STUDY Policy Department Economic and Scientific Policy Financial Supervision and Crisis Management in the EU (IP/A/ECON/IC/2007-069) IP/A/ECON/ST/2007-26 PE 400.992 JANUARY 2004 This study was requested by the European Parliament's Committee on Economic and Monetary Affairs Only published in English. Authors: Prof. Kern Alexander Prof. John Eatwell Prof. Avinash Persaud Mr. Robert Reoch Reoch Credit Partners LLP. Queens’ College, Cambridge, CB3 9ET UK Administrator Responsible: Josina Kamerling and Stéphanie Honnefelder Policy Department Economy and Science DG Internal Policies European Parliament Rue Wiertz 60 - ATR 00L044 B-1047 Brussels Tel: +32-2-28 31413 Fax: +32-2-28 46 929 E-mail: [email protected] Manuscript completed in December 2007 The opinions expressed in this document do not necessarily represent the official position of the European Parliament. Reproduction and translation for non-commercial purposes are authorised provided the source is acknowledged and the publisher is given prior notice and receives a copy. E-mail: [email protected]. IP/A/ECON/ST/2007-26 Page i PE400.992 TABLE OF CONTENTS EXECUTIVE SUMMARY .....................................................................................................................v INTRODUCTION....................................................................................................................................1 1.2 Externalities and the macroeconomics of systemic risk .............................................................3 1.3 The analytical framework .............................................................................................................3 1.31 Homogeneity.............................................................................................................................3 1.32 Regulation and homogeneity...................................................................................................5 1.33 Strategic behaviour..................................................................................................................7 2. THE NATURE OF MODERN CREDIT MARKETS AND THE ORIGINATE, RATE AND RELOCATE MODEL OF MODERN BANKING .....................................................................8 2.1 Bank motivation.............................................................................................................................8 2.2 Fixed income investors ..................................................................................................................9 3. FINANCIAL INNOVATION: AN ANATOMY OF CREDIT DERIVATIVES, SIVs AND CDOs .............................................................................................................................................10 3.1 Credit derivatives.........................................................................................................................10 3.2 Structured investment vehicles (SIVs).......................................................................................10 3.21 Commercial paper .................................................................................................................11 3.22 Managing SIV risks ...............................................................................................................11 3.3 Collateralised debt obligations (CDOs.......................................................................................12 3.31 The Structure and Characteristics of CDOs .......................................................................12 3.4 Market Participants.....................................................................................................................13 3.5 Arranger Rationale for the creation of CDOs...........................................................................14 3.52 Regulatory Capital Management .........................................................................................15 3.53 Economic Capital Management............................................................................................15 3.54 Risk management...................................................................................................................15 3.55 Cost Considerations...............................................................................................................16 3.6 Investor Rationale........................................................................................................................16 3.7 CDO Valuations ...........................................................................................................................17 3.71 Hedging CDO investments....................................................................................................17 3.8 The role of the Rating Agencies..................................................................................................18 4. THE NEW BANKING MODEL: ORIGINATE, RATE AND RELOCATE ..............................20 4.1 Risk traders versus risk absorbers.............................................................................................22 IP/A/ECON/ST/2007-26 Page ii PE400.992 4.2 Risk sensitive models and liquidity ............................................................................................22 4.21 Risk models and strategic behaviour ...................................................................................23 4.3 Liquidity........................................................................................................................................25 5. THE EVENTS OF 2007.....................................................................................................................28 5.1 Sub-prime mortgages...................................................................................................................28 5.11 Recovery of losses by the mortgage servicer .......................................................................28 5.12 Underwriting ..........................................................................................................................29 5.13 Investor impact.......................................................................................................................29 5.2 Impact on the banks.....................................................................................................................31 5.21 Warehousing of assets for CDOs..........................................................................................31 5.22 A fall in value for unsold positions.......................................................................................32 5.23 Bringing risk back on balance sheet.....................................................................................32 5.24 Accounting changes ...............................................................................................................33 5.3 An on-going liquidity and credit crisis.......................................................................................33 6. FINANCIAL REGULATION AND CRISIS MANAGEMENT IN THE EU..............................34 6.1 European financial integration...................................................................................................34 6.2 Legal and Institutional Framework ...........................................................................................35 6.21 The Lamfalussy Process and Institutional Consolidation..................................................37 6.22 The EU and Basel 2................................................................................................................40 6.3 Enhancing financial crisis management ....................................................................................41 6.31 The role of the ECB in crisis management ..........................................................................42 6.32 The ECB/ESCB and accountability .....................................................................................44 6.33 EU crisis management and the lender of last resort...........................................................45 6.34 Recent developments .............................................................................................................47 7. SOME LESSONS...............................................................................................................................49 7.1 Lender of last resort and the supervision of systemic risks .....................................................49 7.11 A legal device to enable banks to be taken into public administration.............................50 7.2 Credit rating agencies..................................................................................................................51 7.21 Standardised nomenclature for credit ratings ....................................................................52 7.22 A new SRO to monitor the ratings industry........................................................................52 7.3 Banking regulation ......................................................................................................................53 7.3 Banking regulation ......................................................................................................................53 7.31 Contra-cyclical capital charges.............................................................................................53 IP/A/ECON/ST/2007-26 Page iii PE400.992 7.32 Common stress tests...............................................................................................................54