Pap(er) from the Financial Stability Forum

The financial stability forum working group on the crash has produced an interim report. It is an insightful document as it gives some clues about the regulator's thinking (and lack thereof). I will focus on the suggested areas of action at the back of the document: the first part discusses the causes of the crash, and that is rather old ground.

1. Supervisory framework and oversight
Capital arrangements: A resilient framework for capital requirements is central to creating appropriate capital buffers in the system and the right incentives for risk management. The implementation of Basel II, and the use of its three reinforcing pillars, is an important step to achieve this.

I read that with a heavy heart. Basel II is fatally flawed, as a number of authors have demonstrated, and just pressing on with it is tantamount to fiddling with Rome burns.

The Basel Committee will take account of the lessons from recent events and assess whether refinements to the Basel II framework are needed, including with respect to the calibration of certain aspects of the securitisation framework.

It is not just the securitisation framework. It is the entire philosophy behind and calibration of the accord. Remember that residential mortgages were one of the bigger winners in Basel II. Remember that ratings are central. Remember the bizarre behaviour of the IRB formula. The supervisors need to start again.

The turmoil has demonstrated the need for larger and more robust liquidity buffers and an internationally shared view among supervisors on sound liquidity risk management guidelines.

How about capital for liquidity risk? Or if the regulators are not willing to go that far, they will at least have to say what they mean by an adequate liquidity buffer. How would you work out how much is enough?

Firms’ managements need to act proactively in response to stress test results.

This is the hardest thing for a supervisor - forcing firms to conduct stress tests is easy. Forcing them to respond to the results of them is much harder. How exactly are they going to require firms to act without taking over management's role?

Off-balance sheet activities: Basel II strengthens incentives in the financial system to manage risks appropriately and will reduce the regulatory arbitrage that generated large off-balance-sheet risk exposures.

Basel II just creates different regulatory arbitrages, at least as currently drafted. Putting a cap on the benefit from any securitisation would be easy first step towards removing those, but the suspicion is that the supervisors are mired in attempts to revise the already complex language of Basel II without seeing the bigger picture. Off balance sheet vehicles are fine provided they are genuinely off balance sheet and there is no implicit support. The problem is that supervisors currently have a set of rules which is penal with regard to genuine risk transfer and laughably generous with regard to sham transfer. Until they can figure out which is which any attempt to revise the rules is likely to damage perfectly reasonable trades.

2. Underpinnings of the originate-to-distribute model
The underpinnings of the OTD model – including origination and underwriting standards, transparency at each stage of the securitisation process, the role and uses of credit ratings – need to be strengthened. [...]

This paragraph is motherhood-and-apple-pie. Pious hope may be necessary, but so are concrete proposals.

3. The uses and role of credit ratings
Investors, many of whom have relied inappropriately on ratings in making investment decisions, must obtain the information needed to exercise due diligence.

Investment guidelines should recognise the uncertainty around ratings an differentiate products according to their risk characteristics.

Yes, but you don't regulate many of the investors, so while this is true it does not amount to a mug of beans.

CRAs must clarify and augment the information they provide to investors on structured finance products. They should ensure that uncertainties surrounding their models and rating methodologies are made transparent. We welcome that CRAs are considering differentiating ratings of such products from corporate ratings. [...]

That is a reasonable idea but it is hard to see how to standardise model risk disclosure. The concern will be that these disclosures will turn out to be boilerplate text rather than a real attempt to analyse the sensitivity of a securities' value to the choice of model.

CRAs need to take adequate steps to address concerns about potential conflicts of interest, including concerns about their remuneration models.

Clearly. That bullet is going to be very difficult for the agencies to dodge.

4. Market transparency
Financial institutions need to improve the usability of disclosed information about risk exposures and valuations, including those related to structured products and off-balance sheet vehicles

Again, the industry has proved adept at making disclosures that meet the required standards but don't actually disclose much useful information. Just look at the memo accounts for any big investment banks. So while one can sympathise with the idea of more transparency, it will need very careful management to be effective.

Further improvements are needed in firms’ valuation methodologies and in the data that they use as inputs to their valuation processes, in particular when markets are illiquid.

You can't improve the view in a mist. Valuation in the presence of size issue, liquidity issues, or model risk is inherently uncertain. Instead the users of financial statements need to be aware of that uncertainty, and we need to develop ways of quantifying it.

5. Supervisory and regulatory responsiveness to risks
Supervisors, central banks and financial authorities - individually and collectively - need to become more effective in translating risk analysis into action.

The point above applies. It is easy to say this. What are you going to do to make sure that this action actually happens?

6. Authorities’ ability to respond to crises
Central banks’ operational frameworks must be able to supply liquidity effectively when markets and institutions are under stress. Central banks are actively investigating what lessons they can draw from recent experiences for their operational frameworks, including the capacity to provide liquidity broadly and flexibly under stressed conditions, for their communication with markets, and for the steps that might be advisable across central banks to address liquidity needs in globalised financial markets.

All of this is a little depressing. It feels as if the FSF is flailing around at roughly the level of an undergraduate seminar. We are going to need more than a bit of disclosure, a wider range of collateral at the window, and management promising on the life of their favourite pet that honestly they will take action if risk gets too big to get us out of this mess.

Update. The FT uses the FSF paper as a launchpad to discuss the broader lessons of the crunch here. Meanwhile Larry Elliott in the Guardian makes the interesting point that the FED, the ECB and the Bank cannot all be right about rates. I might get to that on Wednesday.