Turbulence in the Financial Markets: Regulatory Impact
This article is based on the presentation made by Paul Richards at the FT Compliance Summit on 9 October 2007 in London.
It is clear that the immediate cause of the turbulence in financial markets was the evaporation of liquidity. This started with the sub-prime mortgage crisis in the US, but spread to other types of financial asset across the international financial system as a whole. There was a loss of confidence in the market, as a result of which commercial banks were no longer willing to take normal credit risks, even for very short periods, except on onerous terms.
In that situation, the central banks were right to intervene from 9 August onwards by pumping liquidity into the system, not just overnight but for up to three months, and in some cases by expanding the range of collateral they accepted in exchange. Initially, some commercial banks hoarded liquidity (e.g. by investing in Treasury bills), but in time they extended sufficient liquidity to the wider market. Central bank intervention does seem to have had an effect in steadying the market; and commercial and investment banks have also helped to calm the market by giving a lead for reputational reasons, rather than purely financial reasons: for example, by deliberately drawing on Fed funds when they did not need to do so.
I think that the turbulence in financial markets has presented a classic case for central bank intervention on financial stability grounds. But the difficulty in this case has been that, with limited exceptions such as the classic bank run on Northern Rock in September, the problems have emerged outside the traditional banking sector.
Although the evaporation of liquidity was the immediate cause of financial market turbulence, there seems to be agreement that the underlying cause was the explosion of credit growth in financial markets over the past few years.
As a result of these structural weaknesses, there is no doubt that some credit risks were mis-priced. In particular, some asset-backed securities – with high yields but also high credit ratings – have proved not to be as sound, or as liquid, as they appeared. Many ‘conduits’ are very conservatively structured. But some ‘structured investment vehicles’ (SIVs) have taken on too much leverage. SIVs are typically invested in longer-term securities, but funded short term in the asset-backed commercial paper market, so they are dependent on the funding being rolled over. In the absence of liquidity, the sponsoring banks have sometimes had to fund off-balance sheet vehicles from their own balance sheets. De-leveraging has also led to forced asset sales. And two over-extended banks – IKB and Sachsen LB – have been rescued.
That is the position on the sell-side. But on the buy-side, the withdrawal of liquidity has meant that some money market funds invested in asset-backed securities have had difficulty in pricing their net asset values and in finding sufficient liquidity to handle redemptions.
Another contributory cause is that some hedge fund strategies have unravelled. For example, as a result of the linkages between different asset classes, hedge fund losses in the sub-prime market led to sales of liquid and profitable investments (e.g. large cap natural resource stocks). And in the case of ‘quants’, computer programmes for buying and selling securities did not work in the way in which the originators intended: market movements occurred that were supposedly expected to occur only once in every 100,000 years.
Finally, a critical cause has been uncertainty about where the losses lie. By spreading risks widely across the financial system as tradable assets, securitisation has helped to avoid banking crises in which very large amounts of risk are concentrated on banks’ own books (as in the case of the LTCM crisis in 1998). But instead, securitisation has given rise to the criticism that the originators pay insufficient attention to the risk of default, as they immediately pass it on; and that, as the risks are widely spread, there is a lack of market transparency – nobody knows where the losses lie. In this particular episode of financial market turbulence, uncertainty about where the losses lie has itself become a source of speculation in the market. And bad news has emerged piecemeal rather than in one go.
Those appear to be the more obvious causes of the recent global market turbulence. But what are the consequences? There are issues for central banks and governments; and there are also issues for private banks, such as many of you here today. First, the broader central banking issues.
Undoubtedly, the turbulence in financial markets will affect real growth in the international economy, but it is much too early to say how large the downside will be. That depends on whether the turbulence is limited to a (healthy) short-term market correction or the start of a prolonged downturn. Nobody yet knows for certain. But the central banks do have the opportunity to influence the outcome by reducing interest rates if necessary, as the Fed did on 18 September.
A separate question, when they set interest rates, is whether central banks should in future target asset prices as well as CPI measures of inflation. In general, when they set interest rates, central banks already take account of the impact of asset prices on inflation. But it is difficult to hit two different targets simultaneously.
Although central banks were clearly right to pump liquidity into the market in response to financial market turbulence, the difficulty they face now is how to maintain confidence in the system as a whole without giving the impression that they will always bail out individual institutions, and so encourage imprudent risk-taking in future. ‘Moral hazard’, in central bank jargon.
The turbulence in financial markets has also raised the related question about where the dividing line should be drawn between financial institutions that pose potential risks for the financial system as a whole, on the one hand, and financial institutions that central banks can allow to become insolvent without posing such risks, on the other. And if certain non-bank financial institutions do pose systemic risks, should they be supervised more lightly than banks?
Besides these more general consequences, there are also some more specific consequences for the financial sector:
First, banks have assets on their books that they would normally wish to sell but have not been able to do so. In some cases, they also risk having to take back – onto their own balance sheets – off-balance sheet vehicles they have created. As a result, banks are likely to become increasingly capital constrained, unless they can raise more capital. In addition, the flight to safety means that borrowers and investors may choose to make more use of large bank balance sheets in future, rather than relying on disintermediation.
New issues include the market is clearly going to take time to recover. The market has become much more cautious. Risk is being re-priced. This will have an impact on the quantity of new issues, with less supply as M&A and private equity activity has decreased; and less demand as hedge funds become less active. And there will also be an impact on quality, as arranging banks become much more conservative in their assessment of creditworthiness, and issues with weaker covenants become more difficult to sell to investors.
As nobody knows where the losses lie, there is pressure for exposures to be more transparent. However, in cases in which financial information is not already publicly available, making exposures more transparent is not straightforward, particularly when the exposures are to complex vehicles involving derivatives. There may be no alternative to waiting for the regular financial results of the financial institutions concerned. And financial results for the third quarter are already starting to appear. Even when the results are bad, publishing them reduces the uncertainty.
Another question that arises in consequence of the recent market turbulence is: how should financial instruments and collateral be valued when there is no liquidity? This is a particular problem when the valuation depends on the credit rating provided by a rating agency.
There are also already political calls to reconsider whether rating agencies should be regulated. Rating agencies allegedly have conflicts of interest, as they are paid by the firms they rate, and in particular they are paid for awarding high credit ratings to collateralised debt obligations, which they themselves have helped to structure. Some of these have turned out to be more risky than their ratings suggested. There are two other questions relating to rating agencies. The first is whether ratings are too ‘granular’: i.e. does a rating spectrum from AAA to BBB capture all the different aspects of risk, particularly liquidity risk? The second is whether bank capital standards should be based on ratings in their current form.
It is not clear whether Basel II and MiFID, if they had come into effect earlier, would have made a significant difference either in preventing financial market turbulence or in resolving the problems that have emerged, though they would have led to greater disclosure. One particular problem is that the treatment of collateral under Basel II may need to be rethought. The question is whether Basel II gives excessively generous terms to collateralised instruments and covered bonds (e.g. in relation to unsecured interbank lines). And if the authorities need to rethink elements of Basel II in relation to the banking sector, this may also have implications for Solvency II in the insurance sector.