José De Gregorio: Lessons and challenges on financial regulation
Introductory remarks by Mr José De Gregorio, Governor of the Central Bank of Chile, at the
conference "Financial Regulation: Lessons from the Recent Global Crisis", Santiago,
17 August 2009.
I am very grateful to Luis Opazo for his contribution to this presentation.
* * *
What went wrong? This question has been at the center of recent discussions in academic,
practitioner and political circles, and will probably stay with us for several years. This
conference is a step forward towards finding answers to this question. Specifically, the main
purpose of the conference is to discuss those aspects of regulation that may have triggered
or amplified the current crisis, and those aspects of regulation that in some countries have
contributed to financial resilience.
The Chilean financial system, as well as those of many other developing countries, has
shown to be very resilient. Nevertheless, we also need to be involved in the discussions on
building a safer financial system. Our countries have a lot to say on balancing financial
innovation and financial soundness.
The global economy shows some signs of recovery, but it is not evident that the crisis and its
effects have fully unfolded. More likely, they will continue to evolve for some time. However,
it is not too early to discuss these topics. Hence, we hope that the presentations and
discussions of this morning will shed light on the directions for regulatory change in the
upcoming years.
Causes of the financial turbulences and their implications on financial regulation
The subprime crisis is the result of the convergence of several elements at the same time -
what some observers have called a "perfect storm." Trying to keep things simple, the
element that triggered this crisis lies in the U.S. mortgage sector and a process of rapid
financial innovation. In this regard, the banking industry contributed to the lending and
housing boom as follows. First, the traditional banking model - hold loans until they are
repaid - was replaced by a distribution model, where loans are pooled, tranched, and finally
sold via securitization to other financial investors, thus this process led to banks' off-loading
risk. Second, the funding of highly leveraged financial intermediaries with short term liabilities
increased throughout this period, which exposed those intermediaries to potential stress
derived from changes in market liquidity conditions.
As we all know, the originate and distribute model led to the fast development of
securitization markets characterized by an ever-increasing supply of complex financial
instruments. Given the course of events, these turned out to be quite difficult to value. On
this last point, the rating agencies are involved, as they are responsible for assessing the
credit quality of such instruments, which is an essential piece of information for investors.
Nowadays, these institutions are also under public scrutiny regarding their capacity and
incentives to correctly evaluate risk.
My impression is that the fundamental causes of the current crisis were the same market
failures that have played key roles in many previous financial or banking crises, which we all
know well from our previous experience in emerging markets. The first of these are the
distortions in financial intermediaries' behavior introduced by implicit or explicit bailout
expectations. The second are the intrinsic vulnerabilities of financial intermediaries that
finance long term (or illiquid) assets with short term debt.
What differs in the current crisis is the way in which these components showed up. As for
excessive risk taking, the mechanism to deal with it was the securitization of high risk loans,
which allowed banks to sidestep capital regulations by either creating off-balance-sheet
agents or by bringing back loans packaged into highly rated assets, with low capital
requirements. As for short term funding of long term (or illiquid) assets in the current crisis,
this was prevalent in investment banks, SIVs and conduits.
Hence, the lessons to be learned from the current crisis fall into two categories. The first are
broad reforms that seek to align incentives and reduce the vulnerabilities of financial
intermediaries. Higher capital requirements, a broader regulatory scope, and reforms to
management incentive schemes are all in this category. These are all important aspects.
However, the devil is on the details, and the exact way they should be implemented is yet to
be defined. For example, it has been argued that "systemic" financial institutions should be
more closely supervised and be subject to a more stringent set of regulations. How exactly to
define systemic institutions, and who should deem an institution systemic is far from clear.
Closely related reforms are those aimed at reducing interdependence and, therefore, the
systemic nature of institutions. The push towards central counterparties, in particular for
derivatives, falls in this category.
The second category of reforms encompasses those directly related to the specifics of the
subprime crisis. I would like to offer some comments on these issues. In particular, I would
like to comment on a) accounting methods; b) liquidity; and c) rating agencies.
Accounting methods and valuation
At the onset of the financial turbulences, there were strong concerns on how precise was the
information reported by banks, how large were the losses, and who was bearing these
losses. This uncertainty was a critical factor in the shutdown of key financial markets. The
International Accounting Standards Board (IASB) and the Financial Stability Board (FSB)
have been working and promoting recommendations on accounting and disclosure standards
for off-balance-sheet investment vehicles, and fair value methods, among others. However,
these "information" requirements by themselves are not enough, and other measures could
be necessary, such as forcing originators and other agents to hold part of the risk of the
assets created.
Liquidity
The current financial turbulence has highlighted that for the banking sector liquidity
considerations are as relevant as solvency issues. In spite of this, most of the attention in
banking regulation has been focused on solvency (Rochet, 2008). However, some steps
have been taken in this direction by the BIS in terms of contingent liquidity demand and
related triggers associated with off-balance-sheet positions (BIS, 2008). The literature has
identified several elements that could generate externalities related to liquidity, and therefore
could justify some degree of regulation, where the main arguments are linked to asymmetric
information and market incompleteness.1 Moreover, policies put in place by central banks
after September 2008 have made moral hazard concerns for liquidity management more
pressing.
Nonetheless, there are still open questions as to the kind of regulation to reduce the potential
consequences of the imperfections in this area. There are no straightforward answers on this
matter. Some pending questions are: Should a capital charge be put in place for liquidity
risk? Is it necessary to impose an additional liquidity requirement to intra-day liquidity needs?
Should central banks act as the lender of last resort in this market?
Credit rating agencies
The role played by risk rating in the subprime crisis is also an important corollary to the
current crisis. To illustrate why some authors have gone as far as calling this "the credit
rating crisis" (Benmelech and Dlugosz, 2009) consider that before the crisis more than half of
the structured finance securities rated by Moody's carried an AAA rating and, during the
period 2007-2008, the tranches rated by Moody's that were downgraded was close to thirty
six thousand, where nearly one third of downgraded tranches bore the AAA rating.
This is a complex issue, especially due to the prevailing incentives in this sector. A recurrent
area of criticism on the incentives side is the simultaneous role of advisor and issuers of
ratings. But the spectrum of potential conflict areas could be broader, and thus more efforts
must be devoted to understanding in detail the operation and linkages of this industry.
Final comments
The subprime crisis has opened a debate on the risks of financial innovation. It reminds us
that higher levels of sophistication do not guarantee the normal operation of the financial
system. A reasonable level of regulation, control and monitoring is required. I think we should
move forward in innovation processes, as they are positive, but we must move forward with
caution. It is important to implement policy changes gradually to provide an adequate level of
information and transparency that will ensure an adequate assessment of the risks involved.
It is also crucial to review in detail the incentives and potential conflicts of interest arising
from the new tools and processes.
Another aspect that needs to be addressed is the role of adequate control systems and
financial risk management. A proper system of financial risk control and management must
start by defining policies at the highest level, the board of directors. It also requires the
involvement of senior management in tracking and monitoring risk. And, ultimately, it needs
the development of an organizational culture that is capable of properly combining the goals
of profitability and leadership with risk sensitivity. In this regard, a topic that is central to the
discussion of financial reforms is the overall structure of incentives of financial intermediaries.
I believe this is an issue that all players in the financial system must follow with care.
As a result of the current problems, we will observe more regulation in financial markets and
everyone, even those of us not at the center of these difficulties, must remain watchful.
Problems of moral hazard, transparency and new ways to meet the requirements of central
banks to provide liquidity are leading to a review of regulatory frameworks at the international
level. We must be aware that more regulation leads to the search of ways of avoiding them,
which may end up threatening financial stability. This last dimension must be taken into
account in the analysis and regulatory proposals, which obviously introduces an extra
element of complexity in this area.
Thank you.
References
Allen F. and D. Gale (2000). "Financial Contagion", Journal of Political Economy, 108(1).
Benmelech E. and J. Dlugosz (2009). "The Credit Rating Crisis", NBER Working Paper,
15045.
Freixas X., Parigi B. and J. Rochet (2000). "Systemic Risk, Inter-Bank Realtions and Liquidity
Provision by the Central Bank", Journal of Money and Credit Banking, 32(2).
Morgan D. (2002). "Rating Banks: Risk and Uncertainty in an opaque Industry", American
Economic Review, 92(4).
Financial Stability
Rochet J. (2008). "Liquidity Regulation and the Lender of Last Resort",
Review, Banque de France, February.