Banking Crisis - Treasury Contents

Memorandum from Andrew Crockett

  Evidence submitted by Andrew Crockett, President, JPMorgan Chase International, former General Manager, Bank for International Settlements, former Chairman, Financial Stability Forum

  Note: The views expressed below follow the order of the questions raised by the Committee, and are given on a personal basis. They do not necessarily reflect the views of JPMorgan Chase.


(i)   Role of Auditors

  It is useful to distinguish the role of auditors from that of the accounting standards under which audits are performed. I have no comment to make on auditors' role, other than to note the importance of rigorous implementation of valuations. The role of accounting standards, particularly "mark-to-market" or "fair value" accounting has been criticized as adding to volatility in the valuation of assets held by banks. While it is hard to think of a superior criterion for asset valuation than one established in open markets, uncertainties can arise where assets are not traded, or where market conditions are disturbed. Legitimate concerns about fair value accounting arise when markets are distressed and there is reason to believe that valuations do not reflect long-term equilibria. In these circumstances, I believe a distinction should be made between assets which a holder has both the intention and the ability to hold to maturity, and those which may be sold either for trading reasons or to meet short-term funding constraints. The former might legitimately be valued on a "hold to maturity" basis, while the latter should be held on a current market value basis. I do not believe that ad hoc shifts in valuation methods in crisis situations would help either manage a crisis or provide comfort to bank counterparties.

(ii)   Credit rating agencies

  Credit rating agencies performed poorly in the period leading up to the current crisis, but so did many other forecasters. It is hard to see how regulation can materially improve the performance of rating agencies. That said, there are certain reforms that could reduce reliance on fallible judgments. First, the practice by which rating agencies provide advice on structuring financial products that they subsequently rate, should be avoided by either prohibiting the combination in one entity of advisory and rating services or by ensuring there are strong "Chinese walls" between the activities. Second, regulators of buy-side institutions should satisfy themselves that institutional investors have appropriate due diligence practices in place and do not rely solely on ratings. In this connection, it is for consideration whether, when an institutional investor uses an "issuer-pay" rating agency to evaluate a security, it be obliged to also use an "investor-pay" agency to rate the same security. Third, the role assigned to ratings in regulation (eg, in calculating risk weights for regulatory capital) should be reduced or terminated, particularly in products where it is clear that ratings have been systematically flawed. The aim would be to treat rating agency judgments more like those of any other observer, without any special regulatory favour. This would, of course, require significant modification of Basel II, and would not be simple to achieve.

(iii)   Hedge Funds

  Hedge funds have incurred significant losses in the crisis, but have not been the direct cause of banking problems or credit market difficulties. Still, the activities of large hedge funds clearly have a market impact. Under normal circumstances, informed position-taking by hedge funds can help smooth volatility. In disturbed conditions, however, hedge funds can add to market volatility. They are subject to common pressures when liquidity dries up (or when it is abundant) and may be forced or encouraged to act in similar ways. This "herd" phenomenon can accentuate market movements. As a result, because of their potential contribution to destabilizing market dynamics, I favour some form of regulation of systemically significant hedge funds. One way of doing this is indirectly, through the requirements imposed on hedge funds' regulated counterparties. These counterparties could be obliged to seek relevant disclosures before lending, and to enforce leverage limits. Direct supervision of systemically important hedge funds could involve information gathering by regulators and transparency of appropriate data on assets and liabilities. It could also include limitations on leverage, since highly leveraged funds can be induced to undertake forced sales in times of systemic stress. There is less reason to extend regulation to the wider population of smaller or less leveraged hedge funds, whose activities have less potential for systemic impact. In general, authorities should avoid regulation of a kind that generates an impression of official endorsement, or public expectations that failures of hedge funds can be limited or controlled by official action.

(iv)   Tripartite Committee

  I am not familiar with the detailed working of the Tripartite Committee. It is, however, very important that the Committee be in a position to assess both the micro-prudential risks posed by individual institutions, and the macro-prudential risks that arise from market dynamics. Insofar as the central bank is closely involved with markets, its expertise on market functioning should be properly exploited in the working of the Committee.

(v)   Remuneration structures

  There is understandable indignation among the general public about certain aspects of remuneration in the financial sector. Still, it is not easy to devise implementable proposals for regulating pay that do not create the risk of unintended consequences. It is not the role of financial regulation to prescribe overall levels of remuneration, however strongly outside observers may feel that financial sector pay is "too high". Trying to limit pay will almost certainly lead to techniques to get around a mandated cap. Regulation does, however, have a role if remuneration structures violate good internal governance, or if they promote behaviour that encourages excessive risk taking. The principal protection against these risks is to strengthen internal governance in financial institutions. This involves greater independence in compensation committees, greater expertise among members of these committees and greater transparency to their decisions. Concerning risk-taking, incentive compensation (bonuses) should, as far as possible, be related to risk-adjusted returns, and should be in a form that vests only after a suitable interval has elapsed. Risk officers should be part of internal compensation committees. It could be useful for supervisors to review pay structures, and where these appear to create distorted incentives, to require additional capital holding against the risks these structures create.

(vi)   Capital and liquidity requirements

  This is an area of unique importance and should, in my view, be the principal focus of regulatory reform efforts. Hitherto, regulatory capital requirements have been based on "Risk-weighted Assets" under Basel I and Basel II. I believe this formulation is incomplete as it does not give sufficient weight to (a) macroprudential risks, and (b) liquidity risk. Inadequate attention is paid to the possibility of generalized financial stress, in which market dynamics can lead to a downward spiral of asset valuations. The risk of such stress generally increases during periods of benign credit conditions, as market participants bid up values and financial imbalances accumulate. It would therefore be good to adjust capital ratios to take account of factors which signal the build-up of macroprudential risk. Specifically, it is for consideration whether regulatory risk-weighted capital ratios should be adjusted to take account of both the speed with which credit has been expanded, and changes in leverage at financial institutions. With regard to liquidity, many institutions got into difficulty because of their excessive reliance on short term wholesale funding. When this dried up, they were unable to sell assets or find an alternative source of funding. Therefore, there would be advantage in imposing higher capital ratios on institutions that are more reliant on short-term funding. Finally, it needs to be recognized that non-bank financial institutions can be of systemic importance and that it is desirable to subject their activities to comparable disciplines to those facing banks.

(vii)   International Financial Regulation

  It is not realistic, even if it were desirable, to create a global financial regulator in the foreseeable future. The best that can be envisaged, therefore, is an intensification and formalization of existing cooperative mechanisms. At present, there is a network of international supervisory and standard-setting committees, and one over-arching body, the Financial Stability Forum (FSF). The FSF has the advantages of bringing together regulators, finance ministries and central banks, as well as representatives of the key international organizations and standard-setters at a very senior level. Its relative smallness and informality is also a strength in many respects. However, it suffers from a lack of representativeness and legitimacy, and from the fact that it has no delegated powers. I would favour building on the successful experience with the FSF by giving it greater legitimacy (through broader country representation) and conferring on it specific tasks. These tasks could include right of approval over standards proposed by sectoral standard-setters such as the Basel Committee and the IASB; greater freedom and obligation of mutual information sharing; responsibility for "early warning" signals, in cooperation with the IMF; and responsibility for coordinating crisis resolution activities.

(viii)   Regulation of Complex Financial Products

  Institutions which create and market complex financial products should be under a regulatory obligation to disclose all relevant aspects of the product to potential counterparties, and should be responsible for implementing appropriate "suitability" requirements. Regulated financial institutions that trade in complex products should be adequately capitalized against the relevant risks. Provided these requirements are in place, however, I do not favour prohibitions over bilateral financial contracts between knowledgeable wholesale counterparties. To impose such prohibitions could impair institutions' ability to manage risk. As a more general matter, it may be useful to be clear about the meaning of different concepts used in discussing the nature and trading of derivative instruments. A first confusion can sometimes arise in talking about the complexity of financial products, and the markets in which they are traded. There is not a one-to-one correspondence between complexity and trading venue (ie, "over the counter" (OTC) or exchange-traded). While truly complex products are almost invariably traded over the counter, simpler products can be traded both OTC and on exchanges. The choice of whether to trade these products on an exchange or over the counter is driven by which platform offers the best liquidity, and it is not necessarily desirable to force all trading onto an exchange. A second distinction that should be drawn is that between exchange trading and central clearing. While exchange traded contracts are normally cleared through a central counterparty, it is the clearing aspect, not the trading venue, which offers the possibility of reducing systemic risk. It is possible to secure this risk reduction without requiring trading to take place on an organized exchange. To achieve this risk-reduction, however, it is necessary that the clearing house, which by itself concentrates risk, be adequately capitalized and have robust settlement provisions to deal with the failure of one or more of its members. Where centralized clearing is soundly based and offers the possibility of reduction in systemic risk, it could be useful to encourage the use of such settlement mechanisms, perhaps through preferential capital requirements for contracts cleared and settled in this way.

(ix)   "Originate to distribute" model

  The OTD model has come in for considerable criticism in the current crisis, but has many valuable features which deserve to be preserved in future financial arrangements. The OTD model, if properly applied, enables risk to be distributed more widely, reducing systemic vulnerability, and directs risk to those most willing (and, hopefully, able) to bear it. The problems with the model arise with both origination (poor underwriting) and distribution (too much risk retained by originators, risk distributed to unsuitable holders). I believe reforms should be directed at removing the demonstrated weaknesses in the origination and distribution legs of the model, not rejecting the model outright.

(x)   Non-bank Financial Intermediaries

  Insofar as NBFIs are large players in capital markets, they can have a similar systemic impact to banks. Many NBFIs are highly interconnected with the banking system through derivative contracts, secured lending, credit guarantees, etc. Their failure would have consequences that closely resemble the failure consequences of a large bank. As we have seen in the current crisis, fears of the consequences of the failure of large NBFIs have led authorities in several countries to undertake rescue efforts. In my view, therefore, systemically significant NBFIs should be subject to similar macro-prudential regulation to banks. This should include limits on the extent to which they employ leverage to expand their exposures, both on and off balance sheets.

(xi)   Role of the Media

  This is beyond my area of expertise, but my instinctive reaction is to be very skeptical of any attempt to impose reporting restrictions on the media. Dissemination of information generally strengthens the functioning of markets, however troublesome such information might be to particular market participants in the short term. Of course, the media should be responsible for proper checking of the veracity of the information they publicise.

(xii)   Public sector monitoring

  The public sector has a key role in monitoring financial stability problems. In most countries, this is done through "Financial Stability Reports". There is a role, also, for Parliamentary oversight of such monitoring. But it needs to be made clear that such monitoring and oversight does not constitute public sector endorsement or guarantee of stability.

(xiii)   Short-selling

  In general, the ability to undertake short-selling plays a valuable part in strengthening the price-discovery process in markets. Moreover, certain markets and risk-management techniques rely on short-selling, and the inability to engage in it could compromise effective risk management. I would confine restrictions on short-selling to rare usage, and focus on circumstances where it is associated with market abuse (eg spreading false rumours).


(i)   General approach

  In a severe crisis, taxpayers and citizens in general are likely to be best protected by measures that are demonstrably adequate to restore confidence and maintain economic growth. Avoiding all risks of loss from intervention in markets could greatly increase the risks of prolonged financial turbulence, economic weakness and loss of tax revenues. So, paradoxically, taxpayers may be best protected by putting greater sums "at risk". The doctrine of "overwhelming force" is relevant here. This includes ensuring banks have fully adequate capital at all times, that essential financial markets remain "open", and that overall demand is appropriately supported by fiscal and monetary policy.

(ii)   Recapitalisation and partial nationalization of banks

  An adequately capitalized banking system is essential for economic recovery. In crisis conditions, many banks, being already weakened, find difficulty in raising capital in the market on sustainable terms. While this situation persists, however much banks may be criticized for inadequate foresight, there is no satisfactory alternative to the government underwriting the necessary resources through direct funding or guarantees. To protect the taxpayer, finance should be extended only to those institutions with long-term viability, and on terms that protect the government's investment.

(iii)   Aims, and exit strategy, of recapitalization programme

  The aim of a programme of recapitalization of the financial system should be to enable banks and other financial institutions to resume their core function of intermediating saving and investment. It should not be to transfer decision-making in financial allocation to the Government. Banks should be encouraged to act as prudent risk-managers, in the interest of all shareholders, including the government. If government wishes to encourage certain types of lending or debt forgiveness, that should be done in a transparent manner, on the budget of the authorities, and not through moral suasion of the banking system. Concerning the "exit strategy", the goal should be to reestablish normal financial conditions as soon as possible, and return partially nationalized institutions to full private ownership as soon as their condition warrants. This has been the approach followed after earlier financial crises. Once stability is reestablished, viable banks should be in a position to repay emergency loans. Where support has been provided in the form of equity, a public offering of such equity can be made, with the objective of enabling the government to recoup fully its investment, possibly with a surplus to reward the public assumption of risk.

(iv)   Moral hazard

  It is undeniable that large-scale public assistance to the financial system raises issues of moral hazard. These can be minimized through making sure that the owners and managers of financial institutions are suitably penalized for decision making lapses, and by ensuring that regulatory discipline replaces, and mimics, as far as possible, the market disciplines that would apply in a well-functioning system without government guarantees.


(i)   Banks and government policy

  I would not be supportive of pressure or requirements on banks to act in ways that are not consistent with prudent banking, in order to "fulfil the government's aspirations". Of course, if banks are responsible for problems faced by their customers, they have an obligation to aid in resolving these difficulties. More generally, even where the bank has no such responsibility, it will usually have a direct interest (financial and social) to help customers find ways out of these difficulties. Where additional assistance to bank customers is judged by government to be warranted, this should be transparent and explicit, and financed in ways that do not interfere with normal market incentives.

(ii)   Banking as a "utility"

  Banking does have aspects of a "utility" and as such warrants regulation and protection. However, the synergies between the basic utility of providing a secure payment system and that of providing other financial services are substantial. I would not favour separating out the different aspects of banks activities into different entities. Rather, protection of the "utility" function can be ensured by more effective regulation. In any event, it should be noted that when financial institutions get into trouble and create a risk of losses to customers, public sector assistance is almost always provided, regardless of whether the activity is of a "utility" nature. So in my view it is best to accept this as a fact of life and regulate all financial institutions accordingly.

(iii)   Consolidation and competition

  Beyond a certain point, consolidation in the banking system, however necessary to support systemic stability, poses competition issues. It has not proved possible to lay down general rules as to how much consolidation impairs competition. This is an issue for the competition authorities to watch carefully, taking due account of the "contestability" of markets where there appears to be a concentration of banking services. Competition can be fostered not only by preventing consolidation (which risks impeding efficiency), but by facilitating market entry by qualified institutions, including those coming from abroad.

(iv)   Pricing and consumer protectionIn general, I would favour competition and pricing transparency as the most effective means of protecting consumers. This may involve regulation to enhance the meaningfulness and comparability of product pricing.

(v)   Deposit protection and competition

  Deposit protection means that regulation becomes less necessary to protect depositors' interests. Regulation remains necessary, however, not only to promote systemic stability, but to safeguard taxpayers' interest in the integrity of the deposit protection fund. It is also desirable for deposit insurance premia to be risk-based, as far as possible. This is not easy to do, but there are examples of successful attempts in various jurisdicitions. Such risk-based deposit insurance premia should help avoid the adverse consequences of competitive pricing that does not take adequate account of risk.


(i)   Government intervention to recapitalize financial institutions

  In general, a balancing has to be performed between the interests of taxpayers and those of current shareholders. Where a financial institution would not otherwise be viable, there is a good case for the government to take a large interest in the enterprise. Government should be appropriately compensated for the risk it absorbs, which may mean that in many circumstances, the public sector will generate a profit from the acquisition and subsequent disposal of its interest in a financial institution. Still, the Government should not take undue advantage of temporarily distressed conditions to exploit the weakness of a bank. Where an institution is fundamentally healthy, it should be up to the board of directors, as stewards of the shareholders' interests, to judge how additional capital should be raised. Government should be wary of pressuring healthy institutions to take public funds they would otherwise prefer not to use.

(ii)   Role of shareholders

  In principle, enterprises are owned by shareholders, whose representatives, the Board of Directors, act in their interests. In practice, however, individual shareholders, even relatively large institutional shareholders, have only a modest impact on how the institutions they own are run. This makes it all the more important that good governance practices are set forth and adhered to. Such good governance practices, for financial institutions, would include the appropriate composition and authority of risk committees, compensation committees and audit committees. Now that codes of best practice for financial market activities have been set forth, banks and other financial institutions should be encouraged to take a "comply or explain" approach to these codes.

January 2009

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