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Ladies and Gentlemen,
Let me begin by thanking Lord Hunt for giving me the opportunity to address you tonight.
These are challenging times in the financial markets in which you work. We are now six months in to the turmoil. I want this evening to touch on a number of aspects and to reflect on some of the planned follow-up actions.
Of course at this stage we cannot draw final conclusions. But we can take away some valuable lessons.
The response of policy makers and regulators to the current situation needs to be long term. It needs to be cautious. It needs to be practical. And it needs to be forward looking. I am sure Sir John Major will agree with me that decision-making at European level is usually cumbersome and frustrating. But sometimes this can be a blessing in disguise. It can save us from knee-jerk reactions which usually make things worse- not better.
Fortunately, the Europe's Finance Ministers recognised this back in October when it agreed on its 'roadmap' as a first response to the weaknesses which had been identified in the financial system.
The roadmap has set four objectives on which work should focus:
- to improve transparency in the market,
- to upgrade valuation standards – particularly for illiquid assets,
- to strengthen the EU's prudential framework for the banking sector and
- to investigate structural market issues, such as remuneration packages and their alignment to long term shareholder interests, and the role played by credit rating agencies.
On most of these issues, our responses will have to be coordinated with our main international partners. This turmoil has shown perhaps more clearly than any previous upheaval that our financial markets are deeply intertwined and interdependent. Sub-prime losses in the U.S. have, as we have seen, transmitted themselves via the securitization and credit derivative markets to many corners of Europe and the rest of the world. Common sense demands that we work together to find common solutions with the other major capital markets, especially the United States.
Transparency
Six months since this turmoil started we still don't know how big the losses are. Differences in "guesstimates" are alarming. This matters: Because it undermines trust and confidence. And has caused serious disruption in certain markets – not least in the inter-bank markets. Without a clearer picture (which means more transparency) restoring investor and business confidence will remain a significant challenge. That’s why we are working with industry groups to increase the data available on securitisation markets. As I said before - and contrary to what many people appear to have thought - securitization hasn't made risk go away, it has just made risk get lost.
Financial innovation in itself is a good thing – it facilitates the more efficient hedging and dispersion of risk, the better management of capital and liquidity and generally enables financial products to more closely match the needs of market participants. So the problem isn't financial innovation. The problem is that as innovation has proceeded apace, the understanding of what has been innovated has fallen behind. The opportunities and products that financial innovation spawns have implications for virtually every dimension of risk – regulatory, documentary, credit, market, operational, and last but not least reputational risk.
Recent events have shown that from the board room to the dealing room, understanding the nature of the risks associated with innovative financial products and techniques - and the way they are managed and measured - has fallen too far behind the pace of innovation itself. Going forward, this is an issue that must be addressed – and regularly re-addressed - at regulator, supervisor, and company board room level.
Valuation
What has the turmoil told us about the valuation of assets? We have been through very testing times for our accounting rules. And perhaps there are even more testing times to come. When things settle down will certainly we shall have to have a very close look at the consequences of the 'mark-to-market' rule. Is 'mark to market' always the correct rule when it comes to illiquid assets- or to liabilities for that matter? Does it make sense for example that the worse the credit or liquidity risk attached to a company's bond liabilities gets, the greater the boost to that company's balance sheet net assets becomes, as the "mark to market" value of those bond liability falls? Are the "mark to market" rules having unintended consequences especially in these times of turmoil? I am calling on the Standard Setters, Issuers, Regulators and Preparers to undertake the analysis and draw the lessons from the use of "mark to market" in the light of current market conditions.
Prudential rules
The turmoil has also thrown up some issues in respect of our prudential rules – in the first instance in respect of some provisions in the Capital Requirements Directive, also known as Basel 2. I hope to come to conclusions on this in the very near future. The supervision of banks which operate in different Member States is another issue that has been brought into greater focus – Would Europe be well positioned to deal with the default of a bank which had operations and depositors in several Member States? And if not how do we position ourselves in terms of supervision to deal with this?
Structural market issues
This brings me to the issue of moral hazard. Is it admissible that banks and their managers and shareholders benefit from the good times and taxpayers pay when the going gets tough?
I am certainly not an advocate of the regulation of remuneration structures. But in financial institutions – whether in banking or insurance – the truth is that much of the reward from doing business is front loaded, while much of the cost of that same business – not least the cost related to risk underwriting and bad debts - is back-loaded. The bonuses are paid out before the losses are clocked up. Nobody can claim that this has served either shareholders or taxpayers well. I recognise it is a complex issue because of the competition for talent in the market place. But a balance has to be found – not by politicians - but by industry itself. If it is not found, political reality could well make calls for a more interventionist approach difficult to resist. Perhaps this is a matter that needs to be looked at in the context of revisions to Corporate Governance codes.
The role of credit rating agencies has also come under increased scrutiny as a result of the recent turmoil. The status quo is not an option when it comes to rating agencies. The industry needs to improve its practices. I very much look forward to their proposals, and in particular to more robust structures to effectively manage the potential for several conflicts of interest that are inherent in their business models – particularly in respect of structured finance - and not just between the consultancy and the rating sides of their businesses.
Insurance – Solvency II
As you know, US bond insurers have been caught up in the recent financial turmoil. Fortunately the European insurance industry appears to have escaped relatively unscathed because their exposure to subprime risks is limited. And we expect the industry to continue on this path with the introduction of the new Solvency2 rules for the insurance industry. Capital requirements under Solvency II will be risk based and insurers will be encouraged to further develop their risk management practices. In terms of crisis prevention and management, Solvency2 makes changes to the supervision of groups with the appointment of a group supervisor and provisions on the cooperation of supervisors.
Asset Management
The asset management industry has not escaped untouched from the recent financial turmoil. But the direct fall-out for European retail funds, the so-called UCITS, has been limited. It appears to have been confined to date to a handful of funds that invested in securities and commercial paper backed by impaired mortgage-based assets. This has highlighted the importance of sound risk controls to ensure that funds remain able to liquidate and value assets to meet redemption requests – even when markets for the underlying assets are falling.
The second-round effects of the credit turmoil have taken a significant toll on the fund industry. The fund market is a bell-weather market – highly sensitive to investor confidence. European funds are witnessing net redemptions as investors are spooked by financial uncertainty and tumbling stock markets. This should be a concern not only for the fund industry – but for the wider financial market. It is a warning sign. It suggests a loss of faith in the capacity of the financial system as a whole to deliver decent outcomes for investors.
The years since the dot-com bubble have seen European fund markets go from strength to strength. Now the industry is faced with choppy waters – for the short-term at least. Nevertheless, I believe that the industry model is sound. European fund managers have unparalleled strengths that will help them to rebound - and remain global leaders in this industry. I believe that the European legislative framework for retail funds, the UCITS, is an important asset. We must build on the strong foundations laid by the UCITS Directive and preserve the integrity of the UCITS 'kite-mark', ensuring at all times that investor protection is not compromised.
Conclusion
I note that Lord Hunt has made 'professionalism' and the 'link between enhanced professional standards and improving public confidence and trust' his theme for his Presidential year. The recent turmoil is a timely reminder of the importance of public and investor confidence. We all have a shared responsibility to ensure that we work towards enhancing and strengthening our financial markets to restore that trust and confidence. I am confident that we will do so – because we can and we must do so.
Thank you very much indeed.
