Prime Minister, Excellencies, Ladies & Gentlemen,
Thank you for the opportunity to talk with you today. I have been asked to speak about the current challenges faced by the banking sector – a timely topic given the recent market turmoil.
The extent to which financial markets have integrated over recent years was brought home in a spectacular fashion this summer. The collapse of the US market for sub-prime mortgages sparked a general breakdown in investor confidence, triggering financial losses which were transmitted rapidly across the global financial system via the markets for structured financial products.
The effects did not take long to make themselves felt here in Europe – first with the failure of two banks in Germany and then in September with the first run on a UK bank in over 100 years.
Faced with the challenge of dealing with market turmoil, what should be the response of EU regulators and what are the challenges facing the global banking sector in general?
Firstly, I am convinced that we must avoid a 'knee-jerk' reaction to recent events. As a national politician I used to say that 99 times out of a 100 immediate responses to a crisis tended to be wrong or misplaced. At the European or international level the ratio might even be higher...
Hasty and potentially damaging actions would be counterproductive. What we must do is continue and extend our dialogues internationally with the relevant regulatory, supervisory and political institutions – and ensure that the industry plays its role in bringing forward comprehensive and effective initiatives to improve market transparency and to enhance risk management. A measured, considered response is called for. Medium to long term objectives need to be presented which are designed to deal with any identified shortcomings. I am pleased that there appears to be widespread consensus on this.
Before taking a definitive stance, we need to give careful thought to the underlying causes of the turmoil and to the lessons to be drawn, both by regulators and industry. Even though the problems originated in the US with sub-prime mortgage sellers, the recent turmoil has clearly demonstrated the impact of interconnected global financial markets. Risks have been spread widely. And fast. Diversified risk spreading is positive. But at the same time, this dispersion of risks has brought about uncertainty. Who is carrying the major risks and losses? What are the actual exposures of market players? We still don't know. This uncertainty seriously affects investor confidence - and banks' confidence in each other. Liquidity pressures translate into solvency problems. That’s why this whole episode reinforces the need for greater international cooperation among regulators world wide.
Risk transferred through structured financial instruments has been one of the key factors contributing to the financial turmoil. We must ensure that firms improve their understanding and monitoring of risks in structured products - not just operational, credit and liquidity risk, but reputational risk as well.
It is legitimate to ask how well financial institutions – banks, insurance companies, pension funds - understood the complexity of some of the financial instruments they deployed and invested in. Did they fully appreciate the risks being taken. In many cases clearly not.
How robust were the risk models that were used? How much reliance was put on external ratings? No responsible financial institution could have or should have believed that a subscription to a rating agency publication discharged it from making its own assessments. Not least when the disclaimers of those rating agencies are so extensive and their track record on rating structured finance products so brief in credit cycle terms.
Embedded in many financial institutions' assessments of structured products were assumptions about market clearing, pricing and mark to model accuracy that have been proven to be false. There is one thing that I am certain of. Very few of the models were in any sense adequately stress tested. When downside risks crystallise, the weaknesses in risk management become highly visible and it is now obvious that much of the financial services industry were not managing their risks adequately.
Improving some aspects of transparency for investors, markets and regulators has a role to play in terms of supervision going forward. But I want to make it clear as I have made clear before that as far as transparency is concerned we must not throw out the baby with the bath water by creating a situation where transparency is forced to levels that makes it economically unattractive for market participants to take on meaningful underwriting positions. But regulators do need better data and deeper understanding. We will need too to look at clarifying the role of credit rating agencies in structured finance markets and their governance in general. I have given a mandate to The Committee of European Securities Regulators and the European Securities Market Expert Group to look at a comprehensive range of issues on this – not just conflicts of interest issues and how they are managed but capacity issues, frequency of rating reviews, transparency of methodologies, extent of disclaimers and so forth. Ideally I would like any action we take to be taken in unison with our counterparties in the financial markets regulatory dialogues.
I am still of the firm view that "light touch", principles-based regulation is the best approach for the financial sector. But we need to remain vigilant and draw lessons. If the industry, amongst others, cannot do better in the future - strong pressure for intrusive regulatory action will grow. I am confident that both financial institutions and the rating agencies will "up their game": They have a strong incentive to do so: In the case of the former their financial stability- even survival prospects- will be undermined if they don't: In the case of the latter – the rating agencies – their already tarnished brands risk becoming irretrievably ruined. I should say that we have had indications from them that they do intend to address the issues that have given rise to the now well voiced concerns but I am not interested in cosmetics- their response must be meaningful and comprehensive. They know well what the issues are and I expect them to address them seriously and in a way that will be verifiable.
Without pre-empting final policy conclusions, the EU set the direction of future work when it discussed the lessons from the turmoil this October. Securitisation, liquidity risk management and other problems that surfaced during the summer will be addressed under four broad headings:
- improving transparency;
- improving valuation standards of complex financial instruments;
- improving prudential rules and risk management practices; and
- making progress on wider issues related to market functioning, including, credit rating agencies.
Many of the proposed initiatives are based on the work that is already in the pipeline to strengthen the financial stability framework. Much of this work was already underway before the turbulence, but the range of issues being focused on now needs is broader. I may have been in a small minority 15 months ago when I warned of the risks that could jump out of the structured finance market – at a time when many others were bellowing at me about hedge funds and private equity. We are now all now focused on the structured credit market as a major issue. I am in a small minority no longer. The recent events have only accentuated the need for more rapid progress and should make it easier to build consensus in a challenging environment. Cooperation at the G10 level, in particular with the Basel Committee, to develop policy proposals will be crucial for strengthening international regulatory convergence. This is especially the case for the review of the securitisation framework, rating agencies and liquidity risk management.
We also need to address important challenges for the valuation of complex and illiquid products. These challenges already existed before the turmoil. The freezing-up of the markets has aggravated them. This is particularly important given the use of mark-to-market and mark-to-model valuation methods. The judgement of valuations and wide range of current practices create additional challenges for both industry and supervisors.
In Europe, Basel II will be implemented in the EU in January 2008. Going forward however we must not blind ourselves to the need to ensure that the framework is adapted if need be to take account of the lessons we learn from the ultimate fallout from the current turmoil and in particular to ensure that the rules on securitization are targeted correctly. Engaging in ongoing and regular dialogue with supervisors under Pillar 2 is important. We need to establish where enhancements are needed. If more disclosure is needed to enhance market confidence then that is in issue we must face up to.
As the current turmoil has illustrated, financial liquidity is vital for our economies. We have recently seen firms on both sides of the Atlantic seek out Sovereign Wealth Funds – Why? Because this finance was needed to allow these companies to carry out their strategic aims. I expect that in the future we will see more firms seeking investments from these funds. Reducing or limiting access to these funds would be a backward step. Having said this, there are aspects of Sovereign Wealth Funds, namely around the issues of transparency and governance that, for certain funds, need to be addressed. The Norwegian Pension Fund is often cited as an example of good practice in this area. So what do we need to see moving forward? Firstly, Sovereign Wealth Funds need to be transparent – ideally on the basis of an international code of best practice. We are currently working with International organisations and bilaterally with the US on this issue. Secondly, there needs to be an understanding that investments that have the potential to compromise national security can be blocked. The Commission, and ultimately the Court of Justice, has the task of ensuring that any such measures taken are justified according to public policy or public security. In summary, my approach to Sovereign Wealth Funds is based on openness to investment, avoiding protectionism and engaging with Sovereign Wealth Funds themselves to encourage greater transparency.
In closing I would like to add an important note. The initiatives that I have mentioned earlier do not automatically mean new rules and regulation. It means making sure that what we have is properly applied and understood. Industry - driven efforts to improve the existing framework and to develop the best practice in these areas will indeed be essential.
I believe that these are challenging times for the financial services sector but that the initiatives we have in place, combined with continued cooperation at all levels, puts us in a good position to face the challenges that lay ahead.
Thank you for your attention.
