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

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)