[Herbert Hoover[_3_]]

I've reproduced the entire speech to make things easy for you. You do
know the Deutsches Bundesbank, don't you?....you know, one of those
left-leaning, liberal think tanks?


Axel A Weber: Moral hazard, market discipline and self-regulation €“
what have we learnt?
Speech by Professor Axel A Weber, President of the Deutsche Bundesbank,
at the Ceremony for the 50th Anniversary of Bank Negara Malaysia: "50
Years of Central Banking €“ Stability and Sustainability", Kuala Lumpur,
10 February 2009.
* * *
1 Introduction
Ladies and gentlemen
I would like to congratulate the Bank Negara Malaysia on its 50th
anniversary. 50 years of central banking is a time span which allows a
central bank to gain experience and to learn from the various
challenges it is confronted with. Anniversary celebrations are usually
an opportunity to look back on this period, to honour the achievements
and remember what might have been done better. However, given the
global financial crisis, it is impossible to confine oneself to this
retrospective view. We have to find ways of how to respond to todays
financial market challenges. This is exactly what the Bank Negara
Malaysia is doing by hosting this conference on Central Banking in the
21st century and I am very glad to have been invited to contribute to
the discussion by talking about moral hazard, market discipline and
self-regulation.
These issues take centre-stage in global talks on crisis prevention. As
the current financial crisis dramatically shows, neither market
participants nor the global regulatory framework have kept pace with
the expansion and innovative forces of the global financial markets. At
present, regulators, central bankers, and market participants all over
the world are trying to identify the causes of the crisis and search
for lessons to be learnt from it. While resolute political decisions
are indispensable when it comes to immediate crisis management, it will
take much more time and effort to identify and remedy the causes of the
financial turmoil. For this reason, I will not present you complete
formulas today but I will try to highlight some critical issues that
need further attention. But first, let me briefly outline the
theoretical concepts of moral hazard, market discipline and
self-regulation.
2 Theoretical overview
Moral hazard €“ In order to illustrate the concept of moral hazard, I
would like to look at the process of credit risk transfer in the form
of securitisation, which played a key role in the events leading to the
current financial crisis. Principally, credit risk transfer is a very
beneficial means of allocating risk in the financial market as it
disconnects the originator of a risky asset from the ultimate
risk-taker. The downside of this separation is, however, that once the
credit risk is forwarded there is no incentive for the originator to
monitor the debtor. This is what we call moral hazard and what has
ultimately resulted in an erosion of credit standards not only in US
subprime but also in other credit market segments. In general, the
ultimate risk-taker does not have the necessary information to monitor
the debtor and the transfer process unnecessarily complicates the
default risk assessment of the securitised assets.
Market discipline €“ Market discipline describes a mechanism in which
market participants have an incentive to monitor the risk behaviour of
counterparties with the aim of readjusting their investment decisions
accordingly. In the aforementioned case of securitisation, the
risk-taker might be penalised by its share holders and other
counterparties if a lack of monitoring impairs his ability to assess
credit risk properly. Hence, market discipline has the potential to
correct inefficiencies arising from credit risk transfer. However,
there is a very important prerequisite for market discipline:
transparency. Only if the market participants recognise that
BIS Review 13/2009 1
a moral hazard problem is arising will they have the option of
adjusting their investment decisions accordingly. While transparency is
a necessary condition for market discipline, it is by no means
sufficient on its own. In addition, market participants must have the
ability and incentive to use the information. Especially in times of
economic expansion, the incentive to acquire and use the information
might be low as the general default risk remains relatively muted as
long as the upward trend continues. A restraining effect via market
discipline is rather unlikely in this case. Therefore, transparency and
market discipline can sustain financial stability but they should not
replace market regulation. In addition, market regulation itself is
necessary for enhancing transparency.
Self-regulation €“ In general, there are two possible paths that can be
followed with regard to market regulation. Regulation can either be
imposed on the relevant institutions in the financial sector by
regulator agencies or the institutions themselves can willingly agree
on regulation. In the second case, we are talking about
self-regulation. Self-regulation has the advantage that market
participants tend to identify with the self-imposed rules, which should
result in a higher acceptance of the regulation. Moreover, market
participants might have better knowledge of the market, leading to more
flexible and less costly solutions. However, as the current financial
crisis underscores, self-regulation bears the risk that regulation will
remain too lax or that the market participants will not comply with the
self-imposed rules. This is an example of the well-known problem of
collective action. Consequently, it has to be decided carefully whether
self-regulation can be sufficient for a well-defined field of finance.
3 What have we learnt?
Let me now turn to some specific aspects that I consider to be crucial
in the learning process that we are currently undergoing. First, I
would like to talk about some regulatory issues, asking how we can
enhance transparency and market discipline in the securitisation
market, financial institutions and hedge funds. Then, I would like to
focus on the role that monetary policy can play in preventing future
financial crises.
3.1 Regulation
Securitisation €“ The securitisation market has played a critical role
in the financial crisis. Prior to the crisis, a lack of transparency in
this market aggravated wrong incentives in the originate-to-distribute
business model. As credit risk was well hidden in highly structured
products, it was easily transferred to other market participants. This
in turn increased the incentive to originate credit risk. Consequently,
credit standards deteriorated, contributing to overheating phenomena
such as those seen on the American housing and loan market. The fact
that market participants often relied solely on credit ratings and that
these ratings did not always capture the credit risk adequately
aggravated the situation. Once the crisis had begun, the lack of
information on the risk profile and profitability of the highly
structured products increased the distrust among market participants,
thus aggravating the financial turmoil.
In order to revive this largely beneficial market, a necessary
condition is to restore confidence among market participants by
enhancing market transparency. The transparency and quality of credit
ratings is definitely one starting point in this process. I would like
to stress that credit ratings should never replace the investors
responsibility to evaluate the risk of a financial product. But
transparency in the rating process €“ especially in the segment of often
opaque and multilayered structured credit €“ is a prerequisite for
investors to behave responsibly. Only a sufficiently transparent rating
process that represents negative incentive effects for rating agencies
will enable the investors to make informed judgements about the product
characteristics as well as the quality of the rating process itself. It
should be mentioned in this context that initiatives led by IOSCO, the
international organisation of securities supervisors, point in the
right direction. In the course of this month, IOSCO is
2 BIS Review 13/2009
expected to report on improvements of transparency provisions in
individual Codes of Conducts of credit rating agencies.
Another issue at stake is the lack of market standards in the
securitisation market. Market participants must have easy access €“ for
example, via a central data portal €“ to information on transactions in
the securitisation market, the underlying asset portfolio and further
transformation of the securitisation. The information provided should
include, among other things, details about any retention of a share of
securitised products on the balance sheet of the originator. This would
reveal the originators incentive structure and thus unveil possible
moral hazard problems. In addition, there is strong need for
international harmonisation of common terminology as well as disclosure
requirements.
At present, there seems to be a consensus among regulating institutions
and market participants about the necessity of these standards. The
Institute of International Finance (IIF), a global association of
financial institutions, has stressed in its final report on market best
practices the need for common information standards in the market for
securitised products. Their package of measures is largely consistent
with the aforementioned requirements. Moreover, there are initiatives
underway from both the American Securitization Forum (ASF) and the
European Securitisation Forum (ESF) to develop disclosure requirements
for securitisations.
The Bundesbank welcomes these initiatives and is watching the process
carefully. We hope that market participants in the securitisation
market will agree on and abide by strong self-regulation. Otherwise,
legal disclosure requirements will have to be implemented globally.
Financial institutions €“ Another important starting point for
transparency-enhancing regulation is the treatment of special purpose
vehicles founded by financial institutions in order to transfer their
credit risk off their balance sheets. In the course of the crisis, a
significant loss of confidence in the money market resulted from the
construction of these off-balance-sheet vehicles. As their business
model is built on maturity transformation, they have run into liquidity
problems when money market froze during the crisis and, owing to
reputation concerns, the banks had to take them back onto their balance
sheets. Thus, huge risks that had previously been invisible suddenly
reappeared on the balance sheets of financial institutions, revealing a
severe case of insufficient transparency.
Transparency requirements for financial institutions arise from
accounting standards disclosure requirements as well as from
prudential rules for banking supervision. With regard to accounting
standards, international and national ambitions are to change the legal
framework such that financial institutions must consolidate their
off-balance-sheet vehicles. For both the international financial
reporting standards (IFRS) and for German accounting rules in
accordance with the Commercial Code (HGB), legislation amendments are
underway. Additionally, the Basel Committee on Banking Supervision
recently proposed revisions to the existing pillar 3 requirements of
Basel II, which aim at helping market participants to better understand
a bank's overall risk profile, comprising, for example, requirements to
disclose involvement in off-balance-sheet vehicles. In my view, these
steps are essential for enhancing transparency in the financial markets.
Hedge funds €“ Let me now come to a branch that has not been the core of
the financial turmoil but has still played a significant role in the
course of the crisis: hedge funds. Although the direct credit exposure
of financial institutions to hedge funds seems to have been relatively
modest, hedge funds activities, such as sudden large scale liquidation
and the influence on market price dynamics and market liquidity, have
posed an indirect risk to core financial institutions and the broader
financial system. Furthermore, the strong growth in the hedge fund
sector has been one manifestation of the €œshadow banking system€� that
has contributed to the overall high leverage and the vulnerability of
the global financial system. Hedge funds are prone to price and
liquidity shocks due to their usual combination of leveraged positions
and short-term financing. This underlines the relevance of initiatives
for containing stability risks resulting from the failure or the
collective behaviour of hedge funds.
BIS Review 13/2009 3
There are two basic channels for reducing potential macroprudential
risks associated with hedge funds if direct regulation is still
regarded as an inappropriate measure. The first is to strengthen the
risk management of the prime broker, which has been recommended as the
main instrument over the past few years. However, recent events have
clearly demonstrated that authorities should not rely solely on the
risk management of the prime brokers to contain potential risks.
Therefore, this indirect approach should be combined with a second
channel: strengthening market discipline through higher levels of
transparency and disclosure. The Bundesbank has been calling for
progress in these areas for some time.
As hedge funds operate in global financial markets, only a global
initiative will effectively deal with the international dimension of
this issue. Therefore, the Bundesbank greatly appreciates the fact that
the G20 has explicitly asked the hedge fund industry to bring forward
proposals for a set of unified, self-regulatory best practices building
on several initiatives launched in 2007 and 2008. I am convinced that
this is a suitable way to strengthen transparency and market discipline
as well as the internal management procedures of the hedge funds
themselves. However, the devil is in the detail and I believe the
following points to be crucial. The best practices should include an
adequate disclosure framework, particularly vis-Ã*-vis counterparties
and investors, which includes adequate and regular qualitative and
quantitive risk-related information. In addition, they should include
the requirement to comply with rules aimed at safeguarding the
integrity of the market as well as a transparent and effective process
to enforce the standards and to assess compliance. In particular, an
obligation for hedge funds to submit themselves to third-party reviews
of compliance to best practice standards would be appropriate.
Furthermore, in order to enhance the forces of market discipline,
regulated institutional investors should only be allowed to invest in
those hedge funds that comply with best practices. Finally, an
improvement in the insight of authorities into the hedge fund industry
is urgently needed in order to better assess vulnerabilities in the
broader financial system.
3.2 Monetary policy
So far, I have focused on regulatory issues that are relevant for the
stability of the financial system. I would now like to turn to the part
that monetary policy plays in this respect. In order to identify this
contribution, an analysis of the monetary policy in the years preceding
the crisis is essential. Different analytical methods €“ such as a
comparison of central bank interest rates with the forecast of a Taylor
rule €“ point to the fact that monetary policy in most industrialised
countries has followed a rather expansionary stance in the second half
of this decade. This was particularly the case in the USA after the New
Economy bubble had burst. However, in the euro area, too,
interest-based as well as money and credit-based indicators have
signalled a long phase of expansionary monetary policy.
Boom-bust cycles in the financial markets cannot form independently of
monetary policy. According to empirical results, low long-term interest
rates tend to increase the risk appetite of financial market
participants and thus contribute to a dynamic worldwide growth in
aggregate credit. Why is this the case? Two aspects should be mentioned
here. First, low long-term interest rates €“ which may indeed be
justified from a monetary policy perspective €“ are equivalent to low
financing costs in the financial markets and therefore promote highly
leveraged business models. Second, in the event that the target rate of
returns of financial market participants does not take into account
that the level of the risk-free interest rate has dropped, a €œsearch
for yield€� process starts to trigger an increase in risky business
activities. This process may come to an end very abruptly when market
participants become aware of their high risk positions, for example,
after monetary policy puts an end to the phase of low interest rates.
Consequently, a whole generation of business models will be brought
into question. Moreover, low short-term rates have supported business
models that heavily relied on maturity mismatches. These models have
run into severe problems when short-term rates rose.
4 BIS Review 13/2009
The influence of monetary policy on the behaviour of financial market
participants might be especially strong in the event that the central
bank follows an asymmetric monetary policy that is lowering rates
aggressively in the face of macroeconomic downturns but increasing
rates only gradually when downside risks have vanished. Contrary to
this approach, there is the idea of a symmetrical monetary policy,
which would not consider the boom-bust phases in the financial markets
as isolated events, but would try to look through the financial cycle
and stabilise monetary policy. Moreover, a symmetrical monetary policy
would consider a higher key interest rate in the event of an increase
in risk in the financial markets, even in the absence of inflationary
risk or macroeconomic risks within the usual time horizon for monetary
policy. This does not mean that the central bank would abandon its
primary goal of price stability in favour of other intentions. The
central bank would rather take a longer-term perspective and include
the future consequences of unfavourable trends in the financial markets
in its analysis.
Without a doubt, a symmetrical monetary policy will not be able to
eliminate future financial crises. But I am convinced that a more
symmetrical approach to monetary policy will better alleviate the
negative effects of the financial cycle than a monetary policy approach
that solely tries to limit the damage in times of a financial downturn
by aggressively lowering interest rates. This is even more the case
when one assumes that the higher moments of financial cycles are met
exogenous to the monetary policy strategy chosen by central banks.
In this respect, the Eurosystem has a very valuable analytical tool for
the medium to long-run perspective: monetary analysis. This tool forces
us to extend the analytical horizon beyond the usual time span of two
years and to include the low frequency movements of monetary and credit
aggregates in monetary analysis and the decision-making process. Hence,
the Eurosystem already has an important stabilising element that
enables us to counteract procyclical trends in our monetary
decision-making. In future, this aspect of monetary policy will need to
gain in importance.
4 Conclusion
With this request, I would like to close my speech. In my view, the
highlighted issues are crucial in the ongoing analysis and learning
process of the financial crisis. I think it has become clear that many
promising international initiatives have already been launched.
However, further effort is strongly needed in order to enhance
transparency, market discipline and financial stability.
Obviously, financial regulation is currently being improved on in other
aspects as well, in particular as regards banking regulation. But
getting into these details would surely go beyond the scope of my
speech.
Thank you very much for your attention.
BIS Review 13/2009 5