The current European People’s Party (E.P.P.) Draft Paper is a well balanced document.
It captures pretty well the large consensus we have achieved on both the causes and implications of the recent financial turmoil and the recommendations for increasing the resilience of markets and institutions going forward.
The report is comprised of four sections.
The first two sections produce a good analysis and a right and pertinent diagnosis of the finance turmoil and its impact on the European banking system.
The financial market crisis that erupted in August 2007 has developed into the largest financial shock since the Great Depression.
It is definitely the first major financial crisis of the 21st century.
It has contributed to deteriorating prospects for the real economy, although to different degrees in different countries.
According to the finance ministers and central bank governors of the G7 major industrialized countries “while economic conditions differ in their countries, downside risks to the outlook persist in view of the ongoing weakness in U.S. residential housing markets, stressed global financial market conditions, the international impact of high oil and commodity prices, and consequent inflation pressures.”
The financial turmoil was the culmination of an exceptional boom in credit growth and leverage in the financial system.
This boom was fed, mainly, by two factors:
- A long period of benign economic and financial conditions, including historically low real interest rates and abundant liquidity, which increased the amount of risk and leverage that borrowers, investors and intermediaries were willing to take on.
- A wave of financial innovation, which expanded the system’s capacity to generate credit assets and leverage, but outpaced its capacity to manage the associated risks.
Banks and other financial institutions gave substantial impetus to this process by establishing off-balance sheet funding and investment vehicles, which in many cases invested in highly rated structured credit products, in turn often largely backed by mortgage-backed securities.
These vehicles, which benefited from regulatory and accounting incentives, operated without capital buffers, with significant liquidity and maturity mismatches and with asset compositions that were often misunderstood by investors in them.
Both the banks themselves and those that rated the vehicles misjudged the risks that a deterioration in general economic conditions would pose.
And that occurred.
The 2007 end-year and 2008 first quarter results published to date clearly reflect the negative impact of the turmoil on banks’ balance sheets, including the impact of de-leveraging and write-downs of asset holdings.
However, the overall impact of this crisis on the European banking system is likely to be moderate.
The sound profitability of European banks over several consecutive years has generated substantial buffers against expected losses.
European banks’ solvency ratios have comfortably exceeded minimum requirements.
Thus, banks earnings, due to non-interest income sources, have been negatively affected, but most analysts deem that no major damage to the European banking system must be expected.
In the third section of the report which is entitled “Lessons learned”, the paper highlights four broad problem areas in the banking business model.
I would like to add my remarks-comments on that section.
“1) The general management, assessment and monitoring of credit risks in many banks has proved to be wobbly and opaque, to say the least, even though this task should have been the bank management’s first obligation and priority.”
Indeed, many credit institutions underestimated default risks, especially those that accompany certain financial instruments (i.e. high quality structured finance products).
“2) The role played by international rating agencies must be reassessed, and their revenue model should be changed (for instance, rating agencies to be paid by investors).”
Credit rating agencies (CRAs) play an important role in evaluating and disseminating information on structured credit products.
Many investors have relied heavily on their ratings opinions.
Poor credit assessments by CRAs contributed to the build up of recent events.
The sources of concerns about credit rating agencies’ performance include:
- weaknesses in rating models and methodologies;
- inadequate due diligence of the quality of the collateral pools underlying rated securities;
- insufficient transparency about the assumptions, criteria and methodologies used in rating structured products;
- insufficient information provision about the meaning and risk characteristics of structured finance ratings; and
- insufficient attention to potential conflicts of interest in the rating process.
A number of actions could be taken to:
- improve the quality of the rating process including the models, methodologies and information used for ratings;
- address conflicts of interest, including concerns about analyst remuneration and about the separation of consulting and rating activities; and
- provide investors with additional information on the methodologies and criteria used for ratings, how CRAs address data limitations, and data on the historical performance of ratings.
Thus, we could add the following text at the end of the sentence:
«…so as the financial markets not to depend so much by the credit rating agencies (CRAs). A series of actions could be taken to strengthen ratings quality, enhance the rating process, manage conflicts of interest and enhance the information they provide on rating methodologies and the meaning and limitations of ratings.”
“3) Management and pricing of funding liquidity risks must be reconsidered and largely improved.”
The turmoil demonstrated the central importance that effective liquidity risk management practices and high liquidity buffers play in maintaining institutional and systemic resilience in the face of shocks.
Liquidity remains seriously impaired despite aggressive responses by major central banks.
Recent events have underlined the importance of continuing attention to be paid on liquidity risk management including stress-testing and contingency funding planning.
This reconsideration must include:
- the identification and measurement of the full range of liquidity risks, including contingent liquidity risk associated with off-balance sheet vehicles;
- stress tests, including greater emphasis on market-wide stresses and the linkage of stress tests to contingency funding plans;
- the role of supervisors in strengthening liquidity risk management practices;
- the management of intra-day liquidity risks arising from payment and settlement obligations both domestically and across borders;
- cross-border flows and the management of foreign currency liquidity risk; and
- the role of disclosure and market discipline in promoting improved liquidity risk management practices.
“4) Assessment of counterparty risks has to be reevaluated.”
Recent events have demonstrated the importance of disciplined management of counterparty credit exposures.
With respect to the assessment of counterparty risks, an important feature of the turmoil was that inadequate transparency about the final location of risk exposures led to significant, often excessive, increases in concerns about the creditworthiness of highly rated financial firms with sound balance sheets.
“5) The role played by non-regulated entities (i.e.: off-balance sheet vehicles) urgently needs to be scrutinized. In fact, the weakness of the current financial reporting system allows banks not to list these vehicles in their balance sheets as risks. Thus, deficiencies of this sort from the side of national regulatory and supervisory authorities need immediate correction.”
For example, unregulated entities that originated mortgages in the United States were not subject to appropriate disclosure and consumer protection requirements.
Supervisory guidance will require banks to manage off-balance sheet exposures appropriately. Supervisors will require that:
- prudential reports by financial institutions adequately include the risks arising from off-balance sheet exposures;
- financial institutions’ internal management information systems capture off-balance sheet exposures, so that these form part of firms’ internal capital and liquidity management;
- financial institutions’ stress testing procedures take account of their exposures to off-balance sheet entities, including the risk that they might need to be absorbed on the institution’s balance sheet.
It is especially important to strengthen the prudential framework for securitisation and off-balance sheet activities.
This requires action by supervisory and regulatory authorities to better align incentives, reduce regulatory arbitrage and strengthen market discipline for structured products and for financial institutions’ off-balance sheet activities.
In this direction, the 4th and 7th Company Law Directives will require all listed companies to disclose off balance sheet commitments in the notes to their accounts published from 2009 onwards.
We could change the last sentence and put it as: “Thus, deficiencies of this sort are attempted to be handled through the current application of I.F.R.S. and auditing procedures imposed by international auditing rules.”
In the final section of the paper, and according to the above considerations, the E.P.P. endorses a number of recommendations in order to reach a better functioning regulatory and policy regime in the financial sector in the future.
It seems that there is a general international consensus on how to respond and reach this regime in the medium term. See also:
- World Economic Outlook Report, International Monetary Fund, April 2008.
- Financial Stability Forum Report, G7 Countries, April 2008.
- Economic and Financial Committee Report, April 2008.
- E.U. Banking Sector Stability Report, European Central Bank, November 2007.
- Financial Stability Review Report, European Central Bank, December 2007.
It seems that prudential regulation and supervision, sound disclosure regime and accounting and valuation practices are essential to achieve transparency, to maintain market confidence, to promote effective market discipline and to strengthen the resilience of the financial system.
“1) Improve financial sector surveillance & close accounting gap
The recent events in the financial markets highlight the importance of further improving financial sector surveillance by the responsible authorities and enhancing the risk management practices of financial institutions and rating agencies.
The current internationally valid accounting rules allow for huge risks to be handled outside of banks’ balance sheets. Thus, it is of the utmost importance that this gap is closed in order to establish transparent and efficient accounting rules both in Europe and the U.S.”
Limitations in regulatory arrangements, such as those related to the pre-Basel II framework, contributed to the growth of unregulated exposures, excessive risk-taking and weak liquidity risk management.
Supervisors will use Basel II to ensure banks’ risk management, capital buffers and estimates of potential credit losses are appropriately forward looking.
Moreover, supervisors, accounting standard-setters and other authorities should ensure that the financial reporting framework functions properly, with clear guidelines that can be applied consistently within and across firms and that the applicable accounting rules are enforced.
Risk exposures and potential losses associated with off-balance sheet entities should be clearly presented in financial disclosures, the accounting standards affecting these entities should be enhanced and their international convergence accelerated based on the lessons learned.
According to the G7 press release “urgent action are needed to improve the accounting and disclosure standards for off-balance sheet entities.”
Looking forward, the completion of the implementation phases of the Basel II capital regime and the IFRS accounting standards will further improve the transparency of financial reporting and risk management practices in the E.U. banking system.
I propose to add at the end of the sentence the phrase: “through the coordinated developments in accounting and auditing international standards”.
“2) Strike right balance between sufficient regulatory response, stability of the financial system and financial innovation
The challenge for policy-makers will be to find the right balance between designing responses that enhance the stability of financial systems without imposing restrictions that would unnecessarily hamper innovation and reduce the efficiency of these systems.
This balance must especially take into consideration the needs of Start-Up-Enterprises and Small and Medium Enterprises (SMEs) who create jobs. On the other hand, it is also necessary to examine all the possibilities through which consumers are tempted to take loans that they might not be able to afford.
We are confident that the new Basel II agreement, which is currently being implemented, will bring substantial benefits in this regard.”
Authorities should not pre-empt or hinder market-driven adjustments, but should monitor them and add discipline where needed.
Authorities must be proactive in strengthening the financial system.
The starting point for improving major banks’ capital adequacy is the timely implementation of Basel II.
Basel II, by contrast, provides better support to sound risk management practices by much more closely aligning minimum capital requirements with the risks banks face (Pillar 1), by strengthening supervisory review of bank practices (Pillar 2) and by encouraging improved market disclosure (Pillar 3).
“3) Increase overall transparency of financial institutions
Perceived opaqueness and uncertainty regarding the underlying exposures, in particular of financial institutions, has translated into a loss of confidence with a resulting disruption in the inter-bank market. Improve transparency measures is therefore paramount.”
Public disclosures that were required of financial institutions did not always make clear the type and magnitude of risks associated with their on- and off-balance sheet exposures.
That lack of adequate and consistent disclosure of risk exposures and valuations continues to have a corrosive effect on confidence.
Enhanced disclosure by financial firms of more meaningful and consistent quantitative and qualitative information about risk exposures, valuations, off-balance sheet entities and related policies would be very useful in restoring market confidence.
The Spring European Council Report confirms this conclusion.
The transparency requirements under Pillar 3 of the Basel II framework enhance the quality and consistency of disclosures about banks’ risk exposures and capital adequacy.
“4) Need for improved knowledge and dialogue between supervisory authorities and financial institutions
The cooperation between the private sector, auditors and regulators must be improved in order to avoid a lack of comparability and consistency in the evaluation of more and more complex financial instruments and structured products.”
Financial institutions should establish rigorous valuation processes and make robust valuation disclosures.
Financial institutions, auditors and regulators have worked together to improve valuation approaches and related disclosures in end-year financial accounts.
But further work is needed to provide confidence that valuation methodologies and related loss estimates are adequate, to clearly highlight the uncertainties associated with valuations, and to allow for more meaningful comparisons across firms.
“5) Need for strengthening of international cooperation
European regulations alone are not always sufficient for global financial markets. That is why there is a clear demand to strengthen international cooperation in the framework of G8 and other internationally recognized institutions.”
According to the President of the ECB, we have to reinforce considerably the holistic approach.
The speed of innovation and increasing globalisation pose challenges for authorities in responding in a rapid and internationally coordinated fashion.
Thus there are close interconnections of all markets, all institutions, and all economies.
Authorities’ exchange of information and cooperation in the development of good practices should be improved at the international levels.
Supervisors, both nationally and internationally, will seek further opportunities to compare risk management practices across firms, draw lessons and develop benchmarks to improve those practices.
Given the increased scopes and intensity of the cross-border activities of EU banking groups, the need for effective information-sharing and cooperation in their supervision is now more important than ever.