29 Oct 2007, David Benyon, Operational Risk & Regulation
DUBLIN – Charlie McCreevy, European Union commissioner for the internal market and services, has counselled against regulatory ambition and for a humble evaluation by the financial services industry of the lessons learnt in the aftermath of this summer’s markets crisis.
The speech highlighted the importance of the EU’s policy of open consultation and principles-based regulatory framework in stimulating competition, underpinning financial stability, delivering appropriate investor protection and strengthening market integration across EU member states but it also carried stark warnings for regulators.
“It is especially – indeed sometimes only - in turbulent times that regulation and its effectiveness gets tested. And we cannot, and should not, bury our heads in the sand or ignore the fact that there have been some aspects of our regulatory framework – both at Member State and European level - that are likely to need improving. There are lessons for us all. For regulators, now is a time for humility, not for ambition.”
McCreevy said transparency was useful for improving some opaque financial instruments, but recent experience showed investor confidence and financial recovery could be better resolved behind closed doors.
“Clearly transparency that culminates in panic, followed by a rescue, followed by the proliferation of moral hazard is transparency that we would be better off without.”
The speech praised the principles behind the Basel II Accord in facilitating a more risk-sensitised approach to capital allocation, but called for further development of Basel II’s framework encompassing lessons to be drawn from Northern Rock’s near collapse on liquidity issues as opposed to flawed assumptions based on shareholder equity.
On accounting issues, McCreevy highlighted the unexpected consequences arising from the recent market illiquidity of new accounting standards on the valuation of assets and liabilities.
McCreevy said the increasing use of mark-to-market – and especially mark-to-model for opaque or illiquid assets and contracts – is producing unexpected anomalies. Mark-to-market can mean if an institution’s credit risk and the value of its bonds are declining, its net value can still be boosted with a discount on the bonds, despite the underlying liability of the bonds selling at par on maturity.
Mark-to-model can see profits booked by both counterparties involved, based upon unreliable assumptions. As a result he said it is not surprising that some have referred to this latest accounting practice as “marking to myth”.
The commissioner said the tide of financial crisis had receded, exposing market participants in ways that are widespread, ugly and plain to see.
“Irresponsible lending, blind investing, bad liquidity management, excessive stretching of rating agency brands and defective value-at-risk modelling pose questions for a much wider audience.”
His final point concerned the need for visibly effective corrective action from credit rating agencies (CRAs) to strengthen confidence in their governance, in order to repair damage from recent, unexpected discounts on triple-A rated products.
“They must create a framework where conflicts of interest are properly and more effectively managed.”
McCreevy highlighted the significance for CRAs of next spring’s Committee of European Securities Regulators (CESR) report, and suggested a governance structure involving a direct reporting line from fully ring-fenced rating assessment functions to a supervisory rating sub-committee of independent directors of the rating agency.
Looking ahead, the commissioner said it is national and European supervisors’ duty to review the regulatory framework, but that self-correction would occur in some areas, while rushing to legislate afresh in others would have a detrimental effect.
“When we come through tough and challenging times it is the strong who survive and the weak who go to the wall. Out of this downturn in the credit markets will come some good,” he said.
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