Eddy Wymeersch, chairman of the Committee of European Securities Regulators (CESR), talks to Risk about the effects the financial crisis will have on regulators and central banks.Risk: How are European regulators responding to the current crisis?
EW: On a number of points action is already under way – that is the case for the credit rating agencies, and also for short selling. Additional action will be needed on central clearing for derivatives such as credit default swaps (CDSs), including the initiatives taken by various market participants – Depository Trust and Clearing Corporation being one, Eurex being another and there may be others. We will announce very soon our rules on settlement and clearing.
In 2005, we suspended the work on clearing and settlement – that has now been taken up again and has been approved in the new version by CESR and submitted to the European Central Bank (ECB). It will be finalised next week, subjected to market consultation and finally approved. Of course this deals only with clearing and settlement of equity, it certainly does not deal with derivatives – so we will probably need an addendum for those products.
One of our concerns is that in derivative markets, such as CDSs, we have so little disclosure of prices. There have been projects saying we should put these transactions on the stock exchange. I think that’s going way too far – but we should have more disclosure of over-the-counter prices, so that the markets would be better informed and for valuation purposes we would have more basis for correct valuations. One of the difficulties we have today is that we have no disclosure, we have no information on transactions that have taken place.
This is not a response to the present crisis but it may be a response to the next one. I am sorry to be so cynical: even though the clearing of the positions linked to Lehman Brothers has been relatively well done, and LCH.Clearnet's SwapClear platform for interest rates arrived in a relatively short time, that’s not the issue. We should have ongoing set mapping of derivative positions, possibly even intraday, so you have no outstanding positions and you don’t have the mess you have today.
Certainly there is a risk in this market, but if you could offset different positions during the day you would avoid that risk. You would also avoid having notional positions going into the trillions, which is a figure everyone is afraid of, but it’s not a real figure – it would reduce the perception of risk to real dimensions.
Risk: How far should the short selling ban be extended? Should it be made permanent, at least for some equities?
EW: There is certainly an argument that until further notice, in the very unsettled markets we have, we should have a short selling ban. Whether we will introduce it is another matter, but if it happens it should be more streamlined, applicable everywhere in the same sense; cover indirect forms of short selling; and one that is applicable worldwide because I think there is still a lot of short selling going on in places that are not regulated. I am unable to prove this, but perhaps sooner or later will have more information on what has been going on the market. The markets are still very negative day to day, and though this is not only due to short selling, shorting has triggered the phenomenon and has continued.
Risk: Should the ban be extended to cover other ways of taking a negative view on a stock – such as contracts for difference, for example?
EW: In present circumstances, trading should be strictly limited to cover short selling – and if that is not sufficient and we need to go further, why not just say you can’t take negative positions? It is an extreme view I know. It is difficult to talk about contracts for difference, because we haven’t had time to do the analysis; but if they have the same effect as short selling and they are taking place in the same circumstances, the answer would be yes. And it is the same with CDSs because the market of short selling has moved to the CDS market, and you have the same phenomenon there.
The crisis we have been confronted with is a crisis of confidence, expressed at the level of equity and then reverberating at the level of liabilities, and that is very strange because the liabilities are not necessarily in danger. Equity valuations are based on largely different factors than those that are taken into account for creditworthiness. So you have a shift from one to the other, you have a mixing of the two and that’s not very healthy. I think we will have banks that collapse if current conditions continue – because the shares have gone down and undermined the trust of creditors, even if there was no real reason for the creditors to be worried.
Up until now, the discussion has been limited to financial stocks, because there you have that link between liabilities and equity – you do not have it so clearly with industrial companies. So until further notice we can restrict the ambit to financial stocks. But it’s technically possible that it will affect the entire economy – we are on a slide straight down to hell. It is very evident – we have layoffs, factories closing and so on. The short selling ban would not be sufficient but it’s one of the many aspects in which the financial markets should not control the world.
Risk: How will regulators have to change the way they work in response to the partial nationalisation of so many banks?
EW: In my analysis, and if you do not raise the question of reorganising the supervisory structure in Europe, there will not be much change. I expect the banks that have been recapitalised will continue to be run as private businesses – I don’t think the states will take a very active role in their day-to-day running. For the next few months, I don’t see the states taking any big initiatives – they will certainly prefer to try and calm things down, to restore confidence, to tell the population that things are going on as before, there is no reason to be afraid – that is the right message. They will not start to embark on big manoeuvres, unless it is unavoidable, as was the case with some of the banks in the US.
Risk: Will this represent a conflict of interest – with state-owned banks being overseen by a state regulator?
EW: According to international standards, and my practice, regulators are independent and they will not necessarily follow the instructions of the government. That being said, there are many conflicts of interest – the government is a shareholder in a difficult position; there is a question of competition, of state aid. At the moment, the state and the private banking system are bedfellows. This cannot continue – it is an emergency measure. If you ask me what position the state should take in these firms, I would say that unless emergency measures are needed, the state should keep out, restore confidence and let’s go on with business as usual, except with better risk controls.
Risk: Should governments be moving to sell off their holdings in the medium term – say in two years time – or should they remain involved even after a recovery?
EW: Well, the proviso is that you know the situation will have stabilised in two years – I suppose that might be the case, but I don’t know. I think governments have no intention of staying so heavily involved in the banking system. That in my view would be going back to the situation of the 1960s in continental Europe – since then most of the governments have sold their stakes, and I think it would be the same if things move on normally.
Of course, if the situation remains difficult, things will be different – if you have a continuing credit crunch, I think the states will want to keep a finger in the pie. And that is one of the big risks I see – on the one hand, you will have massive deleveraging and massive reduction in risk, and that is a good thing because it was one of the major faults in the system. But if there is a major credit crunch, the states will have to remain on board. Whether that is for better or the worse I don’t know.
Risk: What will regulators have to do in order to salvage the reputation of credit rating agencies?
EW: The times are gone when we say that they will have to put their house in order based on some vague rules and continue to function; we need to have clearer and stricter rules. This is being prepared at the European Commission level, and we expect to have some proposal later this month or next month.
In general the proposals put forward, essentially by the International Organisation of Securities Commissions and supported by all the large economies, go not in the direction of imposing substantive rules on the rating agencies, but rather on introducing procedures according to which objectives are guaranteed.
For example, in conflicts of interest, which has been a CESR concern, there have to be mechanisms in the agencies for avoiding or neutralising conflicts of interest. The supervisors will see if these exist and if they are sufficient. That would be the new approach. What has to be clear is that supervisors will not look into the substance of the ratings, because that is not their business.
A nationalised rating agency would be the most horrible conflict of interest – it should be independent and not under the direction of the state. If you want an independent banking system, it should be supervised independently and not as part of a government department. There is still the question of who is going to do this in Europe – I have no idea what the commission is going to propose.
Risk: What room is there for regulators to intervene on executive compensation?
EW: Many ideas have been floated in this field – the UK Financial Services Authority has published some guidelines. First of all, it applies to all economic entities, not just the banks. Second, the issue should not be obnubilated by the fact that the top managers get paid a lot of money. It is often the case in banks that traders earn more than they do. So is the real issue that these guys are getting too much money? If that is the suggestion, you would have to extend the rule to footballers and other highly paid professions. So we will not do that.
The real question concerns the risk incentives built into the financial system – and whether higher remunerations are a result of short-term risk taking. If that is true, then those bankers should not get paid until you know exactly what they have been doing, which could be a couple of years later, when you have determined that the risks they have taken were not excessive. So you don’t have to put a cap on the total remuneration, but you have to intervene at the level of the short-termism that you build into the remuneration system. This is also the case for quarterly accounts which are published – exactly the same. We have to move away from such short term assessments – the EU already has moved away - and we will have to intervene in the question of remuneration.
This is one of many issues that need to be addressed at the Basel Committee on Banking Supervision level. In terms of risk approach – there has already been the suggestion that we should introduce, probably in pillar II of Basel II, mechanisms saying that if you take too much additional risk, or you build in risk appetite that is extremely high, then you should take it into account. It may be a long shot, I don’t know, but there are certainly prudential concerns about this question. If you have prudential concerns, you need the Basel committee to develop world wide rules.
Risk: Will the next set of capital adequacy rules – Basel III – address the concerns about the procyclical nature of the Basel II rules?
EW: Basel III has been under way for some time. Procyclicality was discussed in 2002 and 2003 – the issue was very clearly on the table but nobody wanted to touch it at that time except the Spanish, who have anticyclical rules and have done that very wisely in my view. The European Council of Ministers decided a couple of weeks ago to have a working group on the procyclicality issue – obviously I don’t know what their findings will be but there will be initiatives in that area.
It is clear that Basel II rules and the current accounting rules are very procyclical. You see that the mark-to-market approach is driving down the banking system from one week to the next – it’s absolutely ridiculous what has been going on. Prices go down, the assets of the banks go down, they have to sell and so the prices go down more. It’s a self-destructive system – that’s why you have to cut the system here and there. On October 15, there was a little cut in the IAS 39 accounting rules for example.
If you look at the US rules, they are exactly the same as the rules we have in Europe now, after the change – in the US you could reclassify assets from one portfolio to the other. More than that, the Securities and Exchange Commission (SEC) has made it clear that you can use discounted cash flow to put assets in the banking book. So it’s not that the US has to adjust, we have adjusted to the US approach.
There is a lot of confusion about that – but it is clear that the US was more flexible than we were. They have not changed the rules, but the SEC has given an interpretation which I think is in fact a substantive change – allowing discounted cash flow as a way of establishing value in the banking book. It may have been in the rules before – but you can see interpretation as an effective change. The main thing is that we are now on the same lines.
Risk: Should regulators or central banks start acting to deal with future asset price bubbles before they grow large enough to cause serious damage?
EW: In the past, central banks have never been that interested in asset prices. I worked in the Belgian central bank for some time and this was considered of no importance. The evolution of the stock exchange too was outside the scope of the central bank. I think that has changed now. Central banks will have to refine their apparatus in terms of determining what the price evolution is in different sectors. For instance in real estate - in the UK it may be different, but in Belgium price evolution in real estate is still measured in a fuzzy way. It’s not very reliable, so we need to refine the mechanisms. Once they see that prices are moving up very rapidly in certain sectors they can at least have a look at that. I will not say they have to take action, that’s another question.
What we have seen in real estate is that this was mad – especially in the US – everyone was selling to other people for a little more, so they were in an upward spiral which ends up, of course, in catastrophe.
I don’t see the central banks role as preventing crises – first of all they would observe, see what the factors are, and then perhaps intervene. But it is not always easy to intervene. Look at commodity prices over the last year: if you wanted to do something about them I don’t know whether that would have been possible. In real estate you could intervene on the financing – so maybe in commodity derivatives you could do something, by requiring more margin, for example. But whether you can intervene by increasing interest rates – these are questions for further discussion. We’re not there yet.
Risk: Are you talking about central banks taking on the role of a general manager of the economy?
EW: Talking in terms of management is going a little far – it’s observation and adapting those to the general policies of the central bank. But the idea was floated by Gordon Brown that we have to have a worldwide supervisory system, and this is exactly the idea – we would have a system observing each relevant market. It is very striking that the entire subprime crisis was largely unknown in Europe – we knew there was a dramatic price increase, but the fine points, all the fraud and all the illegal techniques used in the market, were unknown, and somebody should have been following it up.
There are two lines of reasoning here. You could say it is part of the remit of the central banks – that their risk departments should be looking at macro development in other countries and determining risks there – but it may make more sense to do it at the International Monetary Fund (IMF) level. The IMF would have a lot of these instruments already to look into the developments and inform the world, if not take action, which would be going too far. That is more or less what the IMF is doing already – they have Article 4 inspections of banking systems every year.
I think you would have to clarify this aspect of macro surveillance in their remit – it would not be a very big change but it would be a healthy change. I don’t know if it is likely – I am not a politician - but it would be welcome.
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