Select Committee on Treasury Sixth Report



The period since early August 2007 has been one of large-scale turbulence and instability in global financial markets, following the revelation by a French bank, BNP Paribas, that its investment funds could no longer value their exposures to sub-prime mortgage loans in the United States. We examine the causes of the dislocation of international financial markets that surfaced on 9 August 2007, subsequent developments in global financial markets and lessons learnt, as well as the prospects for international action and other developments to promote financial stability and transparency.

The new financial structure

The last few years have witnessed the dramatic growth of markets in asset-backed securities, alongside the shift towards an originate and distribute model of banking, where loans are made and then securitised and sold on to investors. These developments have increased the efficiency of financial markets and allowed for the greater dispersal of risk through the financial system. However, the market turbulence since mid-2007 has illuminated some serious flaws in the new financial structure. These include: growing product complexity and looser under-writing standards, as well as increased uncertainty about where risk ultimately lay within the system. Whilst the move towards an originate and distribute model will not be reversed, market participants and regulatory authorities must learn the appropriate lessons from events since mid-2007 onwards.


It is clear that the search for yield and short-termism encouraged many investors to invest in high-yielding and increasingly complex products that it turns out they did not always fully understand. We are concerned that some investors were seduced into such investments by the promise of high returns without adequate consideration of the associated risks. In addition, many investors did not exercise sufficient due diligence on the products they invested in and appear to have been overly-reliant on the credit rating agencies, often using ratings as a green light to invest. Going forward, investors must take responsibility for what they buy and the decisions they make.

The credit rating agencies

The credit rating agencies have played a central role in the growth of securitised markets. The problems affecting financial markets since early August 2007 have highlighted inherent and multiple conflicts of interest in the credit rating agencies business model as well as flaws in their rating methods. The credit rating agencies must tackle these perceived conflicts of interest as a matter of urgency if they are to regain the trust and confidence of market participants and the public. If they are unable to put their house in order, then new regulation may be the only answer.

Heeding the warnings

The public authorities in the United Kingdom as well as the key global financial institutions had been pointing for some time prior to the middle of 2007 to a serious under-pricing of risk, as well the risks of impaired market liquidity. In retrospect, it is clear that some market participants did not heed these warnings and that the framework for issuing warnings of potential problems needs strengthening. We recommend that, in future, when issuing warnings of potential problems, the Bank of England and Financial Services Authority should clearly highlight the two or three most important risks in a short covering letter to financial institutions, for discussion at Board level. The Bank and Financial Services Authority should seek confirmation that these warnings have been properly considered, and publish commentaries on the responses received.

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