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BOX 1 Bank of England’s suggestions for improvement in what ratings agencies report

1. Agencies could publish the expected loss distributions of structured products, to illustrate the tail risks around them 2. Agencies could provide a summary of the information provided by originators of structured products • Information on originators’ and arrangers’ retained economic interest 3. Agencies could produce explicit probability ranges for their scores on probability of default 4. Agencies could adopt the same scoring definitions 5. Rating agencies could score instruments on dimensions other than credit risk • E.g. market liquidity, rating stability over time or certainty with which a rating is made.

Source: Financial Stability Report October 2007, “Role of Ratings Agencies”

My own preference, and here I entirely share Willem Buiter’s views, is for less regulatory oversight of agencies, and therefore less apparent sanc- tification of their product. I believe that is preferable to more regulation. I agree with Jan Kranen, the Director of the Centre for Financial Studies in Frankfurt, who argues that “the rating agencies should be kept out of regulatory reach, as rules and standardisation will almost surely diminish the value added by the use of agency ratings”.16 It is also arguable that the SEC regime has had the effect of raising the barrier to new entrants. Ratings are a useful market indicator, but no more than that. And I believe that, particularly in the light of recent market events, banking regulators would be very wise to review the use they propose to make of them under Basel 2.

16 ‘Securitisation Crisis: How the Credit Market Teaches Us A Lesson,’ Jan-Peter Kranen, CFS Bulletin 2/07, Frankfurt.

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Q5. Do we need a new approach to liquidity?

The fifth area is the regulation of liquidity. Evidently the biggest surprise to market participants and indeed to regulators in this crisis has been the rapid and indiscriminate seizing up of the interbank market, and more particularly the securitisation market. It was a failure to achieve a new securitisation of its mortgage book that drove Northern Rock into the arms of the Old Lady. It is now generally accepted that regulators need to revise their approach to bank liquidity. Indeed the FSA has already published a discussion paper incorporating some new proposals.17 But is it enough for one regulator in one country to revise its procedures or is a new global understanding required? And in the light of what we have learned in recent months, is it right to think about a regulatory approach to liquidity without considering the role of the central banks in the provision of liquidity in crisis conditions? My answers to both these questions are no. One obvious lesson of this crisis is that financial markets are more interconnected than ever before, giving added weight to the significance of globally agreed standards of financial regulation. It seems clear to me, and indeed this is a conclusion of the forthcoming book to which I referred, that central standard setters, whether the Basel Committee, the International Organization of Securities Commissions (IOSCO), or whatever, need strengthening. And the need to consider central bank behaviour and its impact on the banking system as a whole, has been powerfully made in a new paper on liquidity risk management by my colleague at the LSE, Professor Charles Goodhart.18 Goodhart refers to Tim Congdon’s observation that in the 1950s liquid assets were typically 30% of British clearing banks’ total assets, largely Treasury bills and short dated government debt. At present these cash holdings are about half a percent and liquid assets about 1% of total liabilities. Goodhart argues that “the banks have been taking out a liquidity put on the central bank; they are in effect putting the downside of liquidity risk to the central bank”. He therefore argues that “what is surely needed now is a calm and comprehensive review of what the

17 Review of the Liquidity Requirements for Banks and Building Societies. DP07/7. Financial Services Authority, December 2007. 18 ‘Liquidity Risk Management,’ Charles Goodhart, Special Paper 175, LSE Financial Markets Group, October 2007.

28 WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 The Future of Financial Regulation principles of bank liquidity management should be” carried out by the Basel Committee. And this needs to be done taking account of the behaviour of central banks, including the type of collateral which the central bank may accept in the provision of emergency liquidity. Recently central banks have altered their practices very considerably. Would they be prepared to do so again? That could be dangerous. Again quoting Charles Goodhart: “if commercial banks can always rely on the central bank, they will undertake maximum maturity transformation in order to take advan- tage of all liquidity premia and the normally upward sloping yield curves”. So we need a strategy to get out of the current position. Part of it may involve greater consistency among central banks. In recent months banks have been put in very different positions depending on the jurisdictions in which they operate. Liquidity was more easily available within the Eurozone than outside it. We also need to think about what might be an appropriate extent of maturity transformation by commercial banks. This is very difficult territory, and of course we need to acknowledge that tight- ening up on maturity transformation in commercial banks, and requiring them to hold more liquid assets themselves, could be very costly for borrowers. What we know, however, is that we must try to avoid a repetition of the events of the last few months, which cannot be allowed to be a reg- ular feature of the global banking system.

Q6. Is the UK’s regulatory system fundamentally flawed?

For my sixth and penultimate question I turn to the issue of the UK arrangements, and particularly the Tripartite arrangement between the Treasury, the Bank of England and the FSA. Has the crisis demonstrated a fundamental flaw? You might expect me, as one of the authors of the Tripartite agreement in 1997, to be predisposed to defend it. And so I do. I have been puzzled by the certainty by those who immediately rushed to judgment and found it wanting in the light of the problems surrounding Northern Rock. We have a tendency in this country to jump to conclusions about structures, rather than to acknowledge the difficulty of the decisions faced by the authorities in a case such as this and the possibility that, whatever the structure, decisions may have been taken which, in hindsight, do not look optimal.

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 29 Howard Davies

We should recall, first, that the UK structure of responsibilities is not so unusual in an international context. In the first place, in any country with an independent central bank there are bound to be two authorities involved in the provision of liquidity support to a troubled institution, the central bank and the Ministry of Finance, certainly in all cases where that liquidity support is of such a scale and such a duration, that we cannot be certain that it may not turn into solvency support in due course. It is possible to simplify responsibilities in the way some critics would like by putting the Ministry of Finance and the central bank together, or submitting the central bank entirely to political will. That is the case in, for example, Cuba, Zimbabwe and North Korea. We may safely reject that option. So we are stuck with at least two cooks. Then there is the separate question of whether the supervisor should be in the central bank. Internationally, 39 countries now have sin- gle regulators outside the central bank (Figure 8). And in over 50 countries banking supervision is not now carried out by the central bank. This is a very common arrangement today, and is seen for example in Scandinavia,

Figure 8: Non-central bank unified financial regulators

40 39 38 35 35 32 30 30

23 22 20 20 19 15 16 15 15

10 10

5 4 0 1980 1990 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Source: How Countries Supervise their Banks, Insurers and Securities Markets 2007: Central Bank Publications

30 WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 The Future of Financial Regulation

Canada and Australia (Figure 9). The difference in the UK is Figure 9: Central banks in regulation that the responsibilities of the Central Bank three agencies are set out as banking Central Bank supervisor with no direct only clearly in a published memo- 54 50 supervision responsibilities randum. I would regard this as generally a positive step in 10 29 terms of clarity and accounta- Central Bank as bility. Parliament can ask for unified regulator Central Bank with banking the views of the different agen- and other responsibilities Source: How Countries Supervise their Banks, Insurers and Securities Markets cies and hold them to account. 2007: Central Bank Publications We should also recall the three principal reasons for sep- arating supervision from the central bank, and ask how they look in the present context. The first and strongest argument was that in complex financial markets it is important to have a supervisor who can see what is going on across the different sub-sectors of the financial system. One powerful reason for that is that risks may now originate in the banking system but be transferred through securities markets to other institutions and back again. In present circumstances the argument for unified regulation looks to me to be stronger than ever, and it is absolutely clear that one cannot understand what is happening in the banking system without looking at securitisation and the transfer of risk through traded markets. So it would be a very curi- ous moment to wish to dismantle the integrated regulation carried out by the FSA. The second argument was that the supervisor’s view on the need to provide support for an institution may differ from that of the central bank as lender of last resort. The supervisor might be disposed to argue the case for support more forcefully. Where supervision is merely a division of the central bank, the central bank will inevitably have only one public view and we would not know whether the supervisors were arguing for support. That was the case before 1997. A third argument, which at first blush appears to contradict the second, but which is in fact complementary to it, is that where the lender of last resort is also the supervisor it may be more inclined to provide support for a troubled institution, perhaps in order to conceal the inadequacies of its

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 31 Howard Davies

earlier supervision of that firm. There are those who would argue we have seen examples of this phenomenon in the UK in the past. Of course, at present the focus is all on whether support was provided too late, and perhaps in a technically flawed way, but we must recall that in the past there were other opposite concerns. In the case of Johnson Matthey Bank, the issue was whether the Bank of England should have supported it at all, and what signals were sent to banks about their risk management as a result. In thinking about our regulatory structures we must bear in mind the possibility of pressures in both directions. So I cannot see that what has happened provides a strong argument for fundamental revision of the 1997 arrangements. It has not been argued persuasively by anyone, and certainly not supported by the authorities themselves, that there was a failure of communication in the sense of a lack of understanding by the three parties of what the position of Northern Rock was. Of course there are question marks about the judgments made, whether by the FSA as a supervisor (and the Authority is carrying out a review of its past supervision of Northern Rock) about the way the Bank of England provided support and when it did so, and about the timing of the Treasury’s deposit guarantee. But these are, to repeat, issues of judgment which need to be made in any structural arrangement. So I was pleased to read Alistair Darling’s remarks to the Financial Times, in which he rejected further fundamental reform.19 It may indeed be help- ful to relook at the precise terms of the MOU, and to emphasise the pri- macy of the Treasury’s responsibilities for reaching decisions on the provision of support. When originally drafted, the concern was that the Bank of England might be disposed to provide support too easily, and therefore the drafting provided for the Treasury to be able to refuse the possibility of support, rather than to originate it. Now we can see the opposite concern, there is a case for more symmetrical treatment. If there are to be new powers for the authorities to intervene in a failing bank, then it looks appropriate for those powers to be exercised by the supervisor. But careful thought needs to be given to the incentives generated if the FSA can intervene and cut across shareholder rights. If they can, there is a risk that banks may therefore seek to protect themselves by

19 Interview in the Financial Times with UK Chancellor, Alistair Darling. 7 January 2008.

32 WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 The Future of Financial Regulation retaining much larger capital cushions—good for stability but expensive for customers. We must be careful not to promote reckless prudence.

Q7. Does the crisis reveal flaws in the international regulatory system?

My seventh and last question is whether the financial crisis of 2007–2008 reveals significant flaws in the international regulatory system. Here my answer is yes, but the operative word is “reveal”, as I believe these flaws have been present for some time. The question which many have asked domestically—who is in charge?—is even more apposite at the global level. In one sense, of course, the answer is clear. Returning to my earlier wiring diagram (Figure 1) you can see that the G7 Finance Ministers sit at the apex. But the G7 Finance Ministers do not have a usable mechanism to coordinate their responses to problems. The IMF and the World Bank dance to their own tunes. The central banks get together in the G10 at Basel. The banking supervisors (some of them central bankers, some not) meet in the Basel Committee, while securities regulators get together in IOSCO—though the growing importance of the European Securities Regulators Committee (CESR) should not be underestimated. All of these groups are, in their different ways, now addressing different elements of the market malfunctions which have emerged. The obvious body to coordinate all of this activity is the Financial Stability Forum. But, as its name implies, it is an informal body with no powers of its own, and indeed only a small staff. The Forum works almost exclusively through the other bodies which are part of it. My own view, and I believed this before the latest turmoil, is that the Forum, which was put together following an initiative by Gordon Brown after the Asian financial crisis at the end of the 1990s, should be significantly strengthened. It should be renamed the Financial Stability Council and allowed to take much more of a leading role in responding to market problems, especially where they involve central banks in their lender of last resort capacity, banking regulators and securities regulators—and where Finance Ministries which are also members of the Forum, must be part of the story given the possibility of taxpayer backed support. This is not, perhaps, the only change required and a stronger coordinating

WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008 33 Howard Davies mechanism would not in itself solve problems, but it would create a focal point for regulatory bodies to pool their intelligence and determine a coor- dinated response. Even the awareness that such an organisation existed with the capacity to coordinate action would be reassuring to market participants.

Conclusion

Even the seven questions I have addressed—you might think seven is quite enough—cannot hope to cover all the implications of what has been, as they say on Test Match Special, a remarkable passage of play in financial markets. Indeed my focus on financial regulation has left largely out of account probably the most important lessons, which are for financial institutions themselves. Very large losses have been made by German state- owned banks, and by Swiss and US investment banks. There are almost certainly more losses to come, both there and in other firms whose accounting and reporting is less timely and less complete. For a period at least these firms will be very reluctant to be engaged in the types of structures and securitised deals which have been at the heart of the problem. But the half-life of lessons from financial crises is short. Generations change on the trading floors and in the corner offices and, before you know it, a new bubble is being enthusiastically inflated. That is why it is important for regulators, in their continuing supervision of firms, to drive the messages home and continue to do so even when the immediate danger has passed. So, while I do not share the Hutton view that the concrete canyons of Canary Wharf and Wall Street will soon be empty, with only the occasional Will Smith character with a gun and a dog roaming deserted streets, I nonetheless think we have seen a vivid demonstration of the importance of a robust regulatory framework surrounding capital markets. I hope, therefore, that we hear less from politicians in future of the content-free rhetoric about ‘light touch’ regulation, whose meaning has never been clear to me, but which made life harder when I lay on the FSA’s bed of nails.

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