Summary
Overview
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.
Investors
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.
| 
