Review and Update on the Global Financial Crisis

Speech by Richard Collins, Managing Director, Qatar Financial Centre Regulatory Authority, to 29^th International Financial Conference

Amman, Jordan, 09 March 2009

Thank you, Mr Chairman for those words of introduction.   I am delighted to be here today to talk about the Global Financial Crisis, and I would like to thank the organizers very much for inviting me here to speak, I would like to thank the authorities here in Jordan for their welcome and hospitality and lastly I would like to thank the audience here – in advance – for being patient and listening to me!

Much has been written and spoken about the global financial crisis, and the real challenge is whether there is much new to say – apart from the fact that since I prepared this talk and now when I am delivering it there has probably been some further event which changes the dynamics! But in all the material I have seen, at least one thing comes through loud and clear – there is no monopoly of wisdom on the topic, and therefore although of course there is a major risk of people here saying to me today that I am completely and utterly wrong in my views I feel that the canvas of opinion on this topic is sufficiently broad to withstand this! Even in my own organization, with people from diverse backgrounds and experience, I am sure there is no unanimity of view, and I have here to give the clear disclaimer that the views I express here are my own and do not necessarily represent the views of the Qatar Financial Centre Regulatory Authority.

I wondered therefore what take I could put on the subject so that everybody is not going to say ‘Ah, we’ve heard all this before’. I’ve come up with a structure which will include some things that people have heard of before, plus some of my own – possibly provocative – views, with a couple of new twists.  Clearly, however, I need to go a bit further than simply to say ‘the oceans are deep, the sky is blue, the mountains are high, and there is a big crisis out there’ – and so what I thought might be of interest in terms of headings is the following:

• Where we are
• Main areas of agreement on root causes
• Areas of divergence of agreement on root causes
• A brief discourse on ‘Chaos Theory’
• Some solutions – in train and proposed
• What needs to be done
• A zero-based approach to regulation
• A ‘New Style of Regulation’ for the future

Stand by for the chaos theory – speaking as a former mathematician to me it is interesting and I think there is some relevance!

Main areas of agreement on root causes

Hopefully we should be able to rattle through the main areas of agreement – which everyone will no doubt be aware of.

In essence over the years macro imbalances of large current account surpluses have built up in some countries versus large current deficits in others. These in turn have meant that high levels of savings have built up in economies in surplus requiring a necessary return on investment – thus the financial services industry, whose role in summary is to provide the conduit between those who are providers of capital and those who are users of capital, has been chasing higher returns by seeking greater innovation in investment. One way that this has been done in developed countries is to have encouraged a rapid growth of credit extension – this has led to a degradation of credit standards and the fuelling of property booms.

Within the industry, there has been stimulation of demand of securitized credit instruments and an expansion in the scale and complexity of such instruments.

The authorities, however, failed to realize the exponential increase in total systemic risk arising from all of this and thus, when there was a trigger event such as the defaulting on sub-prime mortgages in the US, the whole pile of cards started to come tumbling down. People across the world suddenly woke up and started to have an aversion to risk and began to think rationally again that 2 + 2 does not equal anything more than 4.  The reaction sets in and the asset bubble bursts.

In summary this is no different from any other asset bubble – whether one talks about Tulipmania in Amsterdam in 1636, the South Sea Bubble in London in 1720, the Wall Street crash in New York in 1929, or the dotcom stock bubble of 2000.  However, the components are different, and everything is on a macro scale affecting everywhere – so in fact we could say we are witnessing ‘the Mother of all Asset Bubbles’!

Now, all that above is about what has been happening in the economies across the world. But in financial institutions too there have also been a few problems:

• Flawed business models which were inadequately stress tested
• Shortcomings in risk management philosophy, structure and people in institutions
• Sub-optimal incentivisation schemes
• Weak oversight of financial soundness within firms
• Lack of appreciation of real impact of off balance sheet exposures

What do I mean by the above? Well, there have been a number of business models, for example by banks relying upon borrowing in the marketplace rather than from depositors’ monies (for example, Northern Rock in the UK) where things have gone awry.   Nobody thought to stress test the models properly – or took a naïve approach that there couldn’t possibly be a problem in the marketplace.

As far as risk management is concerned, there have always been issues with risk management within institutions.  What is it there for?   Is it there to challenge, to sanction, or facilitate? I well recall the thoughts of Nassim Nicholas Taleb, who memorably likened them in his book ‘Fooled by Randomness’ to compasses – ie they gave you the direction that the organization was going in, but all the real executive decisions were made by the executive. And this is right, because risk appetite should be set by the Board, implemented by the executive, and subject to governance and oversight by the risk management function. But very few, in my experience, have the real power of sanction. This all needs to be reviewed – risk managers must accept some responsibility for not shouting loud enough with their concerns if they had them – or if they didn’t have them, were the structures and people adequate? Some re-thinking of the whole philosophy of risk management and what it is all about is overdue – and not by the vested interests of risk managers!

There has also been much said about the sub-optimal incentivisation schemes where Tomorrow’s Share Price is put ahead of long term value. Again, this has probably been a contributory factor. So too was a weak oversight of financial soundness and liquidity exposure within the firms, and a lack of appreciation of the real impact of off balance sheet exposures.

Areas of divergence on the root causes

Whilst there has been general agreement on the main root causes, there are few areas of disagreement that I have been able to find, save one. And that one is really all about who is primarily accountable and responsible for the mess we are currently in. Who is to blame?

• the industry?
• the regulators?
• the central banks?
• the governments?

Frankly, I think it is a very brave person who says any one of these does not bear some accountability and responsibility. It is the question of degree.

• Industry contributed through governance failures, complacency, flawed business models, trying to commingle and combine differing risk models in consumer banking with investment banking, and the culture within some institutions;
• Regulators contributed through inadequate supervision philosophy, models and practice
• Central banks contributed through lack of oversight of liquidity and systemic risk to nations’ economies
• Governments contributed through over-stimulation of economies, fuelling of asset bubbles, encouragement of unsustainable consumer debt

Where the real divergence comes is in differing views regarding the degree of culpability of each of the above. Industry may well have a tendency to blame regulators, central banks and governments – anybody but the industry, in fact – whereas all of the authorities, as well as pointing the finger at each other, may well have a tendency to blame the industry. And I should make it clear that in talking about industry, I for one include not just the financial services institutions themselves, but also the accountancy and auditing profession who are supposedly responsible for ‘information integrity’ in respect of financial statements and the like disseminated to the public.

All of these organizational groupings are currently having naval gazing sessions to consider where, if at all, they went wrong and what could be done better. In some cases sweeping changes are being made – as for example with President Obama in the US taking a clean broom to the Securities & Exchange Commission, the UK FSA reviewing all its modus operandi, various banking institutions now with major government shareholdings having to consider their own internal practices, and the workings of central banks being reviewed.

My own view, for what it is worth, is that by logic the primary responsibility for the crisis must lie with relevant governments. It is governments that have fuelled the culture of debt economies and have poured petrol on the flames of asset bubbles through their encouragement of credit expansion.  As examples, the ‘top three’ in respect of household debt as a percentage of GDP are UK 240%, US 180%, Australia 174%.  Truly staggering.  It is governments that have established the philosophy of regulation which has been responsible for overseeing the industry – in some cases missing the issues because there was no mandate, for example, to look at business models. And it is governments that have realized, far too late, that consumers with banking deposits are taxpayers, who are also voters, and that the concept of significant retail banks being allowed to fail has now become redundant – and if governments had realized this earlier then I have no doubt that a different regulatory philosophy would have been in place in many jurisdictions. In other words, governments are the underwriters of it all. More on this later.

But none of the others are blameless – and I think we would all agree that there are a number of cases in the industry where leaders of institutions have seriously failed to live up to the standards expected.  When you see what has happened to Lehman Brothers, Bear Stearns, AIG, Royal Bank of Scotland, Northern Rock, HBoS, to name but some – it beggars belief for any of those at the helm of these organizations to cast around for others to blame. But they try! Apparently it’s all the fault of the regulators for not spotting what was going on and not informing them – I heard someone from Lehman Brothers at a conference last year spout exactly this line and indeed recently in a BBC interview the chief executive of AIG thought so also.

There are actions that can and should be taken against those responsible for the greatest irresponsibilities.  In the English law, we have words such as ‘reckless’ and ‘negligent’, other legal and regulatory systems have similar avenues with which to pursue these individuals. And I think that it is good for the industry if this is done – because one driving principle that we should continue to push is that of individual accountability and responsibility in the industry today.  There is not enough of that sometimes – so many things are apparently ‘everyone’s fault’. Not so, I say.  Someone makes the ultimate decisions and takes the credit – but with this should go the responsibility of taking the flak also.

Chaos theory

I now want to digress for a bit and do a brief discourse on chaos theory – which I think may well have some relevance to this crisis.

Chaos theory is a branch of mathematics which takes us on from classical mathematical physics. Traditional mathematics can calculate the motion of a satellites and the planets, but not that of a snowflake in a blizzard. It can describe the growth of a soap bubble but not that of a tree.

Weather systems are the classic case of where what are known as deterministic systems – ie those we feel confident in predicting because they obey natural laws in a rigid way – do not apply. To predict the weather these days we have computers which calculate millions of variables based on the current conditions of wind, rain, cloud, temperature etc – but even so I am sure we have all witnessed times when frankly the forecast does not seem to convert into reality.

The reason is that, with the best will in the world, the current conditions can be measured only to an approximation. For example, the wind is never exactly measurable to the required degree of accuracy, and indeed the calculations will be rounded off by the computers. So what we think we might predict with our very reasonable and very understandable and indeed very close approximations is never exactly the case. Multiply this by the number of variables in the inputs for the forecasting and even an infinitesimal change in one variable can have extreme consequences on the output. Hence the so called ‘butterfly effect’ – ie the flapping of a single butterfly’s wing today produces a tiny change in the state of the atmosphere.  Over a period of time, what the atmosphere does diverges from what it would have done. So, in a month’s time, say, a tornado that would have devastated the Indonesian coast doesn’t happen.  Or maybe one that wasn’t going to happen, does.

Now, let us attempt a read across to financial services.  We could say that in the financial services world there too are many variables – despite the precision which everyone feels in respect of any financial transaction. For example, we have n institutions operating in the world, conducting x trillion transactions, totalling US$ y trillion, representing the output of z number of decisions made in respect of financial transactions – all of which are subject to a degree of uncertainty in their outcome. When one inputs the whole derivative marketplace into the equation also we have a whole new host of variables, plus whatever happens on the various stock exchanges. All in all we have a large number of variables, with, I suggest, a potential for a large span of outcome over time. What I mean by that is that although it would be nice to think that with all the transactions, we have neat, ordered outcomes which we (or governmental authorities, central banks and regulators) could all predict with a reasonable degree of certainty, in reality any small area of uncertainty with a number of these transactions can multiply up and compound into something quite large. And there is uncertainty – for example, is a loan going to be repaid? Will a convenant be breached?  A natural event can create a stock index dive.

My point is that there is a strong argument for saying that the financial system is governed more by chaos theory than by deterministic systems – notwithstanding whatever the authorities would like to believe. Yes, regulators, governments and industry can do their bit – but at the end of the day the outcome is a result of many variables beyond which any one oversight body can review or will ever be able to review. And, despite the framework in place, for any of the authorities to try and predict what was going to happen was akin to trying to predict the weather – with imperfect and incomplete information. So there is an argument for not blaming anyone for not forecasting what would happen – and I think we all agree that we have not seen the end of these events. The butterfly effect from the sub-prime borrower in the US who defaulted on his mortgage has yet to run its course. And, of course, if we had not been able to forecast the crisis how could it have been prevented or mitigated in advance?

Of course, continuing this analogy, there is a counter argument which says that storm clouds were visible, and that it is prudent to get out the umbrella, and that a forecaster could have told us that it was best to stay indoors, but by that time it may have been a bit too late….

On a serious note, however, I do think there is some merit in someone who has the academic expertise and the time to spare, to research a little into the application of chaos theory here. Because if such is indeed the case, and financial systems are indeed governed by it, then this should influence the thinking of what the optimum structure of governance by the authorities in the future should be.

Some solutions – in train and proposed

Moving on to the solutions, or rather at this stage what are being attempted as solutions. There is no certainty whether these are working or will work. But there is some certainty that they are likely to cost a lot of people, mainly taxpayers, a lot of money.

As far as the recapilisation of the banks are concerned, the favoured approach by the UK and US, I have some sympathy with the thoughts of the Reserve Bank of Australia. The UK, EU and US have all provided billions of taxpayers funds to recapitalize banks. However lessons learned from the Japanese banking crisis shows that unless there is a decision to remove the bad loans from the banks as a precondition for recapitalization you will simply prolong the crisis. If bad loans are not removed from the balance sheet the potential for further asset deterioration in a period of recessed activity will require more capital and/or result in greater deleveraging. It is this slippage that causes the crisis to be dragged out for a longer period of time. This is a potential risk for the recent decisions of the UK, US and EU who have bypassed this step.

There also seems to be groundswell of opinion that an overall systemic overseer, conducted in general by central banks, is needed. This seems to emanate from, er, central banks or former central bankers. The philosophy is that someone needs to see what is happening on an overarching basis – myself, I am not so convinced by reference to the chaos theory above. Also, nobody has yet presented any convincing evidence that central banks would have had complete information to allow them to make the relevant deductions from this. The jury is still out here. But I do think that central banks could sharpen up their act in being able to act more quickly in crises – and of course this must be with wholesome communications between governments (who may have to write the cheques) and regulators (who know what is happening in individual institutions).

More regulation in respect of management, governance, incentivisation – this too will take some time to come to fruition. Where also I think we are in danger here is coming to a view that the cure is ‘more’ – and my analogy here is that if one looks at the road traffic network (also requiring licensing, supervison and enforcement, the same components as in financial services!) we do indeed have the odd crash and multiple pile up. But when there is a crash, there is a tendency to rebuild the car, put on an extra set of bumpers, strengthen the materials – and then decide we can go faster so let’s accelerate in a better machine. And sure enough another crash comes – and the cycle repeats. What we really need is safer drivers. Translated into financial services speak, we need a new way of thinking in the industry, a change of culture in many institutions and that needs to be led from the top.

I do not think anyone would argue that regulators need to strengthen the prudential oversight of institutions and examine their business models rather more rigorously than in the past. Unified standards would certainly help here. Lastly, enhancing cross border communication between authorities is always possible and very desirable.

What needs to be done

As a blueprint for change, the following needs to be done:

• Governments must take more responsibility for establishing appropriate debt levels in their economy and should also consider the ‘social obligations’ of institutions
• Industry must look at its business models, governance and culture
• Central banks should be able to intervene more quickly where necessary
• Regulators should be smarter – the issue is not ‘more’ but ‘more effective’

I will talk about what I call the social obligations of institutions a little later. But what we are saying is that everybody has something to improve.

A zero based approach to regulation

Everyone here will know about zero based budgeting – ie starting by building up from the ground in terms of what is necessary. Let us apply this to regulation going forward – ie if we were all redesigning regulation how would we do it, what do we need?  Let’s throw out the sacred cows and start again.

Well, in order to start we need what I call some ’guiding principles’. These are some ‘givens’ setting the framework of what we are going to regulate. I suggest the following:

• The world economic order will have shifted once the current crisis has settled
• Financial services profitability may well not reach the levels of yesteryear in the future
• There will need to be a fundamental shift in the philosophy of regulation – eg consumers, aka taxpayers, aka voters, have a greater voice than before
• The concept of a significant retail bank being allowed to fail has become redundant
• Business models do actually matter

As regards the world economic order, I defy anyone to state with any degree of certainty what it will look like. It has a number of dependencies – such as politics – but I think everyone would agree that at the moment it is all up in the air and it is still very unclear where it will all settle. But it is unlikely to be as it was 12 months ago even. Many people may take a shot on the centre of gravity moving east from where it is as present, but there is not much else unanimity on this.

Financial services has commanded significant P/E ratios in the past – on the grounds that the resources required for this art (whether financial or human) are scarce and need to be rewarded properly. Wall Street and the City of London paid highly for the brightest and the best of talent – will this really be the case in the future? Is financial services so ‘special’? Or now that governments have realized just what a problem the industry can create if left too much to its own devices, will there be some interference on costs of human capital – ie ‘wage control’, and the incentivisation payments and rewards will no longer be there.  Equally if we might be going back to good old boring banking do we justify such high returns? I think it quite likely that profitability of the industry may well not reach the levels of yesteryear.

Third, there needs to be a fundamental shift in the philosophy of regulation. What is it there for? Systemic stability and open clean markets used to be the watchwords, and consumer protection was usually mentioned somewhere.  Now, governments have realized that consumers, also known as taxpayers, also known as voters, are not going to take kindly to being disappointed by being told their bank has gone bust. So the concept of a significant retail bank being allowed to fail has become redundant. And this is critically important, because the debate where I originally came from many years ago was whether the banks are utilities just like power and water and the like – and should be regulated as such – or were different.  The industry cried ‘rubbish’ to this proposal – on the grounds that banks were allowed to fail whereas one of the pillars of utility regulation is that the utility cannot fail.  But with this ‘privilege’ go ‘obligations’ – more on these later. So there has been a real shift here.

Lastly, we have said before that business models do matter – and need to be assessed to determine their viability from a safety and soundness perspective.  It is not clear whether all regulators look closely at these.

A ‘New Style of Regulation’ for the future

With the above ‘guiding principles’, there will be a real shift in the focus of regulation needed. Here I offer some ideas, and I am sure that we will have a good discussion about these and others later.

• A more active role in setting and understanding macro economic policy of the relevant government
• The balance of prudential regulation vs conduct of business regulation
• In conjunction with government, in some jurisdictions the introduction of a new pillar of ‘Public interest regulation’
• Reviewing their locus in competition policy areas
• Tightening international co-ordination between regulators
• Smarter supervision, including seeking real time information in key areas
• Developing Key Performance Indicators for their business

First, regulators will need to have a more active role in understanding the macro economic policy of governments in order to their job effectively in alignment with such. And there is no point in trying to implement a regulatory philosophy over an industry aligned with such if the policy doesn’t work within institutions – hence the regulator actually needs to be involved in setting the macro economic policy so that the result is achievable.

Second, development through the ages leave regulation standing on the two pillars of prudential regulation – for ‘safety and soundness’ issues – and, very late in the development, ‘conduct of business’ regulation – for consumer protection. Now, the balance of resource and effort applied to each depends upon the risks involved. This will have to be revisited by each and every regulator.

Third, in respect of both the competition issues arising as a result of the reduction in the number of banks across each country consumers need a blueprint for regulation that helps them in the new order right now. They are entitled to a regime which not only sets policies on matters such as product availability, debt collection and other what might be called ‘social obligations’.

So I submit that what is needed is a third pillar of regulation – perhaps called ‘Public Interest Regulation’, Like all regulatory frameworks, a structure will need to be put in place to design the rules, supervise compliance with them, and enforce them. This should also be part of a financial regulator’s remit – to keep the one-stop regulatory oversight principle; and the regulator can agree with government on what needs to be included here.  There is an analogy to this in the ‘price control’ of utility regulation – but for the financial sector it is rather different and wider, and the regulator will need to develop the necessary skills. Whether or not ‘wage control’ should be included here I am not sure, but I suspect that some jurisdictions will do so.

Fourthly, in conjunction with this, the consolidation of the banking industry in many countries mean that the competition rules are likely to be going to need to be rewritten. A regime is needed which prevents abuses of any dominant market position through product pricing controls.  For example, one banking group in the UK has an estimated 33% personal current account market share, and a 29% market share of mortgages in a consumer market of instinctive inertia, viz the effort of changing and the associated paperwork makes this often a route of last resort. Who is it who is going to credibly ensure that this group will not use its dominant position to the detriment of consumers?

This could be aligned to the ‘public interest pillar’ above.

Lastly, I have spoken earlier about the need for tightening international co-ordination between regulators, but also we need smarter supervision in some areas. This can include different styles of supervision, perhaps even accessing real time information within institutions. After all, risk managers within banks have such access – why perhaps should banking supervisors not seek this and consolidate it to see across the board?

With that, ladies and gentlemen, I am going to conclude. Some of what I have said may hopefully have been interesting, some may be known to you already, some may be scary, but nevertheless I wanted to be a bit provocative. But one thing I think we all know – the world has changed and is changing in terms of the interaction of the industry, the regulators and the governments, and it will be a very different one that you assess at your 30^th meeting next year.

I wish you all success in the year ahead. Thank you for listening.