Memorandum from Andrew Crockett
Evidence submitted by Andrew Crockett, President,
JPMorgan Chase International, former General Manager, Bank for
International Settlements, former Chairman, Financial Stability
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.
1. SECURING FINANCIAL
(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
(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
(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"
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.
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
(ii) Recapitalisation and partial nationalization
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
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
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
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.