Chapter 1: The Financial Crisis
The future of EU financial regulation and supervision
1. This report examines the structure, and current
proposals for the revision, of financial supervision and regulation
within the European Union. This has been brought to the forefront
of debate by the financial crisis. Although the crisis began in
financial markets in the United States, its effects have spread
into the real economy around the world, not least in the EU. Measures
have been implemented in response to the crisis globally, at EU
and at national level.
The causes of the financial crisis
2. To understand how to prevent a repeat of the
financial crisis, it is important to try to understand its causes.
The consensus is that global macro-economic imbalances and financial
innovation—which amplified the consequences of excessive
credit and liquidity expansion—together with failures in
regulation, supervision and corporate governance, combined to
cause the financial crisis. The collapse of the subprime lending
market in the United States triggered the crisis. Many commentators
have argued that loose monetary policy did little to counter bubbles
in asset prices.
3. In the belief that central banks had tamed
inflation, interest rates were kept historically low. This led
to plentiful availability of credit, but low returns on investments,
fuelling the housing price bubble and contributing to the build-up
of a large current account deficit in the USA and some other countries
including the UK. Credit expansion in the US was financed by countries
with sizable current account surpluses, notably China and oil
exporting nations.
4. In an effort to achieve higher returns, financial
institutions and their employees devised increasingly complex
financial products, such as Asset-Backed Securities (ABS). This
market expanded rapidly, and by 2007 ABS products were worth £2.5
trillion in the US alone.[1]
For many the focus in financial institutions on short-term profit
at the expense of long-term stability, and the incentive structure
that encouraged bank employees to seek short-term profit, helped
to lead to the greatest excesses of financial innovation.
5. The ability of banks to accrue fees and lower
their capital requirements by selling assets in securitised bonds
(see Appendix 8) led to increasingly higher leverage (capital
to asset) ratios. The originate-to-distribute model and the transfer
off-balance sheet of securitised assets removed much of the incentive
for the lender to ensure the borrower could repay the loan. This
left the institutions vulnerable to even the slightest changes
in asset values and was exacerbated by high levels of leverage.
6. United Kingdom banks were amongst the most
highly involved institutions globally in the trading of securitised
financial instruments. The complexity and opacity of many instruments
led institutions and investors to underestimate the riskiness
of underlying assets. These problems were further exacerbated
by the speed and volume at which the products were bought and
sold. Lord Myners, Financial Services Secretary to the Treasury,
described to us how securitisation led to the belief among many
that "poor quality assets … assembled as a portfolio
… could somehow by alchemy be converted into something stronger
than they were" (Q 62).
7. Each securitised instrument was assigned a
credit rating by a credit rating agency, which also rated the
issuers of these instruments. The highest triple A rating, the
standard rating for government bonds in developed countries, was
increasingly given to complex, opaque and (as was later discovered)
risky securitised products. Martin Power, Head of the Cabinet
of Commissioner McCreevy, told us that around 64,000 securitised
products received a triple A rating (Q 423). The major miscalculation
of the risks inherent in these products occurred in part through
flaws in the methodologies of rating agencies and was exacerbated
by conflicts of interest caused by the originator, rather than
the investor, purchasing the rating. This undervaluation of risk
contributed greatly to the expansion of the securitised debt market
and the "aggressive use of leverage by banks" described
to us by the Minister (Q 62). The problems caused by complex
securitised instruments were exacerbated further by what Marke
Raines of Taylor Wessing LLP described as the "market frenzy"
with many products purchased with little or no due diligence conducted
by the investor (Q 24). Human behaviour and human frailties,
in particular greed, played a role. Professor Goodhart told
us "greed led them to take positions … which obtained
relatively high short-term returns at the expense of excessive
risks which were assumed … ultimately by the taxpayer and
society" (Q 90).
8. Highly leveraged funds and the so-called shadow
banking system flourished in an environment of easy money and
contributed to the build-up of leverage in the system.
9. The financial crisis itself began when the
subprime bubble burst in the summer of 2007, as it became increasingly
clear that many borrowers in the USA were unable to meet their
debt obligations. The lack of transparency in securitised products
led to confusion over the size and location of credit losses,
damaging market confidence. The recognition that markets had underestimated
risk caused many financial institutions to sell off their assets.
Concerns about liquidity helped to prompt banks to hoard cash.
10. The loss of trust and market confidence in
financial products and institutions worsened, particularly following
the failure of Northern Rock and Lehmann Brothers in September
2008, restricting the normal functioning of markets. Banks stopped
lending to each other and some consumers withdrew their deposits,
with panic spreading through both regulated and unregulated financial
institutions. This reduced market liquidity further. As institutions
struggled to find sources of funding, liquidity problems quickly
turned into insolvency problems, with governments stepping in
to provide guarantees and recapitalise financial institutions.
11. As the market value of financial institutions
collapsed, pro-cyclical accounting and capital rules exacerbated
the crisis (see Box 4). Basel rules stipulate the amount of capital
an institution has to hold, in relation to credit risk. They were
first set out in 1988 by the Basel Committee on Banking Supervision.
Rating agencies lowered the ratings of financial institutions
as it became increasingly clear that credit risk was undervalued,
which pushed required minimum capital ratios of institutions higher.
This forced banks to sell off more assets, pushing their value
still lower.
12. The financial crisis led to the bank run
on Northern Rock and its subsequent nationalisation, the merger
of the Lloyds TSB and the HBOS group, the recapitalisation of
the RBS group, the break-up of Bradford & Bingley and many
further Government actions in the financial market in the United
Kingdom alone. Up to February 2009, the European Commission approved
over 40 applications from Member States to recapitalise financial
institutions.
13. The Global Stability Report of the International
Monetary Fund estimates that to return to the bank leverage ratios
of the mid-1990s would require capital injections of $500 billion
for U.S. banks, about $725 billion for euro area banks and about
$250 billion for U.K. banks.[2]
This shows the crisis has had a particularly deep impact on the
European banking system.
14. The scale of central bank and government
intervention in the financial sector in recent months is unprecedented.
The provision of emergency liquidity assistance, the use of conventional
and non-conventional instruments of monetary policy (such as quantitative
easing), the design of various forms of financial support, including
bank recapitalisation and even nationalisation, and the reliance
on expansionary fiscal policies have given the State a prominent
role in the financial system and in the resolution to the crisis.
These are, for the most part, national responses, albeit co-ordinated
to some extent at the European and international level. While
we recognise, in the words of Czech President Mr Klaus, that
fighting the fire has been a priority for policy-makers in recent
months, we must also address the issue of writing new fire regulations.
In this report we address some important issues with regard to
the reform of financial regulation and supervision in the EU,
using our witnesses' version of events as the background for our
analysis.
Our inquiry
15. Given the broad nature of financial regulation
and supervision within the EU, our report comments on the following
specific areas:
- The amendments to the Capital Requirements
Directive, which create new minimum capital requirements for financial
institutions, adopted on 7 April 2009;
- The regulation of credit rating agencies,
adopted on 23 April 2009;
- Crisis managements procedures in the EU;
- The structure of financial supervision within
the EU. This includes detailed analysis of the recommendations
of the de Larosière group, the Turner review, the role
of the European Central Bank and the powers of the home and host
country supervisors over cross-border financial institutions;
- The role of the EU in global supervisory
and regulatory structures; and
- State aid measures in response to the financial
crisis.
16. This report examines the proposed reform
of each of these areas. Though the report focuses on EU responses
to the financial crisis, we do not start from the assumption that
the EU is the right arena for action. Rather, for each issue we
have considered whether it is necessary to take any action and
if so whether action is best taken at a national, EU or global
level or combination thereof.
17. This report is intended to contribute to
an in-depth review of the current regulatory and supervisory regime.
Two previous reports, the Turner Review and the Report of the
de Larosière Group, have already made detailed suggestions
for the reform of supervision and regulation. The recommendations
of these two reports, where they fall within the scope of the
inquiry, are considered in our report, along with the suggestions
for reform by other groups and individuals, particularly those
of Her Majesty's Government, the Financial Services Authority
and the European Commission.
18. The issues involved in any examination of
regulation and supervision in the EU are diverse and we do not
intend to cover them all in this report. In particular, we have
not considered the impact of the crisis on the real economy, UK
participation in the single European currency, regulation and
supervision of insurance firms, remuneration of bankers and corporate
governance issues or the divide between investment and commercial
banking. The inquiry focuses mostly on the banking system, although
we make reference, where relevant, to other parts of the financial
system.
19. The House of Lords Economic Affairs Committee
has conducted a concurrent inquiry into financial regulation and
supervision within the United Kingdom.[3]
The two reports together provide a broad overview of the supervisory
and regulatory architecture in place in the United Kingdom. The
House of Commons Treasury Select Committee has published three
reports into different aspects of the banking crisis.[4]
20. The Membership of Sub-Committee A that undertook
this inquiry is set out in Appendix 1. Lord Woolmer of Leeds chaired
the deliberations on this report in place of Baroness Cohen of
Pimlico. We are grateful to those who submitted written and oral
evidence, who are listed in Appendix 3; all the evidence is printed
with this report. There is also a glossary in Appendix 5. We also
thank the Sub-Committee's specialist adviser to the inquiry, Rosa
Maria Lastra, Professor in International Financial and Monetary
Law at the Centre for Commercial Law Studies, Queen Mary University
of London. We make this report for debate.
1 The Turner Review: a regulatory response
to the global banking crisis, (Financial Services Authority,
March 2009), p. 14 Exhibit 1.5 Back
2
Global Financial Stability Report: responding to the financial
crisis and measuring systematic risk, (International Monetary
Fund, April 2009), p 37. Back
3
Economic Affairs Committee, 2nd Report (2008-09): Banking Supervision
and Regulation (HL 101). Back
4
Treasury Committee, 5th Report (2008-09): Banking Crisis:
the impact of failure of the Icelandic banks (HC 402);
Treasury Committee, 7th Report (2008-09): Banking Crisis: dealing
with the failure of UK banks (HC 416); Treasury Committee,
9th Report (2008-09): Banking Crisis: reforming corporate governance
and pay in the City (HC 519). Back
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