Select Committee on Treasury Sixth Report

8  Off-balance sheet vehicles and the future of the 'originate and distribute' banking model

The future of the 'originate to distribute' banking model

209. The financial market turbulence since mid- 2007 has illuminated the strengths and, in particular, weaknesses of the 'originate to distribute' banking model and raised question marks about the future of this banking model. The Bank of England, in its October 2007 Financial Stability report, stated that banks would have to reflect on their business models as well as on the causes of the recent financial difficulties and, in particular, their reliance on the liquidity of structured credit markets to distribute loans they originated and acquired for the purpose of distribution to other investors. [309]

210. There was a consensus amongst witnesses that the shift to an 'originate and distribute' model was irreversible and that a 'wholesale' shift back to a more traditional banking model would be undesirable. The Governor of the Bank of England thought that "the originate and distribute model has real value and I would not want to see it disappear".[310] Mr Sants agreed, telling us that "to say that we should not have had securitisation would not be a good conclusion to draw from this".[311] However, there was agreement amongst witnesses that the 'originate and distribute' model would evolve and needed to evolve. Mr Sants told us that there would be changes to the structure of the market place with complex structures no longer finding favour with investors. As a result there would be "a disappearance, or certainly a significant diminution in the use of complex structures, but not necessarily a disappearance altogether of a distribute model". However he cautioned that these "are all crystal ball forecasts and it could go in other directions".[312] The Governor of the Bank of England also believed that the securitisation model would survive, "but not in the way in which it has been operating in the last few years" [313] He added that:

in some ways what happened was that it was not a proper originate and distribute model because many of the assets did not actually fully disappear off banks' balance sheets, they were still kept on through the links, through conduits which had to be supplied with liquidity facilities and special investment vehicles. [314]

211. The 'originate and distribute' banking model has many advantages, which have been discussed earlier in this Report. However, problems in the sub-prime mortgage market in the USA have illuminated many weaknesses in the model. We accept that the move from the traditional 'originate and hold' banking model to an 'originate and distribute' model will not be reversed. The priority is therefore to ensure that market participants learn the correct lessons from the problems in the sub-prime mortgage market and act accordingly.

Regulating off-balance sheet vehicles

212. We have already discussed the contribution of off-balance sheet vehicles to the financial turmoil since mid-2007. In particular, we noted that some investment banks had kept these vehicles off-balance sheet, whilst others had brought them on-balance sheet. In some cases, such decisions were made to protect the investment bank's reputation, rather than because of any legal considerations. During out inquiry we considered what role public authorities might take in ensuring a consistent treatment of off-balance sheet vehicles, so as to minimise any confusion about the liabilities incurred by banks in relation to such vehicles.

213. Peter Montagnon argued that there was a need for greater transparency in the reporting of off-balance sheet vehicles, asserting that "we need to know with much greater clarity what is on, what is off, and what has potential to come back onto, the balance sheet than perhaps we did in the past." He also wanted to see a close examination of the role of audit committees and risk committees in managing off-balance sheet vehicle risks and deciding how they should be reported.[315]

214. Professor Wood cautioned however that additional regulation might create yet more problems:

It was, of course, in a sense, regulatory requirements that led banks to put these things off balance sheet. Because the requirements were formal and in place, they knew that if they were not on the balance sheet they did not have to count against capital. So you have to think very carefully about the kind of regulation you have so as not to encourage that kind of behaviour. All regulation is not good regulation; all regulation does not produce improvement.[316]

Professor Buiter's view was that the UK needed to have:

principle-based bank regulation that basically says it looks like a bank, it lends like a bank, even though it may not take too many deposits, we will treat it as a bank for regulatory purposes. So you make an institution pass the duck test when you decide to regulate it, but that is more easily said that done because the principle still has to be translated into actual operational rules. The principle versus rules debate is a false dichotomy; both have always been necessary. It is not easy, and you can do better than we are now, but most of the activity that caused the trouble took place out of the view of the regulators.[317]

215. As with many other elements of today's financial architecture, the UK must consider the international context in contemplating a regulatory response to the problems arising from off-balance sheet vehicles. Bearing in mind Professor Buiter's assertion that the development of off-balance sheet vehicles was itself driven by regulatory arbitrage,[318] banks might have an incentive to shift towards foreign jurisdictions if the UK's existing regulatory framework were to change. The Chancellor of the Exchequer told us that he considered this to be an international problem requiring an international response:

I am all in favour of innovation, but what we need to be wary is of innovation that means that people do not actually know the true picture in relation to a bank. I think there are two aspects of this. One is our own domestic legislation, and that is something that the FSA is looking at, but crucially also, I think this is something where the international work is very, very important because this is an international problem. The Forum for Financial Stability is looking at this, it is also being looked at the European Union level, I will be discussing it with my French, German and Italian counterparts next week and, when the Financial Stability Forum reports at the G7 in Japan in February, I hope we will have proposals in front of us not just in relation to the off-shore SIVs but also in relation to credit rating, in relation to early warning systems, a whole range of matters which need to be looked at and which, frankly, we can deal with to some extent here in the United Kingdom but we actually need international co-operation.[319]

216. Ambiguity and confusion regarding the ownership of risks associated with off-balance sheet vehicles have contributed to the financial market volatility since mid-2007. The FSA, working with international partners, must ensure that banks report their exposure to off-balance sheet vehicles appropriately. The FSA should also consider whether banks have been using these off-balance sheet vehicles for genuine economic efficiency reasons or as a smokescreen to hide behind, given that the capital, reporting and governance requirements on these vehicles are lighter than those incumbent on banks themselves.

309   Bank of England Financial Stability Report, October 2007, p 45 Back

310   Q 1727 Back

311   Q 316 Back

312   Q 1465 Back

313   Q 1674 Back

314   Q 1727 Back

315   Q 1407 Back

316   Q 941 Back

317   Q 941 Back

318   Ev 311-315 Back

319   Q 1852 Back

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