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Good evening Ladies and Gentlemen,
Thank you for inviting me to be with you this evening to discuss some topical economic and market issues, and in particular the lessons that need to be learned from the current credit crisis and the near term outlook for the European and global economy.
If you step back 18 months or so and consider some of the issues that were exercising the minds of relevant interest groups then, one thing is absolutely clear: Many had their eyes on the wrong balls: Hedge funds were being demonised. Private equity was been castigated. And "threats" from sovereign wealth funds - whether real or imaginary - were being fretted about. Calls for regulation were widespread.
But while all this noise was going on a time bomb was ticking – It was primed not in the non-regulated sector but in the regulated sector. To anyone taking an overall view of the financial markets the investment bank-driven explosion in securitization, SIVs and off balance sheet orphans and the risks they posed should have been obvious. Some signals coming from financial institutions as much as a year before the crisis hit were unmistakable.
Indeed in October 2006 I raised the issue of off-balance sheet structured credit in a speech to the Association of Corporate Treasurers in Dublin. I warned then that the extraordinary pace of growth in the issuing of complex structured securities globally, the assessment of the real underlying risks inherent within these securities, and a parallel surge in demand for experienced professionals in investment banks and rating agencies posed a real challenge for market participants, regulators and supervisors. I pointed out that while there may be far more sophisticated ways for investors to hedge risks, and to pass the parcel through opaque, off balance sheet instruments, the more opaque the nature and method of the risk transfer strategies, the more risk there was likely to be that risk was not getting properly managed or measured. And so it has turned out.
And there is certainly an irony in the fact that the entities that were being demonised at that time by many - sovereign wealth funds and hedge funds – have in recent months been the savours rather than the demons, with hedge funds providing much needed liquidity to the markets, and sovereign wealth funds providing much needed capital to systemically important banks whose balance sheets have been critically weakened by the rash of irresponsible underwriting and investment in sub-prime assets.
I have never believed in playing the "blame game". But if we don't recognise and learn from mistakes we are certain to repeat them. And one has to say that there is no part of what one might call the financial services supply chain that emerges from what we have seen "smelling of roses". From the brokers selling the sub-prime mortgages, to the financial institutions underwriting them, to the investment banks packaging and placing them, to the rating agencies rating them, and the investors buying them, mistakes have been made on a truly grand scale.
At the very root of the problems we have today has been the progressive dismissal by market participants of 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 from cash flows that are likely to be sustainable through good economic cycles and bad.
Instead what we saw – not just in the United States - but in parts of Europe as well - was a market progressively moving towards an assumption that one could indefinitely rely on mortgage refinancing with ever-rising debt on the back of ever rising asset values and permanently low interest rates. It was inevitable that this approach would end in tears and so it has. Of course it has always been the case that prudential lending standards become more relaxed the longer the period of an economic upswing. But on this occasion the extent of relaxation was all the greater because of the extent of financial innovation, the explosion in off-balance sheet finance, and the rapid growth of the so-called originate and distribute model. We should all remember that securitization doesn't make risk go away. It just causes risk to get lost!!
The credit markets aside, we have seen in more recent weeks how some parts of the banking industry remain vulnerable to the phenomenon of the rogue trader. As far as treasury and proprietary trading risk is concerned it seems to me amazing that despite all the lessons about controls that should have been learnt from a sequence of multi-billion dollar losses clocked up by rogue traders in several financial institutions around the world over the past decade, a top class institution has once again been exposed as having fundamental control weaknesses and having failed to learn some of the lessons from previous rogue trader experiences. It is inexcusable that the entire market value of a financial institution can be placed at risk by such abject carelessness on the part of a leading European bank, that that institution failed to heed the warnings of a significant market counterparty and failed to learn the lessons that rogue traders have taught us about the checks, balances and controls that must be in place for risk to be effectively managed and controlled.
I want today to share with you some of my current thoughts on the issues that need to be focused on now by financial institutions, and their regulators and supervisors.
First, in relation to financial institutions it is clear that corporate governance needs to be strengthened especially in respect of the oversight of the management of credit, market, liquidity, and operational risk.
Financial institutions and their investors also need to review whether management rewards – particularly the timing of those awards – are appropriately aligned to the interests of shareholders. In credit businesses in particular - where true performance can only be judged over the medium term - the appropriateness of disproportionate short term reward is an issue that needs to be addressed notwithstanding the competitive pressures for talent.
The risks associated with using broker channels to source mortgage transactions, and how those risks are managed is another issue that requires attention.
For regulators, we need to work with Member States to strengthen cross border cooperation and supervision.
In an EU context we need to reinforce the supervision of major cross border banking groups and financial conglomerates as well as our capacity for financial crisis prevention, management and resolution.
Recent events have demonstrated how important it is that investors have confidence in the systems protecting their savings. But it will also be important that whatever we do we should avoid creating moral hazard.
A review of Basel 2 and of accounting rules, including issues pertaining to the valuation of assets in illiquid markets must also be pursued. We have to face up to the fact that some of the rules that have been introduced in recent years risk aggravating market fragilities most at a time when we can afford to least. In respect of off balance sheet entities we need to consider further the reputational, capital, and liquidity implications that they can give rise to for the originating or sponsoring bank and take account of these issues and of the lessons that the current turmoil has taught as we set about revising the current regulatory framework.
In relation to credit rating agencies, we have had some significant interaction with them in recent months. We have made clear to them that things cannot remain as they are and have signalled the major issues that need to be addressed. I know they have been working on this and some useful ideas are evolving. In particular, I welcome the fact that at least one of the agencies has picked up on a particular issue that I said last year required attention, namely the need for distinctive grades to be attached to structured finance. The rating agencies are being constructive in other areas too, including transparency but there is more to be done. I am not going to be prescriptive today but I will say this: Strong, independent, professional oversight of the credit professionals within the rating agencies - including their performance, pay and promotion - and of the operation and processes of the rating functions themselves is absolutely essential if market and regulator confidence is to be restored in respect of the effective management of the conflicts of interest inherent in the rating agencies' business models. And I want to take this opportunity today to make it clear that if proposals in this regard that are meaningful and robust are not forthcoming in coming months I will not hesitate to move forward quickly to have the issue addressed by regulatory action.
Inevitably the financial market turmoil will have negative impacts on the real economy. Against this background, there is always a risk that EU Member States - and indeed the US - will become more protectionist in their instincts. This must be resisted.
Over the medium term the outlook for the global economy is bright – Opportunities have never been greater and provided in Europe we push forward with our programme of economic and structural reforms despite the current setbacks I am confident that we can and will be at the forefront of the next phase of global economic growth.
Thank you very much indeed.
