As I indicated on March 13, BoC Governor Mark Carney has delivered a speech reviewing the credit mess and “corresponding priorities for the official sector and market participants”. He commences:
The social and economic costs of the events in the subprime market are concentrated in the United States, while the financial costs are both widely dispersed and – relative to the scale of the system – readily absorbable. In short, as painful as they are to those affected, subprime losses have been important primarily because they have revealed deeper flaws in the financial system. While a number of underlying causes can be identified, I will concentrate on three in particular.
These three causes are:
- liquidity:
- fed overconfidence in ability to sell holdings at model-derived valuations
- encouraged “originate to distribute” securitization
- when vanished with ABCP, forced long-term assets onto books of investors and liquidity-guaranteeing institutions
- lack of transparency and inadequate disclosure:
- when problems emerged with structured instruments, it became apparent that many investors did not understand them
- opacity makes them hard to value, reducing liquidity
- uncertainty over holders feeds concerns on couterparty risk
- trust in Credit Rating Agencies has been shaken, amplifying stresses
- misaligned incentives:
- if (subprime) loan will be sold immediately, less emphasis on documentation and due diligence
- timing of trader compensation
- provision of funding at risk-free rates to trading desks
- insufficient recognition and compensation of risk-management professionals
- crowded trades result when, for instance, too many players have automatic signals based on credit ratings.
With respect to liquidity, Mr. Carney outlined the changes that Bank of Canada is making to increase its provision of such liquitidity on an emergency basis:
- Accepting ABCP as previously discussed
- Accepting Treasuries
- Possible formalization of term repos
He speaks approvingly of an IIF publication, Principles of Liquidity Risk Management:
The report noted that internal governance and controls are the keys to reducing liquidity risk for a firm since no formulaic approach will yield appropriate or prudential results across different firms. More specifically the Special Committee advocated that:
- Firms should have an agreed strategy for the day-to-day management of funding of all kinds of liquidity risks that they may need to manage.
- Such strategies should be approved by the Board of Directors and reviewed by it on a regular basis.
- Senior management should promote the firm-wide coordination of risk management frameworks.
The report also recommended that firms should have in place:
- Contingency plans to respond to the potential early warning signals of a crisis.
- Strategies and tactics in the normal course of business that prevent liquidity concerns from escalating.
- Possible strategies for dealing with the different levels of severity and types of liquidity events that could cause liquidity shortfalls, with the breadth and depth of these strategies incorporating recovery objectives that reflect the role each firm plays in the operation of the financial system.
- A clear understanding of the role of central bank facilities and the limits on these facilities.
With regard to regulation, the recommendations in the new report reflect approaches that could both facilitate liquidity management for firms and make the system more robust overall. These include issues of supervision concerned with:
- Home-host coordination.
- Harmonization of regulations.
- Principles-based” not “rules-based” liquidity regulations that, for example, focus on qualitative risk management guidance, rather than on prescriptive and quantitative requirements.
- Expansion and harmonization of the range of collateral accepted by central banks and settlement systems.
Frankly, the discussion of responses to liquidity and disclosure is little but platitudes, but he does indicate that regulators could reduce exemptions:
While issuers and arrangers have every incentive to improve the transparency of structured products, ultimately, disclosure guidelines are set – or not – by regulators. One lesson from the ABCP situation may be that blanket disclosure exemptions were too broad. At the same time, however, authorities should resist the temptation to bring forward overly prescriptive regulations. Rather, they should consider greater application of principles-based regulation. There is no point in regulators trying to anticipate every new product or to restrain their development. There is a point in encouraging issuers to ensure the adequacy of their disclosure within a principles-based framework and to bear the consequences if it is subsequently found wanting.
I will also point out that there is no point in requiring disclosure if nobody reads it. And then, on Credit Rating Agencies:
Going forward, securities regulators will want to see agency incentives aligned more closely with those of investors, and will ensure that agencies are quicker and more thorough in reviewing past ratings. Other regulators must also take responsibility for looking at the extent to which the mandated use of ratings has encouraged credit outsourcing, led to pro-cyclical price movements, and encouraged discontinuous crowded trades.
…
In a mark-to-market world, with leveraged, collateralized positions, investors need to make their own judgments about the creditworthiness, liquidity, and price volatility of the securities they own.
He did not address the question of the exemption from Regulation FD (in the States) and from National Policy 51-201 (in Canada) … while I certainly agree that investors should do their own due diligence and understand the credit risk they are talking on, their ability to perform an independent check of credit ratings is constrained by this regulatory policy.
… and he manages to come down on both sides of the fence with respect to trader compensation …
Many financial institutions have pay structures that reward short-term results and encourage potentially excessive risk taking. Investors should take the lead in demanding compensation structures that are more aligned with their interests. Others have suggested that the regulators themselves should make these determinations. While I think regulation of compensation within private institutions is entirely inappropriate, I do think that regulators need to consider carefully the incentive impact of compensation arrangements as they assess the robustness of risk-management and internal control systems.
All in all, an interesting, but not particularly meaty, speech.