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

1 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

2 insurance activities from highly volatile business like 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 problems in risk exposure

It is true that Basel 2 is less crude than Basel 1 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

3 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.

4 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.

5 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 in medium and long term 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

6 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.

On a banking perspective, the key issue is to avoid a loose risk assessment based on nominal guarantees provided by CDS which in turbulent times can turn into ashes. Thus a more stringent policy in this area is needed to avoid taking at face value guarantees that might be unable to deliver their promises in situations of acute liquidity shortages.

On Closing the gap in regulation a) The “parallel banking system”

Hedge funds have not played a major role in this crisis, even if they have contributed to depress stock exchanges by large selling of its portfolio. They usually have a moderate leverage ratio (2 to 3) and best practices as to their supervision (see UK) should be generalised all over the Community.

Investment banking are currently subject in Europe to the same rules as ordinary retail banking and are usually undertaken by the same conglomerates. US supervision should follow the same pattern.

Special Purpose Companies or Vehicles should not be allowed to be run off- balance of the banking institutions for regulatory purposes.

But the real issue is how to draw the line between shadow banking and other financial institutions. In order to avoid regulatory arbitrage, it might be better to provide for a single regulator, covering also banks, and to develop later on adapted rules for these types of players. Should they come under banking ownership, regulatory requirements should be applied for the whole group. b) Secutirised products and derivatives markets

The problems raised by structured products are dealt with in a rather succinct way in the Report. As such, turning assets into securities is not a bad practice so long these products are traded in open markets and held by investors. The odd thing was they were mainly exchanged between bankers, and no one seemed to care about their systemic risk so long they were tagged as AAA. Capital requirement on these products were extremely thin, notwithstanding the fact that any rush to get to the emergency exit would bust the value of these instruments. The sharp deterioration got worse, as guarantees based on

7 collaterals only work in normal conditions. As the AIG collapse showed, any doubt on the guarantor triggers an increase in the amount of collateral to be provided, a grim prospect in the face of faltering confidence by investors.

The seeds for financial instability were there, driven by extremely pro-cyclical instruments, unduly reflected in risk exposure. The key role played by some outsiders to the banking institutions also escaped any effective check. But the root of the problem was the wrong belief that one could get out of this business before it could collapse, even if there was no open and broad market to get rid of such assets. Banks failed to see this risk but also regulators underestimated the overall risk for the financial system, should rapid unwinding of positions be undertaken by all players at the same time.

Ideas proposed under Recommendation 8 are welcome, even if the size of the market makes it very difficult to introduce some general rules on these products. The setting up of a clearing house for CDS would be helpful as it would contribute to identify net positions in counterparty risks, in order to conduct a proper supervision of risk assessment undertaken by individual banks. The idea of obliging issuers to retain until maturity a sizeable part of secutirised products is also welcome to enhance risk share and confidence.

A special effort should be devoted to bring US to a common position with EU, as any unilateral move might prove detrimental to provide a global solution for such huge markets.

ON A MORE CONSISTENT SET OF RULES (Chapter II Title IV)

While recognizing that some room of manoeuvre should be left for national legislation, a more coherent approach to harmonisation needs to be tackled at European level, even if some issues are dealt in other international fora. Thus Recommendation 10 seems a minimum agenda that might usefully embody some more positive moves towards a higher degree of consistency in Europe, especially taking into account the divergences tabled under 105 of the Report. Surely something more could be envisaged and the COM should examine ways to reduce current divergences. This whole Title of the Report provides a rather disappointing view on the subject.

ON CORPORATE GOVERNANCE (Chapter II Title V)

Recommendation 11 on remuneration policy follows a number of common sense principles which should have been enforced long ago. Nonetheless it might be added that any remuneration system should target to foster proper risk awareness and management.

Recommendation 12 on enhancing risk management function seems vital to reinforce internal control. But stressing reliance on internal risk assessment should not be phrased giving the impression that external ratings should be

8 downgraded as a measuring tool. Internal modelling can deliver less reliable and more pro-cyclical indications as to the real exposure.

ON CRISIS MANAGEMENT (Chapter II Title VI)

As the Governor of the Bank of England has rightly pointed, banking remains global in life and turns national in death. There is thus little hope to see a co- ordinated approach to bail-outs at Community level, especially if they concern public money. While this is true, a more pro-active stance in the Report would have been welcome. There is at least a vital area where the Commission has full powers and a duty to enforce the Treaty principles: competition. State aid rules should be used to avoid huge distortions from emerging when public money is involved. Up to now the Communications by the Commission do not provide enough comfort that even playing field principles are respected.

ON EU SUPERVISORY REPAIR (Chapter III)

While the Report has been widely praised by the financial community for delivering a realistic approach to the co-ordination gap between supervisory authorities, this very praise moves to caution. If EU proves unable to come to a common approach under the current pressure exerted by the crisis, it seems unlikely that it might do it in future. Regardless of the intrinsic merit of a balanced and progressive proposal to move step by step towards a European financial supervisory body, the Report fails to make the case for such a move the sooner the better. While these issues tend to be highly sensitive, maybe a bolder move towards unifying EU supervision might have forced a real debate on that issue. As the proposal stands, it seems unclear it might develop beyond the first stage.

It should be reminded that gross failure by supervisors to address the looming crisis, after the clear signals the markets were giving back in mid-2007, has had a devastating effect. Setting-up of Committees might help but they fail to provide a fully effective answer in addressing supervisory challenges at EU level. Only moving to a single EU supervisory authority does provide such confidence, coupled by a more pro-active rule of national supervisors in day-to- day monitoring.

Cross-border issues need to be tackled even if one doubts, taking into account past record in dealing with home banks, that a host control over operations of Landsbanki in UK would have prevented its collapse.

9 ON THE CAUSES OF THE FINANCIAL CRISIS (Chapter I)

One can broadly agree with the main causes listed in this Chapter. Yet, a more detailed account would have been welcome. Above all, what seems awkward is to reason as if unexpected worsening of macroeconomic conditions had played a leading role in the crisis. On the contrary, this was fuelled by the financial sector reckless appetite for turning into high yield products asset-backed securities in an environment of narrowing spreads that failed to reflect the differing risks of issuers. Bankers acted as bet-makers basing expansion of such products on assumptions such an endless boom in residential and commercial real estate, and stretching their maturity processes beyond any reasonable limit, thus becoming highly vulnerable to a change in conditions.

Supervisors witnessed the explosive increase in banking leverage without taking any measure, even when clear signs of the looming crisis were evident. The ill move by the FED by easing monetary conditions in early 2008 gave the wrong signal that running ahead would dilute the toxic assets problems, instead of addressing it. But it should be reminded that European regulators did little to identify pollution and remove it at due time. The cost would have been at the time extremely lower than the one we face now.

Much emphasis is given to problems stemming in the other side of the Atlantic, especially on current account and public finance imbalances. But it is debatable that as such those imbalances were at the root of the problems. For all their importance, they seem quite moderate if compared with the more than 600 trillions in structured securities and derivatives.

Banking supervision failed in US and yet one has to remind that US banking assets amount to 66% of GDP while in Europe that figure rockets to 145%. Mortgage-backed securities, ABS and CDOs have been widely held by European banks, heavily engaged in wholesale business. Culprits are to be found at both sides of the Atlantic.

Ill risk management is certainly the main clue to the crisis. It derived mainly from lack of oversight on long-term performance, excessive confidence on credit rating from CRA and ignoring that in an inter-banking market any collective rush to the exit door might turn into disaster. The flattened spreads created a huge demand for structured products providing extra yields, disregarding their real value and content. But at the end, it is up to regulators to make sure that individual conducts shape into a coherent system. One wonders if that was the case when banks were allowed to dramatically increase their balance sheets, far beyond what might be reckoned as reasonable by the increase of real economy.

Banks lacked an adequate risk measurement method and supervisors did not react to soaring asset growth, paying too little attention to the systemic dangers in collateralised and structured securities in-locked in the banking community, as well as to OTC derivatives and CDS that provided a false impression of stability, for all their exposure in highly stressed circumstances. Much of the fault lies in the desire not to curtail home bankers from expanding faced with

10 sharp competition from others. Thus regulators were led to more lenient than warranted attitudes and some critical remarks on this issue would have been welcome.

NEED TO ACT NOW

The current acute credit shortages and extremely demanding conditions required to borrowers by banking institutions, needs to be addressed in the short run. Little comfort would be derived from a brand new financial supervision, should lack of credit lead to massive failures fuelling a sharp deterioration in banks risk exposure and fresh needs to resort to taxpayers money to revamp balance sheets. Any delay in acting worsens the overall situation and runs into a scenario where confidence in government ability to face the burden might be put into question in some MS.

The credit crunch is fuelled by the need of banks to trim down assets to accommodate own resources to solvency requirements, no investor being willing to fill the gap. Urgent and co-ordinated action is needed Community-wide to do away with bad assets. Up to now measures to address this issue have been taken on a voluntary basis and failed due to reluctance by banks to show their ailing state and/or transform potential losses into real ones. Governments have been forced to step-in at the last minute, disbursing higher amounts than warranted should the problem had been addressed in due time. From the sub- prime crisis, little has been done to identify toxicity and extirpate it before it damaged other assets and the real economy. Time has come to put an end to this prostration.

Addressing deteriorating banks balance sheet is the only way to rescue the real economy from the credit trap and to ensure that current downturn does not turn into an L shaped laggard European low key recovery. Central Banks should engage in sizeable open market operations to curb long-term interest, help capital markets back to normal and promote fund raising by enterprises. This move would prevent any future crowding-out effect in the credit market when fresh public debt enters into competition with fund raising by enterprises, thus impairing the ability to finance a rapid recovery. Some hints on these issues could have usefully taken into account in the Report, as these concerns are key to pave the way back to normal and allow a more balanced discussion on the future regulatory system. It is up to the Commission to push in filling the gaps.

Madrid, 31 of March, 2009

Juan Pedro Marín Arrese