Thank you for inviting me to open the proceedings this afternoon. Inevitably I will cover some of the topics discussed this morning.

Transcription

1 European Commission consultation on Shadow Banking Keynote Speech by Sharon Bowles MEP Chair, European Parliament Economic and Monetary Affairs Committee 27 April 2012 Thank you for inviting me to open the proceedings this afternoon. Inevitably I will cover some of the topics discussed this morning. Shadow banking has been on everyone's lips for some years now so the commission consultation is welcome and the ECON committee is intending to draft a report in response. It seems to be tradition to start a shadow banking speech with reference to the definition produced by the Financial Stability Board. I have found several renderings of this, but it seems to be credit intermediation - involving leverage and maturity transformation - outside the banking system. It is maybe a little unfortunate to define something by what it is not - not a bank - when we do not have an international agreement on what a bank is, and when one leg of shadow activity is often, even almost always, in or connected to a bank. But ultimately this does not matter because disclosure and regulation will, in the end, have to be targeted at specific entities and activities, not at some amorphous shadow world. Maturity transformation and leverage are essentially risky business and one of the reasons why banks have a lot of regulation. Maturity transformation is an important process. Investors don't always want to invest in the same way that borrowers require funds: a pension fund might want to lock money up for 40 years whilst a small business just needs to borrow for 2-3 years to expand a production line. Leverage is used by banks to allow greater lending: holding cash deposits in a bank account leads to dead money, but too much leverage is dangerous, and the more so if it is hidden. The shadow banking sector is the part of the financial machine that the public doesn't see day to day, but it is certainly a sector that we need to 1

2 understand better, and so a key part of our response has to be in the areas of monitoring and transparency. Through that we can then target areas that do pose risk and comprehend, rather than demonise, those areas that are constructive. And as Commissioner Barnier said this morning, there are constructive areas of shadow banking. There has been a lot of interlinkage between the banking sector and shadow banking activity, and the scope for asymmetry of information that exists in the shadow sector was transmitted into - or used by - banks. Indeed it is one of those ironies that banks simultaneously complain about competition from shadow activity yet seem to have made use of it so extensively! Banks created, sold or repo'd the alphabet soup of CDS, ABS, CDO and MBS assets. With other entities such as SIVs, ETFs and money market funds to add to the mix. Many of these came into existence as a pure arbitrage: bundling together future profits in the form of a positive interest rate carry and netting the profits today. This front loading of profit taking has inflated GDP over the past 10 years, creating the illusion of growth, and is one of the reasons why growth is now so hard to find without repeating the sins of the past. The alphabet soups and securitisation featured large in the financial crisis. There are many lengthy elaborations on what went wrong with securitisation, lots of blame and its own rhyming slang of slice and dice. Instead of having products that are capable of evaluation, we got - and in many instances still get - the assembly of a pool of assets, disturbance and re-allocation of all the cash flows to make a new set of products, often not on the balance sheet of those who made it, or with a capital advantage if retained. This might make it attractive to some investors, but it makes it very difficult for people looking in to see where we are and if we are diverting from a stable path. Regulators were unable to understand the products, neither it seems did many asset managers and investment banks, and I doubt whether auditors could do more than find a price from another broker. If I filled this room 2

3 with structured credit analysts, traders and portfolio managers, I wonder what range of prices we could generate. Looking back to before the 2008 crisis, many of us it find it astonishing that supervisors did not check up on what was on the other end of transactions, assets or liabilities. Not least when pillar II of Basel II gave clues suggesting that if products were not understood capital charges should be considered. So the regulated sector seems to have gone mountaineering with nobody checking where - or indeed whether - the ropes were anchored. As a result, we are in the middle of the largest ever revamp and extension of financial legislation - some of it like AIFMD and EMIR already tackling new areas. It seems to me - and colleagues working on CRD agree - that we should not leave it another few years before we start to gather information at least as far as interactions with the regulated sector is concerned. So we consider that, in addition to other things, reporting of securities lending and repos and looking at bank exposures to the shadow and unregulated sector are things that can be commenced now in CRD4, so delivering some of the things that Paul Tucker mentioned this morning. We tried too on segregation in EMIR, but I regret that Council and Commission would not go with us on that. However we live to ride again in MiFID and SLD. Securitisation is attracting our attention too: we are not happy that the retention requirement seems to end up with asset managers rather than banks and we are querying whether there really is risk transfer to justify exclusion from risk weighted exposures. These are issues that need to be followed up in further work and I personally do not see increased blanket retention as the solution. In the Green Paper the Commission highlights securitisation, securities lending and repos as activities under focus and as those are the areas on which I have already been drawn to comment, I think that validates the focus. However, I would add in all off balance sheet activity. In fact I would query why anything should be off balance sheet at all, and look again to IFRS for help with that. 3

4 Now more specifically on repos we must think about what we are doing. Following my article in the Davos edition of The Banker many have beaten a path to my door intent on re-educating me, telling me how huge and important repos are. And of course the LTRO by the ECB - maybe now our largest shadow bank - adds respectability to the process. But it does not stop me from being seriously concerned and I hear more plans for pools of assets to be repo'd instead of banks issuing covered bonds. The basic facts seem to be that someone owns an asset, and so has a credit risk related to that asset. Any mechanism that distorts this makes accurate regulation, evaluation and audit almost, if not completely, impossible. I refer back to my room of analysts, traders and portfolio managers, to which we can add the who owns what. Any repurchase agreement, or collateralised lending, creates a new liability: I postulate that this must be additive, and not a replacement for credit and market risk. Repurchase is also a mechanism used to gain leverage, often disguised. Looked at from the investor side, it is only fair that all lending and borrowing should be clear. Leverage has come in ever more complex form, in part thanks to complex swap products and embedded repos. So to add to the list of activities to watch we have credit transformation, which is what a lot of operations seem to do. More generally, the modern world is running on a collateral-based financial system, which is seen as more liquid, adaptable and cheaper than relationship-based lending. The juggernaut is already on the road, I doubt it can be stopped, many say it should not be stopped, and others will look for ever more collateral to make sure it does not run out of road. Nevertheless we should at least apply the brakes, or have brakes, and for a start keep sight of where credit risk really lies. We have already had too much rocky road. A conclusion I draw from this is that repos should always be regarded as 4

5 lending, never as a sale and repurchase. I think using any old repo as a liquidity definition is suspect as well, which is also receiving a Parliamentary fix in CRD4. Again drawing on the mood of amendments Parliament has produced for CRD and elsewhere, I would say we regret the demise of long term relationship based-banking. Formulaic approaches, with more attention paid to hedging than thinking about the real risks, are at times counterproductive and again, in part, led to everyone doing the same and no-one shouldering the blame. Stepping back to look at the broader swathe of regulation we are handling, there is going to be a lot more data and information. The next step is to be able to interrogate that information in an intelligent and rapid way for supervisory purposes. It is not collection of data that renders markets safer and policeable, but the interrogation and analysis of that data. As I have said before, aircraft wings, vehicle brakes, DVD players, cruise controls and much else all operate through servo-motors, the basic elements of which are a high gain amplifier and a feedback loop. If there are long delays in the feedback loop then servo-systems do not work, the brakes fail, the speed or direction goes awry. The same is true of financial servo-systems: there are plenty of amplifiers - usually leverage - but the feedback loops seem to be in the era of a man with a red flag walking in front of a car. This is ridiculous alongside trading systems that fret over location for milliseconds of latency. So we have to pursue real time tracking of transactions. It is real time analysis that gives safety through a fast feedback loop. Ex post the best you can hope for is rectification and punishment, which is no good if you have already had the crash. This means that standardisation of messaging and identifiers must be on the agenda, and I believe this has a place as much in mapping the shadow sector as in the already regulated sector. 5

6 A final important element is to have international coordination, with the US in particular. What they do there comes over here, and we do not always want it, whether that be sub-prime, Volcker or death bonds. I welcome the moves taken in IFRS, and ask that they keep at it! And I wish the US would sign up. To conclude, the ECON committee will be looking at shadow banking, we welcome the consultation and will prepare a report in response. However we are taking our opportunities as they come in CRD and CRR, and will also too in MiFID and MiFIR, in particular to shine light on the linkages with the shadow sector and to promote plain vanilla over complexity. 6