The Credit Crunch: Implications and Changes Required    
Industry News

Source: bba.org.uk


As the credit crunch continues to wash through, the most obvious casualty to date in the UK is the Northern Rock. This paper analyses a number of the issues that surrounds that case and looks at reviews required and solutions both in a global and local basis.

The BBA believes that however uncomfortable it may be, it is necessary to deal with the issues as they are and answer the question that is being asked by the international community about the handling of the Northern Rock - "did it really have to be done like this?"

It is well recognised that a number of factors combine together to bring about both the liquidity problem that the Rock experienced and also the subsequent customer panic. The BBA believes that the most appropriate way forward is for a clear examination of the points raised in this paper, an open and considered review and sensible changes made where it is appropriate so do to.

The BBA has been examining the implications for the banking industry, from a regulatory and structural point of view, and proposes that the following steps are taken.

At the Global Level

Reviewing institutions' liquidity, market and credit risk practices:

This would particularly cover their risk management and treatment of complex credit products and their exposure to off-balance sheet vehicles such as conduits and SIVs. We believe that this should be closely aligned to the Pillar 2 framework under Basel II, and particularly the ICAAP and SREP, which is in the process of being introduced, and already provides a basis on which to develop this assessment.

Although the ICAAP is an institution's specific tool, in order to broaden its usefulness to regulators and the system as a whole, it will require significant investment in terms of both training and experience for regulators to make this tool truly effective. This is particularly true in relation to the ICAAP for liquidity, and we also make a specific suggestion below in relation to the supervision of institutions' liquidity.

Reviewing accounting and valuation practices for financial derivative instruments, particularly complex, narrowly traded products which become difficult to price in times of stress. There needs to be a review of how these instruments are valued, what market benchmarks can be used, and how value impairment is accounted for.

A further feature is that conventional stress testing techniques, for instance "normal" confidence intervals may not capture the full amount of exposure in abnormal markets, and institutions and regulators should examine what further re-assurance particularly in relation to risk management practices and value impairment accounting - is needed in this respect.

Reviewing basic oversight principles for regulated financial entities:

This would especially cover off-balance sheet items, including contingent claims. We suggest here that this issue should again be closely linked to the existing Basel II framework. A particular concern is whether regulators have concentrated, in recent years, on capital adequacy at the expense of liquidity risk management.

Institutions manage liquidity on a centralised and global basis, but often regulatory requirements are determined at a local or national level. We therefore call on trans-national regulatory agencies such as the Basel Committee and the Committee of European Banking Supervisors (CEBS) to complete work on ensuring that institutions can take advantage of their existing centralised liquidity management practices, including modelling techniques.

It is particularly important that any developing framework should be well thought out, should not be fragmented into local approaches, and does not penalise institutions through additional regulatory requirements. We particularly commend in this context, the liquidity risk management principles developed by the International Institute of Finance (IIF).

Reviewing the role of Credit Rating Agencies ("CRAs") in the valuation of structured credit products:

CRAs play an important role in the global financial system, with ratings providing a proxy for the assessment of risk in the underlying counterparty.

In general terms, this system works well for instance in a Pillar 1 of Basel II capacity, or acting as a haircut for the acceptance of collateral in a central bank's monetary operations. That said, we welcome the Financial Stability Forums examination of this issue, and support the work of IOSCO and others in bringing greater transparency and disclosure to the main features of these products. This can only assist institutions and investors in their assessment of the risk characteristics of such products.

It should be borne in mind that CRAs issue opinions based on the probability of default and delinquency. They should be judged on this basis rather than on price or liquidity of such instruments. An in depth study of ratings transitions over time and through this crunch period should be carried out before any additional measures or regulation is considered. By definition ratings that are lower down the scale are both more likely to be delinquent / default but also by their nature more unpredictable and therefore likely to be upgraded or downgraded.

The BBA has been involved in the consultation process carried out by IOSCO and the Committee of European Securities Regulators ("CESR"), and the European Commission.

We would expect that, in the current review of CRAs being carried out by CESR, they will not heavily focus on the initial rating of a structured finance instrument but rather investigate the issues around the surveillance and monitoring that go into maintaining that rating. We believe that questions could be asked about:

  • the seniority of staff which 'maintain' a rating;
  • the extent to which CRAs receive all the information they should from trustees on a transaction and who rely on a much more qualitative, as opposed to quantitative, review of that information;
  • similarly issues of staff turnover, and the numbers of deals that staff are required to review on an ongoing basis in what has been a rapidly expanding market; and
  • finally, we would put forward that CESR / IOSCO should consider the drivers within rating agencies given the revenue attributable to new ratings as opposed to the surveillance and monitoring of old ratings.

Re-examining whether EU and Global crisis assessment and management arrangements are adequate:

Recent events have been different in that problems in the US sub-prime market and resulting liquidity constraints have been transmitted globally. It will be important to understand the transmission mechanisms by which this contagion is spread and why some markets appear to have been affected in a more serious manner than others.

We note the conclusions of the September Informal Ecofin Council that the financial authorities in the EU will be reviewing their Memorandum of Understanding to encompass the assessment of financial stability, and welcome this.

In relation to EU supervisory arrangements, in general, we believe these are fit for purpose and should be developed along the lines of the Lamfalussy four level system. (See BBA paper "Giving Europe a Regulatory Advantage" - see link below).

During this period of turbulence the financial system infrastructure, notably the payment and settlement systems, has been resilient, proving more than capable of dealing with the increased volatility and the markedly higher transaction volumes, whether traded, cleared or settled. We believe that there are no particular recommendations to make in this sphere, save to continue the work that is being undertaken to develop an efficient and risk neutral system for settling non-exchange traded funds and investment products.

In the United Kingdom

We expect the UK authorities, with their global counterparts, to fully play their part in examining and, where necessary, re-shaping regulatory and other requirements, and that their effect on the UK system of regulation is mitigated. That said, there do appear to be specific lessons for the UK which, in the light of the problems affecting Northern Rock during the course of 2007, need to be addressed:

Re-examining the regulatory framework for institutions' liquidity risk management:

As noted above, we recommend that the FSA plays its part in the shaping of centralised and global liquidity risk management requirements for institutions. As part of this process the FSA will need to ensure that the best features of the existing Sterling Liquidity Stock requirement are retained.

Re-visiting some features of the Sterling Money Market framework:

The new system, introduced this year, has generally worked well and, through the maintenance of remunerated reserve accounts, has expanded the range of counterparties with which the Bank of England deals. The system has been generally successful, until the onset on money market turbulence, in narrowing the borrowing spread on overnight money, and thereby reducing volatility.

More recently, during the credit crunch, Sterling money market rates, as measured by BBA Libor have been driven upwards. There has been a noticeable differential with euro and US Dollar rates as also quoted on BBA Libor. While some of these problems can be put at the door of institutions safeguarding their liquidity and being reluctant to lend to their usual counterparties at any price, we believe that there may be technical impediments to ensuring that the Sterling market operates in a less stressed manner during periods of turbulence.

We therefore call on the Bank of England to re-examine the key features of the present system, in three particular respects. First, we believe the Bank should review whether the standing facility (and the deposit) rate is set at an appropriate level. In the consultation phase for the Sterling Money Market Reform, the BBA argued that a much narrower corridor, 25 or 50 basis points around base rate, should have been established and we believe this should be revisited.

Second, we suggest that the Bank should review its philosophy on collateral, in launching a consultation on extending the list of eligible collateral which can be placed with it. We believe that a range of additional instruments such as sterling certificates of deposit (CDs) and commercial paper CP should be accepted in the weekly and monthly money market operations, and that the Bank should also review the range of collateral, including non-Sterling, it is prepared to accept during stressed conditions, both as to type of instrument (e.g. mortgage backed securities).

We in particular welcome the Bank's statement on 19 September that it was prepared to accept another range of collateral during stressed conditions. We in particular welcome the Bank's statement on 19 September that it was prepared to accept up to 10bn of wider collateral against three-month funds. These arrangements should be made permanent. We consider that, had the Bank acted in this vein at the beginning of September, then many of the problems affecting the money markets in general and Northern Rock in particular might have been mitigated.

We also refer to our comments about institutions managing liquidity on a centralised and global basis. Ensuring greater consistency between the range of collateral that can be deposited with the three major central banks, the Bank of England, the ECB, and the US Federal Reserve is also desirable from this perspective. Greater collateral inter-changeability could well assist in the maintenance of liquidity pools and in smoothing the financial transmission mechanism.

Third, we need to clarify the nature of any disclosure requirements applying to either the Bank or the affected issuer bearing in mind that in this case disclosure had a clear and significant adverse effect on consumer confidence at a time when all of the regulators were insisting that Northern Rock was solvent and depositors' money safe.

Evaluating the implications of the credit crunch on the move to Principles-based regulation:

The BBA supports this initiative from the FSA, notably through our MiFID Connect project. There is no reason why this move from rigid hard-coded rules and regulations and detailed guidance in the FSA Handbook should be discontinued. But there may well be areas that, in the light of recent events, do require firm, explicit and continued regulatory advice.

Safeguarding the interests of depositors and the financial system:

There are three aspects to our recommendations, which are broadly intertwined:

  • Reviewing deposit protection arrangements: we share HMT and FSA's view that this needs to be reviewed. Considerable numbers of depositors and savers in Northern Rock clearly did not trust the authorities reassurances about the solvency of Northern Rock and hence the safety of their savings.

    A further feature peculiar to the Northern Rock is that many individuals had considerable sums deposited in the Northern Rock, a factor in deciding to withdraw their funds was the relatively low of maximum compensation. We suggest therefore that these aspects should be examined, and whether a simpler and faster system can be introduced.

    We are aware that the FSA is reviewing the funding arrangements for the Financial Services Compensation Scheme (FSCS) and would make the point that we regard post-event funding as proportionate and believe that the scheme should continue on this basis. We note also that, at the EU level, the results of a recent EU consultation was that member states generally believed that the pan-EU arrangements worked well.

    When initial assurances about the solvency of the Northern Rock and the significance of the Bank of England backing proved not to be resilient, the Government issued a statement guaranteeing all of Northern Rock's deposits. While successful in reducing the level of panic among depositors, this has also led to further confusion about what was being guaranteed (which deposits, and for how long, and whether the rest of the financial system was covered). The effect of such a move is also unclear, for instance whether this effectively "nationalised" Northern Rock. Again, we suggest that greater clarity about these issues is needed.

  • Clarifying the Operation of Bank of England facilities to the banks. We believe that some confusion existed in the public's mind about the use of these. What Northern Rock appeared to access were the Bank of England's Standing Facilities, at a so-called 1% "penalty" rate above the Bank Rate. Had the authorities been clearer about what giving access to this facility to the Northern Rock was meant to achieve this confusion might have been avoided.

    We consider that clarifying the operation of normal money market operations, the standing facility, and the lender of last resort role is required. We recommend that the authorities examine whether the current arrangements are fit for purpose. They should begin by clarifying publicly, in a paper or a speech, what range of assistance is available to institutions and how this differs from day-to-day monetary operations.

    A particular aspect is the need for clear and precise terminology, and an explanation of the various lending rates and maturities. In addition, the authorities should review how assistance is made and how this is communicated to the market, if at all (see also below).

    A further aspect is confidentiality. According to the Governor, the Bank was obliged to disclose its support operation, because of the obligations in relation to the Market Abuse Directive ("MAD") and other EU legislation. The European Commission has refuted the Bank's legal interpretation in relation to the MAD, so this aspect clearly needs to be reviewed.

    In the past, the Banks support operations for the banking sector, notably during the "Lifeboat" operation in the 1970s have been kept confidential, and we suggest that this should be possible again. Such confusion over whether or not to disclose support operations would not have occurred in other EU Member States.

  • Reviewing the Tripartite Memorandum of Understanding Arrangements: From a technical point of view, we would wish to understand how these - and particularly the Standing Committee's role - have worked, and notably the decision in arriving at the funding support for the Northern Rock and the timing for that decision.

    It is, however, without doubt that the authorities could have better managed the communications aspects of offering re-assurance to the markets. We notably mention the Bank of England and FSA's refusal to comment until some days later. We suspect that the Authorities were caught by the speed of events and believe that greater efforts should have been made at the time of the leak and immediately after to make key personnel - in addition the Chancellor available to explain to the media and the public why the facility from the Bank of England was necessary, and its implications

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