Keynote Speech by Larry Fink FRBNY/GARP Global Risk Forum New York, New York November 18, 2013 (As prepared for delivery)

Transcription

1 Keynote Speech by Larry Fink FRBNY/GARP Global Risk Forum New York, New York November 18, 2013 (As prepared for delivery) It s a pleasure to join to you to talk about a topic close to my heart. I d first like to thank GARP and the New York Fed for organizing this event to discuss issues critically important to the financial markets. In recent years, what you do has become more important than ever. There s certainly a great appreciation for it in our industry. But the area of our business you re involved in deals with a not-always-popular four-letter word: risk. The very word strikes some as irresponsible. The word risky doesn t always have a positive connotation. But you and I know that risk taking plays an indispensable role in our economic system and financial markets. Risk is what creates value for investors, stakeholders AND society - be it investment in a new product, a new technology, or a new line of business. And we know that your role promoting the responsible use of risk is crucial to innovation and economic growth. My appreciation for the value of risk management dates back to my time as a mortgage trader. After some pretty satisfying success, one of the departments that reported to me had a bad trade and I experienced first-hand the consequences of insufficient risk management. That experience made me realize very early in my career the importance of informed and measured risk taking. That also drove me, along with some like-minded partners, 25 years ago, to create a different kind of firm, BlackRock. We believed that financial products were being created with risks that even the most sophisticated institutional investors didn t fully understand. But even worse, the people creating and selling the products often didn't understand the risks either. That lack of understanding raises that obvious question of responsibility. Should investors really be buying financial products whose risks they don't understand? For that matter, should people be selling financial products whose risks they don't understand? I think we would all agree that the answer to both those questions is, No. That s why our business proposition 25 years ago was that people should understand the financial products they are buying and the risks they are taking, and we could help them do that. That simple idea was the foundation of BlackRock.

2 And that the same idea why we are all here today this time focusing not only on the risks of our firms but to the system as a whole. In the wake of the financial crisis a time that showed us the grave consequences of misunderstanding risk you ve come together here as part of a continuing conversation to explore how regulators and financial institutions can better identify and manage risk in the future. Since 2008, the United States and many of our partners around the world have engaged in a historic effort to reshape the global financial system and make it safer and less prone to crisis. We ve all seen firsthand the tremendous damage caused by financial crises, not just to large corporate balance sheets but also to the millions of people whose dreams for the future melted with their savings. And at a macro level, we ve seen a massive loss in economic output. So once again, I want to applaud your efforts to enact reforms that would prevent a similar crisis from happening again it is an often thankless task, but such an essential one. At the same time, I think you ll agree that we need to proceed in in a thoughtful and prudent manner so that in our efforts today to make the system safer don t plant the seeds of the next crisis. Because we all recognize that even the most wellintentioned regulatory changes whether proactive or reactive can actually create new risks. Many of the financial crises I have witnessed during my 37 years in the business relate to well-intended regulations that have had some unintended consequences and inadvertently led to irresponsible behavior. For example, let s take a look back at the Savings and Loan crisis of the 1980s and 1990s. The genesis of the crisis was well-intended regulation designed to help S&Ls which were recognized as important institutions for their local communities to compete more effectively with banks. The S&Ls, of course, were suffering serious disintermediation as they were subject to rate controls at a time of both rising inflation and rising rates. In an effort to stabilize the industry, the thrift regulator, the FHLB (Federal Home Loan Bank Board), allowed the thrifts to market their loans and to amortize the losses, using the cash raised for other investments. This recycling of funds helped make mortgage funding available to fast growing regions of the country. At the same time, Congress allowed S&Ls to offer a new array of financial products and enter into new businesses, including consumer loans, credit cards and commercial real estate loans. 2

3 These changes were intended to make S&Ls more competitive and improve mortgage finance. But they did not anticipate the associated risks. Many S&Ls entered into transactions and got into businesses whose risks they didn t understand especially commercial real-estate and higher-yielding assets. As inflation fell and the commercial real-estate markets soured, S&Ls found themselves overextended and in crisis, putting the health of the broader economy at risk. In the end, nearly 750 thrifts failed, costing taxpayers more than a hundred billion dollars. While the S&L crisis and the more recent one are unique events, they share a great many similarities. In both cases, we saw institutions and investors taking on leverage and move into new areas without appropriately understanding the risk they were taking. And in both cases, we saw this happening on the back of regulatory changes. A major reason for the more recent credit crisis was the massive expansion in home ownership. Behind the expansion was a bi-partisan policy thrust again, quite wellintentioned to relax lending standards to increase home ownership. You had widespread Democratic support for these policies. And you had a Republican President George Bush supporting them as well. President Bush even said: We certainly don't want there to be a fine print preventing people from owning their home. For a while, the results were exactly as intended: there was an increase in homeownership from around 64% of the population to just over 69% during the Bush administration. But there were also unintended consequences that we are all too familiar with: no money-down loans, so-called NINJA loans, automated underwriting the list goes on. In short, there a race to the bottom took off in the effort to originate and resell mortgages. The resulting storm was heightened by a range of other factors: Historically low interest rates; Historically low default rates which masked the risks being building up in the system. o Instead of defaulting, many homeowners were told that they could refinance at lower rates AND take out some cash from the appreciation of their home... an appreciation in no small part driven by the increasing number of people who thought they were suddenly able to afford to own their home. On the capital markets side, an explosion in complex securities to provide the financing for these subprime mortgages being originated, such as derivatives and CDOs, which again, often weren t fully understood, or their underlying assets weren t properly valued; 3

4 A massive increase in the leverage of financial institutions; And the growth of new entrants in the market that operated outside normal regulations and were both highly leveraged and too reliant on risky shortterm funding. And making things even worse, this toxic cocktail of policy changes, new investment products, and higher leverage was combined with a problematic even naïve set of assumptions about the risks involved. A collapse of housing prices on the level of 2007 hadn t happened since the Great Depression and wasn t supposed to happen again until it did. And the markets weren t supposed to see the kinds of correlations we saw in 2008 until they did. And banks were supposed to be sufficiently sophisticated to survive market shocks until they didn t! So once again, much of the 2008 financial crisis stemmed from the unintended consequences of well-intentioned policies, resulting in too many lenders and borrowers either simply not understanding or in too many cases deliberately misrepresenting the risks they were taking. In 2007 and 2008, the cracks began to show. And in 2008, we found ourselves in the midst of the severe crisis that we are still struggling to escape. After a concerted and heroic effort to stem the panic, we were faced with the question of how to prevent something like this from ever happening again. The US has responded with a broad set of new regulations intended to reduce risk, increase transparency, increase capital and give government the tools it needed in a crisis. Dodd-Frank is complemented by Solvency II in Europe and Basel III globally. And there s no doubt this regulation has made the financial system safer Where we once had banks levered 30 to 1 or 40 to 1, that s been lowered to 11 to 1 (for the six largest banks and more sizeable regional banks in the U.S.). And the proposed standard for the largest bank-holding companies in the US is to increase their leverage ratios to 5% - higher than required even by Basel III. The average bank which had around 4% tangible equity now has doubled to around 8-10%. While there is still work left to do, in Europe in particular, we have stabilized and restored faith in the markets. But of course we need to recognize that regulation doesn t come without costs some of them very much worth it, some perhaps not so much. I remember when people howled after Sarbanes-Oxley passed that it would diminish US competitiveness and discourage companies from going public here. For several years, it did have that impact. But over time it built confidence in the 4

5 integrity of companies that listed in the US. And today we are again leading the world in major listings, in part because regulation helped build that confidence. Something very much needed today. The latest round of regulation has also had significant consequences that we need to acknowledge. Certainly, shrinking bank balance sheets have reduced liquidity in the markets, increasing costs for all investors. More transactions are moving to exchanges and that s ultimately a good thing. But the recent glitches faced by some exchanges highlight how this has concentrated risk and the need to ensure that the exchanges work as planned. Basel II has required high capital charges for banks that retain the servicing rights to mortgages, so fewer banks do and they are less vested in preventing default. And as a result, we may see considerable widening in spreads between mortgages and Treasuries. Despite major efforts to reshape the financial system, Fannie and Freddie still dominant the housing market and there is a dearth of private capital available to the non-agency mortgage market. All of these unintended consequences of these well-intended regulations may be worth it in terms of stabilizing markets but we cannot deny or ignore their ancillary costs. Which brings us to the next question where do we go from here? What is the unfinished business on the regulatory front, and what might be some of the unintended consequences of well-intended regulatory proposals that we need to be aware of? Well, an obvious area of interest to BlackRock is the recent OFR report on the potential designation of asset management firms as systemically important financial institutions. Now, I have some obvious disagreements with aspects of the report, especially about where the risks reside. But I believe that Dick and his team have raised some important questions and concerns that need to be addressed. In particular, the report highlighted a number of products and services widely used in our industry that we have long argued need further regulatory action. For example, we ve been out in front pushing for money-market reform, working with the SEC to a sensible industry- and client-oriented solution. That remains a major unfinished piece of business. So we re continuing to push for constructive dialogue. most recently commenting in cooperation with several industry peers on the proposed definition of a retail money-market fund. 5

6 We ve been outspoken in our support of regulations promoting greater transparency in ETFs, including a classification system for these products. The growth of ETFs has provided investors new low-cost vehicles with greater transparency. And we saw during the market stress in May and June this year how ETFs can actually serve as a shock absorber for forced selling in the market. But there are certain types of ETFs that pose more risk than others, and we think additional action would serve the best interests of investors. As swaps trading moves to exchanges, we ve been strong advocates of investor protections on behalf of our clients. We ve also advocated greater transparency on securities lending practices. And of course, we would point out that in many of the areas discussed in the report, the OFR notes that various types of investments, funds, instruments and markets in which we participate are already highly regulated and others will soon be subject to new regulations. My point is this: we are and remain deeply committed to supporting regulatory approaches that help to promote transparency, protect investors and make the system more stable That s the right thing for our clients. After all, it is they who are taking the risks. At an asset manager like BlackRock, we are fiduciaries for our clients. We are not taking risk for our own accounts. We do not trade for our own account nor put proprietary trades on our own balance sheet. To reiterate, there is no question that a sound financial system needs sound regulation, and that any regulation will come with some cost. So we do need to ensure that the potential consequences of regulation are equally well-understood including potentially higher costs for investors, reductions in liquidity and availability of capital for growth, and hampered efficiency. To reduce those unintended consequences, we believe that in the case of asset managers, that regulation should take place where the risk takes place at the product level. And that regulation needs to apply to any firm regardless of size that uses those products. Otherwise the true risks won t be addressed. Designating a handful of asset managers as SIFIs will not address the real risks that the OFR report identified. In fact, major destabilizing events often start with smaller firms or funds less able to withstand losses than larger ones. Consider the S&Ls or Long-Term Capital Management. And then it was the Reserve fund, a relatively small asset manager in the money market space, where we saw one of the most serious runs during the crisis. 6

7 Furthermore, if SIFI designations for a few asset managers are seen as a solution to the risks posed by products used by many firms and investors, we avoid the real problems that exist and require attention. There are indeed fast-growing areas of the market that deserve heightened scrutiny to potentially head off future problems. For example, look at the massive flows into mortgage REITs. These flows should be warning signs for regulators. These could be providing positive benefits for society creating competition for banks and providing necessary capital for small and medium-size companies. But we need to be thoughtful about their regulation and ensure it is based on sound data and analytics. It is the specific individual products their structure, liquidity, transparency, leverage, credit worthiness, counterparty risk that are being used by investors of all sizes, that will likely to be the source future problems in the market. To prevent the next crisis, I believe regulators need to focus additional regulation in our industry at this level on individual products and services, including new products. And that, just as effective risk management must be grounded in solid analytics, so too must effective regulation. To finish where I started: risk-taking is the life-blood of capitalism. But it needs to be a responsible risk-taking that was the foundation and guiding principle on which we founded BlackRock. I do believe that regulators around the world still have important unfinished business to do to address risks in the marketplace. At BlackRock, we have always sought to work with them constructively to that end. And we welcome the opportunity to continue doing so. As we gain some distance from the financial crisis, we should continue to look at what risks remain as well as what risks might emerge as the financial system undergoes a historic set of changes. That process will be ongoing and crucial, and the work of the men and women in this room will be essential to its success. And once again, I think you for your dedication to the task. * * * 7