Ebook Report on the Financial Crisis
The chain of events that led to the crisis has now been identified: the turmoil that erupted in summer 2007 followed a period of exceptional growth in the distribution of credit, financed through extensive use of leverage within the financial system. Banks following the “originate-to-distribute” model sold their loans on financial markets in a totally unregulated manner through structured investment vehicles (SIVs) and other off balance sheet vehicles. Short-term investors financed the SIVs, which held long-term claims of varying quality. After several years of benign macroeconomic conditions and plentiful market liquidity, investors became less and less cautious about the mounting risks associated with these increasingly complex new financial products, which were nevertheless receiving high ratings from credit rating agencies (CRAs), implying low risks to investors, financial firms and other users.
Rising defaults by subprime mortgage borrowers in the USA caused liquidity to dry up on these markets. This impacted interbank relations more broadly through a crisis of confidence, inflicting heavy losses on banks and ultimately triggering a global financial crisis. Central banks were and remain forced to make repeated injections of liquidity to restore confidence.
A key question facing the international financial community relates to liquidity movements. The paradox of the current crisis lies in the fact that liquidity is generally abundant, but it is no longer where it is needed. This financial crisis surprised all actors by its scale and rapid spread, which were largely due, technically, to the level of transformation induced by securitization vehicles and, more fundamentally, to the effects of globalization on extremely confidence-sensitive markets.
A number of lessons can be drawn from this analysis. For regulators and supervisors, it is important: to better understand liquidity movements; to restore confidence in the markets and in specific products that have become illiquid; to watch out for regulatory arbitrage; and to change incentives for large financial institutions with potential systemic risks. For market players, the crisis highlights: the need for greater vigilance towards complex financial products; and the need to better understand both individual risks and systemic risks.
Many of the problems highlighted by the crisis are due to the complexity and increasing opacity of financial instruments. Many actors and factors conspired to sustain this highly undesirable state of play. This was in particular true as regards banks and their management; investors were often not vigilant enough; CRAs have recognized a number of mistakes; and there was a lack of proper supervision.
The full extent of the crisis has yet to become apparent, amid increasing uncertainties about the situation of many financial institutions. It is therefore crucial for the latter, but also for all other players concerned by the crisis, to honestly disclose their exposures.
The volatility in commodity prices over the last year represents an added uncertainty with extremely negative effects for consumers in all of the world’s regions. It is now difficult to dissociate the two crises and we cannot rule out the possibility of a speculative bubble on this market. It is certain that the presence of non-professional investors can only complicate and possibly worsen the situation by creating excessive volatility on these markets. A discussion is needed on whether non-professionals should continue to be allowed to invest so extensively and in such a disconnected way from the fundamentals of physical markets.
It is now possible to identify the key ingredients in the environment that are at the roots of this crisis: excess liquidity, extensive deregulation in some areas, excessive return on equity in the financial sector relative to returns in the real economy and lack of risk management within the banks. This crisis is still developing and is very likely to last as banks might continue to suffer losses in the near future.
Contents
Part A – Origins and causes of the financial crisis
I. The chain of events that led to the 2007 crisis has been identified
II. A key question facing the international community relates to liquidity movements
III. The crisis exposed major problems, many of which were linked to the complexity and increasing opacity of financial instruments
IV. The full extent of the impact of the crisis has yet to become apparent, amid increasing uncertainties
Part B – Existing initiatives and proposals to address the financial crisis
I. A large number of public and private institutions have formulated proposals on this matter
II. An overview of the implementation of the main recommendations
- a) Banks’ capital requirements
b) Liquidity management
c) Oversight of banks’ risk management
d) Institutional investors’ processes for investing in structured products
e) Compensation policy in the financial industry
f) Operational infrastructure for over-the-counter (OTC) derivatives
g) Risk disclosures by market participants
h) Accounting and disclosure standards for off-balance sheet vehicles
i) Valuation of illiquid assets
j) Transparency in securitization processes and markets
k) Quality of the credit rating process
l) Differentiated credit ratings and expanded information on structured credit products
m) Credit rating agency assessment of underlying data quality
n) Use of ratings by investors and regulators
o) Improving information exchange and cooperation among authorities
p) Enhancing international bodies’ policy work
q) Central bank operations
r) Arrangements for dealing with weak banks
s) Cross-border cooperation in crisis management
t) Commodity price increases
Part C – Twelve key points concerning the financial crisis
I. Method for implementing the ECOFIN and G-7 recommendations
- a) Priorities and responsibilities must be clearly defined
b) A new instrument is needed
II. Improving transparency standards
III. Procyclicality caused by the combination of accounting and supervisory standards
- a) Prudential rules and accounting standards have to be considered together
b) Valuing assets in illiquid markets
c) Accounting standards and prudential rules must be tackled in tandem
IV. Financial institutions’ governance
V. The role of credit rating agencies
VI. Statutory audit and statutory auditors
VII. Compensation in the finance industry
VIII. Protecting retail investors and borrowers
IX. Market organization
- a) Increase in commodity prices
b) Supervising certain unregulated entities
c) OTC market functioning
d) Short selling
e) Europe-wide individual pension plans
X. Institutional architecture: questions linked to regulatory consistency and supervision of global markets
- a) Improving Europe's institutional architecture
b) Stronger transatlantic dialogue and more international cooperation
c) Establish an international structure along the lines of Interpol to investigate market abuse and financial fraud
XI. Questions relating to regulation versus surveillance
- a) Regulation versus surveillance
b) Strengthening warning systems
c) Crisis management plans
XII. Solvency II
Part D – Proposals for Europe
I. Strengthening Europe
- a) Reinforce the political leadership of ECOFIN
b) Fulfill the ambitions of the Lamfalussy process
c) State clear policy objectives
II. Europe acting as a global player
- a) Accelerate the decision making process on priority issues
b) Be better prepared to manage future crises globally
c) Progress towards convergence of standards at global level
d) Improve the global regulatory architecture
Appendices
- Appendix I - Assignment letter of the President
Appendix II - Composition of the working groups
Appendix III - Relevant Qualified Persons
Appendix IV - French Government correspondents
Appendix V - Hearings and interviews
Appendix VI - Detailed list of FSF proposals, measures to be taken under the ECOFIN roadmap and G-7 recommendations
Appendix VII - Conclusion of the 2882nd ECOFIN Council, July 8th 2008 (Press Release extracts)
Appendix VIII - Press release of the July 16th French Ministers Council meeting Appendix IX - Glossary
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