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The Regulators Response. Richard Gillingham. Who Should We Blame?. Fraudulent mortgage brokers Inappropriately rewarded bankers Complicit rating agencies Naïve regulators Lazy investors. Cracks in the System?.

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the regulators response

The Regulators Response

Richard Gillingham

who should we blame
Who Should We Blame?
  • Fraudulent mortgage brokers
  • Inappropriately rewarded bankers
  • Complicit rating agencies
  • Naïve regulators
  • Lazy investors
cracks in the system
Cracks in the System?

The stress of the sub prime experience uncovered real weaknesses in the system

  • Liquidity
  • Off balance sheet vehicles
  • Valuation
  • Capital buffers
  • Role of the Rating Agencies
  • Maturity transformation is a key function of banks – liquidity risk is its consequence
  • Regulators will focus on two elements
    • Capturing contingent liquidity exposure
    • More rigorous stress testing
liquidity before the crunch
Liquidity Before the Crunch

Money Market



2nd Tier


1st Tier


2nd Tier


after the crunch
After the Crunch

Money Market




1st Tier



would stress testing have helped
Would stress testing have helped?
  • Not much
    • If you cannot rely on acquiring secured funding on AAA assets then you will not be able to effect any maturity transformation
    • No stress test can allow for the failure of the interbank market
    • Stress test assumptions can cope with company specific problems in a functioning market

But it would help if you counted contingent exposures!

off balance sheet structures remember enron
Off balance sheet structuresRemember Enron??
  • Off balance sheet tests will be stricter and encompass reputational links as well as legal contracts
  • Allocating capital to standby liquidity lines will change the SIV model.
  • Regulators believe that by aligning regulatory and economic capital the incentive to have large off balance sheet vehicles will be removed!

“The crucial question over the next few days and weeks is how do you mark these positions. I can only hope that we do not muddle through and that we mark to the market”

J. Ackerman Sept 7th 2007

mark to market
Mark to Market?
  • Transparency -- Yes
  • Realistic mark to model with clear assumptions --- Yes
  • Proper provisioning – Yes
  • Mark to market in a panic ---??
  • Rather than insist on forcing valuations in a market that has failed, the regulatory pressure will be on transparency and disclosure to allow a market clearing level to be established.
  • The implications of trigger based deleveraging for lenders will be more closely scrutinised.
  • Regulators will use the discretion allowed in Basel II to increase capital requirements
  • They can adjust the confidence level in the model
  • They can impose punitive downturn LGD and asset correlation assumptions
  • Credit offsets will be more closely tested
  • “Old fashioned” gross gearing measures may be introduced.
rating agencies
Rating Agencies

The system has become over dependant on ratings

  • Capital models use ratings as a primary input
  • Asset valuation is ratings driven
  • Investor mandates are ratings based
  • Rating triggers can initiate structure unwinds
  • Rating Agencies act as regulators for monoline insurers
problems with rating agencies
Problems with Rating Agencies
  • The barriers to entry in the business are so high that there is no effective competition
  • The way in which they get paid is open to conflicts of interest
  • Their models are open to arbitrage
  • There is no effective oversight
basel ii the answer
Basel II The answer?
  • Basel II does address some of the weaknesses thrown up by the credit crisis
  • Basel II is flexible enough to allow some discretionary response to market developments
  • Basel II is based on using practitioner risk methodology to drive capital requirements
  • Basel II relies on market discipline to correct excesses and price risk
basel ii the problem
Basel II The problem?
  • 350 pages and 10 years in the making – can a bureaucratic document cover a huge and dynamic industry?
  • Its success is its weakness – convergence of risk models and uniformity of regulation make model risk systemic
  • The unregulated hedge fund industry seems to have coped quite well.
where does that leave the structured credit business
Where does that leave the structured credit business?
  • The regulatory regime will be tighter on capital, liquidity and the use of off balance sheet vehicles
  • The risk of products will need to be clearer
  • Unsophisticated and many regulated investors will leave the market.
  • Investors capable of independent analysis will get paid well for their risk capacity
politics may intervene
Politics may intervene
  • Politicians may wonder why so much public money is at risk to underpin an industry that has moved a long way from “core” banking functions
    • Secure retail deposits
    • Effective mechanism of transmitting monetary policy
    • Efficient payment system
  • An industry that privatises its profits and socialises its losses may face a difficult political debate.