RBA Annual Conference – 2008 The Sub-prime Crisis: Causal Distortions and Regulatory Reform

Table 1: Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience
Underlying weaknesses Solutions
  1. Poor underwriting standards (high LVRs, verification income, etc) Due to risk transfer/weak oversight/the house price boom and low rates
  2. Poor risk management practices in firms: couldn't estimate ‘tail-risks’ for CDOs etc (default, concentration and liquidity risk). Due to lack of history on returns and correlations.
  3. Poor investor due diligence/excess reliance on CRAs
  4. Poor CRA performance
    Due to:
    1. inadequate models;
    2. lack of due diligence on collateral pools;
    3. insufficient transparency;
    4. insufficient education on meaning of a rating (credit only);
    5. conflict of interest (especially where consulting and rating businesses are mixed)
  5. Incentive distortions
    1. Originate-to-distribute → no ongoing information on quality/performance of assets
    2. Basel I encourages securitisation via off-balance sheet conduits with low capital charges
    3. Compensation schemes in financial firms that encourage excess risk taking
  6. Weaknesses in disclosure (unclear risks), especially off-balance sheet/inaccessible presentation
  7. Thin market feedback loop with sharp price falls → losses/capital falls/more selling. There is a major ‘price discovery’ issue with absent markets
  8. Weaknesses in regulatory frameworks pre-Basel II (unregulated exposures and liquidity risk)
  9. Originate-to-distribute model itself
    1. Leveraged off-balance sheet conduits with liquidity risk
    2. Bank still ‘connected’ via credit lines/reputational issues/counterparty credit exposure
    3. Conduit liquidity assumptions wrong
    4. Warehousing pipeline assumptions wrong (large ongoing demand did not eventuate)

Improve transparency and valuation on CDOs etc

  • Require reporting of exposures: total; before and after hedging and writedowns
  • Pillar 3 guidance on all this to be improved after consultation
  • IASB to lead a convergence push on accounting standards on all this
  • Focus on valuation at fair value in illiquid markets; strengthen models and procedures for marking to market on trading books
  • IAASB and national standard setters to enhance audit guidance
  • Regulators to look at scope for post-trade transparency (prices/volumes)

Change the role and use of credit ratings

  • Separate rating from other business and strengthen internal oversight and methods
  • IOSCO will strengthen codes on conflict and methods
  • Separate rating scale for structured products encouraged CRAs must insist on better data from underwriters/publish performance of ratings
  • Investors and regulators to be less reliant on CRAs (own assessments)

Move quickly to a (strengthened) Basel II where capital is required for:

  • Market risk on trading book (stop regulatory arbitrage with banking book)
  • Credit risk on banking book
  • Liquidity for off-balance sheet conduits (to be proposed in 2008)

and where supervisors will:

  • Update risk parameters and study Basel II cyclicality issues in 2008
  • Encourage insurance supervisors (especially monolines) to follow

Dealing with stress in the financial system

(FSF liquidity management guidelines to be released by July 2008)

  • Focus on risks/stress tests/intraday/cross-border

Improve supervisory oversight of risk management including off-balance sheet

  • BCBS Pillar 2 guidance in 2008–2009 to ensure capital ‘buffers’, including for: concentration risk (individuals/sectors/regions/economy); stress testing of capital cushions;
  • guidance on managing securitisation (including warehousing/trading/syndication);
  • issue guidance on exposure to leverage of counterparties; and
  • encourage company boards and investors to do better

Improve infrastructure for OTC derivatives

  • Standard documentation and cash settlement obligation
  • Automate trade to remove crisis spike backlogs
  • Dealer/investor standards for netting, reconciliation and valuation of trades

Responsiveness of authorities/international bodies to be strengthened

  • Improve responsiveness, techniques, coordination domestically; and
  • coordination across borders and currencies

For crisis management and dealing with weak banks (including deposit insurance)

Source: authors' summary of FSF (2008)