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Unformatted text preview: The International Financial Crisis: its causes and what to do about it? Liberals and Democrats Workshop, February 27th, 2008 ALDE 2007-2008 Table of Contents Introduction by Wolf Klinz MEP 5 9 Speeches by Graham Watson MEP by Charlie McCreevy MEP by Daniel Dăianu MEP Panel 1 Panel 2 Conclusions by Wolf Klinz MEP 27 43 65 71 105 Background paper by Daniel Daianu MEP Speakers professional biographies 3 2007-2008 ALDE ALDE 2007-2008 Introduction by Wolf Klinz MEP 4 5 2007-2008 ALDE ALDE 2007-2008 Several months after the sub-prime crisis has started to unfold in the USA, it has become clear that the effects are spreading across other asset markets. Despite the various measures by the US government, a recession in the USA seems imminent, possibly causing a global credit crunch and an economic downturn in major parts of the world. Increased innovation in structured finance products, willingness by lenders to take excessive risks, low interest rates and the greed of investors for ever higher yields coupled with their belief that Credit Rating Agencies’ ratings come close to recommendations, allowed complex investment products to be sold to an extremely wide range of investors. The repackaging of credits, the increased complexity of the products, and the lengthened intermediation chain including off-balance Special Purpose Vehicles (SPV) - that are not being regulated - make it more difficult, sometimes even impossible, to clearly evaluate the nature and magnitude of the risk involved and identify those who bear it. Any measures should ensure that the stability in the future is increased, without having a negative impact on the progress that has been achieved over the past years. These measures would have to address the issues of transparency, conflict of interest among market participants, regulatory and supervisory systems, in particular their cooperation. Due to the global aspect of the crisis, the measures to be taken will only be successful if the key players of the world’s financial markets are willing to work closely together. Thus the ALDE Group in the European Parliament has organised a Workshop on “The International Financial Crisis: Its Causes and what to do about it” on 27 February 2008, in order to discuss the recent evolutions of the financial crisis, the underlying causes and possible ways to address the situation in a timely and topical manner. A variety of high-level speakers and key market players attended the Workshop. This brochure will provide you with an overview of the discussions and conclusions reached during the Seminar. I want to thank Delphine Descamps Ricci for her help in organising the workshop and my fellow MEP Sharon Bowles for chairing the discussion rounds. Wolf Klinz ALDE Coordinator in the Economic and Monetary Affairs Committee 6 7 2007-2008 ALDE ALDE 2007-2008 Speeches by Graham Watson MEP by Charlie McCreevy - Commissioner for the Internal Market and Services, European Commission by Daniel Dăianu MEP 8 9 2007-2008 ALDE ALDE 2007-2008 Opening remarks by Graham Watson, leader of the ALDE Group, European Parliament “They say good judgement comes from experience and experience comes from bad judgement. Yet Europe failed to learn its lessons from the LTCM collapse, the Dot-Com bust or indeed Enron’s accounting debacle and is now suffering the consequences of a crisis in our financial markets which could be more widespread, more profound, and more long-lived than anything we have had to cope with in recent memory. Attached to the myth that the “market would sort itself out in the end” Europe’s financial chiefs ignored the fatal combination of reckless lending low, interest rates and obscure financial engineering. That helped generate those former crises. Believing, wrongly, that these could be contained on the other side of the Atlantic and failed to reform the regulatory system as such, a combination of cyclical and structural factors which have grown unchecked, coupled with the extraordinary growth of cross border transactions and the rapid increase in innovative and creative, financial instruments, means a global credit-crunch and economic downturn is more of a probability than a possibility. The fact of the matter is that none of those previous crises can be treated as isolated historical incidents. Rapid globalisation of the economy has increased the frequency and spread of such incidents by generating a ripple effect which has exposed the fragility of our financial system and it is becoming increasingly clear that the effects of the initial sub-prime crisis are spreading across other global asset markets into the real economy. No-one is immune. Although the EU held out against US triggered economic woes for much of 2007 with a period of record growth and appetite for European goods and investment, early economic indicators for 2008 show progress is now slowing, if not already in reverse. GDP for the EU-27 is down 0.1 percent from 2006 while analysts at the International Monetary Fund expect the Euro zone - feted as a bastion of stability as the pound and dollar sank apace - to slip back to 1.6 per cent in 2008, well below levels needed to achieve the Lisbon targets for jobs and growth and ensure Europe can compete with emerging economic giants like China and India. In the light of these developments, clear, concrete, co-ordinated policies at EU and national level are required to mitigate the effects of the current crisis and build a more stable regulatory framework for the future. The purpose of this workshop and the reason ALDE has gathered MEPs, Commissioners, Commission Representatives, academics and journalists together in the European Parliament is to discuss lessons from the past and put forward proposals for the future. A broad and realistic understanding of the macro economy may take us further than theorems or mathematical models which have proved unable to prevent financial crisis. Over the course of the next few hours we will be debating a wide range of topics, from improving the existing supervisory framework, to combating the opacity of financial markets and addressing the performance of ratings agencies whose conclusions we hope to publish as a comprehensive set of policy ideas before the informal ECOFIN meeting in April where Ministers will meet to discuss financial sector supervision and crisis management mechanisms. This is not before time. Up to now, insufficient attention has been paid to some of the greatest challenges facing Europe’s financial services sector, from the need for greater cooperation and convergence in the supervision of financial markets to the fallout from Northern Rock which reinstated Central Banks reputations as the “lenders of last resort” instead of holding those responsible to account. Dealing with these issues will require a raft of short, medium, and long term measures to update financial regulation in line with current practices while ensuring we do not overreact to the risks involved by implementing supervisory systems that stifle positive innovation and inhibit future growth. As Daniel Daianu -a former Finance minister in Romania - makes clear in his paper, the Enron Crisis and the Sub-Prime crisis are qualitatively different and require qualitatively different responses. The former occurred at a time when financial markets were fairly unsophisticated and financial practices fairly old-fashioned. The latter occurs in an age where regulation has failed to keep up with the changes in the financial model whereby growth of the shadow banking sector - largely unsupervised not to mention an explosion of innovations of financial instruments often misunderstood by bankers themselves and conflicts of interests in rating securitised assets have increased the opacity and the risk at the heart of the financial sector. 10 11 2007-2008 ALDE ALDE 2007-2008 A modern European response must take these factors into consideration in its efforts to improve confidence in the banking sector. The so-called ECOFIN roadmap for improving the systems in which financial markets operate leads in the right direction. Injecting large amounts of liquidity in the money market as the UK Government has done is unlikely to bring an end to the current crisis because it does not address the root of the problem, namely that banks’ balance sheets are in a precarious position due to under-estimating the risks of securitised assets. The fact of the matter is that until banks and hedge funds acknowledge their losses, admit their responsibilities and implement rigorous codes of conduct and transparency that will limit their off-balance sheet activities. Public confidence in the financial sector cannot, and will not, be restored. There is much the EU, acting together, can do to improve the regulatory climate, some of which is already in the pipeline. At the level of the European Parliament, our committees have already got their teeth into some of the finer regulatory details including risk management and alternative investment instruments to improve financial transparency for investors and supervisory bodies alike and improving the functioning of Hedge Funds and Private Equity systems. Another important initiative to be taken at European level is the technical but nevertheless vital issue of VAT exemption for the financial and insurance sectors which is costing businesses millions. When combined with the Commission White Paper on Integrating EU mortgage credit markets, such measures could greatly improve confidence in Europe’s financial framework and improve the regulatory set up for all concerned. However they are only a first step. Other aspects of the current financial regime have yet to be adequately examined from rampant conflicts of interest resulting from rating agencies deficiencies to excessive off-balance sheet financing and calculating who bears the risk while readjustment of the Basel II capital requirements is clearly required, and soon. I know that Commissioner McCreevy is working on improving the Capital Requirements Directive and it is my firm expectation this will be put to Parliament after the summer recess so we can adopt this vital legislation before the 2009 elections. 12 I am confident that the discussion that follows will generate many more positive proposals for common European responses to phenomena like Sovereign Wealth Funds and Private Equity. While respecting subsidiarity and Member State competences in this area and working closely with the industry, whose cooperation will be instrumental in improving market transparency and sustainability for all players involved generating consensus on the broad policy guidelines is never easy. But serious problems need serious solutions. And EU Heads of State must learn to work together to improve supervision and enhance cooperation between national authorities or risk a further descent into financial uncertainty and insecurity that could plague Europe for years to come. William Gladstone, the 19th century British Liberal Prime Minister, once wrote that “Finance is the stomach of the country from which all other organs take their tone.” At the moment we are all feeling quite ill. And it is my hope that Commissioner McCreevy, when he takes the floor after me, will diagnose a healthy remedy.... I wish you luck in your deliberations. 13 2007-2008 ALDE ALDE 2007-2008 Keynote speech by Charlie McCreevy, Commissioner for the Internal Market and Services, European Commission Ladies and Gentlemen, Thank you for inviting me to this workshop of the Alliance of Liberals and Democrats for Europe (ALDE) to discuss the current financial turmoil, its causes and what can be done to minimise the impact on Europe. I will first touch upon the origins of the crisis and then focus on our policy response. Origins of the turmoil 19th century economist Walter Bagehot said that one thing is certain about panics and manias in financial markets: at particular times, a great deal of stupid people have a great deal of stupid money. That money seeks to be invested, which in turn leads to speculation. And speculation often turns into panic ( Source: “Essays on Edward Gibbon” by Walter Bagehot.). In this particular case it is not clear whether this turmoil has been the result of stupidity, ignorance, or misplaced opportunism. However, what is clear is that many of the phases identified by Bagehot were in evidence in the run up to the present turmoil. The last few years have been characterised by very high levels of liquidity. The abundance of money looking for a home – and for a decent yield over and above very low money market interest rates created a favourable breeding ground for reckless risk taking. This “plethora” of liquidity led some market participants to forget some basic banking, lending and underwriting principles. In particular the most basic principle of all: that the only way to prudently lend money is on the basis of a realistic assessment of the capacity of the borrower to repay –not from crystal ball gazing about the prospects of finding someone to refinance – but from the borrower’s sustainable cash flows. In the US much of the market moved towards the assumption that one could indefinitely rely on mortgage refinancing with increasing debt on the back of rising asset values and an environment of permanently low interest rates. This phase of “speculation” was illustrated by the high level of financial innovation including the rise in off-balance sheet finance and the rapid growth of the so-called originate-and-distribute model. However, these financial innovations also increased the opaqueness of the financial markets. Several CEO’s of large financial institutions have admitted in their more candid moments that they did not understand many of the new products that their firms were designing, underwriting and trading. 14 The fragility of this system became clear once falls in U.S. house prices were followed by inevitably high default levels among over- leveraged borrowers. Exposure to these losses was transmitted partly via the securitization markets to financial institutions around the world, including Europe. The opaqueness of the underlying financial instruments – and the trading of them on the over-the-counter markets- made the losses hard to locate. This uncertainty resulted in a more generalised deterioration in investor confidence. The most striking evidence of this “panic” has been the disruption of the typically resilient markets for asset-backed commercial paper (ABCP) and interbank deposits. As market confidence fell, problems started to appear in other credit markets and defaults spread to higher quality segments of the US mortgage market, to credit-card debt and to car loans. More recently, confidence has been undermined further by concerns about the financial health of so-called monoline insurers, which provide insurance for debt issued by local authorities and structured credit entities. The speed and severity of the turmoil that has swept through the financial markets has taken both market participants and regulators by surprise. Hopes that it might be short-lived have now given way to a realisation that significant problems still lie ahead. It will take time before all of the effects – and in particular the full disclosure of exposures and losses – have worked their way through the system and stability has been restored. But the problems have not been limited to the financial markets. They have also spilled into the real economy. Evidence suggests that the economic situation in the US is deteriorating. Against this background, the Federal Reserve has continued to ease monetary policy, a substantial fiscal stimulus has been agreed and there has been a government-sponsored rescue package for holders of sub-prime mortgages. In the EU, the economic situation and prospects appear less worrying. The ECB has played a decisive role in stabilising conditions in the Euro-area interbank markets, while at the same time maintaining a clear focus on its primary objective - price stability. For the moment the EU economy seems to be quite resilient but a slow-down in European growth is inevitable given the inter-linkages with the US economy. With almost daily reports of further deterioration in the US housing market and weakening consumer demand it requires something of a leap of faith to be confident that the jump in loan defaults in the US mortgage and consumer credit markets will not spread to include highly leveraged corporates given the more challenging economic environment in which they will be operating in the months ahead. The policy reaction So what is being done at the EU level in response to the financial turmoil? Last October EU Finance ministries unanimously agreed to a set of conclusions to respond to 15 2007-2008 ALDE ALDE 2007-2008 the main weaknesses identified in the financial system. These initiatives, which are consistent with, but not duplicating the agenda set at global level, are grouped into the so-called “ECOFIN roadmap”. It combines actions of a regulatory and non-regulatory nature which are structured around four main objectives: - improving transparency in the market, notably with respect to banks’ exposures relating to securitisation and off-balance sheet items; - upgrading valuation standards to respond in particular to the problems arising from the valuation of illiquid assets; - strengthening the prudential framework for the banking sector, including the treatment of large exposures, banks’ capital requirements for securitisation, and liquidity risk management, and - investigating structural market issues, such as the role played by credit rating agencies and the “originate and distribute” model. Overall, work is progressing in a satisfactory way and implementation of the roadmap is progressing on time. As for transparency, the Commission has worked intensively with industry groups to identify self-regulatory proposals to obtain comprehensive data on securitisation markets. On the 8th of February, 8 European industry associations (The European Banking Federation (EBF), the Commercial Mortgage Securities Association (CMSA), the International Capital Markets Association (ICMA), the European Association of Cooperative Banks (EACB), the European Savings Banks Group (ESBG), the Securities Industry and Financial Markets Association (SIFMA), the London Investment Banking Association (LIBA) and the European Securitisation Forum (ESF).) published a joint position paper committing themselves to improve transparency for investors, markets and regulators and produce results by June. We welcome this initiative, but await concrete results, especially on secondary market data. Regarding valuation standards a first assessment by the relevant organisations of the issues at stake should be completed before the summer. Our first objective however is to ensure that current accounting provisions are consistently applied to 2007 financial statements. In the longer term, global standard setters will, I am certain, need to adapt or improve accounting standards in the light of the lessons learnt from the current crisis. I have to tell you that I have always been a sceptic about some of the more modern accounting standards –not least the move towards mark-to-market 16 accounting which in many ways clearly serves to aggravate - often unnecessarily - an already difficult situation. On the prudential side, the Commission is rapidly working towards further enhancements to the Capital Requirements Directive (CRD) and will come forward with a proposal no later than this October. We have been working on enhancements to the Directive for some time now, but this work has increased in importance in the light of the recent turmoil. Given the urgency of these enhancements, we need to move fast. It will be essential to secure a commitment from both the Council and the Parliament to finalise agreement on the Commission’s proposal before April 2009. I count on the EP’s support in this respect. Transposition will then have to be ensured as a matter of urgency by the Member States. Clearly, citizens would not understand it if several years were needed to implement the required changes to our regulatory framework for banks. On market functioning, recent events underscore the importance of better understanding the role of credit rating agencies (CRAs). The Commission has requested the committee of European Securities Regulators and the European Securities Market Expert Group to come forward with their assessment of the activities of rating agencies, and in particular, the rating process. Both groups are expected to produce their reports this spring. The Commission will reflect on these reports and, taking account also of our own assessments we will finalize our own views on the steps needed to address the many issues on which we have legitimate concerns. I am happy to acknowledge in this regard that several proposals that I have seen in recent weeks from the credit rating agencies constitute worthwhile first steps towards addressing some of the issues that need addressing, but some more robust steps than currently envisaged by the industry will be necessary to ensure confidence in the long term in the objectivity and independence of the credit rating process. All other actions contained in the roadmap will be delivered as swiftly as possible in the course of 2008. Next to this, financial market integration in the EU calls for further enhancement of supervision to ensure sufficient convergence, cooperation and clear decision making between national authorities. In order to allow for effective crisis resolution, tools and procedures for financial crisis management must also be strengthened. In relation to sovereign wealth funds, people often forget that they have been around for more that 30 years, many with long histories of stable investment in Europe and elsewhere. It is only in recent times that debate has sprung up around them. This marks their increasing financial importance and geographical diversity. 17 2007-2008 ALDE ALDE 2007-2008 We need these funds to recycle their surpluses by continuing to invest in Europe. There are many financial institutions throughout the world which would be in some difficulties today, if it was not for the much needed capital injections made by certain Sovereign Funds. In Europe, we have had traditionally an open response to inward investment. And this will continue. We have already a comprehensive legal framework in place that provides for inward and cross-border investment, including SWFs. This is a predictable framework based on the principle of free movement of capital. There are, of course, Treaty provisions that allow for restrictions to be put in place, if needed, to provide for objectives such as national security, public order or overriding objectives of public interest. In the Communication published by the Commission earlier today we make it clear that we do not see any need to alter the current legal system in regard to inward investment into the EU. The message is simple: We are open for business. At the same time, we agree that it is not unreasonable that investors closely linked with national authorities or governments should follow some common principles on transparency and governance. That is what we propose. Taking forward the work underway in the IMF and World Bank we see this as the best approach for the EU and its Member States to follow together with our international partners in the various fora where these issues will be discussed. Finally, we need time to discuss with our international partners. Many of the issues at stake are by their very nature international and require a coordinated global response. In the very short term, prompt and full disclosure of losses and exposures to distressed assets and off-balance sheet vehicles is essential to bring confidence back in the markets. Our first objective is to ensure that current accounting provisions are consistently applied to 2007 financial statements. More generally, the industry has committed itself to improving the availability of information on securitisation markets both for the primary and secondary markets. This commitment will be strictly monitored by the Commission to ensure delivery by mid-year. On the enhancements to the Capital Requirements Directive (CRD), I can only promise to do everything in my power to deliver a robust and credible proposal by October. After that, delivery will be in the hands of Council and Parliament. But let me conclude by saying this: As we move to address the many issues that require our attention we must be disciplined in seeking to ensure that we avoid interventions that stymie responsible innovation and entrepreneurship. Our role must be to ensure that markets function properly within a robust but facilitative supervisory and governance framework. Our actions must be complemented by responsible oversight of financial institutions by boards of directors, and their audit, remuneration, and risk committees. Much of what has gone wrong might not have gone wrong to the extent that they did had these committees - which exist in all publicly quoted financial institutions - were equipped and enabled to play a more proactive role and if the structure and timing of executive rewards had been more closely aligned to long term shareholder value. I trust that the appropriate lessons from this will have been learned by these committees in all relevant financial institutions and that the necessary follow-up action steps will be taken. I have far greater confidence in these matters being capable of being effectively addressed on a hands-on basis by the people responsible within the relevant organizations than I do in having the issues dealt with by “one-size-fits-all regulatory intervention whether from Brussels or from Member State supervisors or regulators. Thank you for your attention. Conclusion Ladies and gentlemen, the financial turmoil has prompted a reality check of the financial system. We need to keep the focus on what needs to be addressed. I believe the ECOFIN road map identifies the right set of issues. Let me also stress that any over-reaction in the short term risks harming the financial markets. We need time to collect reliable information and to undertake a solid analysis of the causes and consequences of what we are currently seeing in the market. We also need time to consult stakeholders, in particular industry representatives, to determine the most efficient and effective way forward, and in some cases, to ask them to take the lead. Industry-led actions are often quicker and more effective than a regulatory response. 18 19 2007-2008 ALDE ALDE 2007-2008 Presentation by Daniel Daianu of his Background Paper Mr. Chairman, Ladies and Gentlemen, I would make my points as below: 1. How to Read the Current Crisis 2. Historical Lessons 3. Roots of The Current Crisis – Structural and Cyclical Factors 4. Features Of The Current Crisis 5. How to Respond to This Crisis 6. Concluding Remarks believes that large, deep, liquid and innovative financial markets will result in substantial efficiency gains and will therefore bring individual benefits to European citizens, it also believes that greater efficiency does not necessarily go hand in hand with enhanced stability”. After the fall of the hedge fund LTCM Paul Krugman wrote: “…modern financial markets, by creating many institutions that perform bank-like functions but do not benefit on bank-type safety nets, have in effect reinvented the possibility of traditional financial panics” (The Return of Depression Economics, 1999, p.162). In 2003 Warren Buffett called derivatives “financial weapons of mass destruction”. Clever people realized, years ago, what was being in the making… - Some crises are caused, primarily, by macroeconomic imbalances; self-fulfilling prophecies or inconsistent macroeconomic policies play a major role; - Other crises have roots in the financial sector (balance-sheet mismatch): maturity mismatch, currency mismatch, capital structure problems and solvency problems. These crises are related to structural dynamics (ex: the pace of financial innovation/the emergence of the shadow banking sector as in the current crisis) Is history of any guide for the causes of the current crisis? Yes, but there is more in order to explain it! The crises of the past decade originate in the balance sheet problems (Enron, LTCM, Asian Crisis, etc.); cyclical factors were at work, too. The current crisis has been much exacerbated by financial innovation of a certain type and cross border transactions. Solvency problems are caused by a variety of factors: indiscriminate lending; complex financial products; reduced transparency; high leverage. Roots of The Current Crisis Structural Factors - The domineering paradigm of the past three decades: confusion between free markets and deregulation of markets….over-reliance on the self-regulatory/equilibrating virtues of markets - A dramatic rise in the role of capital markets (non-banking financial institutions) in the financial intermediation process - Increasing use of new global financial instruments – spread out risk (but, ironically, heightened risk) + reduced transparency (opacity of markets: the counterparty risk): - the flaws of the new business of “origination and distribution”: the belief that one can sell/get rid of the risk (via synthetic products/CDOs), which is impossible for the system as a whole! On the contrary: systemic risks have gone up! - Blatant conflicts of interest among market participants. 21 How to Read the Current Crisis In my view the current crisis prompts us to ponder on: - policies (ex: easy money; premature opening of the capital account (remember the South East Asian crisis); too fast financial liberalization ; - market structures (ex: structures of regulation and supervision; the propensity to high consumption in the US economy and its implications; structures of reward and penalty - the principal-agent problem -, etc) - the adequacy of policy coordination internationally, or inside the EU; an implied question is “how should we manage globalization”? - whether policies are altered in a timely fashion, or whether we learn lessons (from other crises)? - the theoretical underpinnings of policies (ex: distinguishing between free markets and deregulation)… - Is there a paradigm shift in the making? I would argue that there is such a shift, which is a retreat from “market fundamentalism” - The role of ethics in business? There are lessons from other crises, which shed light on the current one. But the current crisis has pretty specific features. First, I would highlight a few phrases which pay to keep in mind. Thus the Committee of Wise Men, headed by Lamfalussy, stated in 2001: “While the Committee strongly 20 2007-2008 ALDE ALDE 2007-2008 - Increasing inadequacy of incentives’ structure in the financial industry: high/reckless risk-taking disproportionately rewarded as against prudence. - Increased complexity of financial instruments – have rendered worldwide regulatory and supervisory frameworks obsolete. - Inadequate quantitative models to the extent they are supposed to replicate the functioning of actual markets; inability to capture the transition from negative to positive correlations…. - An excess of saving in a number of countries and the global redistribution of wealth and income towards commodities exporting countries –this favours cross-border transactions. Cyclical Factors Excessively low risk-free interest rates at all maturities in major economies - the US, Euro-land and Japan; Unreasonable low credit risk spread across all instruments over the last years; The increasing gap between high returns on capital and the low cost of capital. This gap has been widened over the last years mainly due to integration of Asian labour force into the world economy; big stimulus to cross-border transactions. Features Of The Current Crisis The ‘Shadow Banking System’ - Exempt, to a large extent, to regulation and supervision; - It lengthens the intermediation process – makes it difficult to identify risk bearers; - Facilitates asset securitisation via SPVs (special purpose vehicles); - It is biased toward speculative trading and relies on some highly questionable «financial products « (structured finance) has operated like an «in-built destabilizer» (it has created a Minsky effect!) - Financial innovation is ubiquitous (is not simply a US affair!) Complexity as a feature of the financial system… (the role of financial innovation) - Complexity of rated investments, ultimate investors having, often, little knowledge of what was behind those Breadth of the Crisis and massive erosion of confidence 22 - Already spreading to other financial product markets - Divergence between inter-bank interest rates and CB’s policy rates - Invalidation of the decoupling thesis (among various economic areas) - A “liquidity trap”(Keynes) highlights the structural nature of the crisis Extensive Leverage on a Large Scale by Market Participants - Highly leveraged vehicles - very active in FX transactions as globalisation spreads and opportunities in more traditional markets become scarce due to reduced volatility and low returns. Enhanced systemic risk (system fragility) – due to reduced transparency and contagion effects. Major Rating Agencies’ deficiencies: conflicts of interest; slow to react. How to Respond to This Crisis There were warning signals given by preceding crises, but these were largely unheeded. Numerous recommendations have been made over recent years but decisive measures have been limited. For instance: the report of the Committee of Wise Men (2001), which highlighted the heightened instability and systemic risks which are entailed by financial innovation. Clearly, vested interests were more powerful and resisted changes of the regulatory frameworks… I would list several key issues to consider in dealing with the current crisis: - A fundamental theoretical and policy issue is: can markets sort themselves out properly? I would say that this crisis provides a clear answer in this regard, which is: No, they cannot. - Do we understand financial markets sufficiently? How do we use models in making decisions? Because, models have shown their limits in anticipating crises. - There is need to distinguish between free and deregulated markets. The latter can bring about terrible economic and social pains. I would argue that this crisis is a strong proof regarding the inadequacy of a paradigm (“market fundamentalism”)… - Trade-off: efficiency gains in innovative financial markets vs. enhanced stability (Lamfalussy’s injunction); the policy issue is how to regulate financial markets more effectively. 23 2007-2008 ALDE ALDE 2007-2008 - What should the changes focus on? Improving Basel II, adding significant new legislation? - Dealing with the shadow banking sector (with financial innovation). Is all financial innovation benign? - How can policy coordination be improved in global markets while national prerogatives remain paramount (this is valid inside the EU even more …the Lamfalussy process). - Timing of implementing changes is important: do not “shoot from the hip” sounds sensible, but do no be complacent either…there is a rising sense of urgency - The social and economic corporate responsibility of large financial groups (they create major externalities through their operations; the “origination and distribution” of synthetic products has created a major negative externality for the system as a whole! Improving Transparency - Strengthen disclosure requirements - Enhance the monitoring process of non-transparent off-balance sheet financing - Implement procedures to correctly evaluate the origin of the risk posed by investments in financial products - Banks’ capital adequacy ( the ratio was actually reduced because of Basel II) Improving the Existing Regulatory and Supervisory Frameworks As a general statement: The “shadow banking sector” has to be regulated! There is, in my view, a need to revise the regulatory frameworks for the operation of investment vehicles. There is also a need to regulate the very use of financial instruments (of CDOs, for instance), so that the transparency of markets be restored and investors be adequately informed. As banks are required to hold minimum reserves a similar rule could apply to other financial institutions. Likewise, the magnitude of leveraging could be capped. - Coordinating supervision and regulation activities. - Possible joint regulation of banking and securities activities - Development of an efficient EU-wide supervision and regulation of financial institutions and markets (Schioppa’s proposals should be considered more thoroughly) - Enforcement of conformity and compliance systems - Deposit insurance vs. Moral Hazard. What about banks charter values - Raising capital requirements of the structured finance investment vehicles 24 Resolving (diminishing) Conflicts of Interest Among Market Participants - Correcting the set of incentives for originators and distributors - Delimitation of areas of activity where conflicts of interest arise; ppunishment of fraudulent behavior. Integrity of directors and executives could limit the emergence of future crises - Raising the knowledge base of all market participants - Improved risk management in banks Concluding Remarks - Causes of the current crisis are not new (see Enron, LTCM, etc). - This crisis has been magnified by the depth and breadth of increasingly complex financial products, speculative trading and, not least, defective incentives schemes. - Basel II a good start but needs to be enhanced with regulations evaluating liquidity risk and systemic risks. - Methodologies of pricing risk along the intermediation chain of financial products need to improve. - Increasing transparency is a must, but is not sufficient: a structural root of the crisis is the nature of a range of products, of the financial innovation of the past decade (the origination and distribution” undertaken by major banks) - The “shadow banking sector” has to be regulated, for, otherwise, and as it has been glaringly illustrated by the current crisis, it creates huge negative externalities --for the financial system, and the economy as a whole (when private losses are much inferior to social (systemic) losses public authorities have to step in resolutely). - .Pay attention to systemic risks…crises are not simply micro-rooted events - The complexity of the financial system (due to financial innovation) will stay as a formidable challenge to policy-makers (regulators) - Avoid fundamentalism in theory and policy-making (pragmatism and openmindedness are needed) More humility is welcome when preaching to others what are “best practices” (guess what Asians think about the sequence of crises in the US and EU during the past decade) And a final note: wider and better regulation does not mean a reversal of financial openness. Because, financial openness, in order to be sustainable (and not produce irreparable damage), demands proper (enforceable) regulations. 25 - Use of counter-cyclical control mechanisms or instruments 2007-2008 ALDE ALDE 2007-2008 Panel 1 Current features of the financial systems 26 27 2007-2008 ALDE ALDE 2007-2008 John Purvis, MEP (EPP) In the context of the financial turbulence of the last few months there are two main areas we need to concentrate on in terms of possible future action: systemic risk and consumer protection. I do not consider “sub-prime” to be a dirty word. For broader political, social and economic reasons we need to extend the possibility of owning assets, notably one’s own home, right down the socio-economic scale. It is from this sector of the market, with its more dynamic and innovative business plans, that mortgages for low-income households and first time buyers can be more readily forthcoming. Of course it has to be done gradually, soundly, with circumspection, with due concern for both the borrower’s capacity and the system’s robustness. But it is a worthwhile aim for a long term stable society. In America this clearly got out of hand. The lure of greedy profit overcame any semblance of rational or fair trading. From this the contagion spread systemically across the Atlantic. I do not believe our problem in Europe was so much in the business models of the likes of Northern Rock as in the response of the monetary authorities. I believe the prime responsibility for this setback lies at the door of the Bank of England and its failure to maintain liquidity in the interbank market. Instead, it decided, to the detriment of the situation, to stand back sniffily (while the ECB and Fed acted) and stand on its dignity as to the quality of collateral it would accept. I hazard the hope that this recent crisis will not spell the end of that sector all together. I hope it will be able to pick itself up, dust itself down, and begin all over again. Because that section of society lower income households which may also be higher risk clients does need to be catered for in the interests of building a wide society of wealth accumulators without great chasms between the haves and have nots. Not unexpectedly, hedge funds and private equity have been freely cited as scapegoats for all these problems. In reality, most banks are more highly leveraged than any hedge fund. Also, as Commissioner McCreevy said in the European Parliament in September 2007, these problems have arisen in regulated markets. It is difficult to substantiate hedge funds or private equity as the cause of the recent turmoil. If anything they were victims and their resulting problems were contained and not transmitted onwards systemically. Even the rating agencies, suspect certainly of conflicts of interest, can defend their ratings as being only of credit risk of default at maturity and not of liquidity. How to rate liquidity risk might be a topic for future discussion. In the end it is a matter of (a) trust and (b) maintaining liquid markets. Otherwise the authorities will have to provide 100% guarantees if they want to avoid periodic customer panics and possible systemic meltdown. It also raises the question of whether even BASEL II capital requirements will be sufficient to substitute that level of trust and confidence which the industry itself and its regulators have to exude to the retail financial customer. Eric De Keuleneer, Solvay Business School, Free University of Brussels I think we are not learning enough from history on the matter of conflicts of interest, on the matter of the responsibility of banks in lending, as well as on the handling of the moral hazard. - On conflicts of interest, we all know that auditors have conflicts of interest and they are now being dealt with. We know that also investment banks have conflict of interest, and they are not dealt with. It was particularly evident in the last so-called Dotcom crisis of 2001-2002. This has not been dealt with despite some improvement of “Chinese walls”, which we all know are full of holes…. The conflicts of interest of credit rating agencies have been underestimated so far. They have conflicts of interest because they are paid by the companies they rate, we all know that, but they also have a business interest in encouraging companies to multiply off balance sheet vehicles which have to be rated. It is one of their growing business. Thus I think that where the background paper says that credit rating agencies have been slow in spotting some of the problems, in reality even if they spotted them on time, they reacted too slowly partly because they had to deal with important clients. This was the case with Enron, but it is also obviously the case with many investment banks which are sponsoring many off balance sheet vehicles. - The responsibility of banks in lending is another key issue. It was quite obvious already from the LDC crisis in the late 70’ and 80’ that banks, can, end irresponsibly. Lending too much and borrowing too much can be dangerous. Something should be done to make sure that banks are not lending recklessly. Of course if governments bail out clients to whom banks lend too much, there is a first problem of moral hazard. There is also a problem when because of the systemic banks themselves are too lightly bailed out, for instance by complacent central bank facilities. As soon as big borrowers or big banks are threatened with bankruptcy, they are been bailed out either by the IMF, by Central Banks or by governments. This is so far done and it may have been justified because their bankruptcy would have created more risks. But the problem is that if this is done without sanctions and free of charges, it is a kind of free subsidy for the financial system with increasing moral hazard. The problem of the quantitative models has been mentioned. These quantitative models have flaws and should not be used to give the impression that risk can be summarised in a few figures that can be managed easily. Risk, risk assessment and credit risks are something that has to be judged on a professional basis and on the basis of sound analysis, and sanity checks. In conclusion, I think that one of the reasons why we do not draw the lessons of history is that too many people are fascinated with finance and believe that finance creates wealth. 28 29 2007-2008 ALDE ALDE 2007-2008 I do not want to criticise banking as such and I have been a banker all my life but I do not believe that the financial world in itself always creates wealth. I think it can help others to create wealth but it can also simply displace wealth by, in a way, taxing the real economy. Because of this blind belief in wealth creation, there is a dogma that tends to say that there must be no limit and no ethical constraints to financial innovation and financial transactions. This may explain why regulations are globally quite lax. The Basel II rules are fundamentally good, but were applied is such a way they gave the impression to banks that they had too much equity in the years 2004-2007. Of course having too much equity was an encouragement to reckless lending and reckless acquisitions, and the source of many banking problems today. The issuer- pays model Issuer fees were introduced at Moody’s over three decades ago (as a result of concerns over the quality of ratings). The criticism that the issuer-pays business model is more conflicted and less defensible than alternative models; for example, an investor-pays or government-pays model; fails to account of the sources and drivers of potential conflicts of interest in the ratings business. Specifically, prior to issuance - an issuer would always prefer that a rating agency assign a higher rating to its bond in the hope that it will sell into the market at a lower yield, while - an investor would generally prefer the agency assign lower ratings to bonds it plans to purchase in the hope that the bonds will be issued at higher yields. Nigel Phipps, Head of European Regulatory Affairs Moody’s On behalf of Moody’s Investors Service, I would like to thank you for the invitation to participate in the first panel at this afternoon’s workshop. In the time allocated to me, I have been asked to speak on rating agencies and their management of conflicts of interest and transparency. I will give a Moody’s perspective on these issues. If time permits, I will make some very brief comments on the broader crisis . Independence and Managing Potential Conflicts of Interest To foster and demonstrate objectivity, Moody’s has adopted and publicly disclosed through its Code of Professional Conduct, important fundamental principles for managing the ratings process. These include: - Rating decisions are taken by a majority vote of members of a rating committee and not by an individual rating analyst; - Analysts’ compensation is not linked to the revenue associated with the entities they rate; - Analysts are divorced from fee discussions with issuers; - Our rating methodologies are publicly available on our website, allowing the market to assess whether we consistently adhere to them. While we believe these protections are robust and transparent, the integrity and objectivity of our rating processes is of the utmost importance to us. Our continued reputation for objective and independent ratings is essential to our role in the marketplace. As we understand it, however, two primary areas of concern remain with respect to the independence of our ratings process: the potential conflict presented by the issuer pays model; and the misperception that Moody’s provides consulting services. However, after issuance, once the security is trading in the market - both the issuer of the bond and the investors that hold the bond would prefer that the security not be downgraded; whereas, - would-be purchasers of the bonds and investors with shorts in the derivatives markets would prefer to see downgrades. Governments are also a risky source of fees. Not only are they the largest issuers of debt globally, but they are responsible for determining and implementing public and social policies – such as national labour policies, or protection of entities or industries deemed “national champions” – that will from time-to-time heighten sensitivities to potential rating actions. In sum, the question is not whether potential conflicts exist, because they do, regardless of the business model. Rather, the question is how well a credit rating agency manages its potential conflicts, irrespective of the fee model. We believe that Moody’s manages the potential conflicts in our business model to a global best practice standard. The provision of consultancy services Moody’s is aware that there is a perception amongst certain market participants that we are involved in providing consultancy services relating to securitisation products. Moody’s does not structure, advise on, create or design securitisation products. We do not recommend one proposed structure over another. Structures are designed by arrangers and investment bankers to fit the needs of particular investors. However, in rating any structured security (or any corporate or governmental security) we may hold analytical discussions with issuers and/or their advisors. These discussions do not transform credit rating agencies into investment bankers, consultants or advisors. Instead, they serve the dual purpose of: (1) helping us better understand the particular facts of the transaction as proposed by the issuer; and (2) clarifying to the issuer the rating implications of our methodologies for that transaction. 31 30 2007-2008 ALDE ALDE 2007-2008 The Transparency of Our Ratings and Our Rating Methodologies Some have suggested that Moody’s rating methodologies and rating actions may lack transparency. While we believe that there are ways to improve the means through which we communicate with the market, at present we publish our methodologies and models for assigning and monitoring ratings. We follow a public “request-forcomment” process when developing new methodologies or contemplating significant adjustments to outstanding methodologies. Our rating actions are released publicly and provide discussion of the rationales and assumptions underlying our actions. Moreover, we publish regular performance measures for structured and corporate ratings; and we publish an annual report on the implementation of our Code. It is important to note that Moody’s discourages the use of our ratings for any purpose other than as a measure of potential future default probabilities and expected credit losses. This has been a consistent, public position of Moody’s for many years. Regardless, market participants have expressed demand for tools to augment the information provided by credit ratings. Moody’s and other subsidiaries of its parent company are developing supplemental tools for investors to assess risks beyond expected credit loss, including valuation and pricing services for the structured finance market. Such tools would enhance transparency and strengthen secondary markets for structured products. In June 2005, Moody’s adopted its Code of Professional Conduct, which was closely modelled on the IOSCO Code. In October 2007, Moody’s issued an updated version of its Code of Professional Conduct. The changes made reflected Moody’s continuing efforts to clarify and enhance its policies and processes for ensuring the integrity, objectivity and transparency of its ratings processes, in a manner consistent with the IOSCO Code. IOSCO is in the process of updating its code and Moody’s expects to work with IOSCO during the process with a view to implementing the amended provisions in our Code of Professional Conduct. In Europe, following an evaluation in 2005 by the Committee of European Securities Regulators (“CESR”), the European Commission (the “Commission”) issued a communication in March 20063. The communication favoured self-regulation by credit rating agencies based on the standards of the IOSCO Code and the provisions of relevant EU securities laws that apply to all market participants, including rating agencies. Furthermore, the Commission asked CESR to monitor the rating agencies and their adherence to the IOSCO Code and to report back to the Commission on an annual basis. CESR’s first report on rating agency adherence to the IOSCO Code was published in January 2007. In this report CESR concluded that the rating agency “codes comply to a large extent with the IOSCO Code”4 . In undertaking its review, CESR consulted with market participants as well as the credit rating industry. CESR has commenced its 2007 review. CESR is evaluating the areas identified in its 2006 report, which include the impact of the US Reform Act on the credit rating business in the European Union, and the role of rating agencies in the structured finance process. The report will also respond to specific questions sent to CESR by Commissioner Charlie McCreevy following this summer’s market turmoil. We understand that the final report is due to be published in May 2008. ADDENDUM Existing Regulatory Infrastructure for Rating Agencies operating in Europe A large variety of laws and regulations are relevant in the context of the ratings business. These include laws relating to confidentiality, insider dealing and market abuse (such as the Market Abuse Directive1 and its implementation by member states). In addition, under the Capital Requirements Directive2 , there is the obligation for rating agencies to be recognised prior to banks using their ratings for the calculation of regulatory capital. In December 2004, the International Organisation of Securities Commissions (“IOSCO”) adopted its Code of Conduct Fundamentals for Credit Rating Agencies (the “IOSCO Code”). It provides a global framework of principles for the behaviour of credit rating agencies and for transparent disclosure of their procedures, rating methodologies and rating performance metrics. 1 DIRECTIVE 2003/6/EC of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation (market abuse) 2 DIRECTIVE 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast) Communication from the Commission on Credit Rating Agencies (2006/C 59/02) CESR’s Report to the European Commission on the compliance of credit rating agencies with the IOSCO Code Ref: CESR/06-545 3 4 32 33 2007-2008 ALDE ALDE 2007-2008 Wolfgang Munchau, Financial Times Just imagine an economy which had money just as our economies but no economics and this economy suddenly experienced a rise in inflation. People would naturally start blaming the shopkeepers who raised the prices or the distributors who raised wholesale prices. In reality we, obviously, with the benefits of knowledge know that a rise in inflation is ultimately a monetary phenomenon, it’s an economic phenomenon and not something tangible that we can observe. In this crisis which is very complex, there is a temptation “to blame what you see” and obviously credit rating agencies are a very convenient target here. The first thing we need to discuss is what type of crisis is it? I would caution against the complacent view that this is a sub-prime crisis. In fact this is not a sub-prime crisis. This is a North-Atlantic debt crisis. It is not confined to the sub-prime mortgage debt crisis in the United States. That’s the beginning, where the crisis started out, but we have since seen the crisis spreading to many other segments of the market. Paul Krugman once said that every week a sector of the financial market is falling into crisis that he didn’t even know existed two weeks ago. There are term auctions facilities, which are under news and are very complicated parts of the financial market. If there is a very big part of the financial market that is probably or possibly going into crisis it is the one for “credit default swaps”. This is something that you might be hearing during the course of this year. These are very complicated instruments, which provide in economic sense insurance against default of bonds. They are not regulated like insurance companies and this market is 45 trillions USD which, if you want some comparison, is the size of the world economy in one year. This is therefore a fairly large segment of the financial market. This market could be in difficulty for two reasons: one is the defaults (corporate or private) which have been very low during the good years 2000-2006. Corporate default is now rising as the US is going into recession. The second problem is counterparty risk, an unregulated market based on the notion that the person who ensures your bonds can ultimately pay up for them and ensure you. When this does not happen you may end up seeing a domino effect, a vicious circle stemming out from this particular submarket. Economic theory would say that if a real interest rate is negative, you have an incentive to borrow an infinite amount of money. With a negative interest rate you cannot go wrong. We should not be entirely surprised then that this was what people did. The United States housing market was overprized by about 40 to 50 %. People took on loan after loan and you have reports about people in the United States having 25 credit cards, taking mortgages that are 20 times their incomes, 130 % the value of the house - a ratio that has obviously gone absurd. This together with the global imbalances and account deficits of 5 to 6 % in the USA and the growing wealth and surplus capital in oil-producing countries, China and India was one of the major reasons for the current crisis. Even a stagnation of house prices would basically have cracked that bubble. 34 Summary prepared by the ALDE Secretariat Robert Priester, Head of Department Banking Supervision and Financial Markets, EBF Thank you for your invitation to speak today on the financial turmoil causes of the current international crisis. There has been an increasing disconnection between the real and financial economies in the past few years, with the latter growing at a much faster pace. Although some of the reasons behind financial expansion have been related to growing economic activity, due in part to a long period of low interest rates, the major drivers behind financial growth are the rise in securitisation and the development of structured investment vehicles. Securitisation is not new. Securitisation began in the US in the late 1970s and today concerns the bulk of US retail credit. In 2006, issuance of mortgage-backed securities (MBSs) and more generally asset-backed securities (ABSs) in the US represented $6,168 billion, or more than corporate and government bonds combined. The three recognised benefits of securitisation are that: - It enables companies and administrations to raise funds; - It provides institutional investors with a means to diversify their portfolio; - It enables banks, by economising capital, to increase their financing of the economy. However, over the past few years, the securitisation process has become increasingly complex. The “slicing and trenching” process has allowed for a permanent reallocation of risk between market participants according to their preferences, expectations and risk aversion. As a result, securitisation has fuelled a strong demand for credit risk. This demand, coupled with the extensive use of derivatives, has made valuation and risk assessment more difficult. Consequently, “slicing” and “trenching” has led to a certain mis-pricing of credit risks. It is this context, and from the perspective of banks, the crisis was due to a combination of three levels of underestimated risk or failures by market players: The first level was the credit risk assumed by lenders in the US on sub-prime clients. Sub-prime loans in the US are mainly delivered by institutions which are not regulated by the Fed or an equivalent organisation and lending conditions, especially with regards to ARMs, were based on unrealistic projections on real estate prices evolution and completely overlooked the borrowers’ repayment capacity. This represents a serious failure of the US regulatory system. The second level was the vulnerabilities of the securitisation process. Some of these are: - Structured products, especially CDOs containing sub-prime mortgage loans are not easily understood 35 2007-2008 ALDE ALDE 2007-2008 - Once the crisis starts, investors can no longer rely on the investment banks to give reasonable prices as market makers, even if they had reason to expect them. - Investors, instead of properly assessing the content of the products they were purchasing use the ratings assigned by the ratings agencies. These ratings, however, (a) do not rate liquidity but the probability of eventual default and (b) use the same ratings system for businesses, governments and “tranches” of complex products. - The low level of reliability of the guarantee brought by the monoline industry (credit enhancers), derived from their weak capital position. The third level was the extent of the banks’ commitment, which is mainly assessed in terms of prudential standards (CRD, not yet fully implemented). This system should have limited banks’ risk to the carrying cost of the loans being securitised, or to securities being distributed, with losses on other assets held by investors. However, it seems that the banks’ commitment remained much higher, for three different reasons: - Banks kept various “tranches” of, or degrees of commitment to, the securitisation; - The commitments made by banks to SIV, conduits or to other investors for example in terms of credit facilities. In the event of funding problems, the relationships with these banks are called into play and the banks end up having to ensure financing or reintegrate the receivables into their balance sheets. - The commercial risk for, or reputational risk to the banks promoting certain products, when the characteristics or conditions attached to marketing the product entail a moral commitment of the banks to their customers. For example, this is the case for money-market funds, which are not normally subject to legal commitments involving the banks or investment management companies which are marketing them, but are seen by customers as binding their reputation. It is still not clear how to respond to the current crisis. One thing is clear, however. We are probably going to witness the increasing relevance of basic principles of prudent and risk management to all financial intermediaries. We are not facing a problem of lack of regulation. The challenge is to apply existing regulation in the right and, if you allow me, moral and socially responsible, way. And to create the right incentives to facilitate this process. Ray Kinsella, Director of the Center for Insurance Studies, University College Dublin Western liberal democracies and the growth of international trade and investment have been built on the platform of open, innovative financial markets. It would be difficult to overstate the political importance of this reality. At the same time, it would be foolish not to reflect on whether the pathology of the international credit crisis does not put all of this at risk and what initiatives the EU Parliament should consider to address this situation. There has been a succession of banking and financial crises in western financial markets in recent decades. The Nordic crisis. The Russian ‘default’ event. LTCM – which, in many ways, is a precursor of the contagion. The Asian banking crisis. On top of these, there has been a whole succession of risk-management and control deficiencies within individual banks. The present global contagion is different. It is, by far, the largest such ‘event’ since the collapse of the Bretton Woods international financial system in 1973-which had a wholly different and unambiguously politicofiscal dynamic. Its consequences are still unfolding, requiring on-going ad-hoc reaction on the part of central banks. The duration of the credit crisis is exceptional. It is hardly an exaggeration to say that there is a palpable sense of ‘what next’ and, on occasions, of fear. It has impacted on the balance-sheets of major money-centre banks, which are at the heart of the inter-bank and credit markets. Earnings and capital adequacy have been affected to an extent not seen before. The crisis has impacted on market confidence and Trust –on which the whole structure of financial markets ultimately rests. When one reflects on some of the component parts of what was ostensibly a ‘new’ credit market landscape- populated by euphemistically termed ‘sub-prime’ mortgage market loans which subsequently infected the whole Asset Backed Commercial Paper (ABCP) market, Off-Balance sheet SIV’s and ‘Conduits’- it is difficult to avoid the conclusion that there was something fundamentally amoral about the mind –set as well as the process which generated this contagion. We know the combination of circumstances – global savings/excessive liquidity and a scramble for ‘yield’ against the background of what the market knew had to be unsustainably low interest rates – which was the ‘seedbed’ of the crisis which finally ignited in mid-2007. In fact, the signs of unsustainable speculative ‘bubbles’ were evident well before then. We know that the contagion took root and developed within the most prescriptive regulatory regime in advanced monetised economies We know that it was – and is still being – transmitted across markets which have been considerably strengthened by such initiatives as Basel II and new accounting and auditing standards, as well as by enhanced risk management initiatives within the major banks. It still happened. The injection of liquidity by major Central Banks has not solved the underlying flaws. It has simply bought time. The issue for policy makers and for political leaders is whether, or not, this time will be used wisely. What we also should know by now is that-alongside on going liquidity support which by its nature can only be temporary- ‘band- aid’ in the form of ‘policy-speak’ initiatives, such as ‘intensification of cooperation’ and ‘concerted action’ does not begin to address the underlying issues that have brought us one, perhaps two, steps from the unthinkable: a major fault-line emerging across western financial markets. It is important to acknowledge that the absolute magnitudes of existing and even prospective losses/write-downs are small compared with the total stock of wealth 37 36 2007-2008 ALDE ALDE 2007-2008 encompassed, in one form or another, within the markets. That is not the point. What is of more concern is the innate dysfunctional nature of a highly leveraged set of ‘structured products’ which have subverted enormously innovative markets. The integrity of the whole securitisation process has been subverted .Of equal concern is the scale and depth of the adverse effects on Trust in markets, of the effects on the corporate sector and, most important of all, on individual families and the ‘Common Good ’which the markets are intended to serve.(See Boxes 1,2 and 3). There are three issues which go to the heart of contagion in global credit markets and which need to be addressed: The Effects of Contagion The effects of Contagion cannot be measured solely by its impact on the balance sheet of financial institutions, or even, the functioning of credit markets – even though these are unprecedented in terms of their scale. Contagion creates a virus like pathology in the heart of households as well as within wider social and political structures of western market-based democracies. It impacts on individuals and families (an estimated 2 million in the U.S will loose their homes) and on relationships. It impacts on living standards. Neither “Caveat emptor” nor reactive pledges of ‘closer cooperation’ among regulators or countries are an adequate response to a malign dynamic that generated this Contagion. This is especially the case since the burden of this contagion is primarily born by those in developed as well as poorer countries less able to either understand, or to cope with , its effects. The Business Model The‘Business Model’underlying contemporary western mainstream financial innovation is based upon maximising short-term Shareholder Value. This model is fundamentally flawed. The scarce factor of production today is not capital but intellectual capital. This should be evident from what is driving the pace of technological and financial innovation within the markets; namely People. This ‘Business Model’ gives overriding priority to shareholders, is configured primarily to optimise next quarter’s earnings and is driven by perverse incentives. It is morally indefensible and economically obsolete. We need to rethink this ‘Business Model’ upon which banks and the western financial markets – with all of the benefits which they have generated – are based .At the heart of all economic, political and social ‘constructs’ is the Human Person. What is innovation for-or about-if not to serve the substantive interests of the Human Person? How much time and effort do banks invest in reflecting on the Human Person, compared with what is invested in generating the latest algorithm or the most effective marketing ‘strategy’ to increase ‘share of the wallet’. 38 The banks, as corporate entities, have an almost wholly dehumanised view of their business, their employees, their clients and, in general, society. They are ignorant of and/or have ‘crowded out’ the single most important issue and it is this which is at the heart of the increasing fragility of an exponentially expanding set of interlocking markets. Hijacking the term ‘Ethics’, or embracing CSR, are not adequate substitutes. At another level, the integrity and efficiency of markets themselves including rating agencies, are being subverted by systematic deficiencies (such as failures in risk pricing) and in the separation of markets from their original constitutive purpose. The monumental Compendium of Social Teaching (2006) makes the important point that: “The Financial Sector, which has seen the value of financial transactions far surpass that of real transactions, runs the risk of developing according to a mentality that has only itself as a point of reference, without being connected to the real foundations of the economy” “A financial economy that is an end in itself, is destined to contradict its goal, since it is no longer in touch with its roots….it has abandoned its original and essential role of contributing to the development of people and the human community” . It would be facile to make this point without acknowledging that addressing these deficiencies represents formidable challenges: we confront the need for a ‘Kuhnian’ -scale paradigm shift in our way of thinking about money and markets. On the other hand, there are alternative paradigms based, for example, on the Judeo-Christian as well as Islamic teachings – which have much to say of money and markets, Trust and integrity. No one is in charge The present regulatory structures underpinning Financial Stability are simply incapable of keeping apace with market innovation – and this market innovation. The fragmentation of regulatory governance, in a world of 24/7 global financial flows embodying quite enormous ‘leverage’, represents a ‘Black Hole’ that threatens to swamp global Financial Stability. There is no single body with the global mandate, technical capability and resources to proactively engage with market innovation and to intervene, when necessary, to preserve Financial Stability. The difficulty here is that in the EU and the wider G-7, national regulators operate with different mandates. They arrived ‘a little breathless and a little late’, each with their own agenda, reactively seeking to address a problem of global contagion whose scale and underlying causes manifestly required a joint approach encompassed within a single institution. We need a global Central Bank. The technical and political difficulties which this raises are trivial compared with the vulnerability which western financial markets and economies – and those economies dependent upon them – are faced with in the absence of a failure to act on this imperative. 39 2007-2008 ALDE ALDE 2007-2008 A Way Forward Its worth pointing out that recent theoretical work demonstrates that the severity of macroeconomic impacts of contagion are understated by ignoring ‘second order’ micro-linkages among companies within banks credit portfolios- especially Large Complex Banking Groups (LCBG). Wars happen. So too do global financial crises. What is at issue here is not whether there will be another such event: it is instead the form, nature and scale of such an event and the prospective damage to both financial and political structures in western democracies. We should, as already pointed out, be concerned not alone about the major monetised countries - which drive global markets and economic growth but also about the consequences for smaller countries and, more especially, developing countries which are effectively held hostage to our failure to get to grips with the underling causes of global contagion and to put in place an appropriate global regulatory structure. Within the EU at present there are competing national, regulatory agendas – sometimes within a single country. We need to be very clear that, unless the EU rises above these differences, the prospective outlook for Europe and for the global community are grave: - Europe will be unprepared for the next ‘structural’ event, whatever form it takes and for its impact on European living standards. Moreover, it would be imprudent not to take into account the possibility of such an event occurring within the penumbra of a major ‘shock’, such as , for example, a global pandemic the probability of which is very high indeed. - Europe will cede a leadership role to the US, with all of the consequent dangers of ‘regulatory imperialism’ which were so evident in the imposition of SOX right across global financial markets and the deficiencies of which now acknowledged, even in the US. - The work of the EU Commission and ECOFIN, in partnership with the Parliament, provides a robust basis for taking the discussion on a world Central Bank, with a ‘minimalist’ highly-focussed mandate, forward as a global initiative .An institution based on the Bank for International Settlements (BIS) suggests itself, given the credibility, expertise and experience of the BIS as compared with the evident challenges confronting a ‘Greenfield’ initiative. This could be explored further, initially within the G7 and, later this year, at the IMF/ World Bank meetings. National and international banking and financial services representative bodies need to participate proactively in these discussions. - The Parliament, given its mandate and responsibilities to the people of Europe, will obviously follow-up the outcomes of the discussion on the insightful and authoritative paper by Dr Daianu MEP. 40 of Global contagion. The seriousness of the present situation, albeit that it has slipped from the front pages of business media, stems not alone from the already evident damage to the credit markets and to growth, but also to the living standards of individuals and families across the EU. - The Commission, in briefing ECOFIN, will be aware of competing national, regulatory agendas – sometimes within a single country. We need to be very clear of the need to rise above these differences. At present the causes of the contagion are being evaluated within a number of high-level fora, each with a distinctive perspective and which resonates with both the fragmentation of global regulation and the need for taking a decisive step forward. In fact, the European Union is ideally positioned to take a lead on this initiative .It has demonstrated its capacity to successfully undertake institution-building on a truly historic scale. The establishment of a global Central Bank is an imperative commensurate with Europe’s ambitions to contribute to the creation of a new sustainable world economic order. - Europe will be unprepared for the next structural event, whatever form it takes, and for its impact on European living standards. - The work of the Commission and ECOFIN, in partnership with the Parliament, provides a robust basis for taking the discussion forward , initially within the G7 and, later this year, at the IMF/ World Bank meetings. - It is essential that the markets-in the form of representative bodies across the spectrum are proactively in the process-alongside central banks. It was precisely this non-prescriptive partnership approach that was the essential foundation of the successful preparation for, and transition to, the Euro. - A Communication to the Commission from Parliament should highlight the gravity 41 2007-2008 ALDE ALDE 2007-2008 Panel 2 How to respond to the current crisis? 42 43 2007-2008 ALDE ALDE 2007-2008 Servaas Deroose, Director ECFIN C, Macroeconomy of the Euro area and the EU, European Commission Much of my intervention will echo the comprehensive review of the financial crisis provided earlier by Commissioner McCreevy in his keynote address. My intention is not to revisit the same ground but perhaps to explore some of the issues raised in his insightful account. The potential for serious turmoil in the international financial system has existed for several years, as ample global liquidity, financial innovation and the search for yield increased the willingness of investors to assume increasing levels of risk. The result was a compression in risk premia to historically low levels and stretched valuations in most asset markets. The trigger for the financial turmoil was the emergence of credit losses related to rising default rates in the US sub-prime mortgage market. Exposure to these losses had been spread throughout the international financial system via a process of securitisation involving highly complex financial instruments. Credit losses have now spread well beyond the sub-prime US mortgages to higher-quality residential mortgages, commercial mortgages, car loans, credit cars etc. and estimates of total losses have increased steadily. Uncertainty about the ultimate scale and location of credit losses has undermined investor confidence and has resulted in the disruption of several key credit markets, notably the markets for interbank lending. Conditions in inter-bank markets have been stabilised by decisive central-bank action since mid-2007, but interbank lending has not returned to normal. Persistent strains in interbank lending reflect concern among banks about unanticipated losses on their own balance sheets and credit risk among counterparties, which has encouraged substantial hoarding of liquidity. Problems in credit markets have put particular pressure on bank capital and profitability, resulting in a tightening of lending standards. Concerns about a widespread downgrading of monoline insurances, with possible spillover effects on the vast market for credit default swaps, has resulted in a significant widening in risk premia for lower-rated borrowers and even for some government issuers. Private equity and hedge funds have all been adversely affected as banks have responded defensively to growing pressures on their balance sheets. In considering how to respond to the financial turmoil from an EU perspective, the ECOFIN Council roadmap of October 2007 is the obvious starting point. The objective of the roadmap is to achieve an appropriate balance between restoring investor confidence and retaining adequate incentives for entrepreneurship and innovation in the financial system. 44 Problems with investor confidence relate to three main factors: - information asymmetries due to a lack of transparency; - doubts about the adequacy of risk management and risk measurement instruments; and - more general concerns about the functioning of so-called non-organised markets. In each of these areas, the role of credit ratings agencies and the adequacy of their ratings have come under particular scrutiny. Meanwhile, it is important to remember that these sources of investor concern reflect many of the basic characteristics of a modern financial system. The transfer of risk via anonymous trading of highly sophisticated instruments has brought major benefits to the global economy. It has fostered a more efficient allocation of resources and boosted economic growth potential. Of course, it has also brought problems that are now clear to see in the ongoing turmoil. But, it is essential that any response to the turmoil should not unnecessarily constrain the ability of the financial system to deliver benefits. In short, we must not throw out the baby with the bathwater! With such considerations in mind, the ECOFIN roadmap reflects a balanced and evidence based approach. The roadmap identifies four objectives in responding to the turmoil: - improving financial transparency in the market, notably with respect to banks’ exposures to securitisation and off-balance sheet items; - an upgrading of valuation standards, particularly in respect of illiquid assets; - strengthening the EU’s prudential framework for the banking sector; and - investigating structural market issues, such as the role played by credit rating agencies or the “originate and distribute” model. The roadmap combines actions of a regulatory and non-regulatory nature in seeking to meet these objectives. Most of the regulatory actions will take place in the context of updating the Capital Requirements Directive. However, it is clear that industryled initiatives should receive equal attention. The focus on industry-led initiatives reflects the belief that the primary responsibility for managing risk in the financial system lies with the private sector. So, the roadmap envisages self-regulatory responses in the areas of transparency, asset valuation and credit-rating agencies. On the other hand, regulatory action is certainly not excluded if the industry fails to deliver substantive responses. Implementation of the roadmap is now well underway. The roadmap was endorsed in October 2007 and should be fully implemented by the end of 2008. The ECOFIN will consider an interim report on implementation in April 2008. I would not wish to pre-empt the contents of the interim report. However, I can say that the Commission, the three European Committees of Supervisors and the ECB’s Banking Supervision Committee are cooperating intensively on the regulatory actions. Commission 45 2007-2008 ALDE ALDE 2007-2008 proposals to modify EU banking legislation will be ready no later than October 2008 and the other actions contained in the roadmap will be delivered as swiftly as possible in the course of 2008. Meanwhile, eight European industry associations have published a joint position paper, which commits them to significant improvements in market transparency. A first report on what such improvements would entail is expected in the coming days. Before moving on from the roadmap, I would like to stress two other important aspects. First, the endorsement of the roadmap by the Council of Ministers was an acknowledgement that the EU Member States must respond together. Second, the consistency between the roadmap and parallel initiatives by the G7 reflects the fact that not just an EU response but a global response is required. In a context of globalised financial markets, no country can afford to go it alone. A frequent criticism of the roadmap is that it is largely designed to prevent the next episode of turmoil rather than to resolve this one. I would not fully accept this. Indeed, it is possible to identify measures in the roadmap - such as those relating to transparency, disclosure of losses and credit ratings - which should help to restore investor confidence in the short term. Of course, one can think of other possible measures for the short term. Daniel Daianu suggests stronger punishment of fraudulent behaviour or knowledge transfer to resolve conflicts of interest among market participants. I have some sympathy for these proposals. However, I would be concerned about the moral hazard implications of some other of his proposals such as a “buyer of last resort” for non-bank lenders or a “market maker of last resort” for illiquid products. While not wishing to open a somewhat separate debate, I believe that the response to the current turmoil should not be considered in isolation from the broader debate about the EU supervisory framework. The Commission set out its position on the reform of the Lamfalussy framework in December 2007 and advocates an evolutionary approach within the context of existing arrangements. Others have floated more ambitious ideas of single rulebooks and consolidated supervision. I do not believe that we should be defensive toward such ideas. However, we must recognise that they go well beyond what has been agreed in the ECOFIN and would involve extensive political compromises, major institutional change and probably changes in national legal frameworks. We must keep in mind that the Council conclusions reflect an already difficult compromise between very divergent views in the EU. Accordingly, our efforts should concentrate on progress achievable in the short term under the present agreements. These are notably to: - get a precise view of how national differences in supervision impact on the efficiency and stability of the EU financial markets; - review financial services Directives to improve supervisory convergence; - improve the functioning and funding of the Level 3 Committees; and - achieve progress on the principles and practices for EU financial crisis prevention and management. Before concluding, I will turn to the macroeconomic response to the turmoil – a topic more familiar to me as a DG ECFIN staff member. Problems in the financial system are now spilling over into the real economy. As the risk of economic recession looms large in the United States, the Federal Reserve has already lowered interest rates. Lower rates have been accompanied by a fiscal stimulus package to support consumer demand. However, we should not be lured into a simple prescription that what is right for the US economy must be right for the EU economy. Of course, the EU economy will not escape the negative growth effect from the financial turmoil and associated slowdown in the US economy. But, the economy entered this period of financial turmoil in good shape and better protected than in similar situations in the past. Growth was strong last year and employment was on a steady rising trend. Moreover, the EU economy is not characterised by major financial imbalances and its housing and mortgage markets do not face the same problems as in the US. As the economic situation and prospects appear less worrying in the EU, an aggressive macroeconomic policy response is not appropriate. The ECB has taken the implications of the financial turmoil into account in monetary-policy decisions. But, the stance of policy has been guided primarily by the likely evolution in inflation and inflation expectations. In January, consumer prices rose by 3.2% year-on-year in the Euro area, which is the highest rate of increase recorded since the launch of EMU in 1999. With regard to budgetary policy, it should be noted that the response of the automatic stabilisers in the EU is stronger than in the United States. This is due to a higher public expenditure share in the economy and more progressive tax systems. In addition, many of the Member States have already taken or announced measures to reduce taxes and social security contributions in the fiscal year 2008/09. So there will be a loosening in the EU fiscal stance, even without additional stimulus measures. The EU must reinforce its commitment to stability-oriented economic policies and necessary structural reforms. This is necessary, not only to meet medium-term economic objectives but also to underpin economic confidence amid the effects of the current financial turmoil. Accordingly, the most appropriate economic policy response for the EU is to persist with long term and predictable policies of structural reform, improvement in the quality of public finances and reductions in public debt to more sustainable levels. 47 46 2007-2008 ALDE ALDE 2007-2008 To conclude, I would recall that the recent turbulence in international financial markets has not come as a complete surprise. For several years, market commentaries (including those provided by the Commission) have been highlighting the underpricing of risk that has led to the turmoil. Accordingly, work on vulnerabilities in the financial system had already started well before the current turmoil. We are now able to draw on this ongoing work in various fora to address the identified weaknesses in the financial system. Implementation of the ECOFIN roadmap will be the first step in this process. We cannot afford any backsliding in deadlines for implementation. Nor can we afford to lack of ambition in discussing and addressing difficult issues even if national sensitivities may be involved. Thank you for your attention. Ieke Van den Burg, MEP (PSE) In the public debate about the credit crisis and its impact on the real economy the attention tends to be focused predominantly on monetary or fiscal tools for crisis intervention. At least as important is to learn the lessons from what happened now, and to be better prepared to prevent such crises. European companies, employees and consumers need to be better protected against the harm that financial markets can bring to the real economy. The laissez faire policy that has been promoted by Commissioner McCreevy is over. It is high time to act. I would propose to focus on four fields: more effective European level supervision of major systemic risks, an enquiry into possible market dominance and conflicts of interests at the top of the market, an enhanced system of diversified levels transparency and changes in corporate governance and remuneration package incentives. Joseph Ackerman, CEO at Deutsche Bank, called for a “holistic” approach regarding financial supervision. This is an approach dear to me. I have pushed for that in several reports in the European Parliament. The fragmented structure of national and sectoral supervisors is clearly inadequate to catch up with the developments of innovative financial products and services and the risks that they incur. Informal cooperation and coordination is no longer adequate to monitor the risks of the two to three dozen large international financial conglomerates that dominate the EU market. It’s true that colleges of supervisors are promoted and in force in several cases. These have functioned quite well in situations where several supervisors have a major task for one of the activities of a group, like in the case of Euronext or Fortis. In most of the situations though the main supervisory work lies within the country where the headquarters of the financial institution are located. As a consequence, an uneven level of knowledge and competences is created regarding the “home supervisor” in relation to the “host supervisor”. Besides that the burden sharing in cases of possible default is not guaranteed. So citizens in home countries will feel more protected than 48 those in host countries with only subsidiaries, but in quite many cases a dominance of these large groups. This means there will be an increased risk of regulatory arbitrage and competition between Member States. Financial market regulation is European, the mandate on which national supervisors act is based on national legislation. This encounters the risk that supervisors focus on a national interest, which possibly harms the interests of other Member States of the European Union. It would be better to take also into account the interests of other economies since the national economies are of course very much interlinked with the European (Monetary) Union. What is needed is a European supervisor with oversight of what happens in the global financial markets and with executive powers to act and prevent crises. The activities of financial institutions are very diverse and cross-sectoral and the extent of unregulated, “over the counter”, activities of banks, insurers and traders has seen an enormous increase. The over 80 different supervisors throughout the 27 Member States (including the FSA as has been shown) lack sufficient oversight. Malcolm Knight of the Bank of International Settlements said in Davos that this “balkanisation of regulation”, lies at the heart of the current financial crisis. National financial supervisors and central banks are disintegrated which causes a loss of efficiency and rapid response. A European executive supervisory unit should have the responsibility regarding the prudential and financial stability supervision of the 30 to 40 large cross border/global and often cross sector players that dominate the wholesale activities and create the major systemic risks. Member States with many foreign owned financial institutions that are based elsewhere in the EU, and their supervisory authorities have more influence to exert in such a system in which they participate, compared to the situation in which they have to rely on “lead” or group supervisors (in mainly the big member states) to whom they have to delegate and transfer powers, without any financial guarantee for their citizens in case of crises and defaults. As a consequence, the memorandum of understanding on cooperation between financial supervisory authorities, central banks and finance ministries of the European Union on cross-border financial stability is insufficient, since it is only a non-legally binding instrument. This memorandum, agreed by the ECOFIN on the 5th of April, will not solve the problems of confidence in the financial system and lacks powerful proposals that would enable Europe to act quickly if necessary. Europe needs to be a frontrunner in the innovation of financial regulation. The EU had an advantage on the United States but this lead is diminishing. Henry Paulson, the Minister of Finance of the US, has announced to reform the structure of financial supervision. According to Paulsen, a fragmented system of supervision is no longer sufficient to cover the innovation of complex products in the market. The Americans will bring back the number of supervisors, and give a central role to the Federal Reserve which will be responsible for the stability of the financial market. 49 2007-2008 ALDE ALDE 2007-2008 Europe should do the same and follow up the trend it has set to keep track with this ambition of the US Minister of Finance. The fragmented public overview is in sharp contrast with the extensive global overview available in the boardrooms of the large Wall Street investment banks. What struck me in the last Christmas period was the information about David Viniar, Goldman Sachs’ Chief Financial Officer, that he used all these sources of information available in Goldman Sachs’ dealing room, with its analysts and with its M&A company advisors all over the world, to create excellent 3rd and 4th quarter results. Already in December 2006 Goldman Sachs decided to hedge the risks of a possible sub-prime crisis for its own trading positions, whereas the rest of the world - including many of Goldman’s’ clients - had to wait until August to see and feel the detrimental effects of what has grown to be a worldwide credit crisis. This poses questions to the solidity of the so called Chinese Walls that investment banks claim to have established between their different activities. The suggestions that I did in my draft report on the follow up of the Financial Services Action Plan were weakened due to a lobby of the London Investment Bankers. The information about Goldman Sachs inspired me to raise this issue again in a written question to the European Commission. Commissioner McCreevy answered that is it up to the national regulators to look after the behaviour of market participants. The European Commission would have no competence in this field. In addition I asked Commissioner Kroes on investment banks, she mentioned that “without doubt” there is conflict of interests within the large investment banks. Nonetheless, she refuses to start an investigation on possible abuses of their market dominance. Besides a more coherent and effective structure of financial supervision, we need more transparency. The financial crisis has shown a lack of transparency, especially regarding the non-regulated products. The clearing of over-the-counter products is necessary to assess risks in order to prevent systemic risks. It is preferable to do this clearing on an international basis not to harm European competitiveness. I consider purposive transparency as a prime tool managing risk. Transparency needs to be diversified in various levels. The general public needs to be informed on the objectives, investors on the valuation and risk of investments and supervisors need a full view on the positions and strategies. Better corporate governance is a fourth element that should help prevent the excessive risk taking and the lack of prudence and due diligence. There is a clear link between incentives for high bonuses and remuneration packages and this risk taking. Performance indicators based on quarterly results and volatile stock performance often lead to a perverse focus on the short term and negligence of the risk assessment and long term orientation on the creation of real value. To make the financial markets a fair and efficient tool for economic growth and wealth for all, we must take the lead again and make sure that public oversight on stability and systemic risks, fair competition to prevent market dominance and conflicts of interests, and remuneration packages that stimulate a long term approach of investing and undertaking, will prevail over the profit-orientation of greedy financial engineers and merchants. David Smith, visiting Professor Derby University and Chairman of the IEA’s Shadow Monetary Policy Committee, UK Introduction My brief today was to concentrate on the British aspects of the global credit crisis, rather than the wider international ones, which have been covered by other speakers. I will start with four declarations of interest. Firstly, I spent most of my career between 1968 and 2006 working in the City of London, starting at the Bank of England but mainly working in clearing banks and subsequently the securities industry. Second, I was a depositor in Northern Rock and saw its demise from the inside. Third, the securities house I worked in for the last twenty four years of my City career also got into financial difficulties. This means I do have direct personal experience of some of the issues we are discussing today. Finally, one of my sons is a quantitative analyst in a hedge fund, so I am in a position to observe the new City of London as well as having experienced the old one. Background to the current British arrangements The five minutes allocated to panel speakers does not leave room for a detailed analysis of the full complexities of UK financial supervision. However, an earlier paper of mine for the Economic Research Council (ERC) entitled ‘Cracks in the Foundations? A Review of the Role and Functions of the Bank of England after Ten Years of Operational Independence’ provides a more rigorous analysis of some of the issues that I will be touching upon today. This paper was published in April 2007, several months before the global credit crisis was apparent. However, it anticipated the problems that would arise if the Bank of England found itself in a lender of last resort situation. I will now quote the first summary point of the 28th April 2007 Press Release drafted by the ERC. “The removal of the Bank’s debt management and regulatory responsibilities was probably an error, in part because of the resultant loss of market ‘feel’ when the Bank had to act as a lender of last resort.” This demonstrates that it was possible to foresee problems with the British tripartite system of financial regulation, if a bank got into difficulties, well before Northern Rock appeared on the UK authorities’ radar screen. Indeed, my former Derby colleague, Professor David Gowland, had argued that the, then brand new, institutional arrangements contained flaws in a Politeia pamphlet written as long ago as 1997 (Gowland (2007)). Nevertheless, the small amount of criticism of Britain’s supervisory arrangements pre-Northern Rock appears to have predominantly come from former Bank of England officials, who were concerned with what would work in practice, rather than the political opposition, financial journalists or the academic community. 50 51 2007-2008 ALDE ALDE 2007-2008 In order to understand how such a flawed structure was implemented in Britain, and why it went largely unchallenged for so long, it is necessary to look at how the UK’s current supervisory arrangements were implemented originally. It was revealed in 2004 that the then Bank of England governor, Lord George, had been having conversations about making the Bank operationally independent with Tony Blair and Gordon Brown for two years before the 1997 general election, with the blessing of the then Conservative Chancellor of the Exchequer, Kenneth Clarke. However, the Governor was not forewarned of the intention to remove the Bank’s responsibility for managing the National Debt and the transfer of the Bank’s regulatory role to the Financial Services Authority. Lord George was allegedly rendered ‘volcanic’, when this was announced three weeks after the Bank was granted the operational independence to set the short-term rate of interest five days after the May 1997 election. The current Labour minister, Ed Balls, has since stated that reasons of political economy explain the speed with which these changes were announced. There was a concern that the issue would get bogged down if an open debate were permitted. There is, however, a lesson here for all trigger happy legislators. It was precisely this lack of a proper open debate that allowed the faulty institutional arrangements that exacerbated the Northern Rock affair to become solidified in statute law. My ERC paper suggested that the current British institutional set up may be acceptable when viewed from the viewpoint of the neo-Keynesian Conventional Theoretical Macroeconomic Model (CTMM), widely employed by Anglo-Saxon economists, but looks very fallible when viewed from alternative theoretical perspectives, such as broad-money monetarism. In its simplest form, the CTMM can be reduced to three equations: one determining the output gap; one deciding the rate of inflation; and one the short-term rate of interest. The essential idea is that, if inflation expectations are steady, tweaking the official REPO rate alters the real rate of interest, which influences the output gap, and then the rate of inflation. This theoretical approach appears to have been trebly codified into the way the Bank of England operates; once in the institutional structure established in the 1998 Bank of England Act, again in its intellectual approach, and finally in its main forecasting model. As far as the latter is concerned, none of the macroeconomic models operated by the world’s leading central banks incorporate the multiplicity of market interest rates, ‘passthrough’ problems whereby changes in REPO rates do not affect other borrowing costs, or credit rationing, which have been such important aspects of the global credit crunch. This intellectual lacuna does not make policy making any easier. Northern Rock The real significance of the Northern Rock affair is that it probably represented the first retail cyber run on a deposit taking institution in a major developed economy. Large depositors who had internet accounts appear to have whipped their money out at the first sign of trouble and the institution was doomed before the first of the picturesque queues so beloved of the international media had formed the following morning. It has since been confirmed, in evidence to the House of Commons Treasury 52 Select Committee, that the cash withdrawn from internet and postal accounts was the decisive factor. It was also stated that some 5% of depositors controlled around 50% of Northern Rock’s deposits. For politicians, the unit that matters is the number of voters affected. However, what matters for the stability of the banking system is the volume of deposits, and this has implications for how high any deposit insurance should go. One could safeguard the great majority of individual depositors, but still face the cumulative collapse of several financial institutions, for example. The question of deposit insurance inevitably entails a discussion of the moral hazard involved. However, it is clear that some of the more gung ho advocates of letting depositors suffer have failed to distinguish between the responsibilities of depositors, shareholders, and the management of institutions that suffer from a liquidity crisis. Quite simply, it is unreasonable to expect small savers to know more about the financial position of Northern Rock than the Financial Services Authority, Bank of England, HM Treasury and the entire community of City banking analysts combined. Although retail depositors cannot act as a check on the management of financial institutions, the collapse in the value of Northern Rock shares certainly reduces the moral hazard aspects of its bail out where the shareholders of other commercial banks are concerned. The main principal/agent problem that remains is how the managements of failed institutions – who seem to be largely beyond the control of shareholders - can be made to share the pain, if their reckless behaviour endangers the organisation concerned. All too often, managers of failed financial institutions on both sides of the Atlantic have walked away with country mansions, huge pension pots, and performance related bonuses, which were unjustified by their reckless stewardship of the institutions concerned. Arguably, the contracts of the senior management of institutions that have to be bailed out should be declared null and void – this is legally possible because statute law takes priority over civil law – and they should receive no compensation for loss of office. It is also possible that the British regulatory authorities need to be more aggressive in the pursuit of wrong doers, in the same way that their US counterparts have been. One has a nasty feeling that the most lucrative course for the rational economic man that appears in economics textbooks – who is essentially a socialised psychopath - is to take charge of a reputable financial institution and run it totally recklessly, while pocketing performance related bonuses, before leaving it in ruins after a few years, with vastly more personal wealth than could have been acquired in forty years of sound and responsible stewardship. Recommendations I would now like to make some specific recommendations, with the recent British experience in mind. Deposit Insurance. The need to avoid future panics, suggest that the present system of deposit insurance needs to be extended. I would suggest 100% cover for deposits 53 2007-2008 ALDE ALDE 2007-2008 of up to £5,000, then 90% up to £100,000, and perhaps zero beyond that point (the present upper limit is £35,000). There are economies of scale in managing money and it is socially inefficient to have depositors breaking their savings up into small parcels in order to ensure that they are covered by deposit insurance. This, together with the speed with which funds can be removed from internet accounts, argues for a reasonably high upper limit to the insurance protection. The provision of unlimited 100% deposit insurance would act as a crooks’ charter and encourage people to place their money with irresponsibly run institutions. This is why only 90% coverage is being advocated for larger depositors. Northern Rock’s top end ‘Silver Saver’ account, for example, was only offering 60 basis points more than its rivals. The prospect of even a 10% loss should adequately concentrate investors’ minds on the risks involved. Mandatory Liquid Assets Ratio Requirements. The 1988 Basle agreement specifies the capital requirements of the world’s banks and is designed to ensure that deposit taking institutions always have enough capital and reserves to avoid a solvency crisis. However, Northern Rock was solvent and brought down by a pure liquidity crisis, according to the official account, which I have reservations about, however. There is a long tradition of central banks imposing liquid asset ratio requirements on their banking sectors in return for the provision of lender of last resort facilities. Such requirements should not be too onerous, because that would encourage disintermediation and the growth of dubious secondary banks. However, there are potentially high social costs to a situation where banks can easily expand their balance sheets while relying on the central bank to supply liquidity on tap. These include the risk of boom/bust credit cycles and serious macroeconomic instability. This externality explains why free market forces cannot operate untrammelled in the banking sector, once depositors are protected by the state. Before the introduction of Competition and Credit Control in 1971, for example, British clearing banks were meant to maintain an 8% cash ratio, and keep another 20% of their assets in government debt with a maturity of less than five years. It was not until the 1980s that all such balance sheet restrictions were abolished, following several reductions in, and re-definitions of, the required liquidity ratio. It is now worth considering whether the re-imposition of modest mandatory liquidity requirements of the order of, say, 5% to 10% of eligible liabilities should be a response to the enhanced deposit protection that now seems politically inevitable in Britain. One advantage of such requirements is that the Bank of England would know with confidence the true value of the assets that were being pledged as collateral in a lender of last resort situation. There is a risk with mortgage backed and similar securities that the collateral accepted by central banks is worth less than its alleged value, exposing the taxpayer to potentially serious capital losses. However, one danger that must be avoided is the imposition of such a large or abrupt increase in reserve asset requirements that it causes a collapse in money and credit growth and induces a recession. This suggests that any new liquidity requirements should be phased in over several years, not imposed all at once. 54 Bank of England or Financial Services Authority? The re-imposition of mandatory liquidity requirement on banks should be accompanied with a decision to make the Bank of England responsible for supervising all the deposit taking institutions whose liabilities are included in M4 broad money. Secondary institutions outside the M4 sector should not have their deposits insured by the state and people should be informed that placing money with them carried a default risk. One advantage of this development would be that it would introduce a firebreak in the spectrum of liquid assets, and allow broad money to be more clearly defined and perhaps better controlled. The Bundesbank was a great believer in the need for reserve asset ratio requirements in the 1980s and early 1990s and considered them to be an important monetary tool (Deutsche Bundesbank (1990)). Another advantage of returning supervisory responsibility for M4 deposit taking institutions to the Bank of England is that the Bank would have better market intelligence on the institutions that it might have to bail out, but it would not have to be concerned with large numbers of very small institutions. These could be left to the Financial Services Authority. US Federal Reserve officials have recently commented that their supervisory responsibilities have made it easier to know with confidence that they were not being stuffed with duff collateral, when lending to the commercial banks. Macro-Prudential Regulation and Money Supply Targets. There is a growing interest in so-called ‘macro-prudential’ regulation (see, for example, Borio and Shim (2007)). The basic idea is that the capital requirements imposed by the original Basle agreement acted perversely to amplify boom/bust credit cycles. The reason is that commercial banks tend to be flush with profits during the boom phase of the credit cycle, and find it very easy to build up their capital and reserves, but the converse applies in the downturn, with the result that they ration credit unduly stringently. The remedy that is now being suggested is that the mandatory capital ratios imposed on commercial banks should be varied with the phase of the credit cycle, being raised in the boom and reduced in the slump. It is widely accepted that the authority operating such a counter-cyclical policy would need to be forward looking and that this role could only be properly carried out by central banks - since they are already engaged in economic forecasting - unlike bodies such as the Financial Services Authority, who have no expertise in this area. There seems to be a connection here between the desire to have the balance sheets of commercial banks growing at a reasonably steady progression over time, in order to smooth the amplitude of credit cycles, and the late 1970s and early 1980s vogue for money supply targets, which were an attempt to control the growth of the liabilities side of the banking sector’s balance sheet, if the small proportion of broad money accounted for by notes and coin is ignored. The policy of money supply targeting broke down in Britain because the authorities found it impossible to control the growth of broad money by interest rates alone. One reason is that the demand for interest bearing broad money balances rose when the interest rate paid in bank deposits went up, squeezing the economy through a rise in the demand for money rather than a cut in its supply. It is possible that the use of alternative monetary instruments, such as variable liquidity ratios, would have 55 2007-2008 ALDE ALDE 2007-2008 reduced some of these difficulties. However, such devises were never tried because such ratios were being phased out in order to encourage financial competition. A personal view is that a macro-prudential approach to financial regulation would be done better through liquidity requirements than capital ones. Macro-prudential considerations also provide an independent justification for the European Central Bank’s second monetary pillar – this time as a device for heading off boom/bust credit cycles - in addition to its established role as a long-stop against the build up of inflationary pressures beyond the conventional macro-economic forecasting horizon. Caveat Legislator I have now nearly finished my remarks. However, I am aware that this is a legislative body, and legislative bodies tend to churn out laws the way sausage factories turn out sausages, without necessarily considering all their potential adverse consequences. There is a long history in monetary economics of ill-considered banking legislation inducing a credit crunch and an economic recession. President Roosevelt’s decision in the late 1930s to punish the banks for their perceived earlier excesses by increasing their reserve requirements stopped the recovery from the Great Depression dead in its tracks, and led to a renewed downturn. More recently, the 1988 Basle agreement caused virtually all the world’s leading commercial banks to simultaneously try to re-organise the assets side of their balance sheets away from lending to the private sector – where the capital requirements were higher – in favour of government bonds. The result was a global credit crunch, a collapse in the value of the collateral such as property whose price had been supported by earlier robust lending growth, a marked slowdown in total OECD broad money growth, and the generally unexpected global recession of the early 1990s. The long period of subdued monetary growth that followed did, however, have the benefit of bringing down OECD consumer price inflation and paved the way for the ‘great moderation’ that followed. There are two further concerns about legislative intervention. The first is that it can lead to the monetary authorities being captured by the financial services industry that it is supposed to be regulating – this may have happened to the US Federal Reserve over the past decade – with the result that interest rates are set with the needs of financial speculators in mind, rather than the population at large, leading to an inflationary bias. The second worry is that regulations can lead to financial intermediaries playing the system to their own advantage. The 1988 Basle agreement gave commercial banks an incentive to securitise their lending and get it off their balance sheets, for example. There would be less doubt as to the value of the underlying assets, and processes such as foreclosure would have been simpler, if this had not happened. The unintended consequence of the Basle agreement was correspondingly to replace a situation where lenders faced risk, but at least had some feeling for the parameters of the probability distributions involved, with one of complete uncertainty. It is because market counterparties cannot even start to 56 calculate the odds that they have all became hyper cautious, and more risk adverse than was objectively justified originally. This is why the present credit crunch is more intractable and dangerous than it would have been under a better thought out regulatory framework. The good news is that there has been so sign of the implosion of commercial bank balance sheets observed in the Great Depression, when the level of the US money supply contracted by over a quarter. The latest figures show that the year-on-year growth of the aggregate OECD broad money stock (excluding high inflation countries) accelerated away from the remarkably narrow band centred on 5½% or so that characterised the low inflation ‘great moderation’ observed in the period 1992 to 2005 to 6½% in the fourth quarter of 2005, 7¼% in late 2006, and 8¾% in the final quarter of last year. There is clearly a risk that, while the world’s monetary authorities have been concentrating on avoiding a re-run of the 1930s, they have replicated the monetary laxity of the late 1960s and early 1970s in practice, and let the evil genie of global inflation out of the bottle again. Finally, I am conscious that I have said nothing until now about the joint Consultation Paper issued by the Bank of England, HM Treasury, and Financial Services Authority in January 2008 but have concentrated on putting forward my own views instead. This partly reflects the time available. I would certainly encourage people to read the joint consultation paper, which is a remarkably humble document in some ways, and canvasses external opinion to an unprecedented extent. My main regret is that this consultation process was not followed in May 1997, before the weaknesses in the present system were set in legislative concrete. The moral is surely pass laws in haste, repent at leisure. References Bank of England, HM Treasury and Financial Services Authority (2008), Financial Stability and Depositor Protection: Strengthening the Framework, Joint Consultation Paper, January 2008 ( Borio, Claudio EV and Shim, Ilhyock (2007), What Can (Macro-) Prudential Policy do to Support Monetary Policy?, Bank for International Settlements Working Paper No 242, December 2007, ( Deutsche Bundesbank (1990) ‘Minimum Reserve Arrangements Abroad’, Monthly Report of the Deutsche Bundesbank, volume 42 no 3, March 1990. Gowland D (1997), Banking on Change: Independence, Regulation and the Bank of England, Politeia, 22 Charing Cross Road, London WC2 0HR. Smith, D.B. (2007) ‘Cracks in the Foundations? A Review of the Role and Functions of the Bank of England After Ten Years of Operational Independence’, Economic Research Council, Research Paper no 23, May 2007, Economic Research Council, 7 St James’s Square, London SW1Y 4JU ( 57 2007-2008 ALDE ALDE 2007-2008 Bertrand Huet, Managing Director Securities Industry and Financial Markets Association Process issues Although we still do not know the full extent of the sub prime fallout, what has become clear is that all stakeholders have their share of responsibility: US mortgage brokers, investment banks, rating agencies, investors, regulators and supervisors. So the only adequate response to the crisis will be a collective one. We are all in this together. The good news is we know the list of issues we each need to work on, and public and private sector are already hard at work. Deadlines are tight, but we must go through the assessment process in a thorough and disciplined fashion. We must cooperate with one another, and we must be coordinated – in Europe, and globally. Key considerations as we go through this work We cannot throw the baby with the bathwater. Securitisation has been good for our economy. Its fundamentals are sound. We should focus on the excesses, but in so doing we must be careful we don’t damage the creativity of our people and the modern EU regulatory regime we operate under, both of which have contributed to making Europe’s’ capital market an increasingly more attractive alternative to the US. We must carefully balance market driven vs. regulatory responses. Mr Daianu’s report makes the point well. Regulation alone is not the answer. Market driven responses alone are not the answer either. We need each other if we are going to get this right. We must stop with mis-informed statements and generalities about securitisation. It hurts what we need the most urgently restored: confidence. Eg. • many structures are neither complex, nor opaque • not true to say this is an unregulated market: EU has sound mortgage underwriting regulation, most ABS deals are listed on a regulated market and thus subject to PD, TOD, MAD, MiFid. A stronger Basel 2 framework for securitisation is on its way. • increasing finger pointing at hedge funds as one of the causes of the crisis, as in Mr Daianu’s paper, is a red herring. Most of the leverage was in the SIV structures. These are dead. The part of the securitisation market that is broken is the AAA RMBS market. Hedge funds do not invest in this market. Our No 1 priority • Has to be to get the securitisation market re-started as soon as possible. In particular the RMBS sector. This sector (half of the securitisation market) is of huge importance. Not just to the big banks. In the last 6 years, RMBS and covered bonds together funded over 50pc of EU mortgages. So it matters to EU citizens as well. • If disruption in this market continues much longer, it will lead to a dramatic reduction in mortgage lending, which in turn will have a negative effect on the economies of the €urozone. It is already had. • So very much agree with Mr Daianu’s conclusions. Timing is important. Caution is needed and knee jerk reactions are not warranted - but too slow a change is not warranted either • As the last G7 communiqué states, the most immediate priority is to get confidence back. Transparency has an important role to play. Industry initiatives on transparency On 8 Feb, 8 industry bodies signed a letter to the EC committing to deliver on a number of initiatives to improve transparency in the EU securitisation market. A working group of 280 participants, including 25 associations (EU, global, national, US, Asia), banks, investors, law firms, CRAs, data vendors, infrastructure providers, exchanges, is working on 13 initiatives organised around 3 main themes. 2 of those themes are those listed in the transparency section of the ECOFIN Oct 07 roadmap • ensure disclosure of securitisation exposures under the new Basel II Pillar 3 regime are both relevant and granular enough; to this end we will issue draft industry guidelines on good disclosure practices in June for consultation. • improve policy makers’ ability to monitor the securitisation market and better assess trends; to this end we are developing a comprehensive and consolidated data report which will be issued on a frequent and regular basis, starting June 08 But we will go beyond the ECOFIN roadmap, with a number of additional initiatives to improve transaction information for investors. We think what is lacking is investors’ ability/incentive/willingness to perform thorough and independent assessment of risks. This is what these additional 10 initiatives are about. They are listed at the end of the presentation in your pack. Stanislaw Kluza, Chairman of the Polish Financial Supervision Authority International dimension of potential financial crisis Financial markets have become increasingly fast moving and international in scope. This has brought considerable benefits, by allowing increased access to financing, more efficient allocation of capital around the globe. The increasing complexity and interconnectedness of the markets mean that developments in one market can be quickly transmitted to other markets. For as long as the financial sector continues to 59 58 2007-2008 ALDE ALDE 2007-2008 develop, and the role of innovative financial instruments is constantly increasing, the likelihood of a crisis scenario is growing accordingly. This constitutes a substantial challenge for the regulatory system, which must respond to these challenges in mitigating financial stability risks and protecting consumers. The main problem is securing financial stability. Liberalization of financial markets and cross-border mergers and acquisitions have resulted in many financial institutions the fail of which may have systemic relevance for several European countries. Therefore, preparation in advance for an effective protection of financial stability in a cross-border context shall require enhancing of international cooperation and strengthening national regulatory and supervisory frameworks in the first place. The role of supervisors- prevention, crisis management, problem solving We believe that both national and the European framework for prudential supervision as well as crisis management and resolution must allow a quick response to crossborder systemic financial crisis and its implications. It is worth mentioning that financial supervision nowadays performs a largely preventative function, whereas a proper coping with the eventual crisis requires something more - the construction of a financial safety net. Efficient and effective supervision is only one part of the safety net if we understand it as a set of regulations and facilities for protecting the investors from the losses incurred from an insolvency of a financial institution. A well constructed financial safety net should include the efficient and effective supervision, a system of guaranteeing deposits, and a crisis management in cases of financial system destabilization. Prevention In our view appropriate preventive policy toolkit shall encompass two essential components: - strengthening the role of the national supervisory authorities by statutory ensuring their role with respect to financial stability. This requires necessary amendments in the legislation enhancing full operational independence as well as clear and precise mandate. - Effective cooperation with foreign counterparts to improve international exchange of information and crisis management arrangements. In May 2005 a memorandum of understanding was signed in the EU on cooperation between banking supervisory bodies, central banks and finance ministries in the event of the appearance of crisis situations with an international range. The memo mainly included a set of rules and procedures related to the exchange of information, opinions and estimates for making easier the fulfilment of each authority of its function aimed at increasing the stability of the financial systems of specific countries and the EU as a whole. Certainly, college of supervisors shall be perceived a right forum to exchange the relevant information on a permanent basis in order to prevent financial instability. Nevertheless, the competence to perform the actual supervision (e.g. to authorize model validation for credit institutions) shall remain by the local supervisors. In this context the legislative tendency of delegation of competence from the host supervisors to the consolidating supervisor is not justifiable in terms of efficiency. Local supervisors shall also not hesitate to undertake necessary action preventing the suspicious asset transfer from domestic subsidiary to foreign parent company. One may ask as to whether in the event of the parent bank nationalizing its losses in its subsidiary would then the local central bank have to save the subsidiary with public funds? Assuming the local supervisors are properly maintaining adequate overview of the financial system as a whole, the probability of the crisis shall decrease. Assuming a financial crisis is inevitable: some remarks on crisis management The probability that a crisis occurs cannot be eliminated even by the best system of prudential supervision. If this is the case, then we have to develop efficient crisis management regulations. Crisis management may be defined as the set of tools that supervisor may launch if a disturbance in the financial system occurs. Supervisors may, for instance, take measures regarding the management of a financial institution, require capital addon from shareholders, or impose reorganization measures. The objective of crisis management is to protect the stability of the financial system in the country exposed to the harmful economic impacts at the lowest possible cost. The key role in the crisis management may be played by the domestic standing groups that have been put in place in many EU member states. In Poland we have established the Financial Stability Committee that brings together the Supervisory Authority, the central bank and the Ministry of Finance. It aims to enhance preparedness of authorities through the exchange of information, development of tools and also by conducting crisis simulation exercises. In a real crisis situation the domestic standing groups shall take over the coordination of management measures on behalf of all involved authorities, i.a. the information policy. It shall also implement an appropriate contingency plan. I would like to stress at this point that regulatory framework shall always give primacy to private sector solutions which as far as possible will build on the financial situation of a particular company or a group. The use of public funds to calm down a crisis shall never be taken for granted and shall be used only in no other solution is provided. Solving after a crisis: how we proceed with the consequences of a crisis for the market participants? The core issue of tackling the problem of “what after the crisis?” is the system of deposit guarantees. Currently, national deposit system guarantees operate in all EU states. They differ from one another in terms of size and range of guarantees, the ways in which fees are collected, the principles of providing support etc. and in practice represent a system that would be able to handle banking system stabilization risk in the event of bankruptcy of a local financial institution. The question that arises in this context is as to whether one can design a pan European system that would guarantee e.g. deposits of a multinational bank. I am sure this question is puzzling many of you and certainly this is the right time and place to discuss this important issue. 60 61 2007-2008 ALDE ALDE 2007-2008 Home-host relations in financial supervision In the current situation, the home Member States are responsible for performing financial supervision on a consolidated basis. On the other hand all subsidiaries in a financial group have to comply with the host Member State regulations. For the last months, e.g. in the course of legislative work on the Solvency II Directive, we can observe a tendency for shifting of regulatory powers (e.g. approval of capital requirements) from host to home level. In the same time the responsibility for effects of a solvency crisis remains in the host country. Therefore, it is not a beneficial situation from a supervisory perspective if some relevant regulatory competencies are being transferred from host- to home- country level. The host supervisors shall remain responsible for ensuring that appropriate compliance standards to be preserved by subsidiaries with their registered seat in the host country. We also believe that host supervisors have best possible credentials to properly assess and-if necessary- enforce the sound manner in which financial institutions shall conduct their business activities. 62 63 2007-2008 ALDE ALDE 2007-2008 Closing remarks by Wolf Klinz MEP 64 65 2007-2008 ALDE ALDE 2007-2008 A few months ago, we talked about the turbulence or turmoil in the financial markets. Today, nobody hesitates to use the word “crisis”. Indeed we are in a very difficult situation. What started out as a sub prime crisis has spread across other asset markets and is affecting the financial system as a whole. Many citizens have not merely lost confidence in the financial markets but in the economic system as a whole. People start to question the way Western democracies function. They feel that big profits remain in the hands of a few bankers - Wall Street bonuses and compensations totalled $65.6 billion in 2007 (source: Bloomberg) which is more than the annual GDP of a country like Vietnam - while on the other hand failing banking groups are being bailed out with tax payer’s money, socialising any possible losses. Confidence needs to be given back to the citizens by taking corrective actions. Turning back the clock is not an option; we need to show that even though flawed, our market based system is the most reasonable system. The recent financial euphoria, caused by “large, deep, liquid and innovative financial markets” (Baron Lamfalussy), led to an increasing risk appetite and search for higher yields. The global macroeconomic circumstances with low interest rates and huge current account surpluses in countries like China were among the main causes for abundant liquidity and the economic boom. This general set-up paired with rapid financial innovation of complex structured products led to readily available capital in the whole system. Increased innovation in structured finance products, willingness by lenders to take excessive risks, low interest rates and the greed of investors for ever higher yields coupled with their belief that Credit Rating Agencies’ ratings come close to recommendations, allowed complex investment products to be sold to an ever wider range of investors. The repackaging of credits, the increased complexity of the products, and the lengthened intermediation chain including off-balance SIVs - that are not being regulated - make it more difficult, sometimes even impossible, to clearly evaluate the nature and magnitude of the risk involved and identify those who bear it. Every link in the chain, every player profited from commissions arising from selling the highly complex financial products to other market participants. Everyone was involved. The ‘originate-to-distribute’ model led to a watering down of responsibility of market participants. The growing intermediary chain led to a vaporisation of the final lender and a disguise of risk. On the positive side, this made access to capital for SMEs and individuals easier, as risks were diversified. On a more negative side, this financial innovation and liquidity did not go hand in hand with enhanced stability. 66 Thus it seems to be important to take a number of measures that could help contain the crisis and regain confidence in the functioning of the global financial system. These corrective actions can be structured around the headings responsibility, transparency and sustainability: Responsibility: All financial market actors need to assume their respective responsibility for the role they played leading to the current situation. Banks have so far been rather slow in admitting failures on their part, partly due to the knowledge that they will be bailed out by government in any case. Banks should assess their responsibilities and propose initiatives for corrective action. Financial institutions should furthermore reconsider their very short-term compensation scheme that creates wrong incentives by rewarding management long before the final outcome of a business transaction is known. Corporate governance needs to be strengthened. Credit rating agencies have been willing to assume some responsibility, making deficiencies public and proposing ways of self-regulation in this respect. However, they deny any conflict of interest in their activities. It is also the Credit rating agencies’ responsibility to ensure a proper understanding of the underlying criteria of ratings and hence they should communicate this accordingly. Transparency: Banks have to be transparent about their goals and activities. There are substantial differences in banks’ missions; a bank (like a German Landesbank owned by the state) set up to finance infrastructure or a small bank to finance SMEs (like IKB in Germany) should not compete with global investment banking groups, but stick to its respective business strategy. It is simply unacceptable that e.g. the SachsenLB or IKB invest in complex structured products. On the other hand, it is highly unethical that investment banks sell risky structured financial products to these above mentioned banks, the role and mission of which they are well aware of. Risk management systems of banks need to be adequate and properly applied. The sole reliance on models is detrimental and can only work if combined with experience and common sense. A faster reaction by credit rating agencies to changes in the underlying criteria for the ratings is essential in the future. This goes also hand in hand with disclosing the right information on the rating to the investors. The quasi-monopolistic structure is something that needs to be broken up in order to ensure competition and solve the conflict of interest in the long-term. Sustainability: First and foremost supervisory cooperation needs to be improved. National supervisors need to send first warning signs of fragility to their respective Central Banks, but supervisors should also exchange information on a European level in 67 2007-2008 ALDE ALDE 2007-2008 order to prevent and if necessary resolve systemic risks. Moreover, regulators have to come up with rules for off-balance sheet items. Banks need to be transparent about all their activities. The role of Basel II is essential to ensure the future stability of the system. It seems surprising and unacceptable that in certain cases the capital charges under the new Basel II system are lower than under Basel I. Basel II does allow for capital underlying for off-balance sheet conduits or SIVs, but only if held more than 365 days. This intrinsically means that banks could commit themselves to hold a conduit for 364 days without having to put any capital aside. Furthermore, Basel II allows for a “normal” distribution of assets, which implies higher concentration of risks. Concentration of risks should be penalized but Basel II fails to do so. A final point: further consideration should be given to the appropriate application of fair-value accounting and the mark-to-market principle. Particularly when tradability of products does not or only partially exist, determining the fair value remains arbitrary. Therefore, better tradability of OTC products on open markets needs to be ensured to reduce mark-to-model practices. To conclude, the free cross-border movement of capital, new innovation in products, and the integration of financial markets have led to economic growth as a whole and we need to be careful not to suffocate these vital gains by overregulation. Due to the global aspect of the crisis, the measures to be taken will only be successful if the key players of the world’s financial markets are willing to work closely together. Any measures should ensure that the stability in the future is increased, without having a negative impact on the progress that has been achieved over the past years. 68 69 2007-2008 ALDE ALDE 2007-2008 Background Paper Why Is This Financial Crisis Occurring? How to Respond to It?* by Daniel Daianu, MEP and Laurian Lungu, Cardiff Business School * Background paper prepared for the ALDECON seminar on the international financial crisis, 27th February, 2008. We thank for very helpful comments to Sharon Bowles, Wolf Klinz and Patrick Minford. We also thank Eric De Keuleneer, Nigel Phipps, Robert Priester, Ray Kinsella, John Purvis, Ieke Van den Burg and other ALDECON seminar participants for their useful comments. We assume full responsibility for the content of this paper. 70 71 2007-2008 ALDE ALDE 2007-2008 Daniel Daianu MEP and the School of Political and Administrative Studies, Bucharest (SNSPA) Laurian Lungu Cardiff Business School March 2008 Abstract. A combination of cyclical and structural factors has lead to a situation which could threaten financial stability worldwide. As the current financial turmoil is unfolding it becomes clearer that the effects of the initial sub-prime crisis, which originated in the US, are spreading across other asset markets worldwide, increasing the likelihood of a global credit crunch and an economic downturn. In the light of these developments there is a need for the implementation of strategies for action. This paper focuses on structural causes of the current crisis and on policy issues such as enhancing transparency, resolving conflicts of interest, incentives structures in the financial industry and, not least, improving the existing regulatory and supervisory frameworks. JEL Classification: G18, G28. Summary Financial innovation brings about benefits when it fosters dynamism and economic growth. But it also entails significant risks; the more complex financial innovations are and the more broadly based their use is, the higher ensuing systemic risks can be. In other words, the fragility of financial systems can increase substantially. Recent events in international financial markets show it amply. As a matter of fact, complexity has become a key issue to deal with in both internal risk management (by banks) and in the overall functioning of financial markets. At the time of writing, a combination of cyclical and structural factors has lead to a situation which could threaten financial stability worldwide. As the current financial turmoil has been unfolding it becomes clearer that the effects of the initial subprime crisis are spreading across other asset markets, increasing the likelihood of a global credit crunch and an economic downturn. The breadth of the ongoing crisis has brought into attention, once again, issues related to the transparency and liquidity of financial systems. Excessive risks taken by lenders, at the expense of necessary prudence, together with a high degree of financial engineering have allowed complex investment products to be sold to a wide range of investors. The emergence of the so called ‘shadow banking system’ - which is exempt, to a large extent, from regulation and supervision (as it is experienced by the banking system) - has facilitated the proliferation of highly leveraged investment vehicles and has accentuated systemic risks. Major players in this game have been leading banks through their “origination and distribution” activities; these activities have increased the opacity of markets and systemic risks. With the implicit lengthening of the intermediation chain, it becomes increasingly difficult to assess the nature and magnitude of the risk involved or to locate those who bear the risk; markets have become opaque. These effects have been compounded by the lack of adequate due diligence by banks and investors. Inadequate incentive schemes, short-termism and unregulated conflicts of interest have increased the bias toward speculative trading. Two of the most important policy challenges ahead are those related to transparency and liquidity. But, arguably, the most arduous task is to combat the scope for higher systemic risks when financial innovation is very intense. For, ironically, financial innovation that was designed, purportedly, to diminish risk at the individual or micro level has ended up in exacerbating it at the macro level, thus increasing systemic risk. One feature of the current crisis is the high degree of uncertainty regarding the distribution and extent of incurred losses. This uncertainty, massive lack of trust, have made investors to take a flight for quality, which, in turn, has led to an increased liquidity demand. Central banks have responded to that by injecting large amounts of liquidity in the money market. However, the pursuance of such a policy is unlikely to bring an end to the current crisis for two reasons. First, this measure does not address the root of the problem, namely that of the underlying fear that banks’ balance sheets are in a precarious position. At the moment, the existence of counterparty risk is prevailing in the money markets. And second, the liquidity does not reach the market participants which mostly need it – i.e. the ‘shadow banking system’. In hindsight, recent crises, such as the LTCM or Enron, can be seen as stress tests for the financial system. Although these crises were quite severe, their global effects were contained in the end because, at those periods of time, the financial markets’ degree of sophistication did not, arguably, reach the level and depth as witnessed nowadays. Delays in the effective implementation of changes in regulatory systems, as flagged out by these warning signs, are partially, at the root cause for the turmoil we are witnessing nowadays. It is, therefore, quite surprising to hear officials (central bankers, supervisors, etc.) claiming that the magnitude of the current financial crisis could not have been imagined a year ago. Alexander Lamfalussy, who is an eminence grise in the world 73 72 2007-2008 ALDE ALDE 2007-2008 of finance, underlined the trade-off between apparent higher efficiency and stability after the LTCM and the Dotcom episodes. And in 2003 Warren Buffett called derivatives “financial weapons of mass destruction”. In the light of the developments mentioned above there is a need for the implementation of appropriate strategies for action. This paper brings together points of view expressed by academics, market participants or analysts. These views focus on a few directions centered on issues such as enhancing transparency, resolving conflicts of interest, incentive schemes, and, not least, improving the existing regulatory and supervisory frameworks. The current crisis is an additional strong proof that free markets are not tantamount to deregulated markets and that over-reliance on the self-healing/regulatory virtues of markets is quite dangerous. This paper also reflects our own thinking on how to respond to the current crisis. Contents: 1. Introduction 2. A Classification of Financial Crises 2.1 What Causes Financial Crises? 2.2 Relevant History Lessons and Policy Implications 3. The Current Crisis – What Has Triggered It and Implications 3.1 The Roots of the Current Crisis 3.2 Features of the Current Crisis 3.2.1 The ‘Shadow Banking System’ 3.2.2 The High Level of Concentration 3.2.3 The Breadth of the Crisis and the Lack of Trust 3.2.4 Extensive Leverage on a Large Scale by Some Market Participants 3.2.5 Rating Agencies Deficiencies 4. What Should Be Done 4.1 Improving Transparency 4.2 Resolving Conflicts of Interest Among Market Participants 4.3 Improving the Existing Regulatory and Supervisory Frameworks 5. Summing up References Appendix 1. The Recurrence of Financial Crises in Economic History Appendix 2. Three-Month Inter-bank Spread Rates Over The Base Rate ”While the Committee strongly believes that large, deep, liquid and innovative financial markets will result in substantial efficiency gains and will therefore bring individual benefits to European citizens, it also believes that greater efficiency does not necessarily go hand in hand with enhanced stability.” (Alexandre Lamfalussy) 1. Introduction Increasing innovation in financial markets together with rapidly growing crossborder transactions (globalisation) aided by favourable low-interest rate conditions in developed markets, against the background of inadequate regulatory frameworks, have created the premises for a potentially devastating financial crisis (more severe than the ongoing current crisis). It is too early to tell what the consequences of a full blown crisis would be as it is quite difficult to assess its impact on both the financial sector and the real economy; what is certain, however, is that this impact would be very damaging. The purpose of this policy paper is to have a look at the main causes that have triggered the current crisis and then review some of the suggestions to tackle it as highlighted by various market participants. From the start it looks as if at the roots of today’s unfolding crisis has been market participants’ behaviour of making reckless lending, often against no collateral, while regulatory and supervisory institutions were failing. But equally important it has been the very intense financial innovation of the past decade, which has allowed a wide dissemination of risks together with a blurring of the line delimiting who bears them. Without this wide dissemination the sub-prime mortgage crisis could, presumably, have been contained to a large extent, to the US markets. Ironically, what was thought to diminish risks at individual (micro) level has turned out to increase systemic risks; the latter have to be examined in conjunction with the expansion of global markets. It has to be said, however, that elements of the ongoing crisis make integral part of the long standing pattern of booms and busts in asset markets. Often, the mechanism through which these financial crises develop is, as mentioned by Michael Bordo (2007), the emergence of new financial instruments. The latter are often designed in such a way as to avoid regulation and necessarily require a test of financial stress in order to be proved successful or not. Initially, the euphoria of the boom, financed through credit, blurs the distinction between sound and less profitable prospects, a situation which could induce an asset price bubble. Information asymmetries compound the initial problem leading to moral hazard and adverse selection . The bust – often triggered by an increase in interest rates - brings an end to the lending cycle. In hindsight, recent crises, such as the LTCM or Enron could be considered as stress tests for the financial system. Although they were quite severe, their global effects could be contained in the end because, at that time, the financial markets’ degree of sophistication did not, arguably, reach the level and depth as witnessed nowadays. It seems that delays in the effective implementation and enforcement of changes in regulatory systems, as flagged out by these early warning signs , are at least partially, at the root cause for the turmoil we are witnessing nowadays. 74 75 2007-2008 ALDE ALDE 2007-2008 Financial crises are powerful events and can have very serious implications. If the effects of the crisis affect the real economy, this could in turn trigger a fall in consumers’ wealth and consumption and it might take years until the economy settles back to the economic path at the point preceding the crisis. In effect, this is one of the main questions addressing the existing situation. Given the current state of short-term credit concerns in an economic environment where GDP has still been growing and house price declines have been rather modest, the question posed is what can be expected if the US enters a full-blown recession and average real estate values fall by a large amount. Spillover effects to other global asset markets would, undoubtedly, magnify the outcome of such a scenario. The paper proceeds as follows. Next section deals briefly with the issue of classification of financial crises, as documented in the literature. It also highlights similarities the current financial crisis has with more recent episodes of this kind. Section 3 describes what is particular of the current crisis. Finally, the last section summarises points of view expressed in the literature and the media about what can be done to avert the occurrence of such a crisis in the future. 2. A Classification of Financial Crises 2.1 What Causes Financial Crises? Financial crises are recurring phenomena which can have a significant impact on the economy. Depending on how one defines a financial crisis, there are various ways in which these can be classified. For instance, Anna J. Schwartz, a reputed US monetary economist, argued that a financial crisis should involve a run on the monetary base. Otherwise it would be difficult to distinguish between a pseudo-crisis and a real one. In practice, however, things are more difficult to assess once a crisis is unfolding. Financial crises could involve either bank or currency crises or indeed, both of them could take place at the same time. Historically, credit booms – that fuelled unsustainable rates of economic growth - seemed to have preceded financial crises. Delargy and Goodhart (1999) argue that both the late 19th century crises and those in the late 20th were more likely when loose credit conditions in the lending countries were in place. Subsequently, when credit conditions suddenly adversely changed it generated a boom and bust economic cycle. The causes for financial crises are multiple and nowadays, a standard classification of currency crises revolves around one of the three generational models. The first generation models, pioneered by Krugman (1979) and Flood and Garber (1984) deal with crises that are mainly caused by macroeconomic vulnerabilities. In essence, at their origin is the government’s need to finance constantly higher deficits, eventually resorting to monetisation. Because these crises necessarily envisage a dynamic path for economic policies, they are therefore predictable. Classic examples 76 are recent crises in Russia (1998) and Argentina (2001). Moreover, these type of crises could include a broader array of factors that trigger them, including monetary policy indiscipline, overvalued exchange rates and contagion from crises in relevant trading partners countries. Because of improved macroeconomic policies at the global level however, the frequency of these crises tend to be more rare nowadays. The second generation crises models focused on macroeconomic trade-offs and decisions. They emphasise non-financial conditions that may abruptly turn adverse in such a way that would present the authorities with a range of policy choices. As an example of the second generation crisis is the series of attacks on some European currencies within the European Monetary System in 1992-1993. Obstfeld (1986) has shown how crises can be self-fulfilling in such a situation. They also exhibit multiple equilibria and occur mainly because market participants expect them to materialise. The third generation crises address the balance sheet problems. A distinctive feature of those is that their causes reside in the financial sector vulnerabilities (Kaminsky and Reinhart, 1999). At the root of these vulnerabilities are mismatches between assets and liabilities, whether they are held by financial institutions or by the nonfinancial sector, and irrespective whether they are a matter of concern for the public or private sectors. The frequency of this later strand of currency crises has become higher recently, as financial markets have become increasingly integrated. Different third-generation models explore various mechanisms through which balance-sheet exposures may lead to a currency and banking crisis. Thus, according to Mark et. al (2002) there are four types of balance sheet mismatches that can be identified: maturity mismatches, where the gap between short term liabilities and liquid assets leaves an institution incapable to pledge its contractual commitments if lenders refuse to roll over debt or if creates exposure in the face of interest rate rising currency mismatches, where sudden changes in exchange rates lead to a capital loss; capital structure problems, where excessive leverage leaves a firm or bank exposed to uncertain revenue shocks in adverse market conditions solvency problems, in cases where assets are insufficient to cover liabilities. Solvency risk can arise from various reasons. For instance, Chang and Velasco (2001) show that a liquidity exposure leads to the possibility of a Diamond and Dybvig (1983) style bank run. In Caballero and Krishnamurthy (2001) firms face a liquidity problem because they finance risky long term projects with foreign loans but have access to limited amounts of internationally accepted collateral. 77 2007-2008 ALDE ALDE 2007-2008 It is within the third generation models that most recent financial crisis are part of. A characteristic of the latest financial sub-prime crisis is the collapse of short-term commercial paper market, thus impeding the attraction of new financing or rolling over existing short-term liabilities. There are quite a few episodes of financial crises in the economic history . Probably the earlier classic example of a financial bubble is that of the Dutch tulip mania of 1634-1637 . A single bulb of Semper Augustus traded from a few florins in 1634 and rose to 6,390 florins in 1637, before collapsing to a tenth of a florin, at which price it traded for the next century. But there are more other famous examples like the Overend and Guerney (1866), Barings Bank (1890 and 1995) or The Great Depression (1929-1933). Subsequent to these crises, landmark changes in the regulatory and supervisory rules were introduced. 2.2 Relevant History Lessons and Policy Implications After Overend and Guerney went bankrupt in 1866, Walter Bagehot advocated the ‘lender of last resort’ role for the Bank of England. Its main objective would be to avert a systemic crisis by providing liquidity to the financial system during crises. In the aftermath of the 1929 crisis, the so-called New Deal was introduced by the US President, Franklin Roosevelt. This included extensive regulation of financial markets and the banking system through the creation of the Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation (FDIC). It also led to a separation of banking activities through the Glass-Steagall Act. Subsequent to the Barings crisis in 1995, the Bank of England restructured its Supervision and Surveillance system. It implemented a new model (RATE) for assessing risk while increasing cooperation with other central banks supervisory departments. Its changes were followed suit by other national Supervisory institutions (for instance Germany’s, which introduced minimum requirements for the trading activities of credit institutions). After the Black Monday crush of 1987, regulatory bodies introduced the so-called ‘circuit-breakers’ aimed at limiting programme trading and allowing them to suspend all trades for short periods. The seriousness of the LTCM crisis in 1998 prompted the US President’s Working Group on Financial Markets to issue a report on the hedge fund implications for systemic risk in financial markets . Its central policy recommendation was that regulators and supervisors should foster an environment in which market discipline constrains excessive leverage and risk-taking. Investigations by SEC in the Enron scandal (2001) revealed major flaws in the existing regulatory and supervisory system. Among these were rating agencies’ conflict of interests, fraudulent management activities and the extensive leverage of the offbalance financial entities. Obviously, there are many similarities among this crisis and previous episodes. Reinhart and Rogoff (2008), for instance, provide a historical comparison. They were preceded by periods of credit booms facilitated by low interest rate environments. Often the emergence of crises was facilitated by obsolete framework designs of institutions which have a regulatory and supervisory role. But there is also a number of issues, such as the workability of securitised lending and the roles of central banks and regulators, which makes this crisis different (Wolf, 2007). Table 1 below provides a succinct explanation of the causes and consequences in recent crises. More about those is presented in Appendix 1. Table 1. The Causes and Consequences of Recent Crises Causes The Enron Scandal, 2001 Consequences Con icts of interest; Systemic e ects – on complex structured nance creditors, banks and other transactions rolled via energy trading companies. through o -books nancial entities; fraudulent activities Limited investment Temporary closure of the knowledge of individ ual nancial markets; business market participants investment falling and the US economy slowing High leverage factor; Threatening systemic sophisticated computer failure i n international models to assess nancial markets investment strategies Indiscriminate investments Credit crunch and due to cheap credit widespread bankruptcies; availability and premature slower global growth opening of the capital account Programme strategies and perception trading The US stock market market su ered its largest oneday fall The DotCom Crash, 2000 LTCM crisis, 1998 Asian Crisis 1997 78 The ‘Black Crash of 1987. Monday’ 79 Asian Crisis 1997 2007-2008 ALDE availability and premature slower global growth opening of the capital account Programme strategies and perception trading The US stock market market su ered its largest oneday fall ALDE 2007-2008 The ‘Black Crash of 1987. Monday’ - An increasing use of new financial instruments (securitisation) which have spread out risks across national borders, but which have made markets more opaque (reduced transparency). ). In part this was due to the lack of due diligence . However, the lack of effective trading of many of the new financial products has made rising opacity quite inevitable. - Rising opacity of financial markets has accentuated systemic risks. There has been a fallacy of composition at play here. The ‘origination and distribution” of synthetic products was meant to diminish individual (micro) risks by their diversification and spreading. But micro-rationality clashes with macro-rationality when markets lose transparency. As thoughtfully highlighted by Lamfalussy (2000, 2008) there is here an apparent trade-off between expected higher efficiency of financial intermediation and the stability of the financial system; the latter is becoming more fragile! - The pressure of globalisation and the rise in cross-border operations. Transactions costs have been reduced constantly over the last years and, as a consequence, large volume of transactions can be carried out in short amounts of time. Again, these evolutions may in fact, have enhanced a lack of due diligence. - Inadequate quantitative methods (risk and econometric models) to the extent they are meant to replicate the functioning of actual markets and decision-making relies heavily on them. - Seemingly intractable conflicts of interest among market participants. - Inadequate incentive structures (compensation schemes) in the financial industry that have encouraged excessive risk-taking at the expense of prudence. - An excess of saving in a number of countries – notably China – and the global redistribution of wealth and income towards commodities exporting countries. But, also, one would have to mention, in this regard, the unusual situation of the US economy as the wealthiest and most developed in the world: instead of showing high domestic savings, and elatedly, substantial net capital outflows (which befits wealthy economies) its savings ratio is stunningly low and it relies on foreign capital in order to finance its large current account deficit; the US economy is overdriven by consumption. - And most importantly, inadequate and obsolete worldwide regulatory frameworks; regulatory and supervisory failures have compounded the magnitude of the debt and credit risk. - An over-reliance on the self-regulatory virtues of markets. Cyclical Factors: - Excessively low risk-free interest rates at all maturities in major economies (the US, Euro land and Japan) . For instance, Taylor (2007) shows that a higher federal rate path would have averted much of the housing boom in the US. A higher interest rate would have decreased the supply of funds to the mortgage market. The excess liquidity was reinforced by countries with large exports to the US, such as China or Asian countries, those who had their domestic currencies pegged to the US dollar or the oil and commodities exporting countries which wanted to limit their appreciation 81 Latin American Default of 1982 Debt Economic and nancial Credit crunch and liberalisation; widespread bankruptcies; Indiscriminate investments slower global growth due to cheap credit availability Unsound lending real estate Potential systemic risk S&L crisis 1980 The Penn Central crisis, Unable to roll over short Threat of the spill over 1970 term debt into the banking system 3. The Current Crisis – What Has Triggered It and Implications The first signs that signalled the emergence of the current financial crisis first surfaced in June 2007 when two hedge funds run by the investment bank Bear Stearns got into difficulty . The funds borrowed against collateral which was held by the lenders - known as prime brokers. When one of the brokers tried to sell the collateral its actions succeeded only in driving prices sharply lower. More than eight months into the crisis it seems that it would continue well into 2008 and, possibly, 2009, and its effects could be felt for years to come. Although the emerging markets do not seem to be affected so far substantially it might be only a question of time before the crisis would spill over into their markets because of globalisation effects, The current financial crisis is so severe and many-sided that its implications can hardly be underplayed. Policies and market structures (including supervision and regulatory frameworks) have to be re-examined and mended. This crisis prods us to return to tenets of pragmatism and open mindedness in policy making. 3.1 The Roots of the Current Crisis The root causes of the current financial market turmoil are to be found at both macro and micro level . An analytical classification would identify structural and cyclical factors. Structural Factors: - A dramatic rise in the role of capital markets (non-banking financial institutions) in the financial intermediation process. The growing complexity of financial markets has become an issue in itself. 80 2007-2008 ALDE ALDE 2007-2008 of domestic currency against the US dollar. - An unreasonable low credit risk spread across all instruments. Structural factors create the general conditions favourable for potentially generating a crisis while cyclical factors are those which help triggering it. The history of financial crises shows in fact, that, with regard to cyclical factors, the current turmoil is no different from previous episodes. Thus, it is the gap between high returns on capital and the low cost of capital, with irresponsible lending, which sows the seeds for financial crises. For instance, Ferguson and Schularick (2007) argue that this gap has been widened over the last years due to the recent integration of Asian labour force into the world economy. This has increased global returns while the cost of capital was maintained at a low level – as measured by low real interest rates. This situation is no different from the Barings crisis (1890), Latin America debt default (1980) or the Asian crisis (1997) when low yield investment opportunities in developed economies made capital from these countries to fly to economies where higher return on capital could have been earned. Eventually, indiscriminate lending led to defaults, bankruptcies and, finally, crises. 3.2 Features of the current crisis One legitimate question to ask is what makes this crisis different. There is a combination of factors that have led to the current situation. Some of them are similar to the ones that caused previous recent financial crises – as mentioned in the earlier section. However, increased innovation in financial products and their growing complexity, together with the failure of regulatory and supervising institutions to keep up with those innovations, appear to have created the conditions for this crisis to emerge. Without being exhaustive, below are several characteristics that distinguish the current crisis from previous ones. 3.2.1 The ‘Shadow Banking System’ What seems to have been happening is the irrevocable transformation of the modern-day banking system, as we knew it. Traditionally, the main source of credit was commercial banks which were attracting deposits and then made loans to companies or consumers. Banks, through their combination of assets (loans, secured or unsecured) and liabilities (deposits withdrawable at demand) were in effect borrowing short and lending long. Thus, they were vulnerable to bank loans by deposit holders. Implicitly, the credit risk was retained on their books. Because banks provided a public utility, they were deemed to be systemically important and, to protect them from bank runs, the government devised measures to protect them, the most common being deposit insurance. However, over the past 10-15 years, this financial market model has changed substantially. On the one hand, banks have increasingly started to sell their credit risk to other investment groups, either via direct loan sales or by repackaging loans 82 into bonds . This process, known as securitisation , allows banks to divide up the resulting residential mortgage-backed securities and place them in instruments called collateralised debt obligations or CDOs. The latter are then sold to a wide range of investors, depending on their appetite for risk. For instance, one set of securities, known as an equity tranche, pays the highest returns but is the first to suffer if the underlying bonds default. Other securities offer a lower yield but a triple-A credit rating, because a lot of defaults would be needed to trigger losses. More generally, asset securitisation involves the sale of income generating from various financial assets (mortgages, car loans, leases) by a company or bank to a special purpose vehicle (SPV). SPVs are the broad category of vehicles that can qualify as off balance-sheet. They are used for a broad range of items, from term securitisation issuance, conduit securitisation issuance, and other entities. Many of the SPVs, which could be a trust or a company, have financed the purchase of these assets by the issue of short-term commercial paper, secured by those assets. Structures such as Conduit Financing Vehicles (CFVs) or Structured Investment Vehicles (SIVs) disintermediate banks by enabling a range of long dated debt instruments to be financed by short-term debt. A SIV is a type of SPV, most commonly associated with having CDOs and other longer-termed assets. The main benefit of SIVs is that they exploit an arbitrage, using higher-rate assets funded by short-term, lower rate, liabilities. SIVs are often called “conduits” because they create a channel through which the long-term debt they invest in can be funded by short-term debt. Because SIVs conduct their operations through capital markets – being often offshore entities – they evade the capital adequacy regulations to which banks are subject to!!! Because of this, the resulting ‘shadow banking system’ – as it is often called – is exempt, to a large extent, to regulation and supervision as undergone by the banking system. And, as recent experience has shown, activities that involve a high degree of risk could take place undetected, or indeed ignored, until adverse conditions materialise – much in the same vein as in the LTCM or Enron crises. Moreover, recent regulatory reforms have even allowed some banks to reduce the amount of capital that they need to hold against the danger that borrowers default . Moreover, recent regulatory reforms have allowed even banks to reduce the amount of capital that they need to hold against the danger that borrowers default. In this respect, the recently introduced Basel II capital framework has been aimed at improving Basel I, which was adopted nearly two decades ago. Basel II is intended to provide a more conceptually consistent and transparent framework for evaluating systemic risk in the banking system, particularly through credit cycles. It represents a capital framework consisting of three pillars. Pillar 1 seeks to enhance the way minimum regulatory capital is calculated while Pillar 2 provides a supervisory review and oversight of the institution’s overall capital adequacy. The first two pillars are reinforced by the Pillar 3, which deals with transparency requirements. However, 83 2007-2008 ALDE ALDE 2007-2008 this approach is more focused on the microeconomic risk and less on the overall implications of systemic risks. A new approach towards including systemic risk in the design of regulatory institutions would be beneficial. This is, arguably, the crucial challenge in reassessing supervisory and regulatory frameworks. One of the effects of the ‘shadow banking system’ is the lengthening of intermediation. With more market players, it becomes increasingly difficult to assess the nature and magnitude of the risk involved or to locate those who bear the risk. Securitisation of mortgages has spread the financial risks around the economy in such a way that banks were no longer deemed likely to go bankrupt because of holding the bad loans they originated. The repackaging of mortgages in complex collateralised debt obligations has made it difficult to identify who is holding what. As a consequence, this has led to fears of credit risk among banks when dealing in the interbank lending market, pushing up the spread between three-month interbank rates and the policy rate in the US, the UK as well as in the Euro-area . As a matter of fact, financial innovation of the less benign sort operates as an in-built destabilizer for the financial system (creating a Minsky effect ). The unexpected losses incurred by assets backed by US sub-prime mortgages have highlighted the potential high costs investors face regarding the type of loans underlying the assets they acquire. As a result, at the moment, the markets in these instruments have become extremely illiquid. Vehicles financed by short-term commercial paper, namely the SPVs, find themselves unable to issue more debt. More and more banks – which created the SPVs in the first place, are forced to take these losses on their balance sheets. The current crisis resembles an old-fashioned bank run – in what a sudden demand for liquidity can lead to a fire sale of assets that depresses their price, making otherwise solvent institutions insolvent . The difference is that it takes place outside the banking system, namely in the ‘shadow banking system’. But the economic principles of the current crisis are still the same, it is only the market actors that have changed. In the traditional ‘banking system crisis’ the institution was a bank, its long term assets were loans, and its short term liabilities were deposits. In the ‘shadow banking system crisis’ the institution could be either a bank or an investment fund whereas the assets could be mortgage-backed securities or their derivatives, and the short-term credit is commercial paper. 3.2.2 The High Level of Concentration According to a report by Autorité des Marchés Financiers (AMF, 2007), concentration has been one of the main characteristics of the structured finance market. In Europe for instance, the structured finance market grew by an impressive 25% in 2005 reaching Euro 450 bn. in 2006. Over 70% of these deals are structured by 12 banks and the three rating agencies, Fitch, Standard & Poor’s and Moody’s cover the whole market . The high level of concentration has also been identified as one of the main 84 issues arising from changes in banking fundamentals in the Institute of International Finance report (2007). Nowadays, there are a few large firms which provide a large part of the volume and liquidity in specific markets. This aspect raises liquidity issues because of the way in which market players are interconnected. 3.2.3 The Breadth of the Crisis and the Lack of Trust Another salient feature of the current crisis is its extensive breadth across a large spectrum of financial market products. Consumer confidence has already been affected beyond the home loan sector. The trend on losses on credit card and auto loans is going up. Moreover, mortgage-related losses have started to be felt outside the banking sector. For instance, widening credit spreads on senior tranches of structured instruments have resulted in marking to market losses on the value of insurance written on these products. This, in turn, triggered market concerns which increasingly have affected higher-rated products and assets other than credit (Fender and Hordahl, 2007). The latest concerns relate to the impact of the sub prime crisis on the Credit Default Swaps (CDS) market. If the current trend of increased insolvency rates in the economy is maintained, the impact on the CDS market, which is worth a staggering US$ 45 trillion, would be significant. Such a scenario could lead to contagion, an abrupt contraction in credit and a sharp downturn in both US and, to a lesser extent, the Euro zone economies. Higher uncertainty regarding the distribution and extent of losses has made investors to take a flight for quality, which, in turn, has led to an increased liquidity demand. Central banks have responded to this by injecting large amounts of liquidity in the money market. However, the pursuance of such a policy is unlikely to bring an end to the current crisis for two reasons. Firstly, this measure does not address the root of the problem, namely that of the underlying fear that banks’ balance sheets are in a precarious position. Until banks, hedge funds, private equity funds and the rest acknowledge their losses, confidence will not be restored in the money markets and trading of structured finance products will continue to be impaired. Unfortunately, losses can be unduly magnified because of strong multiplier effects. At the moment, the existence of counterparty risk is prevailing in the money markets. Secondly, the liquidity does not reach the market participants which mostly need it – i.e. the ‘shadow banking system’. This happens because liquidity is offered by central banks mainly through their discounted window operations, where only the banks have access. Moreover, these banks seem to be reluctant to access the offered available credit due to the stigma associated with this action. At the moment this effect seems to be more predominant in the US that in the EU. A bank tapping into central bank’s credit lines could be perceived as being in trouble by the other banks. The latter could cease of being involved in interbank transactions with the ailing bank. 85 2007-2008 ALDE ALDE 2007-2008 3.2.4 Extensive Leverage on a Large Scale by Some Market Participants An issue often raised during current debates concerning the causes of today’s crisis refers to a certain class of investors and the incidence of their decisions on the financial markets. In recent years, highly leveraged vehicles have been very active in foreign exchange transactions as globalisation spread and opportunities in more traditional markets became scarce due to reduced volatility and low returns. Carry trades, a preferred investment choice for hedge funds, for instance, seem to be an important driver of cross-border bank lending. This magnifies their exposure to exchange rate fluctuations. One of the reasons why hedge funds decisions could have a strong impact on financial markets – even with systemic consequences, because of the institutions which are counterparts to hedge fund transactions – is that they use a very high leverage, required to ensure a high return on investors’ capital. True, so far, systemic risk has not been proven in this scenario but if hedge fund activities grow at the current rate it may well happen. In favourable times this strategy can multiply returns, but, if market prices move against the investment strategy, it also augments risk by the same measure. Although hedge fund’s capital under management is still modest relative to traditional investment vehicles , such as pension and mutual funds, because they are highly leveraged and their operations less transparent, their market impact can be significant . However, hedge fund capital under management has posted a remarkably strong growth in recent years with investor capital increasing by more than three times between 2002 and March 2007, to well over US$1.5 trillion. As history shows, a small amount of hedging could drive asset prices down significantly. In other words, the amount of asset selling seems not enough to explain large drops in asset prices, which were observed for instance in the 1929 or 1987 crashes. One reason why this could happen is because of the determinants of market liquidity (see Gennotte and Leland, 1990) through asymmetries in investors’ information sets, which works as follows Hedging plans create additional supply as asset prices fall. Thus, a relatively minor change in the investors’ information set could trigger lower asset prices, which, in turn, due to hedging, lead to an even higher excess supply and a further fall in asset prices. Moreover contagion is possible and the crisis could spread to foreign markets even in the absence of hedging programmes in these markets. The propagating mechanism is through the price signals. Foreign investors observe the drop in asset prices in the hedged market, but because they are unaware of the extent of hedging, revise downwards their expectations, leading to a global fall in asset prices. Gennotte and Leland’s (1990) conclusion is that successful policies which would minimise the chance of future crashes occurring involve a wider dissemination of knowledge about hedgers’ actions. The authors reckon that increasing market knowledge on the size and trading requirements of hedging programmes could lessen the impact of such trades by a factor greater than 100 and, thus, could radically reduce the likelihood of market crashes . 3.2.5 Rating Agencies Deficiencies As in the Penn Central crisis back in the1970s, most of the companies selling shortterm commercial paper were able to do so because of the prime rating given to those securities by the international rating agencies such as S&Ps, Moody’s, Fitch and others. In a number of cases, rating agencies rated investments without the ultimate investors knowing exactly what was behind the bonds . In fact, as in the Enron’s case, every market player had an incentive to make the deal, regardless of the homebuyers’ ability to repay the loan. The buyer hoped to make a fast profit while the real-estate agent and mortgage broker were taking the fees. The banks in turn, by selling rapidly the loan, alleviated much of the implied risk. One of the criticisms addressed to the rating agencies is the fact that they have been notoriously slow in spotting the signs of the crisis. This situation resembles once again that of Enron, were credit agencies failed to signal company’s huge exposure. Then, the regulatory institutions all over the world designed a voluntary code for the agencies. But this was mainly aimed at sorting out the conflicts of interest whereby agencies were being paid by the companies they rate. Moreover, the agencies have been criticised for giving upbeat assessments of investments which turned out to be linked to risky home loans in the US. The failure of rating agencies to warn over the sub-prime crisis has already made both US and EU to take steps to bring in legislation in order to improve and monitor the performance of the agencies and make them legally responsible for their actions . Recently, the US Financial Services subcommittee on capital markets said that it would hold a hearing into the role of credit rating agencies in the structured finance market - including mortgage-backed securities. 4. How to Respond to This Crisis Over the last years, there has been an increased interest on the issues concerning financial stability. However, in spite of the warning signals given by preceding crises, changes required to minimise the impact of future crisis have been slow to being implemented. Numerous recommendations have been made by various working groups, supervisory committees, etc. but decisive measures have, so far, been limited. The seriousness of the current crisis has pushed public policy and private initiatives to a new level. The Financial Stability Forum for instance, has released an updated report (FSF, 2007) on highly leveraged institutions in which the focus is on financial stability issues relating to the hedge funds. IMF (2007) published a comprehensive report analysing the causes and consequences of the current financial turmoil together with a list of suggested policy actions. In the UK, the Northern Rock episode is likely to lead to regulatory changes being implemented in order to avoid such events in the future , including credible deposit insurance arrangements and regulating the liquidity position of banks. 86 87 2007-2008 ALDE ALDE 2007-2008 One reason why the changes have been slow to implement is the prevailing belief, by some market actors, that markets would sort themselves out in the end. This may well be true, up to a point. After that, however, the risks posed to the real and financial sectors of the world economy might threaten to become greater than the benefits of non-regulation . The practical difficulty is, however, in determining exactly where that point lies. Structured finance instruments are useful because they offer a higher dispersion of credit risk. But higher dispersion is not automatically a better one; recent events have cast doubts over the functioning of securitised lending, as it is in its current form. One problem is that adding structured instruments to a bank’s portfolio has proved that it can lead to unanticipated risk concentrations, which, given the existing state of market knowledge together with the current supervisory and regulatory framework, are difficult to be dealt with (Fender and Mitchell, 2005). Another problem relates to various aspects pertaining to rating agencies in structured finance operations (BIS, 2005). There are a number of proposed strategies for action that would lead to improved financial stability. Strengthening national supervisory and regulatory frameworks, improving transparency, regulatory and public disclosure and finally, adopting an international approach to exercising effective surveillance, regulation, and supervision of financial activity have been suggested quite a while ago . Two of the most important policy challenges ahead are those related to transparency and liquidity . But, arguably, the most arduous task is to combat the scope for higher systemic risks when financial innovation is very intense. The policy actions which are mentioned below are aimed at dealing mainly with the structural factors identified in the previous section. The roots of cyclical factors are an inherent part of the business cycles and, therefore, more difficult to be dealt with. Nevertheless, sorting out issues relating to the structural factors would greatly enhance the stability of the global financial system. 4.1 Improving Transparency - There are certain market players’ categories which have minimum disclosure requirements. Given the fact that their trading decisions have significant impact on the overall financial system, it would make sense to strengthen their disclosure requirements. For instance, hedge funds and private equity funds are only a few of the market players that have, at most, rudimentary reporting obligations. As mentioned earlier in the paper, increased transparency of highly leveraged institutions – such as the hedge funds – has the potential to reduce market volatility when market conditions become adverse. It could also lessen the impact of trades by a large factor, thus, lowering radically the likelihood of market crashes. Recently, a number of hedge funds seem to have agreed to make voluntary disclosures of parts of their activities. 88 - Identify the ‘needs’ of the ‘Shadow Banking System’. It has become clear with the current sub-prime crises that the regulators’ ability to monitor the financial system had been hampered by banks’ use of non-transparent off-balance sheet financing. Consequently, addressing this issue would necessarily involve finding the answer for the ‘needs’ to be addressed. Given the large exposure of the financial system to nonbank lenders another option could be to set some kind of ‘buyer of last resort’ to stand behind the markets, much as central banks do for the banking system. With lending becoming so disintermediated, in many sectors this is done by investors and not banks. Then, a run on the markets through the evaporations of liquidity raises the question of who is going to step in and provide that liquidity. - Finding out who bears the risk. Over the last two decades the pace of product innovation in financial markets has by far outstripped regulators and supervisors capacity to keep up. Therefore, new mechanisms that would address this gap might be necessary. Apart from not being able to set a price for those complex structured products, it is not known who bears the risk. Thus, being able to correctly evaluate the origin of the risk these products possess and who bears it, would be a step forward in aiding to a proper re-design of the regulatory and supervisory frameworks. Recently, the Committee on the Global Financial System (CGFS), which monitors financial market functioning for the central bank governors of the G10 countries, has established a working group to explore the structured finance instruments Fender and Mitchell (2005) highlight some of the group’s principal findings pertaining to the complexity and riskiness of tranched products. An important result is that, in order to understand the risk properties of these products, the evaluation of the risks should be done according to their contractual structure – as allowed in Basel II. The particularities of transactions make the mission of assessing the riskiness of tranched instruments even more difficult. - Re-design of the risk assessment specification procedures. Quantitative models employed to model investment decisions and risk assessment in financial markets have, inherently, a built-in conceptual flaw. The main problem is that risk cannot be summarised in a few figures, entailing a more comprehensive description. - Addressing the costs of failure. The bailout procedures by central banks or the IMF tend to be provided, in general, free of charge. Making the institutions who fail to pay for this would discipline their behaviour. One way to address this could be by imposing some sort of Tobin’s tax, the equivalent to a transaction cost aimed at deterring speculation. 4.2 Resolving Conflicts of Interest Among Market Participants - Credit rating agencies have, inherently, conflicts of interest. They act on behalf of investors but, often, they are being paid by the issuers. Being paid by those they rate, and not by the investors, the common view is that credit rating agencies are under pressure to give their clients a favourable rating. While some credit rating agencies openly acknowledge that they are dependant on investors’ fees to stay in business, 89 2007-2008 ALDE ALDE 2007-2008 others argue that this income accounts for a small percentage of their total revenue and deny such conflicts of interest. - Conflicts of interest between individual and company objectives. There have been several proved cases where individual managers engaged in fraudulent behavior for their own benefit. As a consequence, the punishment of fraudulent behaviour should be applied at both the institutional as well as individual level. There should be a set of rules which could tighten requirements for directors to be vigilant and also provide protection for those who bring improper behaviour to public attention. However, in the end, it is the integrity of directors and executives which would limit the emergence of such crisis in the future. The current credit crisis, LTCM, Enron all involved improper behaviour by individual decision-makers. Absent integrity and in a permissive environment, such individuals will find ways to conceal information or to engage in fraud. Introducing high punishment penalties for such improper behaviour could limit the scale of the problem. - Perceived conflicts of interest in the current business model. For instance, a set of investors and the issuers have, in general, a clear interest to have a stable financial market and a wide range of high-rate graded assets. On the other hand, the investors who take short-positions and the secondary market participants might have a higher interest to see downgrades so that they could pocket the ensuing financial gains. Financial markets tend to benefit from such speculative activities (though not always). The problem emerges when such actions are blown out of proportions, increasing uncertainty and spreading individual risks in such a way that systemic risk goes up incommensurately. - Increased coherence between short-term corporate governance objectives and long-term planning strategies. Often, managers’ incentives to achieve short-term performance indicators are not consistent with a company’s longer term expansion plans. Thus, increased pressure on companies’ management to deliver short-term results might not be beneficial in the longer run. Compensation schemes should be revised so that risk-taking be not rewarded at the expense of prudence. - Increasing knowledge transfer to all market participants. Arguably, the poor knowledge of some of the market participants has a lot to do with the development of the current crisis. The shifting of the risk on to the shoulders of those least able to understand it has been a common feature of the existing crisis. Plans aimed at raising the knowledge base of all market participants, so that they would be aware of the potential risk entailed by their actions should, at least, help create a market awareness that higher risk could, in extreme circumstances, mean virtually negative returns. 4. 3 Improving the Existing Regulatory and Supervisory Frameworks - Collective regulation. The intrinsic workings of the current financial systems indicate that banking institutions can no longer be separated from the securities 90 markets. If so, it follows that the best option is to create a regulatory framework that would regulate concerned institutions as a whole. The on-going credit squeeze has proved that risk is apportioned to whoever market participant could bear it, so that regulating institutions individually would fail to close the gaps in the existing regulatory framework. A first step in this direction seems to be taken by the UK, where the Chancellor of the Exchequer has proposed changes to the regulatory regime which would involve all three participating institutions, the so-called tripartite system of HM Treasury, Bank of England and Financial Services Authority. - Coordinating Supervision and Regulation Activities. Currently there are an increasing numbers of financial institutions which operate across many different national jurisdictions. Supervision and regulation are often organised at the national level, although in several instances national models share a large number of similarities . However, coordination attempts among national jurisdictions are difficult to achieve due to the ongoing creation of new institutions and new instruments. The development of an efficient EU-wide supervision and regulation of financial institutions and markets should allow a reduction in the current number of arrangements to be concluded. In an article in the FT, Tommaso Schioppa (2007) argues for a supervisory structure for multinational financial institutions at the EU level. Moreover, international co-ordination of supervisory and regulatory policy has to become of commanding interest. The integration of the global financial system means that counterparty and systemic risks ceased to be a national or regional concern. - Markets for Structured Finance Products. The sub-prime crises effects were compounded because there was no liquid market for the complex structured finance products issued by the banks. These products have tended to be frequently ‘marked-to-model’, with models whose intricate mathematical and computational features have been quite often beyond the grasp of institution’s risk managers. Other alternative pricing methods, such as those used by credit agencies, proved to be flawed due to conflicting interests between the designers and the issuers of the instrument . One alternative to sort this out, as suggested by Buiter and Sibert (2007) , is through the creation of a market-maker of last resort. This institution would ‘create’ market prices for illiquid assets by purchases and sales of private sector securities and through the acceptance of a comprehensive range of private sector securities as collateral in repos. This could be done through the central bank but another institution could be as easily set up which would have the necessary reputation and credibility to perform those operations. Practical considerations, however, would make this suggestion difficult to implement. - Steps to integrate banks’ balance sheets. Some lessons from Japan’s 1989 property bubble bear striking similarities with the sub-prime crisis. As highlighted in an article in The Economist , one reason both crises were not detected earlier was because most of the warning signs were not at parent banks but down the intermediation 91 2007-2008 ALDE ALDE 2007-2008 chain, namely in affiliates, subsidiaries or other off-balance sheet vehicles. Precrisis condition shared similarities in that in both cases financial engineering made available easy credit which sparked a property-related bubble, commercial in Japan and residential in the US. Integrated balance sheets reflecting the whole picture of banks’ lending would have aided in the identifications of the problems much sooner and would have allowed a timely intervention by the regulatory and supervisory institutions. Thus, measures to report integrated bank balance sheets could be taken to diminish the intensity of future crisis. - Deposit insurance versus Moral Hazard. As shown by Keely (1990) deposit insurance worked well prior to 1980’s However, increased competition within the banking and financial service industry has led to a moral hazard problem, in fact rewarding banks who took an excessive risk taking. Thus, these commercial banks were provided in fact with a ‘put’ in which the central bank was expected to bail them out in case they went into trouble. Banks could, in effect, borrow at the risk free rate through the issuance of insured deposits and then invest the proceeds in risky assets. This problem appeared to have been compounded in the early 1980’s when, increased competition in financial services industry caused banks charter values to decline (Keely, 1990). Thus, bank charter values, which previously were a high entry barrier in the industry, appear to have lost some ground in the face of demand for higher returns triggered by increased competition in the banking industry. One set of proposals is to give to some national authority enough powers to intervene in banking crises. Such models draws heavily on elements of the US, Canadian and Belgian where emergency roles are given to new institutions, such as Federal Deposit Insurance Corporation in the US, for instance. While this special insolvency regime for banks would allow a badly bank run to fail with diminished effects in triggering a systemic crisis caused by a loss of public confidence, this also compounds the moral hazard problem, and, as recent events in the US have shown, is of limited use when crisis spreads in other markets. - Raising the capital requirements of the structured finance investment vehicles. This would reduce the liquidity risk – a major factor of concern in the current crisis. Again, these aspects are already covered under Basel II. But the challenge would be to enforce these rules and avoid loopholes to be exploited. Moreover, under Basel II banks were left with the impression that they have too much equity, thus encouraging excessive risk taking from their part. - Enforcement of conformity and compliance systems. This is yet to be seen how would be resolved under the Basel II framework. It is true that, at the time when the crisis started, Basel II was half in half out. However, following recent developments, it becomes clearer that Basel II would need to be revised. The current crisis is different from the previous ones in what its spreading occurs in spite of the existing framework of accountancy and Basel II regulations. Therefore, it tends to suggest that these are inadequate to deal with the severity of the crisis. One drawback of the Basel II framework, for instance, is that it fails to incorporate systemic risks into the design of regulatory institutions and risk management (apparently, it relies too much on the efficient capital markets hypothesis ). These aspects would need to be addressed. - Risk management procedures and mechanisms in banks have to improve considerably. - Use of counter-cyclical control mechanisms or instruments. Some authors argue that bank capital requirements should not only be contra-cyclical but also related to the rate of change of bank lending and asset prices in the relevant sectors . This is because risk models employed today undermine the assumptions that should make them work. They systematically underestimate risk in ‘good’ times and overestimate risk in ‘bad’ times. - The timing of introducing new changes in the regulatory and supervisory systems is particularly important. Rushing radical changes overnight in these systems might actually exacerbate the crisis by worsening the credit crunch. Caution, is therefore, needed in the design and implementation phases of changing the regulatory and supervisory systems. At the same time, however, complacency and too slow change are not warranted. The flaws and creaks in the current supervisory and regulatory frameworks are quite visible and demand firm action. - Cooperation between public and private institutions. This needs to be enhanced and re-designed to account for recent developments in the financial market innovations. 5. Summing up As the current crisis unfolds and the time passes by, it becomes clearer that we are being confronted with an event whose implications are bound to be long lasting. It is hard to understand why those in charge with regulating markets have been so oblivious to warnings which had been sent by highly knowledgeable individuals years ago. Almost a decade ago Alexandre Lamfalussy cautioned against the use of derivatives that enhance instability and increase systemic risks against the backdrop of global markets. And Warrant Buffet called synthetic products “financial weapons of mass destruction”, in 2003. For them and others “casino type trading” was more than a threat to the financial system. Addressing the roots of the problem that have triggered this crisis should be of paramount importance. In the past, such crises tended to be more localised and were dealt with more easily. The difference this time has been in the rapid spread of intense financial innovation (the “origination and distribution” which has been undertaken by leading banks), which has occurred during the last couple of decades; this allowed dissemination of risks on a large scale at the expense of transparency. As a consequence, the emergence of the shadow banking system, largely unregulated and lacking appropriate supervision has brought about more opacity in financial markets and has accentuated systemic risk. The excessive trust in the ‘self-healing’ power of markets has not yielded the result some expected. It follows from here that one line of action should, necessarily, be the regulation of the shadow banking system. Likewise, the intrinsic workings of the current financial system indicate that banking institutions can no longer be separated from the 92 93 2007-2008 ALDE ALDE 2007-2008 securities markets. Thus, one feasible option would be the creation of a regulatory framework that would regulate concerned institutions as a whole. Securitisation of mortgages has spread the financial risks around the economy in such a way that banks’ exposure to their bad loans has become, nominally, minimal. But, the repackaging of mortgages in complex collateralised debt obligations has made it difficult to identify who is holding what. Ironically, financial innovation that was designed to diminish risk at the individual or micro level has ended up in exacerbating it at the macro level, thus increasing systemic risk. Moreover, this innovation has favoured speculative trading. Two of the most important policy challenges ahead are those related to transparency and liquidity. But, arguably, the most arduous task is to combat the scope for higher systemic risks when financial innovation is very intense. In these cases traditional ways of risk assessment become obsolete. The complexity of today’s financial market instruments render risk assessment models unreliable. Thus, quantitative models employed to model investment decisions and risk assessment in financial markets have, inherently, a built-in conceptual flaw. One of the problems is that risk cannot be encapsulated in a few figures, asking for a more comprehensive description. There is a scope for a re-design of the risk assessment specification procedures. Another line of action should address the costs of failure. The bailout procedures by central banks or the IMF tend to be provided, in general, free of charge. Making the institutions which fail to pay for this would discipline their behaviour. One way to tackle this could be by the introduction of various measures aimed at deterring speculation. An issue closely related to this is managers’ performance compensation packages. Managers’ incentives to achieve short-term performance indicators are not consistent with a company’s longer term expansion plans. Thus, increased pressure on companies’ management to deliver short-term results might not be beneficial in the longer run. Compensation schemes should be revised so that risk-taking is not rewarded at the expense of prudence. Although the Basel II regulatory framework has been devised to prevent crises occurring, the current one has highlighted existing flaws in its design. Regulatory measures aimed at dealing with liquidity and system risk ought to be revised. Moreover, the use of counter-cyclical control mechanisms or instruments should be seriously considered. Capital requirements should not only be contra-cyclical but also related to the rate of change of bank lending and asset prices in the relevant sectors. Last but not least increasing coordination among national supervision and regulatory bodies should be enhanced. Global financial markets require a global approach in dealing with such issues. This cooperation is simply required in order to limit the potential devastating effects such crisis could have in the future on both the financial system and the real economy. Inside the EU this coordination is a must and Padoa Schioppa’s proposals should be given a more sympathetic hearing . References: Allen Mark, Rosenberg Christoph, Keller Christian, Setser Brad, and Roubini Nouriel (2002). ‘A Balance Sheet Approach to Financial Crisis’. IMF Working Paper WP/02/210 Autorité des marchés financiers (2007). “Is Rating An Efficient Response to the Challenges of the Structured Finance Market?”, Risk And Trend Maping, No.2, March. Bank of International Settlements (2005). “The role of ratings in structured finance: issues and implications”, Report submitted by a Working Group established by the Committee on the Global Financial System, January. Becker, Chris and Clifton, Kristina (2007). ‘Hedge fund activity and carry trades’, BIS Quarterly Review Bordo Michael (2007). ‘The Crisis of 2007 :The Same Old Story, Only the Players Have Changed.’ Remarks prepared for the Federal Reserve Bank of Chicago and International Monetary Fund conference; Globalization and Systemic Risk. Chicago, Illinois September 28. Buiter, H. Willem (2007), “Lessons From the 2007 Financial Crisis”, CEPR, Policy Insight No. 18, December. Buiter, H. Willem and Sibert, Anne (2007). ‘Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort’, September. Available at: Caballero, Ricardo J. and Krishnamurthy, Arvind (2001). “Smoothing Sudden Stops”, NBER Working Paper No. W8427, August. Chang, R., Velasco, A. (2001). “A model of financial crises in emerging markets”, The Quarterly Journal of Economics, May. David Dodge (2007). Remarks by the Governor of the Bank of Canada to the Institute of International Finance Washington, D.C.October. Daianu, Daniel (2008), “Better Regulation is a Must for Financial Markets”, The European Voice, 31 Jan.-6 Febr. p.12 95 94 2007-2008 ALDE ALDE 2007-2008 Delargy, J.R and Charles Goodhart (1999). “ Financial Crises: Plus ca Change, plus c’est la meme chose. LSE Financial Market Group Special Paper No. 108. Diamond, Douglas W., and Dybvig, Philip H. (1983). “Bank runs, deposit insurance, and liquidity”, Journal of Political Economy 91 (June): 401–19. Fender, Igor and Hordahl, Peter (2007). Overview: Credit Retrenchment Triggers Liquidity Squeeze”, BIS Quarterly Review, September. Fender, Igor and Mitchell, Janet (2005). ‘Structured finance: complexity, risk and the use of ratings’. June, BIS Quarterly Review. Ferguson, Niall and Schularick, Moritz (2007). “ ’Chimerica’ and the Global Asset Market Boom”, International Finance, Vol 10, No.3 pp 215-239. Financial Stability Forum (FSF) (2007). “Update of the FSF Report on Highly Leveraged Institutions”. May. Fischer, Stanley (1998). “The Asian Crisis: A View from the IMF”, Address by First Deputy Managing Director of the International Monetary Fund at the Midwinter Conference of the Bankers’ Association for Foreign Trade Washington, D.C., January 22. Flood, Robert, and Peter Garber (1984), “Collapsing Exchange Rate Regimes: Some Linear Examples,” Journal of International Economics, Vol. 17, pp. 1–13. Gârleanu Nicolae and Pedersen , Lasse Heje, (2007) Liquidity and Risk Management, American Economic Review, volume 97, Issue 2, pg. 193-198. Gennotte, Gerard and Leland, Hayne (1990). ‘Market Liquidity, Hedging and Crashes’. American Economic Review, vol 80 no. 5, pg 999-1021. Greespan, Alan, (2008), “We will never have a perfect model of risk”, Financial Times, 17 March, p.13 Huberto M. Ennis and Todd Keister (2007), “Commitment and Equilibrium Bank Runs”, Federal Reserve Bank of New York Staff Reports, no. 274, May. IMF (2007). “Financial Market Turbulence Causes, Consequences and Policies”, Global Financial Stability Report, October. Institute of International Finance (2007). “Principles of Liquidity Risk Management”, March. 96 Kambhu, John , Til Schuermann, and Kevin J. Stiroh (2007). “Hedge Funds, Financial Intermediation, and Systemic Risk”, Federal Reserve Bank of New York Staff Reports, no. 291, July. Keely, M., Michael (1990). ‘Deposit Insurance, Risk, and Market Power in Banking’. American Economic Review, December, pg 1183-1200. Kindleberger P. Charles (2000). Manias, Panics, and Crashes: A History of Financial Crises. ISBN 978-0471389453. King, Mervyn (2007). Opening Statement to the Monetary Policy Committee, December. Kornert, Jan (2003). “The Barings crises of 1890 and 1995: causes, courses, consequences and the danger of domino effects”, Journal of International Financial Markets, Institutions and Money 13, pg.187-209. Krishna Guha (2007). “Credit turmoil ‘has hallmarks of bank run’ “, Financial Times, September, 2. Krugman, Paul (1979), “A Model of Balance of Payments Crises,” Journal of Money, Credit and Banking, Vol. 11, pp. 311-325. Krugman, Paul (1999), “The Return of Depression Economics”, New York, Norton Lamfalussy, Alexandre (2008), “Looking Beyond the Current Credit Crisis”, remarks made at the meeting of the Economic and Affairs Committee of the European Parliament with national parliaments, 23 January Minsky, H.P., (1986), “Stabilising an Unstable Economy”, New Haven, Yale University Press Mishkin, Frederic (1997) “The Causes and Propagation of Financial Instability: Lessons for Policy Makers’ in Maintaining Financial Stability in a Global Economy. Federal Reserve Bank of Kansas City. Jackson Hole Symposium. 55-96 Pimco (2008). “Pyramids Crumbling”, Investment Outlook, January. Available at Reinhart, M. Carmen and Kenneth S. Rogoff (2008). “Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison”, presented at New Perspectives on Financial Globalization (AEA), January. 97 2007-2008 ALDE ALDE 2007-2008 Schinasi, Gary (2005). “Preserving Financial Stability”, IMF, Economic Issues, No. 36. Schioppa Tommaso (2007). “Europe Needs A Single Financial Rule Book”, published in Financial Times, December, 10. Taylor, John (2007) ‘Housing and Monetary Policy’, September. Tett, Gillian and Paul J Davies (2007). “Out of the shadows: How banking’s secret system broke down”, Financial Times, 16 December. Tobias, Adrian (2007), “Measuring Risk in the Hedge Fund Sector”, Current Issues in Economics and Finance, Federal Reserve Bank of New York, Vol. 13 No. 3, MarchApril. Wolf, Martin (2007), “Why the credit squeeze is a turning point for the world”, Financial Times, 11 December. Wyplosz, Charles (2007). “No more easy cash: banks must take their losses”, Financial Times, 20 December. Appendix 1. The recurrence of financial crises in economic history The Enron Scandal, 2001. Enron, an American energy company, boasted revenues of more than US $110 bn in 2000 and was named by Fortune ‘America’s Most Innovative Company’ for six consecutive years. By November 2001, Enron was undergoing the largest bankruptcy in history. There are many causes of the Enron collapse, most of which could be found at the root of today’s sub-prime crisis. Firstly, there was the conflict of interest between the two roles played by Arthur Andersen, as auditor but also as consultant to Enron . Secondly, the company presented false and misleading pictures of its financial health and results of operations. Most of these operations were complex structured finance transactions rolled via through off-books financial entities such as special purpose vehicles (SPVs). Thirdly, the objective of these fraudulent activities was twofold: to convince analysts and credit rating agencies that its reported earnings were real and to achieve its stated profit target which would allow company’s employees to receive their bonuses. In some ways, the culture of Enron was in itself the primary cause of the collapse. This seems to become more apparent today when not a few companies are, sometimes, involved in a similar type of activities. The DotCom Crash, 2000. The public’s increasing interest in the internet-based companies had pushed up their share prices at a very fast rate. People, having no prior knowledge of stock trading, bought technology shares based on expectations of higher returns generated by future profits. But in March 2000, the bubble burst, and the technology-weighted NASDAQ index fell by 78% by October 2002. The crash had wide repercussions, with business investment falling and the US economy slowing in the following year, a process exacerbated later by the 9/11 attacks. Subsequently, these events led to a temporary closure of the financial markets. The response of the Federal Reserve was to gradually lower interest rates throughout 2001, from 6.25% to 1%, in order to stimulate economic growth. The collapse of the Long-Term Capital Management Fund (LTCM) in 1998. Four years after its inception, the LTCM hedge fund collapsed, precipitating the first in-depth analysis by policymakers of the potential systemic risks posed by the hedge fund industry. Although LTCM had, at the beginning of 1998, a leverage factor of thirty to one , LTCM’s partners believed, on the basis of their complex computer models, that the long and short positions were highly correlated thus, yielding a small net risk. While the LTCM problems started to emerge when Russia defaulted on its government obligations, its collapse was precipitated by the ‘flight to liquidity’ across global fixed-income markets, when investors started to shift their assets into more liquid assets. As a consequence LTCM’s short positions were priced higher relative to its long positions causing the hedge fund to collapse. However, the LTCM crisis proved to be much deeper, threatening to pose a systemic risk to the financial system. This happened because other large hedge fund managers followed similar 98 99 2007-2008 ALDE ALDE 2007-2008 strategies as suggested by sophisticated computer models . Other reason was the similarity of positions held by a number of market participants, like investment banks. After the fund had lost substantial amounts of the investors’ equity capital, in order to avoid the threat of a systemic crisis in the world financial system, the Federal Reserve co-ordinated a US $3.5 billion rescue package from leading U.S. investment and commercial banks. The seriousness of the crisis prompted the US President’s Working Group on Financial Markets to issue a report on the hedge fund implications for systemic risk in financial markets . As Ben Bernanke put it, ‘The Working Group’s central policy recommendation was that regulators and supervisors should foster an environment in which market discipline--in particular, counterparty risk management--constrains excessive leverage and risk-taking. Effective market discipline requires that counterparties and creditors obtain sufficient information to reliably assess clients’ risk profiles and that they have systems to monitor and limit exposures to levels commensurate with each client’s riskiness and creditworthiness’ . Although those recommendations seemed to have common economic sense, they have failed to be comprehensively applied. Much of the on-going sub prime crises stems from excessive leverage and risk-taking by market participants against the background of reckless use of new financial instruments. Asian Crisis 1997 This was caused by large private capital flows to emerging markets in the search of higher yields. The resulting large quantities of credit that became available in Asian countries ignored risks and induced a highly-leveraged economic climate which pushed up asset prices at an unsustainable level. Subsequently, asset prices collapsed, generating large credit withdrawals from the crisis countries which caused a credit crunch and widespread bankruptcies. The ‘Black Monday’ Crash of 1987. The US stock market suffered its largest one-day fall, dropping by more than 22% with European and Japanese markets following suit. The crisis was sparked by market participants’ conviction that insider trading and company takeovers on borrowed money were dominating the markets. Pprogrammed trading strategies for selling stocks indiscriminately, as markets fell, also exacerbating the decline. In order to prevent major commercial banks to fail, the central banks cut interest rates aggressively. In the aftermath of the crisis, regulatory bodies introduced the socalled ‘circuit-breakers’ aimed at limiting programme trading and allowing them to suspend all trades for short periods. Latin American Debt Default of 1982 During the mid 1970s many nations in Latin America, including Chile, Mexico, and Argentina introduced substantial economic reforms, involving the liberalisation of foreign trade, domestic financial markets, and privatisation of public industries. Exchange and capital controls together with other economic barriers were loosening without any increase in regulatory oversight. As a result of financial reforms foreign capital became easily available to domestic banks. The borrowing frenzy led Latin America to quadruple its external debt from US $75 billion in 1975 to more than US $314 billion in 1983, equivalent to 50% of the region’s gross domestic product (GDP). As interest rates increased in the US and Europe in 1979, Latin America countries found more difficult to finance their interest payments. As most foreign banks refused to roll over Latin America debt – most of which was short-term – many banks became close to being insolvent until a massive rescue was engineered between the Federal Reserve and the IMF. In this case the traditional banking crisis was compounded by the effects of the subsequent currency crisis. As in the S&L case (see below) irresponsible lending was the prime cause for the crisis. The Savings and Loan (S&L) Crisis of the 1980s. This represented the failure of the savings and loan association in the US when, over 1,000 savings and loan institutions ended up with a position of net equity. However, this did not prevent them from being able to borrow large sums at favourable rates, thanks to deposit insurance. That recklessness in lending was a factor aggravating both the boom and the subsequent bust of the S&L crisis. As in the current sub prime crisis, the banking problems of the 1980s came primarily – although not exclusively - from unsound real estate lending. The final cost of resolving failed S&Ls was estimated at over $160 billion, with much of this cost being paid with taxpayers’ money . Probably the most important lessons to be taken from this crisis are those pertaining to regulatory issues. The S&L crisis highlighted the need for strong and effective supervision of insured depository institutions. Moreover, it showed that sorting out ailing financial institutions requires that the deposit insurance fund be strongly capitalised with real reserves, not just governmental guarantees. The Penn Central crisis, 1970. The Penn Central Transportation Company, was, at that time, the largest nonfinancial company in the United States to go bankrupt. It had massive amounts of short-term commercial paper outstanding when the interest on its loans became an unbearable financial burden. The ensuing collapse of the railroad company led to a panic in the commercial paper market. Although an attempt was made by the government to save the company by guaranteeing its loans, it failed. This episode has striking similarities with the sub prime crisis. The creditworthiness of the rating agency ensured the issuance of large amounts of commercial paper which, subsequently, could not be rolled over. Then, as today, the Federal Reserve opened the discount window, fearing that the crisis would spill over into the banking system. 100 101 2007-2008 ALDE ALDE 2007-2008 The Great Depression (1929) The Great Depression triggered by the 1929 crash is another benchmark episode in the history of financial crashes. At that time, the bull market prevailing prior to the crash seemed to be fully justified. The post war economic boom spurred by new technologies were promising large increases in sales and corporate profits. The stock market fall was massive, by the time it reached bottom in 1932, 90% had been wiped off the value of shares . The effects on the economy were severe, by 1932 the US economy had declined by half, and one-third of the workforce was unemployed . In March 1933 the US President, Franklin Roosevelt took office and launched the New Deal, which addressed landmark changes in regulatory and supervisory rules. Barings crises (1890 and 1995) In 1980, llosses by a leading UK bank, Barings, made on its investments in Argentina forced a massive sale of securities in the United States. These were mainly triggered by the liquidity problems of British banks. In England, the Bank of England acted in its ‘lender of last resort’ role and intervened in financial markets in order to prevent a systemic collapse of the UK banking. More than a century later, the same bank went bankrupt due to an explosive combination of financial and organisational shortcomings. Fraudulent activities of the bank’s management were facilitated by weak internal and external controls. Important supervisory and supervision rules were introduced by central banks in the aftermath of the 1995 Barings crisis. Overend and Guerney 1866. Overend and Guerney was a discount bank which was supplying cash to London’s commercial and retail banks . A large number of these were left without access to funds when Overend and Guerney went bankrupt in 1866. It was then when Walter Bagehot advocated a new role for the Bank of England, namely the “lender of last resort”. Its objective would be to avert a systemic crisis by providing liquidity to the financial system during crises. Appendix 2. Three-Month Interbank Spread Rates Over The Base Rate % Difference between 3-month interbank rates and base rate 1 0.8 0.6 0.4 0.2 0 01 02 03 04 05 06 Ja nJa nJa nJa nJa nJa n- -0.4 BofE ECB US BofE – Bank of England ECB – European Central Bank US – The US Federal Reserve 102 Ja n- -0.2 07 103 2007-2008 ALDE ALDE 2007-2008 Speakers’ professional biographies 104 105 2007-2008 ALDE ALDE 2007-2008 Daniel Daianu Member of the European Parliament (since December 2007); Professor of economics, School of Political and Administrative Studies in Bucharest, fellow of the William Davidson Institute, University of Michigan; Chairman of The Romanian Economic Society and of the Romanian Center for Global Studies; member of the Advisory Board of the European Association for Comparative Economic Studies (EACES); associate member of the Romanian Academy; fellowships at Harvard University, The Wilson Center (Washington DC), IMF (Washington DC), NATO Defence College (Rome), etc; visiting professorships at Berkeley, UCLA, Bologna University, etc. President of Junior Achievement, Romania and President of Harvard Club, Romania; Honorary President of the Romanian Association of European Studies; founding member of the international policy association “The Bucharest Club”; member of the advisory board of several foreign journals. Finance Minister of Romania, 1997/1998; Chief Economist of the National Bank of Romania, 1992-1997; Deputy Minister of Finance, 1992; Chairman of the OSCE Economic Forum, 2001; Selected writings: “South East Europe and The World We Live In”, The Romanian Diplomatic Institute; 2008“What will Romania be in the EU” (in Romanian), Iasi, Polirom, 2006; with Radu Vranceanu (ed.), Ethical Boundaries of Capitalism”, Ashgate (UK), 2005; with Thanos Veremis (ed.), “Balkan Reconstruction”, London, Frank Cass, 2001; “Transformation As A Real Process”, Aldershot (UK), Ashgate, 1998; “Economic Vitality and Viability. A Dual Challenge for European Security” Frankfurt, Peter Lang, 1996. Bertrand Huet-Delaherse Bertrand Huet-Delaherse is the Managing Director, European Legal & Regulatory Counsel of the Securities Industry and Financial Markets Association (SIFMA). SIFMA brings together the shared interests of more than 650 securities firms, banks and asset managers, representing its members’ interests locally and globally. It has offices in London, New York and Washington D.C. and its associated firm, the Asia Securities Industry and Financial Markets Association, is based in Hong Kong. Bertrand handles all European policy issues for SIFMA and its European affiliates, the European Primary Dealers Association (EPDA), the European Securitisation Forum (ESF) and the European High Yield Association (EHYA). His primary current focus is on the modernisation of cross-border regulation and the industry response to the ongoing financial markets turmoil. He qualified with the international law firm Linklaters & Alliance in 1994 and, prior to joining SIFMA in June 2004, spent nine years in the legal departments of Bankers Trust and Deutsche Bank. Bertrand holds a Master Degree in English and French Law (Hons) from Pantheon Sorbonne University, Paris and King’s College, London. Eric De Keuleneer Born : Brussels 10/4/1952 Ingénieur Commercial Solvay, Université Libre de Bruxelles, 1974. Master of Business Administration, Wharton School, University of Pennsylvania, 1977. Centraal Bureau voor Hypothecaire Krediet - Office Central de Crédit Hypothécaire (since May 2001 CREDIBE NV - SA), managing director (since 1995). University Foundation, Managing director Previously head of Corporate and Investment Banking at Generale Bank (1983-1995) Previously head of Capital Markets at Kredietbank Luxembourg (1977-1983) Varia - Professor of Finance at Solvay Business School – Université Libre de Bruxelles - President of Royal Film Archives of Belgium - Member of various Boards - Various publications on capital markets, governance, regulation. Servaas Deroose Servaas Deroose is Director for the “Macroeconomy of the Euro area and the Union” at the Directorate General of Economic and Financial Affairs in the European Commission, a post he has held since December 2002. As Director of the Euro-area economy, he is responsible for: surveillance and analysis of the economic situation and macroeconomic policies of the Euro area; budgetary policies, including Stability and Growth Pact and fiscal sustainability; monetary and exchange rate policies of the Euro area and ERM II; convergence, Euro adoption and legal aspects of Economic and Monetary Union; as well as financial markets analysis. He is editor-in-chief of the “Quarterly Report on the Euro Area”, the annual review “Public Finances in EMU”, the “Report on the long-term sustainability of public finances in the EU”, and the “Annual Report on the Euro Area”. He serves as a member of the Economic and Financial Committee of the EU, which prepares the monthly meetings of the Ecofin Council and the Eurogroup. He was the Commission’s representative in the Council Working Group negotiating the revision of the Stability and Growth Pact. He has had a long and varied career in the European Commission since joining it in 1985. He has been in charge of units dealing with economic forecasts (1991-95) and economic policy coordination, including the Broad Economic Policy Guidelines for the Member States and the European Union (1996-2002). 107 106 2007-2008 ALDE ALDE 2007-2008 Servaas Deroose was born in Blankenberge (Belgium) in 1957. He studied at the University of Ghent, where he took a degree in Economics. He also served as Research and Teaching Assistant (1979-1985) there, and is currently a member of the Advisory Board of the Economics Faculty. He has written numerous articles and economic papers, including on the Stability and Growth Pact, economic adjustment in EMU, the Maastricht convergence criteria, economic policy co-ordination and economic growth in the EU. Ray Kinsella Professor Ray Kinsella is on the Faculty of the University College Dublin Graduate School of Business, and The Management Institute of Paris (MIP). He is Visitng Professor at the Institute of European Finance. Ray received his PhD at the University of Dublin, Trinity College, followed by a Diploma in Financial Analysis at the IMF Institute Washington DC. He as an economist at the Central Bank of Ireland and, following a two year period as an Economic Advisor in Government Service, he was appointed Professor of Banking and Financial Services. He has published extensively in the field of Financial Regulation including ‘Internal Controls in Banking’ (Wiley International), and his forthcoming book ‘Regulation, Corporate Governance and Ethics in Financial Services’ is scheduled for publication in late 2008/ Wolf Klinz Dr. Klinz, born in 1941, finished grammar school in Hanover in 1960 and studied economics and business administration in Paris, Vienna and Berlin. He graduated as Diplom-Kaufmann (M.Com.) in 1963, followed by a PhD in 1965 and a MBA from Insead, Fontainebleau, in 1966. Dr. Klinz worked for several international industrial companies and as a Partner with McKinsey & Company in London, Düsseldorf and Paris. From 1990 to 1994 he was a member of the Executive Board of Treuhandanstalt, the German Government’s agency for the privatisation of the former East German industry. He then acted as Vice Chairman and Chairman respectively of the Executive Board of two companies in Frankfurt. Dr. Klinz is currently a member of the supervisory board of two companies in Germany and abroad. From 2001 to 2004 he assumed the honorary office of President of the Chamber of Commerce and Industry (CCI) Frankfurt am Main. In this capacity he was Chairman of the Association of Hessian Chambers of Commerce and Industry and Member of the 108 Board of DIHK (Confederation of the German Chambers of Commerce and Industry) in Berlin. In addition, he was Vice-President of Eurochambres and a member of the Professional Chamber Enterprise Policy Group of the European Commission. Since June 2004 he is Member of the European Parliament and in this capacity coordinator of the liberal group (ALDE) in the Committee on Economic and Monetary Affairs und substitute member of the Internal Market and Consumer Protection Committee. Stanisław Kluza, Chairman, Polish Financial Supervision Authority Economists, former Vice-minister and Minister of Finance of the Republic of Poland Born on 2nd June 1972 in Lubliniec (Silezian Voivodship). Graduate of the Warsaw School of Economics (SGH). Ph.D. of economic science with specialization in monetary policy, statistics, econometrics, macroeconomics, banking and business situation research. The founder and President of the National Investment Funds’ Research Team (reorganized later into the Interdisciplinary Research Team on Economic Processes, established under aegis of the Institute for Statistics and Demography of the Warsaw School of Economics). In the years of 2002-2003 the manager of research project “Schemes of monetary assets allocation”, carried out under aegis of the State Committee for Scientific Research. Researcher in the Institute for Statistics and Demography, Warsaw School of Economics. Accomplished short-time studies at Washington University in Saint Louis and Glasgow University in Scotland. Awarded with numerous prizes: Top Ten Diploma of the Warsaw School of Economics (1995), Rector’s Prize of 2nd Degree for a doctoral thesis (2001/2002), President’s of the Council of Ministers of the Republic of Poland prize for a doctoral thesis in Economy (2002), as well as scholarships (for scientific research purposes): State Scholarship of the Foundation for Polish Science (1998), Fulbright Scholarship at Washington University in Saint Louis (1999-2000), Dekaban-Liddle Scholarship at Glasgow University (2001). Since 2002 he worked for Bank Gospodarki Żywnościowej S.A. in Poland, as a director, and subsequently – as the Head Economist and President of the Board’s Advisor. Mr. Kluza also performed functions of Undersecretary of State and Vice-Minister of Finance, and subsequently – the Minister of Finance of the Republic of Poland. Since 29th September 2006 he is the Chairman of the Polish Financial Supervision Authority. Stanisław Kluza was also awarded with a title of Man of the Year in Finance 2007. He is the author of numerous publications and articles. Charlie McCreevy Charlie McCreevy, born in 1949, qualified as a chartered accountant. In 1977 he was first elected to Dáil Eireann (Irish Parliament) for the constituency where he was born - County Kildare, Ireland. He has resigned his seat to become a Member of 109 2007-2008 ALDE ALDE 2007-2008 the European Commission. Since 1992 he has held various cabinet posts in Fianna Fail-led governments including: Minister for Social welfare, Minister for Tourism and Trade and latterly (1997) Minister for Finance. Wolfgang Munchau Wolfgang Munchau, 45, is associate editor and European economic columnist of the Financial Times. Together with his wife, the economist Susanne Mundschenk, he has founded, a macro internet site for the Euro area, offering daily comment and analysis. Wolfgang was one of the founding members of Financial Times Deutschland, the German language business daily, where he served as deputy editor from 1999 until 2001, and as editor-in-chief from 2001 until 2003. FT Deutschland is now a firmly established player in the German media market with a daily circulation of more than 100,000 copies sold. He was economics correspondent of the Financial Times ahead of the start of economic and monetary union, and held several senior positions at that newspaper, and at the Times of London - in Washington, Brussels and Frankfurt. In 1989, he was the recipient of the Wincott Young Financial Journalist of the Year award. He holds the degrees of Dipl-Betriebswirt (Reutlingen), Dipl-Mathematiker (Hagen), and MA in International Journalism (City University, London). Wolfgang and Susanne live in Brussels with their son Joshua. Nigel Phipps Nigel Phipps is Head of EMEA Regulatory Affairs at Moody’s Investors Service. In his role, he is responsible for coordinating our communication with Regulatory authorities and assisting senior management in better positioning Moody’s in the changing EMEA regulatory environment. He joined the rating agency after 10 years in UK regulation focused on European and International capital market issues. He was a Manager in the FSA’s international policy co-ordination team and a member of the CESR (Committee of European Securities Regulators) Secretariat. Prior to regulation, he was a senior lecturer in finance following a number of years with Nat West markets (European equity research) and Barclays (international banking). Nigel holds an MA (Hons.) in French with Contemporary European Institutions from the University of Edinburgh. He is an Associate of the Chartered Institute of Bankers and a Fellow of the Securities and Investment Institute. 110 Robert Priester Robert Priester is Head of Department, Banking Supervision, Financial Markets and International Affairs at the European Banking Federation. He is a Dutch national with a Law Degree from Leyden University. Robert joined the EBF in 2004 as Head of the Legal and Consumer Affairs Department, before moving to his present position in September 2006. Before joining the EBF, Robert was Senior Legal Adviser with EFAMA (formerly FEFSI) the fund and asset management federation based in Brussels, where he dealt with issues ranging from UCITS, MiFID, FSAP, Lamfalussy, fund as well as corporate governance questions and taxation matters. Before joining EFAMA in March 2000, Robert was executive assistant with CEA (Comité Européen des Assurances) in Brussels for 6 years with responsibilities for international affairs (OECD, GATS) and EU-sponsored technical assistance project management work in the Russian Federation and various Central and Eastern European countries. Prior to that Robert was assistant to the Secretary General and adviser on tax, social affairs and legal matters at the European Savings Banks Group in Brussels from 1991 until 1994. Robert also previously completed a traineeship with the European Commission in their competition services in 1990. Robert is married and has 3 children. John Purvis, CBE, MEP John Purvis is a Conservative Member of the European Parliament representing Scotland. Being an MEP from 1979 to 1984 and from 1999 to date, he is currently Vice-Chairman of the Parliament’s Economic & Monetary Affairs Committee and a member of the Industry, Research & Energy Committee. He was the Parliament’s draftsman on Mortgage Credit in the EU. Outside politics, John Purvis worked in banking in London, New York, Milan, and Edinburgh. With his own business, he consulted for businesses in Europe and the USA. He has an MA degree from St Andrews University and in 1990 he was appointed CBE for public and political services. He lives near St Andrews, Scotland, and is married with three children and nine grandchildren. 111 2007-2008 ALDE ALDE 2007-2008 David B. Smith David B. Smith studied economics at Trinity College, Cambridge and the University of Essex. He has since worked at the Bank of England, the Royal Bank of Scotland, National Westminster Bank, Cambridge Econometrics, London Business School and the London stockbrokers Williams de Broë plc. David is a Visiting Professor in Business and Economic Forecasting at the University of Derby, Chairman of the Institute of Economic Affair’s (IEA’s) Shadow Monetary Policy Committee, and a visiting lecturer at the Cardiff University Business School. His monograph ‘Living with Leviathan; Public Spending Taxes and Economic Performance’ was awarded the Arthur Seldon Award for Excellence by the IEA in 2007. David is perhaps best known for his macroeconomic model of the international and UK economies. This is now maintained at his consultancy Beacon Economic Forecasting and topped the Sunday Times league table of forecasting accuracy for 2006 before becoming fourth (equals) for 2007. Ieke Van den Burg Group of the Party of European Socialists, Member Committee on Economic and Monetary Affairs, member (ECON) Committee on the Internal Market and Consumer Protection, substitute (IMCO) Delegation for relations with Australia and New Zealand, Member Netherlands, Partij van de Arbeid Born on 6 March 1952, Apeldoorn - Two children High school (1993-1970) University Utrecht Social Sciences (1970 - 1976) Certificate offset printer (1982) Experience FNV Federation of Dutch Trade Unions Equal opportunities adviser Printing Trade Union FNV 1984-1986 Policy adviser/coordinator Equal Opportunities Department Trade Union Confederation FNV 1986-1990 Elected Member of the Executive Committee FNV, 1990-1997 responsible labour law and labour relations, ILO and European Affairs Representative of the FNV in: - Member Social Economic Council (SER) 1987-1997 - Member of the Executive of the ETUC (European Trade Union Confederation) 19901997 - delegate and International Workers Delegation negotiator ILO conventions Part-time Work and Homework 1991 - 1996 - Member Economic and Social Committee (and member Bureau 1994-1996) 19931998 112 - president of ESC Social Affairs Committee 1996-1998 Special adviser ETUC dealing with relations with the European Institutions 19981999 Group of the Party of European Socialists, Member 1999-2004 Committee on Employment and Social Affairs, Member Committee on Economic and Monetary Affairs, Substitute Member Delegation for relations with Japan, Member Graham Watson Graham Watson was born in March 1956 in Rothesay, Scotland, the son of a Royal Naval officer and a teacher. He was educated at the City of Bath Boys’ School and at Heriot Watt University, Edinburgh, where he gained an Honours degree in Modern Languages. He is a qualified interpreter who speaks four European languages and is currently learning Mandarin Chinese. From 1983 to 1987 he served as Head of the Private Office of the Rt. Hon Sir David Steel MP, the then Leader of the Liberal Party and subsequent Presiding Officer of the Scottish Parliament. He had previously been politically active as General Secretary of the Liberal International’s Youth Movement, and was a founder of the European Communities’ Youth Forum. Before entering Parliament, Graham Watson worked for the Hong Kong and Shanghai Banking Corporation in both their London and Hong Kong offices, encompassing a three-month stint with the European Bank for Reconstruction and Development. He maintains an active interest in the Far East as a member of European Parliament Delegation for relations with China and Korea whilst promoting Liberal Democratic ideals in Asia through his work with the Council of Asian Liberals and Democrats. He is an Adviser to the Asia-Pacific Public Affairs Forum. Graham Watson was the first British Liberal Democrat to be elected to the European Parliament, winning the Somerset and North Devon constituency in 1994 with a majority of over 22,500. In June 1999 Graham was elected to represent the new enlarged South West of England constituency, which covers Bristol, Gloucestershire, Somerset, Dorset, Wiltshire, Devon and Cornwall. From 1994 to 1999 Graham was a member of the Committee for Economic and Monetary Affairs and Industrial Policy and of the Budgets Committee. From July 1999 to 2002 he served as Chairman of the Committee on Citizens’ Freedoms and Rights, Justice and Home Affairs. On 15 January 2002 Graham Watson was elected Leader of the 53 strong group of the European Liberal, Democratic and Reform Group in the European Parliament. After 113 2007-2008 ALDE ALDE 2007-2008 the European Elections in 2004, Graham was re-elected as President of the newly formed Alliance of Liberals and Democrats for Europe, which comprises 89 MEPs from 20 different countries as well as Observer MEPs from Romania and Bulgaria. Graham lives with his wife and two children in the small market town of Langport in Somerset. He has published 5 books, the most recent being ‘Liberal Democracy and Globalisation’, a compendium of essays by leading Liberal Democrat MEPs. 114 115 © Designed by Lara Szpiro ...
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This note was uploaded on 02/22/2009 for the course ECONOMICS 4313 taught by Professor Tsui during the Spring '09 term at HKU.

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