The Future of Financial Regulation future of financial regulation.pdf · The Future of Financial...

The Future ofFinancial Regulation

Howard Davies

The last quarter of 2007 was a very good time not to be a financial regula-tor. And I suspect that the first quarter of 2008 will not be much easier.The turmoil in global financial markets, which as recently as last July wasa cloud no bigger than a man’s hand, has spread from the wilder shores ofthe subprime mortgage business in trailer parks in central Florida, to theheart of the London interbank market.

It is not surprising that US mortgage lenders, and the investment bankswho securitised their loans and traded them extensively, have run intoproblems. But so have German and Geordie banks. What began as a houseprice correction transmuted into a general widening of spreads on riskyassets, then a liquidity squeeze and now looks well on the way to becom-ing a full scale credit crunch. Martin Wolf, Chief Economics Commentatorof the Financial Times, has talked of a “revulsion” in capital markets, asinvestors in all types of asset-backed securities have rushed to the exit.

In the central banks it has been all hands to the pump to supply liquid-ity which the markets themselves are unwilling to provide. They came tothe task with varying degrees of enthusiasm. Yet in spite of this massiveassistance the crisis seems far from over, and looks highly likely to have asignificant impact on the real economy, certainly in the United States, andprobably in Europe as well.

As a result, politicians and others have raised serious questions aboutthe adequacy of market regulation. Could the crisis not have been pre-vented? Were the regulators asleep at the wheel?—a common cliché whichis proudly trotted out by politicians at these times, as if freshly minted.

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

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

12 WORLD ECONOMICS • Vol. 9 • No. 1 • January–March 2008

Howard Davies

In the regulatory bodies themselves, the loudest sound is that of stabledoors being slammed shut. But there are also countless reviews under way,both domestically and internationally, to try to understand what wentwrong and what might be done to strengthen our defences in the future.

In this article I shall try to parse some of the so far rather inchoate criti-cisms of the performance of the regulatory system and to give a prelimi-nary assessment of where there is a case for a change. But first let meprovide one simple conclusion from my new book with David Green, whowas head of international affairs at the UK’s Financial Services Authority(FSA).1 The global regulatory system is rather complex. Figure 1 showsthe heavily simplified version. It has grown up like topsy and committeeshave proliferated extravagantly. New committees rarely die. That is espe-cially true in the European Union, where it is given to few to understandhow things are supposed to work (Figure 2). There is a powerful case forsimplification. (How this might be done is described in the book.)

FATF(money laundering)

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

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

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


The Future of Financial Regulation

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Howard Davies

A health warning

Before I begin parsing, I should enter a health warning. It is always dan-gerous to devise regulatory policy in the midst of a crisis. As I have arguedelsewhere, financial regulation in the UK, and indeed elsewhere, can bestbe explained as a series of Dangerous Dog Acts. Legislation is often con-ceived in haste in response to a particular example of excess. In the UnitedStates, the Sarbanes–Oxley Act is clearly in this category.2 It may well havesome merits, but almost all observers would acknowledge its inflexibilityand unintended consequences. It was certainly legislated in haste andAmerican markets have now been repenting for a while. So it is quiteimportant not to be seduced into new regulations and controls by marketpanic, controls which might in the long run be very costly and deliverinsufficient benefits.

But even with that health warning in mind, we must acknowledge thatthe last six months have raised some interesting and difficult questions forcentral banks and regulators, whether unified or separated. I identifyseven, as follows:

Question 1 is about the causes of the crisis. Did the Federal Reserveitself inflate the bubble by pushing interest rates down too far in the after-math of the collapse of the dot com boom and 9/11? Were other centralbanks accessories after the fact?

Question 2 is, in some ways, more fundamental. Does this crisis showthat liberalisation in financial markets has gone too far, and that there arefundamental flaws in what people, especially the French, call the Anglo-Saxon model?

Question 3 relates to the origin of the crisis last summer in the US sub-prime mortgage market. Is there a fatal flaw in that market, which was pos-itively encouraged by the Ancien Régime in the Fed on the essentiallypolitical grounds that home ownership was thereby expanded?

Question 4 relates to the Credit Ratings Agencies. Did they fall downon the job, and was their failure attributable to fundamental conflicts ofinterest in their business model which need to be corrected?

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



Question 5 relates to liquidity. Can we be happy that central banks havehad to inject liquidity on such a massive scale? Do bank regulators needan entirely different approach to liquidity?

Question 6 relates specifically to the UK: Does the Northern Rockproblem demonstrate a fundamental flaw in the UK arrangements,whether in the Tripartite system itself or in the separation of bankingsupervision from the Bank of England?

Question 7 relates to global financial regulation, the subject matter ofmy book with David Green. Does the response to the crisis show thatthere are gaps in the global regulatory system which need to be filled? Isthere a leadership problem within the complex network I illustrated inFigure 1?

I shall attempt to answer these seven questions in the remainder of thisarticle.

Q1. Did the Fed cause the problem?

This is the one of my seven questions on which I am proposing to enteran open verdict. My excuse is that it is essentially a macroeconomic ques-tion, rather than an issue of financial regulation.

It was almost universally acknowledged that the markets were awashwith liquidity and that real interest rates were very low, indeed often neg-ative. So credit expanded extravagantly. Were central banks focused onthe wrong indicators, fiddling while New York burned? In focusing exclu-sively on the use of interest rates to target inflation (and stabilize output)are we shifting volatility to other markets?

The case for the prosecution has been trenchantly argued by SteveRoach of Morgan Stanley. In a piece in Fortune magazine unambiguouslyentitled “The Great Failure of Central Banking” he argues that “centralbanks have failed to provide a stable underpinning to world financial mar-kets and to an increasingly asset dependent economy”.3 Roach maintainsthat “the current financial crisis is a wake up call for modern day centralbanking” and that “the art and science of central banking is in desperateneed of a major overhaul”. His principal concrete recommendation is thatmonetary authorities need to take the state of asset markets into explicit

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


Howard Davies

consideration when framing policy options and that “failure to recognisethe interplay between the state of asset markets and the real economy isan egregious error”.

This is a powerful critique, and even more powerful today than it waslast August. But Roach’s concrete recommendation is one fraught withcomplexity. Which asset markets? Since CPI measured inflation hasremained low, what would a tighter monetary policy in the last few yearshave meant for the overall price level and for the behaviour of the realeconomy? These are questions which go well beyond the subject of thisarticle, though I plan to reflect on them further this year as I work onanother book about the political economy of central banking. I am quitesure that central banks themselves are thinking hard about the problem,about how they take account of balance sheet issues in setting monetarypolicy, and about the way in which their financial stability responsibilitiesinterface with monetary policy.

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

The essence of the second question is whether the nature of this crisisreveals fundamental flaws in the Anglo-Saxon capital market structure,based on securitisation, risk transfer and the trading of almost anything.Are we witnessing the twilight of the masters of the universe? It is all overfor the originate and distribute markets?

Will Hutton is in no doubt.4 He is clear that what we are seeing is“testimony to the exhaustion of the conservative free market world view”.The new interconnectedness of global markets, which has been trum-peted as a success for London in particular, means that the world’s finan-cial authorities have “lost control”. As a result, the US and UKgovernments “will have to devise new forms of regulation and control”, asyet undefined but clearly draconian.

Martin Wolf is not far behind Hutton in his assessment. The creditcrunch is, as he sees it, “a huge blow to the credibility of the Anglo-Saxonmodel of transactions-orientated financial capitalism”. What has gonewrong is an example of both “crony capitalism and gross incompetence”.5

4 ‘The Worst Crisis I’ve Been In 30 Years,’ Will Hutton. Observer, 4 November 2007.5 ‘The Helicopters Start to Drop Money,’ Martin Wolf, Financial Times, 12 December 2007.



He notes that the principal argument in favour of securitisation and risktransfer, which has been at the heart of the market dysfunction, is that, asa result, it is possible to shift term-transformation risk to those best able tobear it. But instead, he argues, through securitised investment vehiclesand complex credit risk transfers, risk has gone not to those best able tobear it but “to those least able to understand it”. The result is what heterms a “market revulsion”, and a dramatic widening of spreads. The factthat AA asset backed commercial paper moved from 30 basis points abovetreasuries in the summer of 2007 to 270 basis points above in Decembersuggests a degree of volatility and mispricing which points to serious mar-ket malfunction.

Is this a commonly held view? Well, commonly perhaps, but not uni-versally. The Financial Times, in a leading article, took a very differentline.6 (The Leader conference which preceded it must have been an inter-esting discussion.) The FT lists all the great benefits which have comefrom financial liberalisation, which led to “a surge of competition andinnovation, cheaper financial intermediation and a more complete andefficient set of markets. Not only has capital been allocated more effi-ciently as a result, but foreign investment has been a channel for the trans-fer of technology and management skills, and so increased growth”. Evensome of the failures have a thick silver lining: “A system of bank rescuesin which shareholders lose all their money creates the right incentives”and “subprime mortgages made home ownership possible for hundreds ofthousands of people who would otherwise have been tenants”. So there isno case for a dramatic response: “financial regulation, especially on bankliquidity and consumer lending, should be tweaked in response to thecredit squeeze. But its liberal direction, which has brought great benefits,must remain”.

Who is right, Martin Wolf or his tweaking editor?On the specifics of the subprime mortgage market I believe the Hutton/

Wolf tendency has the better of the argument, but is it indeed a sign of amore fundamental market malfunction?

This question is not capable of a definitive answer. It is hard to draw upa balance sheet of the costs and benefits of financial liberalisation.

6 Leading article, Financial Times, 30 December 2007.


Howard Davies

My own view on the broader issue would tend towards the FinancialTimes leader. I see nothing sinister in securitisation. It is generally correctto argue, as a matter of principle, that securitisation allows risk to be spreadaround the market. Indeed it is notable that in spite of the turbulence of the last few months, there have been relatively few failures of banks or other financial institutions. The losses, so far, and they have been considerable, have been widely spread around the market. Hedge Funds, insurers and reinsurers who are active in the securitisation markethave in practice acted as shock absorbers, which has been generallybeneficial.

On the other hand, there is, as Martin Wolf argues, a problem of com-plexity. Part of the origin of the liquidity crisis is that counterparts are notsure where the risks originating in the subprime mortgage now lie,because of the highly complicated nature of the securitisation processwhich investment banks have undertaken. So they have been reluctant tolend to anyone. It is in fact a version of the ‘market for lemons’ problem.

Alan Greenspan, in a conversation with me at the London School ofEconomics in October, acknowledged also that securitisation had meantthat the crucial link between borrowers and lenders had now been broken.No one was very interested in the quality of the underlying credit, andmany market participants relied on ratings almost exclusively. This hasturned out to be an unwise approach, as I shall explain in a moment. Now,of course, the holders of these complex instruments are very interestedindeed in the dynamics of the underlying credits, but that interest hasemerged rather late in the day.

What is the appropriate regulatory response? I suggest that in the shortto medium term the market will resolve much of the problem itself. Thereis not likely to be much in the way of new issues of super senior AAA mez-zanine tranches of subprime mortgage securitisations driven out of theBBB tranche of the original mortgage pool. Could regulators ban securiti-sation or make it so costly in terms of its capital treatment that the marketdried up? This would, I believe, be an overreaction and would be costlyfor many ultimate borrowers, with adverse consequences for the real econ-omy. This is not to say that nothing should be done. Fundamental reformsin the US mortgage market are necessary, and there are clearly issues inrelation to rating agencies. I suggest, too, that the accounting and regula-tory treatment of liquidity and of off balance sheet vehicles needs to be



readdressed. (Basel 2 should help here.)7 The International AccountingStandards Board (IASB) will soon be making proposals on the first point.But the cost of reintermediating all these securitised risks would be veryhigh, and I do not believe it would be justified. So on this broad questionmy overall view is that it has been a very embarrassing episode, especiallyfor investment banks and rating agencies, but though there is more trou-ble to come I suspect it is not the beginning of the end of Anglo–Americancapital markets. Will Hutton will have to wait a little longer for this con-summation for which he so devoutly wishes.

The short-term economic consequences may be severe, however, asKenneth Rogoff and Carmen Reinhart argued at the recent AmericanEconomic Association conference in New Orleans.8 Comparable pastepisodes have resulted in a significant contraction of GDP. That may nowbe happening in the US.

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

It is generally acknowledged that the origin of the crisis lies in the sub-prime mortgage market. Clearly there are other dimensions, and perhapsmore fundamentally one might say that the underlying problem was oneof a general mispricing of risk. Indeed Alan Greenspan pointed to thisphenomenon, and the risks of unwinding, in his final Jackson Hole speechin 2005, when he said that history had not dealt kindly with the aftermathof periods of severe narrowing of spreads and mispricing of credit risk.9

But what about the subprime market itself?The market grew, very rapidly, in the early years of this century (see

Figure 3). In 2001, subprime mortgages represented only 7½ percent ofthe total of mortgage origination in the US. By 2006, subprime mortgages

7 The original Basel Accord was agreed in 1988 by the Basel Committee on Banking Supervision to helpstrengthen the soundness and stability of the international banking system as a result of the higher capital ratiosthat it required. Basel 2, initially published in June 2004, is a revision of the existing framework, which aims tomake it more risk sensitive and representative of modern banks’ risk management practices. Its purpose is tocreate an international standard that banking regulators can use when creating regulations about how muchcapital banks need to put aside to guard against the types of financial and operational risks they face. Advocatesof Basel 2 believe that such an international standard can help protect the international financial system fromthe types of problems that might arise should a major bank or a series of banks collapse.8 ‘Is the 2007 Sub-Prime Financial Crisis So Different? An International Historic Companion,’ Carmen Reinhartand Kenneth Rogoff, AEA Conference, January 2007.9 ‘Reflections on Central Banking,’ Alan Greenspan, Jackson Hole Conference, August 2005.


Howard Davies

accounted for 23% of the total. In the subprime sector credit quality is low,leverage is high and documentation is very modest. Most borrowers certifytheir own income, etc.

It is quite clear from these figures that the nature of the subprime mar-ket changed during that period. Lenders were drawing into house pur-chase many borrowers who would not have been considered for amortgage earlier. (If you want a good explanation of the way the Americanhousing market works, go to see Glengarry Glen Ross on ShaftesburyAvenue—a play by David Mamet, in which estate agents in Florida sellplots in swamps to people they meet by chance in Chinese restaurants.)

Also, during this period, it became clear that the original credit qualityof the borrower was of little or no interest. As house prices rose, loans weresimply refinanced when the borrower could not pay. Indeed, in manycases it seems that borrowers borrowed significantly more than the valueof the house in order to make the first few payments, long enough for thelending bank to securitise the mortgage while it was still being serviced.In retrospect, one can see that this was a classic bubble, fuelled by irra-tional exuberance and a dose or two of fraud.

%

Figure 3: Mortgage origination by product (%)

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

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

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

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Source: Standards and Poor’s

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Howard Davies

How do we know what the default rates on these recent mortgage poolswill be? We do not know with any accuracy, but an estimate can be devisedfrom the percentage of loans which are delinquent, in other words whereinterest payments are more than two months late. The escalation of thosedelinquencies rates for the more recent mortgage pools is dramatic, andshows no signs of levelling off.

That is not wholly surprising given the resets, in other words the num-ber of loans which are what we would call low start mortgages, with inter-est rates discounted for the first 12 months, but where the monthlypayments may almost double at the moment of the reset. The best proxyfor the value of these bonds is something called the ABX index, which fellfrom 100 cents in the dollar in January last year to around 30 cents inDecember (Figure 7). In other words the triple B tranches lost around 70%of their value during the year, and some of those losses occurred in CDOsrated triple A. This is what we regulators used to call, in technical lan-guage, a complete shambles.

Figure 5: Subprime mortgage pool securitization

Note: Ratings are Rating Agency defined

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Figure 6: ABS CDO securitization

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Figure 7: Recent ABX BBB price history (2007)

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

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Howard Davies

Underlying this market is, of course, a lot of human misery, with manydispossessed families now homeless. But it may be argued that there arenonetheless more people with homes, who have benefited from rapidhouse price escalation over the last 6 or 7 years. Indeed, Alan Greenspanin his book argues that the social benefit of this market place is net posi-tive.10 He maintains that the expansion of home owning democracy was avery positive political development in the United States. He does notthink, therefore, that regulatory intervention would have been appropriateor justified.

Not surprisingly, perhaps, Paul Krugman takes a very different view. Hepoints out that home ownership rates have now fallen back to where theywere in the middle of 2003 and that they may well fall back below wherethey were at the beginning of the Bush presidency as a result of this dra-matic market unwinding. He sees this as a classic case of over reliance onmarket disciplines which prove to be fundamentally flawed.11 Indeed, hesays, “it is hard to imagine a more graphic demonstration of what is wrongwith the Republicans’ economic beliefs”. And the critics are not just oper-ating with the benefit of hindsight. Ned Gramlich, a former Fed governorwho died recently, made all these points over 3 years ago.12

The Federal Reserve has now decided on a significant restructuring ofmortgage regulation in the United States.13 They have proposed changeswhich would outlaw no documentation or low documentation mortgagesand would require more explicit disclosure of teaser rates and the effect onrepayments when those rates are reset. Most of their proposals would workon the lenders rather than the brokers and have been described by theChairman of the Senate Banking Committee, Chris Dodd, as “deeply dis-appointing”.14 It is possible that Congress will legislate something morerestrictive and which bites more directly on the broking community.

This is an extremely difficult area, but it is hard to avoid the conclusionthat the US would benefit from the imposition of a regime of mortgagebroker regulation such as the one introduced in the UK about 3 years ago.On the whole the market has welcomed that regime, which has tightened

10 The Age of Turbulence: Adventures in a New World. Alan Greenspan. Penguin Press, 2007.11 ‘A Catastrophe Foretold,’ Paul Krugman, New York Times, 26 October 2007.12 ‘Subprime Mortgage Lending: Benefits, Costs and Challenges,’ Edward Gramlich. Financial ServicesRoundtable Annual Housing Policy Meeting, Chicago, 21 May 2007.13 ‘Proposed Changes to Regulation Z,’ Federal Reserve, 18 December 2007.14 Statement by Sen. Christopher Dodd, 18 December 2007.



up lending practices and improved ethical standards among brokers. So inthis area I answer firmly yes to the question of whether regulatory changesare required.

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

The fourth area of concern is the ratings agencies. The very rapid down-grading of securities rated triple A has focused attention very sharply ontotheir procedures. Indeed it has become open season on the rating agenciesand all their works.

One of the sharpest shooters has been Willem Buiter, Professor ofEuropean Political Economy at the LSE. He argued in front of theTreasury Select Committee that there are fundamental problems in thebusiness model of the ratings agencies who are paid by the issuers of thesecurities they rate. In Willem Buiter’s view that practice should stop. Theratings agencies should sell nothing but ratings and the critical role of therating agencies in Basel 2 should be abandoned.15

Buiter’s analysis of the potential conflict of interest which rating agen-cies face is clearly correct. Issuers have an incentive to achieve the highestpossible rating, to maximise their chances of getting the security away at agood price. But what is the alternative? If agencies are paid by investors insecurities, there is a similar but opposite potential conflict in that investorshave an incentive to see a lower rating, so that they pay a low price andsecure a high yield. It is also technically rather difficult to see howinvestors, especially secondary investors, can be made to pay for ratings,without regulatory intervention of some kind. And regulatory interventionof that sort may imply greater official sanction for ratings that is justified.

So I suspect that, while there is a potential conflict, it must be managed,just as conflicts of interest within banks or investment banks must be man-aged. But whether or not the rating agencies have been managing theseconflicts well, they have clearly not convinced the market that they do so.Many believe that agencies have been prepared to negotiate ratings withissuers of securities in a process of iteration, where the agencies explainwhat is needed in terms of adjustments to the structure of securitisation toachieve its desired double or triple A status. Of course it makes no sense

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


Howard Davies

to prevent agencies from holding discussions with clients, but they mustbe within a transparent framework. Furthermore, there need to be checksand balances in place within the agencies, perhaps with some regulatoryoversight, to ensure that ratings are objective, that rating agency staff arenot remunerated in relation to the profitability of the enterprise, or in rela-tion to the number of ratings they deliver.

The broader issues, and in the long term the more important ones,relate to the way in which ratings are used by investors, and indeed to theregulatory status of both the agencies and their ratings.

On the first point, it would seem that many investors have substitutedratings for thought. They appear to have taken little interest in the behav-iour of the underlying credits, and simply invested on the basis of the rat-ing. I suspect that the dramatic losses suffered in the CDO market willchange that behaviour. There is also a specific problem in the way ratingsare used in the securitisation market which needs to be addressed. Theagencies may well argue, as indeed they do, that such statistical evidenceas they had about the behaviour of these credits suggested that the ratingsthey gave them were equivalent to those which they gave comparableplain vanilla corporate debt. But it is equally clear that in turbulent mar-kets they can behave very differently, and the default rate on securitisa-tions graded AAA in conditions of liquidity stress has been dramaticallydifferent. The agencies need to consider whether the same ratings scale isappropriate for these instruments, or whether a separate scale, or somekind of “starred” arrangement indicating that the securities may behavedifferently in certain circumstances, ought to be adopted. This would inturn facilitate a better understanding in the market place of the nature ofthe risks investors take on when they invest in these structured products.This could be the response to one of a number of recommendations whichthe Bank of England made last year (Box 1). The others are worth consid-ering, too.

As for the regulatory environment surrounding ratings agencies, theyare registered in the United States, and indeed last year a new Act was putin place which gave the Securities and Exchange Commission (SEC) agreater oversight role. There is no similar regime in the European Union,though under pressure from the European Parliament regulators and theCommission are investigating whether a similar regime should be intro-duced in the UK. There is significant political pressure to do so.



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

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

ratings agencies report

1. Agencies could publish the expected loss distributions of structured prod-ucts, to illustrate the tail risks around them

2. Agencies could provide a summary of the information provided by origina-tors of structured products• Information on originators’ and arrangers’ retained economic interest

3. Agencies could produce explicit probability ranges for their scores on prob-ability of default

4. Agencies could adopt the same scoring definitions

5. Rating agencies could score instruments on dimensions other than creditrisk• E.g. market liquidity, rating stability over time or certainty with which a

rating is made.

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

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


Howard Davies

Q5. Do we need a new approach to liquidity?

The fifth area is the regulation of liquidity. Evidently the biggest surpriseto market participants and indeed to regulators in this crisis has been therapid and indiscriminate seizing up of the interbank market, and more par-ticularly the securitisation market. It was a failure to achieve a new secu-ritisation of its mortgage book that drove Northern Rock into the arms ofthe Old Lady.

It is now generally accepted that regulators need to revise theirapproach to bank liquidity. Indeed the FSA has already published a dis-cussion paper incorporating some new proposals.17 But is it enough for oneregulator in one country to revise its procedures or is a new global under-standing required? And in the light of what we have learned in recentmonths, is it right to think about a regulatory approach to liquidity with-out considering the role of the central banks in the provision of liquidityin crisis conditions?

My answers to both these questions are no. One obvious lesson of thiscrisis is that financial markets are more interconnected than ever before,giving added weight to the significance of globally agreed standards offinancial regulation. It seems clear to me, and indeed this is a conclusionof the forthcoming book to which I referred, that central standard setters,whether the Basel Committee, the International Organization ofSecurities Commissions (IOSCO), or whatever, need strengthening. Andthe need to consider central bank behaviour and its impact on the bank-ing system as a whole, has been powerfully made in a new paper on liq-uidity risk management by my colleague at the LSE, Professor CharlesGoodhart.18 Goodhart refers to Tim Congdon’s observation that in the1950s liquid assets were typically 30% of British clearing banks’ totalassets, largely Treasury bills and short dated government debt. At presentthese cash holdings are about half a percent and liquid assets about 1% oftotal liabilities. Goodhart argues that “the banks have been taking out aliquidity put on the central bank; they are in effect putting the downsideof liquidity risk to the central bank”. He therefore argues that “what issurely needed now is a calm and comprehensive review of what the

17 Review of the Liquidity Requirements for Banks and Building Societies. DP07/7. Financial Services Authority,December 2007.18 ‘Liquidity Risk Management,’ Charles Goodhart, Special Paper 175, LSE Financial Markets Group, October2007.



principles of bank liquidity management should be” carried out by theBasel Committee. And this needs to be done taking account of the behav-iour of central banks, including the type of collateral which the centralbank may accept in the provision of emergency liquidity. Recently centralbanks have altered their practices very considerably. Would they be pre-pared to do so again? That could be dangerous. Again quoting CharlesGoodhart: “if commercial banks can always rely on the central bank, theywill undertake maximum maturity transformation in order to take advan-tage of all liquidity premia and the normally upward sloping yield curves”.

So we need a strategy to get out of the current position. Part of it mayinvolve greater consistency among central banks. In recent months bankshave been put in very different positions depending on the jurisdictions inwhich they operate. Liquidity was more easily available within theEurozone than outside it. We also need to think about what might be anappropriate extent of maturity transformation by commercial banks. Thisis very difficult territory, and of course we need to acknowledge that tight-ening up on maturity transformation in commercial banks, and requiringthem to hold more liquid assets themselves, could be very costly for bor-rowers. What we know, however, is that we must try to avoid a repetitionof the events of the last few months, which cannot be allowed to be a reg-ular feature of the global banking system.

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

For my sixth and penultimate question I turn to the issue of the UKarrangements, and particularly the Tripartite arrangement between theTreasury, the Bank of England and the FSA. Has the crisis demonstrateda fundamental flaw?

You might expect me, as one of the authors of the Tripartite agreementin 1997, to be predisposed to defend it. And so I do. I have been puzzledby the certainty by those who immediately rushed to judgment and foundit wanting in the light of the problems surrounding Northern Rock. Wehave a tendency in this country to jump to conclusions about structures,rather than to acknowledge the difficulty of the decisions faced by theauthorities in a case such as this and the possibility that, whatever thestructure, decisions may have been taken which, in hindsight, do not lookoptimal.


Howard Davies

We should recall, first, that the UK structure of responsibilities is not sounusual in an international context. In the first place, in any country withan independent central bank there are bound to be two authoritiesinvolved in the provision of liquidity support to a troubled institution, thecentral bank and the Ministry of Finance, certainly in all cases where thatliquidity support is of such a scale and such a duration, that we cannot becertain that it may not turn into solvency support in due course. It is pos-sible to simplify responsibilities in the way some critics would like by put-ting the Ministry of Finance and the central bank together, or submittingthe central bank entirely to political will. That is the case in, for example,Cuba, Zimbabwe and North Korea.

We may safely reject that option. So we are stuck with at least twocooks. Then there is the separate question of whether the supervisorshould be in the central bank. Internationally, 39 countries now have sin-gle regulators outside the central bank (Figure 8). And in over 50 countriesbanking supervision is not now carried out by the central bank. This is avery common arrangement today, and is seen for example in Scandinavia,

Figure 8: Non-central bank unified financial regulators

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

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20062005200420032002200120001999199819971996199519901980

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Canada and Australia (Figure 9).The difference in the UK isthat the responsibilities of thethree agencies are set outclearly in a published memo-randum. I would regard this asgenerally a positive step interms of clarity and accounta-bility. Parliament can ask forthe views of the different agen-cies and hold them to account.

We should also recall thethree principal reasons for sep-arating supervision from the central bank, and ask how they look in thepresent context.

The first and strongest argument was that in complex financial marketsit is important to have a supervisor who can see what is going on across thedifferent sub-sectors of the financial system. One powerful reason for thatis that risks may now originate in the banking system but be transferredthrough securities markets to other institutions and back again. In presentcircumstances the argument for unified regulation looks to me to bestronger than ever, and it is absolutely clear that one cannot understandwhat is happening in the banking system without looking at securitisationand the transfer of risk through traded markets. So it would be a very curi-ous moment to wish to dismantle the integrated regulation carried out bythe FSA.

The second argument was that the supervisor’s view on the need to pro-vide support for an institution may differ from that of the central bank aslender of last resort. The supervisor might be disposed to argue the casefor support more forcefully. Where supervision is merely a division of thecentral bank, the central bank will inevitably have only one public viewand we would not know whether the supervisors were arguing for support.That was the case before 1997.

A third argument, which at first blush appears to contradict the second,but which is in fact complementary to it, is that where the lender of lastresort is also the supervisor it may be more inclined to provide support fora troubled institution, perhaps in order to conceal the inadequacies of its

Figure 9: Central banks in regulation

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

Central Bank with no direct supervision responsibilities

Central Bank as unified regulator

Central Bank with banking and other responsibilities

Central Bank as banking supervisor only

50

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Howard Davies

earlier supervision of that firm. There are those who would argue we haveseen examples of this phenomenon in the UK in the past. Of course, atpresent the focus is all on whether support was provided too late, and per-haps in a technically flawed way, but we must recall that in the past therewere other opposite concerns. In the case of Johnson Matthey Bank, theissue was whether the Bank of England should have supported it at all,and what signals were sent to banks about their risk management as aresult. In thinking about our regulatory structures we must bear in mindthe possibility of pressures in both directions.

So I cannot see that what has happened provides a strong argument forfundamental revision of the 1997 arrangements. It has not been arguedpersuasively by anyone, and certainly not supported by the authoritiesthemselves, that there was a failure of communication in the sense of alack of understanding by the three parties of what the position of NorthernRock was. Of course there are question marks about the judgments made,whether by the FSA as a supervisor (and the Authority is carrying out areview of its past supervision of Northern Rock) about the way the Bankof England provided support and when it did so, and about the timing ofthe Treasury’s deposit guarantee. But these are, to repeat, issues of judg-ment which need to be made in any structural arrangement.

So I was pleased to read Alistair Darling’s remarks to the Financial Times,in which he rejected further fundamental reform.19 It may indeed be help-ful to relook at the precise terms of the MOU, and to emphasise the pri-macy of the Treasury’s responsibilities for reaching decisions on theprovision of support. When originally drafted, the concern was that theBank of England might be disposed to provide support too easily, andtherefore the drafting provided for the Treasury to be able to refuse thepossibility of support, rather than to originate it. Now we can see the oppo-site concern, there is a case for more symmetrical treatment.

If there are to be new powers for the authorities to intervene in a failingbank, then it looks appropriate for those powers to be exercised by thesupervisor. But careful thought needs to be given to the incentives gener-ated if the FSA can intervene and cut across shareholder rights. If theycan, there is a risk that banks may therefore seek to protect themselves by

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



retaining much larger capital cushions—good for stability but expensivefor customers. We must be careful not to promote reckless prudence.

Q7. Does the crisis reveal flaws in the international regulatorysystem?

My seventh and last question is whether the financial crisis of 2007–2008reveals significant flaws in the international regulatory system. Here myanswer is yes, but the operative word is “reveal”, as I believe these flawshave been present for some time.

The question which many have asked domestically—who is incharge?—is even more apposite at the global level. In one sense, of course,the answer is clear. Returning to my earlier wiring diagram (Figure 1) youcan see that the G7 Finance Ministers sit at the apex. But the G7 FinanceMinisters do not have a usable mechanism to coordinate their responses toproblems. The IMF and the World Bank dance to their own tunes. Thecentral banks get together in the G10 at Basel. The banking supervisors(some of them central bankers, some not) meet in the Basel Committee,while securities regulators get together in IOSCO—though the growingimportance of the European Securities Regulators Committee (CESR)should not be underestimated. All of these groups are, in their differentways, now addressing different elements of the market malfunctionswhich have emerged.

The obvious body to coordinate all of this activity is the FinancialStability Forum. But, as its name implies, it is an informal body with nopowers of its own, and indeed only a small staff. The Forum works almostexclusively through the other bodies which are part of it.

My own view, and I believed this before the latest turmoil, is that theForum, which was put together following an initiative by Gordon Brownafter the Asian financial crisis at the end of the 1990s, should be signifi-cantly strengthened. It should be renamed the Financial Stability Counciland allowed to take much more of a leading role in responding to marketproblems, especially where they involve central banks in their lender oflast resort capacity, banking regulators and securities regulators—andwhere Finance Ministries which are also members of the Forum, must bepart of the story given the possibility of taxpayer backed support. This isnot, perhaps, the only change required and a stronger coordinating


Howard Davies

mechanism would not in itself solve problems, but it would create a focalpoint for regulatory bodies to pool their intelligence and determine a coor-dinated response. Even the awareness that such an organisation existedwith the capacity to coordinate action would be reassuring to market par-ticipants.

Conclusion

Even the seven questions I have addressed—you might think seven isquite enough—cannot hope to cover all the implications of what has been,as they say on Test Match Special, a remarkable passage of play in financialmarkets. Indeed my focus on financial regulation has left largely out ofaccount probably the most important lessons, which are for financial insti-tutions themselves. Very large losses have been made by German state-owned banks, and by Swiss and US investment banks. There are almostcertainly more losses to come, both there and in other firms whoseaccounting and reporting is less timely and less complete. For a period atleast these firms will be very reluctant to be engaged in the types of struc-tures and securitised deals which have been at the heart of the problem.But the half-life of lessons from financial crises is short. Generationschange on the trading floors and in the corner offices and, before you knowit, a new bubble is being enthusiastically inflated. That is why it is impor-tant for regulators, in their continuing supervision of firms, to drive themessages home and continue to do so even when the immediate dangerhas passed.

So, while I do not share the Hutton view that the concrete canyons ofCanary Wharf and Wall Street will soon be empty, with only the occasionalWill Smith character with a gun and a dog roaming deserted streets, Inonetheless think we have seen a vivid demonstration of the importanceof a robust regulatory framework surrounding capital markets. I hope,therefore, that we hear less from politicians in future of the content-freerhetoric about ‘light touch’ regulation, whose meaning has never beenclear to me, but which made life harder when I lay on the FSA’s bed ofnails.

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