The European Commission on 27 February 2008 adopted communications on sovereign wealth funds and on adapting European and global financial systems to better promote financial stability. These communications are the Commission contribution to EU leaders’ discussions on these subjects at the Spring European Council on March 13-14. On financial stability, the Commission wants the European Council to confirm the principles which will guide the EUs efforts to improve financial market transparency and reinforce prudential control and risk management, and to set out the broad lines of the action to be taken.
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In summer 2007, financial markets experienced a sudden and turbulent re-assessment of risk by investors, as the default rate on US mortgage loans increased significantly. The rising risk aversion spread to other financial market segments as well, often through collateralised debt obligations (CDOs, see below), which are frequently based on those high-risk mortgages which experienced serious downgrades. CDOs have been bought in large quantities by financial institutions throughout the world in recent years.
The resulting large losses, and the uncertainty as to who holds the risk, affected inter-bank lending in a negative way, which forced the central banks to pump large quantities of liquidity to the banking sector. The problems have spread to other segments of the financial system, such as commercial real estate securities, bond insurers and highly leveraged private equity loans, which banks continue holding, given the lack of outside investor interest for buying them.
The origins of the current turbulence have been excessive risk taking derived from low interest rates and the pursuit of yield. A specific consequence of these unusual favourable financing conditions has been an increase in borrowing for residential housing and a consequent boom in housing markets in many parts of the world. Demand for housing in the US was further fuelled by a generalised relaxation of acceptance criteria for lending, the development of “teaser” loans with relatively low initial reimbursement charges, and by rapidly accelerating financial innovations that have made mortgage financing more accessible. In particular, the creation of a secondary market for mortgage loans in the United States has made access to mortgage financing possible for borrowers who were not previously deemed creditworthy, either due to a lack of credit history or previous loan defaults (see question below “what is the sub-prime mortgage sector”). This was because banks and brokers could sell their risky housing loans to outside investors, who were often more than willing to buy those loans with a higher interest rate attached in the prevailing low interest rate environment.
An important downside to this development was the potential for widespread defaults and foreclosures among these marginal borrowers in the event of deteriorating broader economic and/or financial conditions which occurred during 2006/2007 as the US housing prices weakened and interest rates rose.
The impact of the market turbulence is ongoing and the duration remains uncertain as banks may record more losses and write-downs. As a result of this crisis, risk aversion has risen. On the positive side, due to the intervention of central banks, banks have recently become more relaxed in lending to each other. However, a number of indicators are continuing to weaken and increasingly new segments of the financial sector are experiencing unusual turbulence, e.g. caused by worries related to monoline insurers (see below).
The current financial turmoil started in the US. To bring in more home buyers, lenders in the USA began offering mortgages with less scrutiny of the borrower’s qualifications and inquiry into the borrower’s repayment ability than had been customary in the past. In both 2005 and 2006, lending to this so-called ‘sub-prime’ segment of the market for residential mortgages represented about 20% of all new US mortgage loans. These sub-prime mortgages provide housing loans to high-risk borrowers with weak credit or a bad credit history that do not qualify for conventional mortgages. Some sub-prime loans were secured by the ability of borrowers to roll-over their debts backed on the value of their houses rather than being based on their ability to repay them. The sub-prime mortgage contracts had low starting interest rates that would rise over time. After the initial interest rates were reset to much higher interest rates reflecting normal market rates, a significant number of sub-prime borrowers were unable to continue payments. With falling house prices many subprime borrowers could not sell or refinance their mortgage as they owed more than their house was worth: delinquency and foreclosure followed. Sub-prime mortgages are generally only sold in the US and are relatively uncommon in the EU.
The original lenders of sub-prime loans bundled the mortgage loans together and sold them to investors as mortgage backed securities in essence these investors bought securities that would entitle them to a return from these mortgages in return for taking on all or part of the risk. These securities were rated by credit rating agencies and then sold to other financial institutions and investors. The process of packaging and pooling assets like mortgage loans, and selling them to investors as securities is referred to as ‘securitisation’. Banks transferred most of these mortgage assets to off-balance sheet entities (so-called structured investment vehicles or SIVs), which financed themselves via short-term loans. This made them vulnerable to a sudden financing disruption if those providing the loans were to lose confidence, which is exactly what happened in August last year.
Monoline insurers are specialised insurance companies providing insurance guarantees, backed by their own high (‘AAA’) rating, to boost the ratings of various kinds of bonds. This makes those bonds more attractive to investors. Monolines’ traditional area of business was the issuance of the US municipal bonds; more recently monolines have also guaranteed sub-prime mortgage backed securities and other complex securities. Several monoline insurers have faced difficulties as a result of the fact that they both invested in and provided guarantees for mortgage backed securities including subprime mortgages. The financial health of these financial guarantors is being questioned. Their ratings are under severe pressure and some of them have already been downgraded. Many monoline insurers have been seeking additional capital and there is increasing talk of a split of their business into a “low-risk” and a “high-risk” part – the latter covering structured finance products such as CDOs. However, in recent days there has been more optimism as the outlook for some of the largest monolines seems to have improved somewhat.
CDOs represent a portfolio of different debt receivables. Sub-prime loans were bundled together with other securities e.g. based on prime mortgage loans or loans raised by companies to create CDOs. These CDOs are typically subdivided into different risk categories, ranging from very high (junk) to very low risk (AAA). Each tranche is assessed by a credit rating agency and sold on this basis to investors, including hedge funds, pension funds, insurance companies and banks. In this way, the credit risk associated with US sub-prime mortgage loans was distributed around the global financial system.
In principle, both securitisation and CDOs are attractive instruments for financial institutions as well as investors. Securitisation allows an institution to sell its existing loan portfolio for raising additional funds, which can then be used for additional lending activity. This technique is also a means to reduce the credit, interest-rate rate and market risk taken by the bank by transferring a part or all of such risks to other willing investors. CDOs typically offer a trade-off between risk and return and can be tailored to specified requirements. For these reasons, demand for CDOs has been high in recent years and the market for these instruments has expanded rapidly. On the other hand, the complexity and lack of standardisation in CDOs can make them opaque, relatively illiquid and difficult to value, in particular in times of market stress. The functioning of the CDO market was not widely understood and had not been tested in conditions of generalised stress before the end of July last year.
The turmoil, which originated in the US, has hit Europe through three different channels:
- Some EU financial institutions faced losses because they were exposed to the US sub-prime market. Some EU banks invested directly in mortgage backed securities or CDO’s backed by US sub-prime mortgages, or had contracts requiring them to support the liquidity of Structured Investment Vehicles (see above) that were trying to sell financial products backed by US sub-prime securities. Other EU banks have suffered because banks have been unwilling to lend to each other because of a general lack of confidence as to which banks were exposed to the US sub-prime market ;
- The US sub-prime problems have considerably slowed down US growth prospects. Given global trade inter-linkages this affects the EU economic growth as well; and
- The general market uncertainty has disturbed the functioning of many financial markets also in Europe, including the interbank liquidity market. Equity and certain debt securities’ market prices have been eroded. This has affected consumer confidence.
An update of the autumn forecast of the Commission, which takes into account the changes in the economic environment, was presented on 21 February (the so-called “interim” forecast). It notes that Europe clearly begins to feel the impact of the global headwinds in terms of lower growth and higher inflation. However, Europe’s increased resilience, thanks to the reforms already carried out under the Lisbon Growth and Jobs Strategy, together with sound fundamentals, are helping to weather the storm.
Economic growth is expected to slow to 2.0% this year in the European Union (1.8% in the euro area) as some of the downside risks identified in the autumn forecasting exercise the ongoing financial turmoil, a sharp slowdown in the US, and high commodity prices have materialised. This is 0.4 percentage point less, for both areas, than forecast in November.
While it is very likely that the EU economy will be affected by the slowdown, several factors support the argument of the relative resilience of the EU economy:
Swings in the US business cycle are larger in general, partly reflecting the smaller automatic stabilisers than in the EU. As progress has been made in consolidating public finances in many EU Member States in recent years, most Member States should be able to allow their stabilisers to operate fully.
European labour market conditions are still improving, while they have started to deteriorate in the US.
While balance sheets have improved on both sides of the Atlantic since the start of this decade, the level of the respective households’ savings ratios indicates a more favourable situation in Europe.
The impact of a correction of house prices may be larger in the US. This follows from the fact that US consumers tend to react more to variations of their total wealth and not all EU economies have been exposed to rapid house price inflation in recent years.
Soaring oil and commodity prices will take their toll, but probably more so in the US. Somewhat higher energy efficiency in Europe compared to the US suggests that the overall impact is smaller for the EU. The strengthening of the euro in the recent past helps also to cushion the impact on the euro-area economy. Moreover, the EU has a larger export share to oil-exporting countries than the US, benefitting more from the recycling of petro-dollars. A final important difference with the US is that taxes levied on fuel products in the EU are predominantly excise duties. These are calculated on volume, rather than value, acting as a buffer between prices for crude oil and prices for oil product prices.
The origin of the current financial turmoil came from the US sub-prime mortgage sector and a large portion of the European financial sector is not directly affected by the turmoil at this stage. Where financial institutions have sizeable direct exposures to the US sub-prime market, or indirect exposures through structured products, the affected entities have well diversified portfolios and large capital buffers.
The EU has established a robust regulatory and supervisory framework. Over recent years the regulatory and supervisory framework has been greatly reinforced, thereby strengthening the resilience of EU financial institutions and markets.
The European economy, including the financial sector, was in a strong position when the sub-prime crisis occurred. Household and enterprise balance sheets had improved markedly and external balances are sound. This makes the European economy relatively resilient.
The ECB and other central banks were prompt in providing liquidity to the wholesale market very early on in the turmoil. This quick intervention implied that most banks were not exposed to prolonged periods of tight liquidity, despite the liquidity drain in the financial market.
Problems in the credit markets have had serious implications for the global banking system. Many of the most important international banks are exposed to credit risk from collateralised debt obligations (CDOs). As problems in CDO markets have intensified, these banks have incurred significant financial losses through write-downs of their asset valuations. About USD 163 billion (about 108 billion) in losses have been reported by 20 major global banks for 2007 and further losses are expected when the majority of European banks publish financial reports in the coming weeks. While some of the major banks have managed to recapitalise, often by attracting investments from sovereign wealth funds, they remain vulnerable, e.g. to further deteriorations in the CDO markets and existing commitments to finance highly leveraged private-equity deals. Bank profitability is also likely to suffer from the financial turmoil, as the outlook for non-interest income deteriorates and loan-loss provisions are set to rise from historical lows.
When the Financial Services Action Plan (FSAP) was adopted back in 1999 the guiding principle was to create an integrated, Europe-wide, single market in financial services underpinned by a strong regulatory and supervisory framework. The FSAP has delivered state-of-the-art prudential rules and supervision that have the flexibility to evolve with changes to the regulatory environment and changes in industry risk management practices. As a result, the current EU regulatory and supervisory framework is in a much better position to deal with potential market disruptions than was the case before the introduction of the FSAP. However, ongoing competition, consolidation, integration and innovation have intensified the challenges with which we are faced. We therefore constantly need to reflect on how the regulatory and supervisory framework should react to the requirements of the present. In this respect, the White Paper on Financial Services Policy 2005-2010 already indicated that obligations to cooperate and exchange information between supervisors have to be reinforced, and cooperation in crisis situations has to be secured.
The turmoil began in the US market, so EU legislation per se could not have prevented it from happening. The firms selling sub-prime mortgages to high risk borrowers were not banks, but unregulated mortgage companies; the low quality of the mortgages and degree of risk accumulating in the financial sector only became clear with a time delay. It should also be acknowledged that although financial innovation has allowed risk to be spread more in the markets, there has been a lack of transparency in some financial markets. On the one hand, some regulators and supervisors struggled with identifying and understanding market developments in a timely manner, on the other many firms did not exercise significant due diligence in understanding the riskiness of their investments and exposure to structured credit markets. In response the industry has committed itself to strengthen transparency of securitisation markets. In addition, supervisory authorities must have the capacity to fully understand market developments, to assess whether the management of risks by banks is appropriate and to enforce corrective action respectively.
In October 2007, and in close cooperation with the Commission, EU Finance ministers unanimously agreed with a set of conclusions to respond to the main weaknesses identified in the financial system. These initiatives, which are consistent with, but not duplicating the agenda set at global level, are grouped into the so-called “ECOFIN roadmap”. It combines actions of a regulatory and non-regulatory nature which are structured around four main objectives:
- improving transparency in the market, notably with respect to banks’ exposures relating to securitisation and off-balance sheet items;
- upgrading valuation standards to respond in particular to the problems arising from the valuation of illiquid assets;
- strengthening the prudential framework for the banking sector, including the treatment of large exposures, banks’ capital requirements for securitisation, and liquidity risk management, and
- investigating structural market issues, such as the role played by credit rating agencies and the “originate and distribute” model.
- Many of the proposed initiatives are based on the work that the Commission was already working on before the turbulence, but the range of issues being focussed on now is broader.
Overall, work is progressing in a satisfactory way and implementation of the roadmap is on time. In the very short term, prompt and full disclosure of losses and exposures to distressed assets and off-balance sheet vehicles is essential to bring confidence back in the markets. The Commissions’ objective is to ensure that current accounting provisions are consistently applied to 2007 financial statements. In this regard, the role of the external auditors remains to be overseen properly under the new Statutory Audit Directive. Moreover, the Commission has worked intensively with industry groups to identify self-regulatory proposals to obtain comprehensive data on securitisation markets. On 8 February, 8 European industry associations published a joint position paper committing themselves to improve transparency for investors, markets and regulators and produce results by June. The commitments are related to comprehensive disclosure of securitisation exposure, frequent publication of data on the overall activity in the markets for securitisation and providing investors with comprehensive and standardised information about individual securitised products. These commitments will be strictly monitored by the Commission to ensure delivery by mid-year. In addition, in September amendments to the 4th and 7th Company Law Directives came into force requiring that for all listed companies all material arrangement with off balance sheet vehicles might be disclosed in the accounts.
On the prudential side, the Commission is rapidly working towards further enhancements to the Capital Requirements Directive (CRD) and will come forward with a proposal no later than in October this year. The Commission has been working on enhancements to the Directive for some time now, but this work has increased in importance in the light of the recent turmoil. In the area of credit rating agencies, the Commission has mandated the Committee of European Securities Regulators (CESR) and European Securities Markets Expert Group (ESME) to advice on the role and the practices of the credit ratings agencies in the context of the financial markets turmoil (reports expected April-May 2008). On the basis of these reports, as well as with regard to the collective and individual initiatives currently under preparation by the agencies to remedy the situation, the Commission will decide how to tackle adequately the identified problems.
Banking regulators in the EU and at G-10 level are currently drawing conclusions from the market turbulence. As Basel II framework for capital requirements was not in force last year, they are particularly keen to understand to what extent Basel II would have impacted on banks’ behaviour if the new rules had already applied. To date a number of issues have arisen that may require further attention. These involve clarifying the current rules for concentration risk, and the requirements for banks’ securitization operations that still remain on their balance sheets (so-called ‘warehousing’ and ‘pipeline’ risk). In addition, bank regulators are considering whether, in the light of recent experience, some of the detailed capital requirements for banks securitization operations are accurate reflections of the risk those banks are assumed to be exposed to. Finally, the need for greater cooperation between all of the authorities involved in periods of distress has been seen as an area for further work. The ECOFIN Roadmap of October 2007 identified these areas as requiring improvement in banking regulation. The Commission is currently preparing possible technical proposals to improve the current rules, and intends to come forward with formal proposals by October 2008 at the latest.
The fraud at Société Générale is not directly related to the current financial turmoil. It is for the French authorities to deal with. What seems to have happened is that a trader overstepped his responsibilities and internal controls with Sociéte Générale did not lead to action to remedy this. It will however always be very difficult to completely protect a bank from a rogue trader. What is important is also that the Société Générale loss is not likely to spread to other banks, or to damage the rest of the economy.
Even before the financial turmoil different initiatives were launched to strengthen cooperation at the EU and global level. As for the latter, regulatory dialogues as well as regulatory cooperation in international fora are long established and successful ways of working. Banking regulators continue to meet on a frequent basis, both at global G-10 level in the Basel Committee and within the EU in the Committee of European Banking Supervisors (CEBS). As regards fostering regulatory cooperation and convergence at the EU level, the three Lamfalussy committees (CEBS, CEIOPS and CESR) have developed into important contact points for the national supervisory authorities. In addition to the many bilateral agreements between regulators, Memoranda of Understanding have been concluded between EU financial supervisors, central banks and finance ministries to reinforce cooperation on crisis prevention, management and resolution. Frequent and more sophisticated crisis simulation exercises are being carried out to test the EU’s preparedness and responsiveness to potential further disturbances to the financial system. Recently, agreement has been reached to work on a crisis-simulation exercise between all G-10 banking regulators.
Considering the need to reach a global solution for many of the outstanding issues related to the current turmoil, close cooperation at international level is required, especially with the G-7 Financial Stability Forum (FSF) and international standard setting bodies, such as the G-10 Basel Committee on Banking Supervision, the International Organisation of Securities Commissions (IOSCO) and the International Accounting Standards Board (IASB) and the International Auditing and Assurance Standards Board (IAASB). The EU Member States are actively engaged in discussions with their financial partners in these fora and actively promote European positions. Participation of the Commission in the FSF would also provide an important platform for this.
The financial turmoil is being discussed with the US on a bilateral basis. It was the main issue on the agenda during a trip of Commissioner McCreevy to New York and Washington three weeks ago. Cooperation is excellent and both sides agree on the need to develop common solutions to many of the challenges posed by the current turmoil. In addition, longstanding and direct working relationships exist with the four US banking regulatory agencies (Federal Reserve Board, OCC, FDIC and OTS) in which information about market developments and regulatory responses is frequently shared. The successful EU-US financial markets regulatory dialogue will take forward a number of the above issues.
