The Global Financial Crisis - Lessons for the Australian Financial System

Wayne Byres, Executive General Manager - Australian Economic Forum, Sydney

I am pleased to join with one of Australia's most respected economists and one of our best-known shareholder activists to discuss the fallout from the global financial crisis.

Pairing a prudential regulator with a shareholder representative has a natural symmetry. APRA itself, of course, has no mandate to protect the interests of shareholders and we do not involve ourselves in shareholder issues. Our immediate beneficiary groups are depositors, insurance policyholders and superannuation fund members. Acting on their behalf, however, our role in promoting sound and prudent behaviour, and robust risk management, on the part of financial institutions is surely consistent with the long-term interests of their shareholders. And active shareholders with a long-term perspective are an important ally in our work.

Alas, the fallout from the global financial crisis is replete with examples of shareholders of major global financial institutions — particularly institutional shareholders — being seduced by short-term profit figures and share price gains, and failing to exercise the vigorous scrutiny and persistence expected of owners. As the recent Walker Review of corporate governance in UK banking institutions has lamented, major institutional investors were slow to act as issues of concern were raised, but quick to ‘cut and run’. Similarly, the OECD has noted that shareholders of major global financial institutions have tended to be reactive rather than proactive and seldom challenged boards in sufficient number to make a difference. In these cases, shareholder allies were not standing shoulder-to-shoulder with the prudential regulator!

But I am digressing into Stephen’s territory.

Post-mortems on the global financial crisis generally find no one single cause but a complex interaction of macroeconomic and microeconomic factors. At the macroeconomic level, the main contributing factors were the persistence of large global capital account imbalances and the sustained period of low real interest rates, which generated credit booms in a number of countries and an increasingly intense ‘search for yield’. At the microeconomic level, the contributing factors were failures in risk management and corporate governance arrangements, distorted incentives, inadequate investor due diligence and weaknesses in regulatory frameworks — in particular, porous regulatory borders.

This complex story provides no shortage of issues for policymakers and others determined not to repeat the mistakes of history. In the short time available, I would like to single out four general lessons from the global financial crisis that have resonance for a prudential regulator. These lessons relate to the evolution of risk in the financial system and they have obvious implications for risk governance and the regulatory framework, globally and in Australia.

One other key lesson, though, remains to be learned — how quickly the traumas of the past two years will fade from the memories of financial market participants when the global financial crisis finally eases, ‘animal spirits’ rekindle and financial engineers regain employment. The apparent re-emergence of the short-term bonus culture in the United States and the United Kingdom is not a happy portend.

1. Risks can materalise very rapidly and substantially

Despite growing signs of unease, the scale and speed with which risks materalised in major financial institutions after August 2007 appear to have taken markets, and most commentators and policymakers, by surprise. Only a short time earlier, a key forward indicator of the perceived riskiness of banks — spreads on bank credit default swaps — reached record lows. Notwithstanding bouts of market volatility after August, in the early months of 2008 Lehman Brothers increased its dividend payments and continued with its share repurchase program while two UK banks, now partly in public ownership, boasted in one case of being able to continue on its ‘impressive growth trajectory’ and in the other case, claimed to be ‘well positioned’ to take advantage of opportunities.

Not that central banks and others weren’t warning about the underpricing of risk and the build-up of leverage. However, these warnings were drowned out as the music played on, with markets convinced that the strong performance of the global economy over preceding years — described by some as ‘the great moderation’ — had become a permanent state of affairs.

Buoyant times — and they will return! — can dull the collective senses in risk management. Boards and shareholders find it difficult to distinguish between skill and luck and readily reward the easy yards. Risk managers find it difficult to get their message through that underlying exposures are building up. They become like the prophetess Cassandra in Troy, condemned to prophesy accurately but with no-one willing to listen. And if markets are myopic, it is especially challenging for prudential regulators — in the face of inevitable industry and political pressure — to call time on a boom and take action to shore-up the capital levels of their banking institutions. Acknowledging this, the Basel Committee on Banking Supervision, which is working to introduce countercyclical buffers into capital frameworks, is looking closely at whether such buffers should be determined in some mechanical way, or left to regulator discretion.

2. Risks need to be clearly identified and well understood

The risks building up in the global financial system, particularly in complex structured instruments, were obscured. In its 2007 Annual Report, posing the question as to who holds the risks in these instruments and whether they can manage the risks adequately, the Bank for International Settlements said “The honest answer is that we do not know.” How right that answer proved.

Securitisation markets were meant to distribute credit risks to a diversified group of non-bank end investors and thereby make banking systems safer. Instead, when the crisis broke, the majority of securitised credit risks, hidden in increasingly complex and opaque instruments, actually lay on the books of major international banks and of unregulated, highly leveraged near-banks. And the risks were not well managed.

The lesson here is straight-forward. When the basic business purpose of an activity or product is difficult to fathom, boards and management need to be very wary. They should have been challenging, for example, the underlying business need for conduits and structured credit products, and how these supported their traditional customer relationships. And if boards cannot understand the risks involved, that activity or product should be a ‘no go’ area.

Australian financial institutions had little exposure to complex structured instruments collateralised by US sub-prime mortgages. A few were indeed end investors in what was promoted as highly rated paper. One or two acquired exposures through what they perceived to be low-risk trading activities. Generally, however, this was a ‘no go’ area.

Globally, securitisation markets remain weighed down by the large overhang of securitised products and high illiquidity premia. However, traditional or ‘vanilla’ securitisation markets have a role to play in providing a source of funding and in diffusing risks, and there are a number of initiatives underway, by market participants and regulators, to revive and improve these markets. These initiatives are aimed at reducing the complexity of products, strengthening transparency at each stage of the securitisation chain, improving the use of ratings and enhancing incentives for originators. Prudential regulators have already taken steps to tighten regulatory capital requirements for securitisation activities and reduce regulatory arbitrage incentives.

3. Agency risk has been more pervasive than may have appeared

Although the global financial crisis shone an immediate spotlight on liquidity and credit risks, it is now clear that agency or conflict-of-interest risk was a pervasive influence on risk-taking and leverage. This risk manifested itself in a number of ways:

poor underwriting standards in US sub-prime mortgage lending driven by commission arrangements for mortgage brokers;

• conflicts of interest for credit rating agencies as complex structured instruments came to dominate their revenues;
• commissioned sales forces driving volume growth of these structured instruments; and
• remuneration arrangements in some major financial institutions that paid insufficient regard to longer-term risks and encouraged executives to ‘roll the dice’ on leverage, volume growth and risk controls.

The Walker Review drew attention to another dimension of the agency problem — namely, the growing distance between owner and manager, and the waning influence of long-term institutional investors, in the listed company sector in the United Kingdom.

This is the context in which APRA recently published its proposals on remuneration, which will give effect to the Financial Stability Forum’s Principles of Sound Compensation Practices. Our proposals, which will be incorporated into our prudential framework for governance, emphasise that the entire board of a regulated institution is responsible and accountable for decisions taken on remuneration matters, that remuneration needs to be aligned with prudent risk-taking and that an institution’s remuneration policy must cover all persons or groups of persons within the institution whose decisions could materially affect the interests of beneficiaries and owners. This would include any personnel who receive a significant proportion of variable remuneration through bonuses, commissions and the like.

4. The importance of good governance cannot be understated

When market discipline and disclosure prove ineffective, as they did in the lead-up to the global financial crisis, the role of boards of financial institutions in determining the risk appetite of their institution, ensuring that strategies are consistent with that appetite and overseeing risk management systems becomes even more critical. In a number of major financial institutions, however, there were severe shortcomings in how boards carried out that role, and these were a material contributor to the global financial crisis.

The shortcomings are now clear in the cold light of day. In some cases, basic failings such as not putting in place mechanisms to monitor and control potential balance sheet growth. Or not requiring consistent and comprehensive stress testing to determine liquidity and capital needs. Or not ensuring that those oversighting risk management were incorporated into the implementation of enterprise-wide strategy.

The shortcomings are now clear in the cold light of day. In some cases, basic failings such as not putting in place mechanisms to monitor and control potential balance sheet growth. Or not requiring consistent and comprehensive stress testing to determine liquidity and capital needs. Or not ensuring that those oversighting risk management were incorporated into the implementation of enterprise-wide strategy.

It may well be that many boards became transfixed by the shift in risk management practices towards more quantitative or models-based approaches. Risk management practices have indeed become more rigorous over recent years, but quantitative approaches built on a benign view of the world created a false impression of the underlying levels of risk. There are dangers here, of course, for prudential regulators that oversee their institutions’ risk profile and risk management practices and, in benign conditions, can also get caught up in the misperception of risk, particularly in complex and innovative products. The heightened emphasis on rigorous stress testing now being built into regulatory frameworks is intended to stiffen the spines of boards, risk managers and prudential regulators alike and act as an antidote to any early outbreak of post-crisis complacency.

My focus, in these brief remarks, on the critical importance of robust risk management is not to deny that prudential regulators do not have considerable work to do “… to build a stronger, more globally consistent, supervisory and regulatory framework”, as the Leaders of the G20 have charged us. But prudential regulators are not the first line of defence against excessive risk-taking, or even the second. Most importantly, we do not sit in board rooms where risk appetites are determined, strategic decisions taken and senior executives and risk managers challenged. As an insight into responsibilities, the UK House of Commons Treasury Committee report on the failure of certain UK banks is worth reading. In prose more pointed and colourful than the usual officialese, the Report concluded “…some of the banks have been the principal authors of their own demise … Bankers have made an astonishing mess of the financial system”. As I said, certain UK banks, not Australian!