Discussion of 2008 FSF Report on Financial Stability
April 13, 2008 – 5:30 pmThe FSF Report on Financial Stability (called “Enhancing Market and Institutional Resilience”) was yesterday approved by the G7.
To assess the impact of the report on the global financial architecture and the responses to the credit crisis in the financial markets, it is worthwhile recalling the original demands of the G7.
In essence, the FSF was asked to look at the underlying causes of the credit crisis (which it did) and make proposals for tackling the problem. Quite clearly the FSF concentrated mostly on the micro-economic implications of Financial Regulation and not so much on more macro-economic developments, such as global interest rates, exchange rate movements or the role of new actors like Sovereign Wealth Funds as (de-)stabilizing force in the Financial Markets.
The general message of the report cam be summarized as follows: Blame the banks, blame the credit rating agencies, blame national supervisors! There is very little blame directed at the political level, the central banks or the international bodies coordinating supervision.
This however was expected, given that G7 wanted the conduct of business by the banks (especially the business of off-balance-sheets-vehicles which speculate heavily in structured products) and the credit rating agencies (which are involved in analysing and rating structured products, but also in giving advice on how to set-up structured products) to be at the heart of the global regulatory response.
The FSF reponse shows a tricky balance when it comes to the global framework for Banking Regulation. On the one hand, the FSF wants to increase the scope of Basel II and encourage more countries to adopt the framework, on the other hand Basel II has some deficiencies which have worsened this crisis, that a reform Basel II will undergo a scrutinous review.
The report addresses the fields where Basel-II will undergo a review:
- Increased minimum capital requirements for capital requirements for complex structured credit products (such as Colleratlized Debt Obligations of asset-backed securities) when they are in the balance sheets of financial institutions, especially taking into account liquidity risk when the secondary market for these products evaporates.
- Increased minimum capital requirements for the so-called off-balance-sheets vehicles.
- Less reliance on the ratings of credit-rating agencies when assessing the liquidity risks of securities and less reliance on the ratings of monoline-insurers in Basel II.
The main task of reforming Basel-II will reside in the BCBS, but it seems that other organisations such as IOSCO and IAIS will provide guidance. Furthermore, the FSF will provide guidance for the national regulators to improve their supervision and enforcement of the Basel-II-rules and ensuring that the financial institutions have adequate risks management models.
The enforcement of the national supervisors is also crucial when disclosing losses, which the FSF has enphasized in quite drastic words. The FSF has put out the mid-year reports as a condition for the banks to disclose their losses for two reasons:
- firstly, it wants to overcome the prisoner-dilemma of banks which are faced with the problem that a joint disclosure of losses in the long-term leads to increased trust in the interbank-lending-markets, but in the short-run represents a punishment by the markets when share prices drop.
- secondly, disclosing the losses will be a precondition for a bail-out through lower interest rates by the central banks which the financial institutions could use to recapitalize themselves.
Interestingly, also the IAASB is called upon for to improve the auditing standards, despite the fact that at least in the public mind, incorrect auditing was not the big problem of the credit crisis. The IASB is also called upon to update International Accounting Standards, especially for structured products. Finally, markets are urged to implement better settlement standards for OTC-derivates. All three events point to the problem that underlying causes of the credit crisis is really market information.
The heavy attack on the Credit Rating Agencies follows the market information perspective, but seems to be politically motivated. The internal code of conduct of Credit Rating Agencies does minimize conflict of interests and the IOSCO-2004-Code for CRAs (which is called for an update by 2009) is too vague and general as to really provide some substantial guidance.
Most likely there will be regulation calling for internal firewalls between the departments dealing with the consultancy for structured products, and the analysts rating structured products. As the FSF indicates, there will also be regulation that the CRAs have to introduce differentiated rating schemes for structured products.
Yet it is not clear that all of these measures will help to tackle the fundamental problem of the global financial market, which is an often incoherent and overlapping financial architecture regulating financial markets.
For large financial conglomerates, the regulatory landscape is very complex. The FSF proposes to introduce “Colleges of Supervisors” from the main jurisdictions. This is an interesting idea, especially because such “Colleges of Supervisors” are also going to be introduced for Cross-Border Financial Institutions.
It is also to be welcomned that the international bodies are encouraged to develop more closer cooperation, especially the IMF and the FSF are moving closer again. Whether this is motivated by the idea of strengthening the role of the IMF or linking macro-ecnomic and micro-economic aspects of Financial Stability, can only be speculated.
In any case, there is no central, singular, international, supervisory authority and given the complexity of the problem, it is unlikely that such an authority will emerge any time soon. But until then, the reform of the financial architecture will be patchwork - and the FSF Report is a good example of this principle.
Topics of this post: banking supervision, banks, credit rating agencies, exchange rates, financial regulation, financial stability, fsf, g7, imf, Reports, sovereign wealth fund, subprime crisis