The extraordinary rise in the value of internationally traded financial instruments over the past decade has been made possible, in the main, by wholesale banks’ ability to innovate and provide new products.
Arguably, it is this innovation that has made London the world’s largest and most important financial centre, thanks largely to the acceptance of principles-based regulation in its three forms: self-regulation, co-regulation and statutory regulation.
But the persistence of the US subprime mortgage debacle and the rating agencies’ role in promoting innovative financial instruments (the ORR – ‘originate, rate and relocate’ – model) has raised questions about the fitness of principles-based regulation. Should regulators consider statutory rules to address what some see as a market failure inherent in innovative products?
Innovation, by its very nature, tends to ‘front run’ the law. Principles-based regulation gives participants in financial markets the crucial flexibility to develop new products. It allows self-regulation and co-regulation to be the ‘glue’ between the innovator and the late arrival of the statutory regulator. Inherent to principles-based regulation is an understanding that the innovator will have to make more complex judgements than in a rules-based system and that the regulator will severely punish infringements of the law.
Market failure
The Takeover Code, the JMLSG industry guidance on money laundering and the Banking Code are examples of how self-regulation and co-regulation can complement their statutory cousin. However, clear evidence of market failure is an obvious justification for introducing new rules.
Has there been such a failing of the ORR banking model and is further regulation needed? First, consider that in adopting Basel II, most large banks have started using an internal ratings based approach when considering how much capital to set against risk. Consequently, they have started managing their capital more rigorously, spawning an increase in the sale of loans to optimise use of capital.
Second, consider that rating agencies are subject only to a voluntary code of conduct without independent monitoring. This type of regulation is questionable, especially when originators (mostly banks) pay for the product (the rating). Is this sufficient to protect users of ratings?
Third, consider that risk is typically transferred from a bank, whose main skill is risk assessment, to a ‘risk trader’, who is usually not versed in the disciplines of credit risk assessment, probably relies solely on the rating, and does not intend to hold the instrument for long. Add further concerns about the competence of long-term owners of the risk, in its new, synthetic coating of, say, an AA rating, and one must ask whether subprime mortgage credit risk is now in the hands of the party most able to bare that risk?
The cream of the international banking sector has confessed to being the ‘final owners’ of the subprime ‘toxic waste’, which may tempt the informed observer to believe that the chickens have come home to roost. I wish that were so. But what of the most prominent holders of long-term assets: pension funds and life assurers? Plus, of course, hedge funds, which have found eager customers in some of these long-term holders of financial instruments?
Taken in isolation, these separate factors – increasing loan asset sales, flaws in the ORR model, possible misuse of the trust between rating agencies and their main customers, and pensions partly reliant on toxic synthetic bonds – would cause no more than a light gale to blow through financial markets. But with all four coinciding, are there the makings of a perfect financial storm?
In any case, what could be the downside in the FSA, the City and rating agencies forming a taskforce to assess the depth of the problem and suggest how the three forms of regulation might address the risk to the UK market? They might even consult Sally Scutt, managing director of the London-based International Banking Federation, on the nature of the industry’s global response.
Ian Mullen is foreign chairman of the China International Finance Forum and a former chairman of the International Banking Federation.
