Remarks by Superintendent Julie Dickson Office of the Superintendent of Financial Institutions Canada (OSFI) to the Langdon Hall Financial Services Forum Cambridge, Ontario Tuesday, May 6, 2008 CHECK AGAINST DELIVERY For additional information contact: Jason LaMontagne Communications and Public Affairs jason.lamontagne@osfi-bsif.gc.ca www.osfi-bsif.gc.ca
Remarks by Superintendent Julie Dickson, Office of the Superintendent of Financial Institutions Canada (OSFI) to the Langdon Hall Financial Services Forum Cambridge, Ontario May 6, 2008 Challenges Facing Financial Institutions and Regulators Opening Thank you for inviting me to address the 2008 Financial Services Invitational Forum. Last year at this event, I asked whether it was possible to magically turn sows' ears (sub prime) into silk purses (AAA rated securities). Unfortunately, we now have the answer to that question. The fallout from this into the world s financial markets has led to many additional questions being asked. It is these questions that regulators the world over are now seeking answers to. Reputation Risk Regulators are just figuring out how significant reputation risk is for a bank. Global regulators agreed when banks said they could transfer credit risk to third-party investors via Asset Backed Commercial Paper (ABCP) conduits or Structured Investment Vehicles (SIVs). Because we were armed with legal opinions and accounting opinions, we believed that off-balance sheet meant offbalance sheet. But since last summer, we have seen banks support off-balance sheet vehicles, and we have seen them step in to protect investors in money market funds. We have always known that reputation risk was important, but until now we have not had proof that it is a serious risk for banks and that they will do what is needed to protect their reputation. That is good news for bank clients. But for regulators it also means that we cannot continue to agree that things are offbalance sheet and can be ignored for capital purposes, even if accountants and bankers say they are off-balance sheet. We now know that it is very difficult for a bank to transfer credit risk. And banks have also figured this out. 1
Unexpected Losses and Capital The world of banking is never predictable, which is where capital comes in: capital is for the unexpected. While Canadian banks are well capitalized, this is an area that can never be put to rest. We can't be complacent about capital. As noted above, banks around the world actually entered this period of turmoil with significantly different levels of capital (and quality of capital was also very different in various countries). Indeed, large Canadian banks are very well capitalized relative to many global banks. They currently have Tier 1 capital ratios well above our well-capitalized target of 7 per cent, while many global banks are bumping along at 5 per cent and 6 per cent. That is one reason why the Canadian banking system is seen as robust. In my view, we still have a long way to go here, despite the implementation of Basel II, and despite views that in the run-up to the global market turmoil, regulators focused too much on capital, to the detriment of liquidity and stress testing. There are risks that are difficult to measure precisely, or where we think we have measured the risk correctly and find out otherwise after the fact. So it is clear that a cushion above the minimum risk measured in Pillar 1 of the Basel II accord continues to be necessary. It is also clear that the leverage ratio represents a second mechanism for promoting the maintenance of capital (again recognizing that we can't measure every risk, and those that we do measure can't always be measured precisely). Model Risk Many people have suggested that "models" played a big role in the turmoil. Models are all about taking what you have experienced in the past and trying to make sense out of it, so that if history repeats itself, you do not make mistakes that you could have avoided if only you had properly considered your own data and experience. Thus, while models are important, they should not be blindly relied on because they are based on the past, as well as on confidence intervals (they are right 99 per cent of the time or 95 per cent of the time). As we know, it is the tails of distribution that pose the problem. And, as many have realized, increasingly we seem to be in the tails, not in the range of the expected, which requires that even more judgement be brought to bear. Risk Management Risk management weaknesses at many global banks have now been well documented. Supervisors of the largest global banks and securities firms issued 2
a report on March 6, 2008, on the risk management practices that worked well in the period leading up to August 2007 and in the months immediately after the market turmoil began. Four firm-wide risk management practices differentiated the better institutions from the others, but no institution that was reviewed was strong in all of the areas. First, firms that generally shared quantitative and qualitative information more effectively across the organization performed better. As a result, the report notes that some firms identified sources of significant risk as early as mid- 2006; they had as much as a year to evaluate the magnitude of those risks and to implement plans to reduce exposures or hedge risks while it was still practical and not prohibitively expensive. In firms that experienced greater difficulties, business lines and senior management did not discuss promptly among themselves and with senior executives the firm's risks in light of evolving conditions in the marketplace. This left business areas to make some decisions in isolation regarding business growth and hedging, and some of those decisions increased, rather than mitigated, the exposure to risks. Second, the best firms, before the turmoil began, had rigorous internal processes requiring critical judgement and discipline in the valuation of holdings of complex or potentially illiquid securities. These firms were skeptical of rating agency assessments of complex structured securities and had developed in-house expertise to conduct independent assessments of the credit quality of assets to help value their exposures appropriately. In contrast, firms that faced more significant challenges in late 2007 generally had not established or made rigorous use of internal processes to challenge valuations and they lacked relevant internal valuation models. They continued to price the super-senior tranches of Collateralized Debt Obligations (CDOs) at or close to par, despite observable deterioration in the performance of the Residential Mortgage Backed Securities (RMBS) collateral and declining market liquidity. Third, the better performing firms maintained a firm-wide perspective and had more active controls over the consolidated organization's balance sheet, liquidity and capital. They aligned treasury functions more closely with risk management processes and they charged business lines appropriately for building contingent liquidity exposures to reflect the cost of obtaining liquidity in a more difficult market environment. Fourth, the firms that tended to avoid significant challenges through year-end 2007 typically had management information systems that relied on a wide range of measures of risk, versus specific measures of risk. They had systems that could easily integrate market and counterparty risk positions across businesses making it possible to identify consolidated firm-wide sensitivities and concentrations. 3
At the best performing banks, more of these practices were employed. Members of the bank were not working in silos. There was considerable interaction at a very senior level. There was productive discussion between those focused more on controlling risk and those focused more on growth, new ideas, and taking risk. Finally, they were better equipped to detect threats and take action. The point is that the global banks that fared the best had succeeded in establishing state-of-the-art risk management practices, while the rest thought they had succeeded and found out otherwise. And many of these practices are not practices that can be easily judged from the outside, as they are cultural. Culture played a significant role here. Accounting Lastly, I think that a few words on Fair Value (FV) accounting are called for. This is a hot topic. Some have noted that the new accounting requirements show the market volatility clearly and immediately in the income statement and have said that this is inappropriate, because it is short-term noise when the assets are not for trading, and will create an unintended reaction to losses and gains when none may be realized in the short term. Management of financial institutions have suggested that explaining this volatility takes up management time that could be used elsewhere. Others have said the accounting makes sense because people want to know what is going on at the financial statement date and that the institution just needs to explain the situation to analysts. And others have noted the serious consequences for financial institutions of decisions taken and how you can't look back after taking some decisions; e.g. if you put your assets in the trading account, you have a lot of flexibility if you ever want to sell them, but you have to provide fair value along the way, which can be an enormous challenge in an illiquid market. But, if you decide to put your assets in the held-to-maturity basket, you will avoid the FV challenge, but potentially create another problem: the inability to sell the asset or move the asset out of that book without a major accounting impact. Some (the IMF) have said that since models can be used to derive fair values where markets are illiquid, the assumptions regarding the nature and direction of 4
a downturn would lead to a variety of outcomes in the timing and scale of loss recognition. This variety of outcomes means that judgement is needed, but also that comparability may be challenging. Some have talked about the knock-on effects in a time of market instability, where market values are driven to levels that are below what the underlying cash flows would imply, thus creating uncertainty about the ultimate value and maybe even resulting in a forced sale of assets due to margin calls, or additional collateral requirements, and possible unnecessary losses. They add the view that while FV represents a point-in-time measure and does not reflect the eventual realizability of the income or loss attributed to the asset, investors may not realize that and may react in ways that amplify distortions. Financial statements work to give investors confidence in the results that are reported and, when confusion and uncertainty occur, then investors may not react rationally. Clearly, many have found the issue vexing. There is much agreement that more disclosure of fair value methodologies where assets are illiquid -- the so-called level 3 assets -- is important. There is also some understanding that accounting standard setters are not trying to disrupt business, but are instead representing the interests of investors. This is why they are currently not focussing on the unintended consequences of FV accounting but on the strengths. (It has largely been the financial institutions and regulators who have been focussing on possible weaknesses -- not the investors.) The fact that the International Accounting Standards Board (IASB) is focused on investors is key to how this file will evolve. On April 25, Sir David Tweedie reinforced this point 1 by noting that the Chartered Financial Analyst (CFA) Institute, which represents financial analysts around the world, asked its members whether FV requirements for financial institutions improve transparency and contribute to investor understanding of the risk profiles of these institutions. Seventy-nine percent said yes. While a slight majority believed that fair value is aggravating the credit crisis, 74 per cent believed that fair value accounting improved market integrity. While the IASB will likely be more driven by investor interests than by the interests of others, such as regulators, I think that more discussion of what is in the interest of investors is also called for. While clearly investors are saying that FV has many positive features, are investors saying they really like the status quo, perhaps with a little more disclosure? A recent Financial Times article by Peter Wallison (May 1, 2008) poses a question: does it make any difference to 1 http://www.iasb.org/news/announcements+and+speeches/sir+david+tweedie+addresses+the+empire+c lub+of+canada.htm 5
an investor in a bank an investor who is looking to the bank s success in corralling cash flows - -that the market value of the assets that produce these flows may vary? I think that is an interesting question. So while many support the concept of fair value, there are enough concerns being expressed with fair value when markets are illiquid, that the IASB should not just push ahead to adopt full fair value accounting to create so called simplicity (as they suggest in their March 2008 Discussion Paper, called Reducing Complexity in Reporting Financial Instruments. We need to get more clarity around the issues of fair value. Thus, the expert panel being set up by the IASB (and which is referred to in the recent Financial Stability Forum (FSF) report) is very important before considering a move to full fair value. Also, comments on the March 2008 Discussion paper are due September 19, 2008 and it is important to respond. Conclusion Much has already been done by central bankers, regulators and accounting standard setters to identify the causes of the global market turmoil, and to identify what should be done, but the implementation of the FSF report recommendations will take considerable effort by regulators and the industry and will go a significant way toward strengthening the global financial system. Thank you. 6