Conclusions and recommendations
1. The
unfolding crisis of confidence is important to keep in mind because
of its widespread impact on financial markets, its particular
impact on the United Kingdom via Northern Rock, and its emerging
impact on the real economy. (Paragraph 1)
2. The market turbulence
since August 2007 has propelled the issue of financial stability
to the top of the political agenda. The terms "financial
stability" and "serious threat to financial stability"
are used in the Banking (Special Provisions) Act without a legal
definition. There is a continuing lack of clarity about what is
meant by financial stability as well as what events constitutes
a "serious threat to financial stability". We believe
there is a need for clarity from the Tripartite authorities about
how they define financial stability so that stakeholder can assess
whether particular events constitute a threat to financial stability.
This clarification should be in advance of Parliamentary consideration
of the Banking Reform Bill. Such a step would ensure that policy
interventions to maintain financial stability would in future
take place against a more objective backdrop and would be particularly
important in aiding the work of the tripartite authorities in
promoting financial stability. (Paragraph 7)
3. The 'search for
yield' has spawned the growth of complex new financial instruments
as well as new types of institutional investors. This 'search
for yield' encouraged many investors to invest in high-yielding
complex products that it turns out they did not always fully understand
and is at the heart of the problems which have affected financial
markets from mid-2007 onwards. We discuss the consequences for
financial stability of this 'search for yield' in greater detail
later in this Report. (Paragraph 15)
4. The increased prominence
of hedge funds makes it important to analyse the role they play
in financial markets. We intend to examine the role of hedge funds
as part of our ongoing work on financial stability and transparency.
(Paragraph 20)
5. We are continuing
our work on private equity, examining the proposals in Sir David
Walker's report as well looking at the impact on private equity
of the changing economic environment. We will also continue to
explore the implications for financial stability of the growth
of private equity in recent years as part of our ongoing work
on financial stability and transparency. (Paragraph 26)
6. We recognise the
important role that Sovereign wealth funds have played in helping
to stabilise the financial system through their investments in
financial services firms in 2007. However, the increasing prominence
of such funds as institutional investors does raise valid public
policy questions about governance, transparency and reciprocity.
We intend to examine the role of Sovereign wealth funds as part
of our ongoing work on financial stability and transparency. (Paragraph
30)
7. We will undertake
further work on offshore financial centres in the context of our
ongoing scrutiny of financial stability and transparency to seek
to ascertain what risk, if any, such entities pose to financial
stability in the United Kingdom. (Paragraph 34)
8. Our inquiry has
highlighted the complexity of many new financial instruments,
such as Collateralised Debt Obligations. Nevertheless we are surprised
that the Chairman of the UK branch of a leading investment bank
could not explain to us what a CDO is, a financial product in
which he told us that his organisation deals. The fact that senior
board members may not have sufficient understanding of products
that their organisations are originating and distributing is a
major cause for concern. If the creators and originators of complex
financial instruments have only a limited understanding of these
products then it raises serious questions about how investors
in these products can possibly understand such complex products
and the risks involved in such investment decisions. We discuss
this issue in greater detail later in our Report. (Paragraph 39)
9. The relatively
recent innovation of tranching, whereby a pool of assets is converted
into low-risk, medium-risk and higher-risk securities, has led
to a mushrooming of triple-A securities available for investment.
Rating these securities has been an increasing source of income
for the credit rating agencies. Tranching has proven successful
at tailoring investment opportunities to meet the risk-appetites
of investors, particularly those bound by strict investment mandates,
specifying AAA investments. This market innovation has, however,
led to greater complexity. (Paragraph 63)
10. Looser underwriting
standards have played an important role in the problems affecting
the sub-prime mortgage market in the USA. We are concerned that
these looser standards are linked to the decisive loosening of
the link between creditor and debtor under the 'originate and
distribute' banking model. There are therefore important lessons
to be learnt that go far beyond the sub-prime housing market in
the USA and which apply to other markets. We discuss the issue
of a loosening of underwriting standards under the 'originate
and distribute' model further later in this Report. (Paragraph
82)
11. We note with concern
that the credit rating agencies appear to have been slow to downgrade
their ratings for securities backed by sub-prime mortgages. Additionally,
the ratings downgrades they made over the summer of 2007 were
large scale in nature and appear to have been 'unexpected' by
many market participants. Large, belated and unexpected shocks
can only serve to exacerbate the problems in credit markets. The
very fact that the credit rating agencies began reviewing their
methods during this period is an implicit admission that they
got it wrong and that they did not have the appropriate models
to rate such securities during a time of stress. (Paragraph 90)
12. The decision of
the Bank of England to take part in coordinated action with other
central banks in December 2007 is to be commended. We will continue
to monitor the Bank's actions, and consider the effects of continued
financial market disturbances on the macroeconomy as part of our
regular work scrutinising the Inflation Reports of the Bank of
England. (Paragraph 133)
13. As the Governor
of the Bank of England has said, uncertainty about the scale and
location of losses has led to concerns about the adequacy of bank
capital and hence the ability of the banking system to finance
continued economic expansion. There are now growing signs that
developments in financial markets are feeding through to the wider
economy in the United Kingdom. The continuing health of the UK
economy therefore depends to a significant extent upon the banking
sector's ability to re-establish reliable pricing and the restoration
of confidence in each others' balance sheets. A prolonged failure
to do so by the industry would have implications for economic
growth. We recognise that some banks have already taken steps
to establish losses and repair balance sheets. Nevertheless, the
risk remains that if the banking sector does not put its house
in order then the problems in that sector will have a significant
adverse macroeconomic effect.
(Paragraph 137)
14. We support the
Chancellor's approach to seek to make the IMF the international
community's early warning system, identifying global economic
and financial risks, acting to identify problems before they occur.
In our Report of 2006 on Globalisation: the role of the IMF we
supported proposals that "the IMF should focus more on crisis
prevention as well as on crisis resolution, and … there should
be a new focus on surveillance". We note, however, that whilst
the IMF should play a leading role in identifying global economic
and financial risks, it lacks the necessary policy instruments
to enforce action by market participants. Yet the international
turbulence of since mid-2007 has served to emphasise just how
great the challenge facing the global financial community is in
improving their response to financial problems. We support a greater
role for the Financial Stability Forum sharing information and
coordinating the global response to such shocks. (Paragraph 147)
15. We support the
Government's efforts to promote a review of the Capital Requirements
Directive/Basel II framework, and in particular to ensure that
that framework does not provide perverse incentives to banks to
reduce capital adequacy. (Paragraph 153)
16. We share Professor
Buiter's assessment that many of the new financial instruments
are ludicrously complex. Such products have introduced opacity
into the financial system, as is demonstrated by continuing uncertainty
over the scale and distribution of losses in the banking sector
resulting from exposure to sub-prime mortgages. There is also
heightened ambiguity about where risk is borne within the financial
system. This is a serious concern because it exacerbates the risk
that senior executives might not fully understand investments
or strategies adopted by banks and so lack a clear picture of
the risk-profile of their financial institution. (Paragraph 159)
17. We are concerned
by the sheer weight of evidence which suggests that many investors
did not have sufficient understanding of the products in which
they were investing. We share the Governor of the Bank of England's
assessment that many investors were seduced into investing in
products that they did not fully understand, and that this was
in part driven by their 'search for yield', as well as short-termism
on the part of many investors. The end result is that many investors
appear to have 'thrown caution to the wind' when making investment
decisions. Going forward, we agree with the Governor of the Bank
of England's view that investors must take responsibility for
what they buy and the decisions they make. (Paragraph 164)
18. We believe that
there is an urgent need for enhanced transparency around complex
financial products so that investors are able to undertake their
own due diligence on the products they are investing in. Even
where such information exists, it is, as the Association of British
Insurers stated, often indigestible for investors. We believe
the originators of complex financial products must ensure greater
transparency of products whilst there is a pressing need for investors
to undertake greater due diligence on the products they are investing
in. (Paragraph 166)
19. The evidence presented
to this Committee suggests that many investors did not have a
sufficient understanding of, and failed to exercise due diligence
on, the complex financial products they were investing in. This
failure on the part of some investors is linked to the complexity
of many securitised products. Detailed regulation of products
is one response to the problem of product complexity, although
not one that we instinctively favour. However, if the market and,
in particular, the investment banks prove unable to address the
problem of overly complex products, then regulation will need
to be seriously examined in the future. (Paragraph 168)
20. The market turbulence
since mid-2007 has illuminated a number of serious flaws in the
'originate and distribute' business model. In particular, the
evidence suggests that originators of loans did not have had sufficiently
strong incentives to assess and monitor credit risks as carefully
as investors would expect, given that risk would subsequently
be dispersed to investors. This incentive problem places greater
responsibility on investors to exercise sufficient due diligence
over the products in which they invest. However, the fact that
end-investors have less information about underlying loans than
those at the beginning of investment chains makes it much more
difficult for investors to exercise such due diligence. We are
concerned that these features of the 'originate and distribute'
model have led to over-reliance by investors on credit rating
agencies. (Paragraph 178)
21. We are concerned
that many investors were overly-reliant on the ratings provided
by credit rating agencies and that some investors misunderstood
the narrow scope of these ratings. This over-reliance on credit
rating agencies by some investors appears to have been compounded
by the lack of due diligence on the part of some investors in
the products they were purchasing, with many investors taking
a triple A score as a 'green light' to invest. It is incumbent
upon the credit rating agencies to work together with investors
to ensure that investors have adequate information to undertake
their own effective due diligence and a clear understanding of
the meaning of a rating. (Paragraph 184)
22. We support the
principle of improving the information content of credit ratings.
To this end we welcome the Bank of England's proposals to improve
the information content of ratings. We urge progress on measures
to improve the information content of ratings and, to this end,
will continue to monitor progress towards greater transparency
of credit ratings. However, increased information content should
not imply to users that they have any less obligation to pursue
due diligence. (Paragraph 188)
23. It is incumbent
upon the credit rating agencies to provide further reassurance
that conflicts do not exist between their advisory and rating
functions. If the credit rating agencies fail to demonstrate that
Chinese walls alone are a sufficient safeguard then it may be
necessary to look at alternative approaches to tackling this problem.
(Paragraph 201)
24. We are deeply
concerned about the conflicts of interest faced by the credit
rating agencies and agree with Professor Buiter that the credit
rating agencies are subject to multiple potential conflicts of
interest. These conflicts of interest have undermined investor
as well as public confidence in the rating agencies and must be
tackled as a matter of urgency. Without reform the credit rating
agencies will be unable to regain public trust and confidence.
It is therefore incumbent upon the ratings agencies as a matter
of urgency to demonstrate that they can effectively manage and
be seen openly and transparently to manage the conflicts of interest
in their business model out of the system. To this end, the credit
rating agencies must put in place policies and procedures to identify,
manage and, where incapable of being managed out, disclose conflicts
inherent in their individual business models If they are unable
to do this then new regulation will have to be seriously considered.
(Paragraph 204)
25. Professor Buiter
and Sir John Gieve both suggested to us that the conflict of interest
problem could be tackled if investors paid for ratings. However,
this may merely serve to encourage conflicts in the opposite direction.
For example, if investors paid for ratings they may have an incentive
to bargain down ratings so as to maximise their rate of return.
This suggests that it may prove difficult to remove such conflicts
of interest simply through moving to an investor pays model and
that the priority should be to ensure that a robust framework
for managing conflicts of interest is put in place. (Paragraph
205)
26. We are not convinced
that the credit rating agency market is sufficiently competitive
or efficient. At present the market is dominated by the two big
US ratings agencies, Moody's and Standard & Poor's plus the
European agency, Fitch. We therefore call upon competition authorities
to examine what barriers to entry have prevented greater competition
in the industry and how competition within the industry could
be encouraged. (Paragraph 207)
27. We expect to continue
to monitor the role of monoline insurers and the risks associated
with the problems they face. (paragraph 208)
28. 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. (Paragraph
211)
29. 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. (Paragraph
216)
30. The
Bank of England and FSA both gave warnings of deteriorating market
conditions during 2007. It is has been reported to us that these
warnings were not taken on board by some banks and building societies.
We do not believe that public authorities should be prescriptive
in how financial institutions must react to such warnings. However,
given the strong public interest in avoiding banking crises, there
is a strong case for establishing a mechanism by which receipt
of warnings from public authorities would be formally acknowledged
by financial institutions. We recommend that when issuing warnings
of potential problems, the Bank of England and the FSA should
highlight the two or three most important risks in a short covering
letter to financial institutions, for discussion at Board level.
The Bank and FSA should seek confirmation that these warnings
have been properly considered, and publish commentaries on the
responses received. (Paragraph
222)
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