The Financial Crisis and its Implications for Regulation in the 21st Century

World Trade Institute, 17 November 2008Judson Berkey

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Summary

1. What has Happened?

2. What were some of the Causes?

3. What were the initial Reactions?

4. What still needs to Happen?

5. What may change in Banks and Regulators?

6. What are the links to Trade and Globalisation?

7. Are there other Opportunities in the Crisis?

Disclaimer: the following are personal views and do not represent an official position of UBS AG or any of its affiliates.

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What has Happened?

The fastest reshaping of an industry ever seen leading to questions about the future of financial system and whether a “social contract” has been breached

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What has Happened? House price falls

Bank writedowns/losses leading to solvency concerns, capital raising and forced mergers

Decreased availability/increased cost of funding leading to liquidity problems

Stockmarket crashes

Source: Bloomberg 30 Sep 2008

Source: Finance Times, Martin Wolf, 1 Oct & 16 Sep

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What were some of the Causes? Interest rates held too low for too long mixed with low inflation and freely moving

capital (including alternative capital pools such as foreign banks, govts./wealth funds, institutional funds and a “shadow banking system” consisting of hedge funds and other unregulated entities like money market mutual funds) provided funds that were invested in housing or securities based on housing

Much of this was speculative buying (up to 40% of all mortgages by 2006) and/or by people of low credit quality (i.e. “subprime”– up to 20% by 2006) fueled in part by deliberate government-directed policies to expand home ownership via Fannie Mae and Freddie Mac and a belief that prices would always rise

Inventory became too great and when combined with foreclosures due to resets on mortgage rates this led to falls in house prices and the securities based on them

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What were some of the Causes?

Houses became a “one way” investment due to house price appreciation being greater than the mortgage cost to finance the house. People assumed this would last.

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What were some of the Causes?

Innovation (securitisation; off balance sheet vehicles) had allowed for even more loans and investments to be made (in housing and in other assets) than in previous bubbles because additional securities could be created from the underlying mortgages and these securities could in turn be used as collateral for additional lending

The theory was that this innovation was beneficial since it expanded available capital without unduly increasing risk because the risk was spread across a broader range of market participants and structures

But this only encouraged even less sound lending and investment as the moral hazard was increased and some of the interconnections in the system were not seen

Source:FDIC - http://www.fdic.gov/news/news/speeches/archives/2007/chairman/spapr1707.html

Source: Economist 16 Oct 2008

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What were some of the Causes? Regulatory standards (e.g. capital requirements, accounting standards, tax incentives,

misplaced oversight responsibilities) and/or incorrect risk assessments (i.e. too high rating agency ratings of securitisations in light of underlying risks and the actual nature of the credit and liquidity guarantees provided) had given banks scope to increase leverage.

Once the downgrades started to occur then the process went into reverse and fed on itself (i.e. reduced asset values led to margin calls led to more sales to raise funds which led to further asset falls) . Many products had embedded leverage due to the tranching and this was often compounded by the fact that the products were purchases using leverage (e.g., at 30 to 1 leverage a 3% loss in asset value wipes out the equity).

Source: BIS Quarterly Review Sep 08

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What were the initial Reactions? Deposit Insurance: increased coverage

– Europe: various guarantees and increases

– US: FDIC temporary increase in deposit insurance for individuals to USD 250 K; full guarantees of non-interest bearing (i.e. small business) accounts; voluntary USD 50 billion guarantee program for money market funds (a main liquidity provider to banks)

– Others: Kuwait full guarantee of all deposits

Solvency: injections of capital into banks and purchases of troubled assets

– Europe: see next slide; CHF 6 B investment in UBS by Swiss Confederation and Swiss National Bank loan of CHF 54 B to new entity to take over assets from UBS

– US: $ 125 B mandatory investment in 9 major banks with $ 125 B more available; $ 450 left in TARP authority for asset purchases

– Others: South Korea injection of capital

Liquidity: central banks provide direct liquidity or provide guarantees of debt (intended to reduce LIBOR)

– Europe: see next slide; in addition, ECB, Bank of England, and Swiss National Bank offer of unlimited liquidity to banks at fixed interest rates

– US: Fed purchase of unsecured commercial paper from corporates and banks; FDIC insurance for investors in new debt issued by banks

– Others: Hong Kong, Australia, South Korea, Denmark, Sweden guarantees on bank debt

Nationalisation: complete takeovers of parts of the banking industry

– Europe: Fortis in the Netherlands; RBS, Northern Rock, & Bradford and Bingley in the UK; Hypo Real Estate in Germany

– US: Fannie Mae, Freddie Mac & AIG

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What were the Initial Reactions?

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What still needs to Happen? Decrease leverage not just in financial institutions (IMF estimates that balance

sheets need to shrink by USD 2 trillion a year over 5 years) but also in consumer portfolios (i.e. people in the US must save more)

Banks raise equity capital to ensure solvency and that new loans can be made (e.g. some, including George Magnus of UBS and the IMF, estimate that at least USD 700 B was needed to recapitalise the system)

Shine light on where the risks have gone (e.g. concern over AIG collapse largely due to fact it had written so many Credit Default Swaps; concern over Lehman bankruptcy because USD 400 B notional CDS trades referencing Lehmans (ISDA estimates actual settled cash was 1-2% of notional); most CDSs are OTC and not on regulated markets)

Source: Economist, 16 Oct 2008Source: Economist, 11 Oct 2008 Source: Economist, 16 Oct 2008

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What may change in banks? Improve risk management (back to basics in analysing position fundamentals but also

try to adopt more holistic and portfolio views, enhance stress testing & concentration analysis; “not just getting things right but doing the right things”)

Adjust compensation mechanisms (salaries and incentives for senior officers and front office; increase pay/standing of back office controllers)

Modify the originate to distribute model of securitisation (e.g. enhance due diligence; provide mandatory buy-back guarantee or retain some of the risk on balance sheet; reduce overall use of off-balance sheet vehicles)

Embrace the universal bank model to ensure more stable sources of funding & liquidity (i.e. better match the risks) and reduce use of short term funding

Operational and financial separation of units based on riskiness and overall more disclosure to provide greater clarity on risk taking

Improve market infrastructure (e.g. clearing facility for CDS)

Source: Finance Times, 23 April

Have we been here before or is this an “enough is enough” moment?

• Black Monday & US S&L crisis (86-95)

• Japan “lost decade” crisis (90-99)

• Asian Banking Crisis (98-99)

• Tech/Telecom “dotcom” crash (00-01)

• Subprime credit crisis (07-?) Source: Financial Times, Martin Wolf, 15 Oct

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Institute of International Finance Financial industry statement of actions necessary to help re-establish confidence in financial

markets and limit future system crises published in Final Report of the IIF Committee on Market Best Practices (July 2008)

Risk Management

– Enhance governance (CEO ultimately responsible with Board oversight; strong Chief Risk Officer) and risk culture

– Articulate clear appetite across all major risks and involve finance and treasury in monitoring of risk in a holistic manner

– Take integrated approach to managing complex products including looking through structures and concentrations

Compensation Policies

– Base compensation on risk-adjusted performance and performance over time

– Ensure incentives do not induce excessive risk-taking and compensation policies are transparent to all stakeholders

Liquidity

– Ensure robust approach to liquidity management aligned with the business model

– Ensure sound stress testing of potential effect of adverse market conditions on liquidity profile

Valuation

– Maintain robust valuation processes aligned with accounting principles and ensure independence of valuation

– Initiate dialogue among auditors, rating agencies, investors, analysts, standard setters, supervisors and banks on valuation principles and techniques

Transparency

– Enhance quantitative and qualitative disclosures

– Initiate a Market Monitoring Group among banks to monitor global markets and try to detect vulnerabilities with systemic implications

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Counterparty Risk Management Policy Group III Group of senior financial industry professionals that have produced prior reports in response to

major financial industry dislocations. New report Containing Systemic Risk: The Road to Reform issued in Aug 08.

Common denominators in systemic financial shocks since 1980

– Credit concentrations - Broad-based maturity mismatches

– Excessive leverage - Illusion of market liquidity

– Collective human behaviour: unbridled optimism on the upside and fear on the downside

Five core precepts on which management and supervision of banks must rest

– Corporate governance - Risk Monitoring - Estimating Risk Appetite

– Focusing on contagion - Enhanced oversight

Detailed recommendations on accounting consolidation, high risk complex instruments, risk monitoring and management, enhanced credit market resiliency and emerging issues. Among them

– Revise US GAAP standards for consolidation to align with IAS standards that focus on control and sharing of risks and rewards

– Establish standards of sophistication for participants in high-risk complex financial instruments and provide one page “term sheets” for products with clear explanation of economics of product

– Provide more information to investors about the basis on which valuations are made and following trade execution intermediaries to make reasonable efforts to keep counterparties informed of material developments regarding performance of key positions

– Enhance due diligence particularly with regard to high-risk complex asset-backed securitisations with disclosure to investors of due diligence results including “health warnings” about characteristics and risks in products that may give rise to significant loss over life of the instrument

– Improve risk management information systems, concentration & liquidity risk management, stress testing, and governance of risk management and control frameworks. Address liquidity and capital management in an integrated fashion.

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What may change in regulators?

Changes in capital requirements (overall increase – tier 1 of at least 9% w/ counter-cyclical adjustments? leverage ratios? )

Enhanced cross-border cooperation and harmonisation of standards to avoid regulatory arbitrage and keep up with internationalisation of finance (e.g., response to Fortis and deposit insurance)

Bring into the regulatory fold the institutions that have been outside the system but either are direct participants or facilitators through functional regulation (bond guarantors, rating agencies, mortgage brokers, hedge funds, insurance companies)

Technical changes in accounting rules (allow for circuit breakers or temporary suspension of mark-to-market rules in certain cases; require more consolidation of assets held in off-balance sheet vehicles)

Focus on consequences and overall health of system (principles) and not individual entities and their specific actions (rules) to ensure ability to keep up with innovation and to help limit regulatory arbitrage

Generally an increased skepticism of self-regulation by institutions, particularly those large institutions in the “too big to fail” category (e.g., more information requests and challenge of conclusions)

Changes in the structure of regulators (e.g., single regulators like UK FSA and CH FINMA = combined regulator across all financial sector and a separate central bank; twin peaks like Netherlands = prudential regulation with central bank and conduct of business left to separate regulator)

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Financial Stability Forum

International cross-sectoral body that provided set of recommendations on actions needed to address weaknesses in the financial system in April 2008 Report on Enhancing Market and Institutional Resilience – update published in October 2008

Strengthen Prudential Oversight of Capital, Liquidity, and Risk Management – Basel Committee raised capital requirements for trading book exposures (additional incremental charge for

rating migrations) and for re-securitisations and short-term liquidity facilities provided to asset-backed commercial paper conduits (i.e. will help to reduce incentive for regulatory arbitrage by moving assets off-balance sheet).

– Basel Committee to monitor overall capital levels under Basel II and determine if any adjustments are needed.

– Basel Committee issued new standards for robust liquidity cushions sufficient for times of market stress (includes requirements to consider off-balance sheet exposures, securitisation activities, and other contingent liquidity risks that may manifest themselves during market turmoil)

– Basel Committee to issue guidance for supervisory oversight of firm-wide risks including concentrations, off-balance sheet exposures and securitisations, valuations and liquidity risk, and stress test principles.

– IOSCO to review investment managers’ due diligence practices and coordinate with Senior Supervisors Group in study of internal control systems, particularly with respect to structured products.

– Market participants to improve infrastructure for settling OTC derivatives across all asset classes and move as soon as possible to central clearing of credit derivatives

– National supervisors considering additional measures (e.g. leverage ratios).

Enhance Transparency and Valuation– Basel Committee to enhance Pillar 3 disclosure requirements particularly for securitisation levels and valuation,

off-balance sheet vehicle sponsorship, liquidity commitments, and pipeline and warehousing risks in line with recommendations of Senior Supervisors Group.

– IASB to issue enhanced guidance on risk disclosures and consolidation of off-balance sheet entities (i.e must consolidate where there is control or material risk/reward sharing; abolish qualifying SPE treatment exemption).

– IASB to issue guidance on valuation of financial instruments, particularly allowing for greater judgment when markets are inactive. To be coordinated with US SEC/FASB fair value guidance and aligned with Basel Committee guidance on Pillar 2 assessment of valuation practices.

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Financial Stability Forum Role and Uses of Credit Ratings

– Credit Rating Agencies to adopt revised IOSCO Code of Conduct for Fundamentals for Credit Rating Agencies (enhancements on independence and conflicts of interest requirements; develop a different scale for structured products from corporate bond ratings; enhance transparency on data history on which ratings are based particularly for strutured products). IOSCO to develop mechanisms to monitor compliance.

– US SEC proposed enhanced guidance. EU Commission considering standards for authorisation and supervision of rating agencies. Canada and Japan also considering actions.

– Investor associations to develop standards for due diligence and credit analysis for structured products.

– Joint Forum (Basel Committee, IOSCO, IAIS) to review use of ratings in regulatory frameworks.

Strengthen authorities responsiveness to risks– FSF to establish protocols for supervisory colleges for major global financial institutions and FSF to conduct

review in 2009 to determine how process is working.

– National supervisors to enhance expertise of staff and ensure regular dialogues with senior management and boards.

– IMF and FSF to cooperate more closely (e.g. IMF to share Financial Stability Note with FSF) to help monitor global financial vulnerabilities

Strengthen arrangements to deal with stress in the Financial System– Central banks to conduct lessons learned exercise through Committee on Global Financial System (e.g. need

for measures such as inter-central bank swap lines and cross-border collateral arrangements to distribute liquidity internationally).

– FSF to develop high level principles for cross-border crisis management.

– International Association of Deposit Insurers to finalise draft core principles

– FSF to examine forces (e.g. capital requirements, loan provisioning, compensation, valuation) that increase procyclicality in the system and report to G7 in April 2009

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Group of Thirty Analysed current practices across 17 jurisdictions which resulted in the report The Structure of

Financial Supervision: Approaches and Challenges in a Global Marketplace (6 Oct 2008) as part of broader work program that is intended to deliver specific recommendations in early 2009

Key findings

– Financial sector has changed from domestic firms engaged in distinct banking, securities, and insurance businesses to more integrated financial services conglomerates offering broad range of products globally

– Traditional lines between banks, insurance companies, and securities firms have substantially blurred, as each has sought to maximize profits through business expansion and financial innovation.

– There are different supervisory models - no one is best but some are clearly suboptimal.

Key conclusions

– Strong leadership and high quality people can make up for suboptimal supervisory structures in the short term but longer term changes are required.

– Effective, transparent, and efficient deposit protection schemes are important

– Supervisory “colleges” for systemically important global financial institutions are necessary but must be flexible in procedures and operations

– Need for convergence to high quality, internationally recognized regulatory standards (e.g. international accounting standards)

Still open questions

– Regulation of currently unregulated entities (e.g. hedge funds and private equity funds)

– Optimal role of central banks in the future regulatory landscape

– Systemic implications of rescuing failing institutions with important operations in several jurisdictions

– Mechanisms necessary to permit the orderly liquidation of major financial institutions, particularly with important operations in several jurisdictions

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Approaches to Bank Supervision

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What are the Links to Trade and Globalisation?

The history of financial liberalisation has been a history of capital flow and banking crisis cycles. The exception was the 2000s (until now)

Trade liberalisation has usually gone hand-in-glove with financial liberalisation (the early inter-war period and the Great Depression showing how these can go into reverse)

The open question now is whether there will be retreat of financial liberalisation (seems likely at least in short term) and what it means for trade and globalisation more broadly.

However financial liberalisation (correctly focused) does increase wealth. Thus, can we figure out a way to contain the political reaction and not “throw the baby out with the bathwater”?

Source:

National Bureau of Economic Research “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”, Working Paper 13882

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Are there other Opportunities in the Crisis? Two key challenges for the next 30-40 years: Global Governance & Resource

Tradeoffs

Global Governance

– Need to manage further integration of emerging markets into the current international political, economic, and regulatory structures

– Should there be a “grand bargain” between emerging markets and the developed world (e.g. further injections of capital in exchange for re-balancing of power structures in the Bretton Woods institutions) or an overall reform of global governance to better address internationalisation of finance (e.g. as called for by EU leaders)?

Resource Tradeoffs

– Tradeoffs in how resources are used for food, energy, and economic development require holistic thinking and investment of significant amounts of capital for the long-term (e.g. Stern has suggested that flows of USD 20-75 billion by 2020 and up to USD 100 billion by 2050 are needed to ensure low carbon growth in the emerging markets; at the same time Zoellick has called for a New Deal for Global Food Policy with some UN estimates calling for USD 8-10 billion per year in new agriculture investment in emerging markets to ensure sufficient food supply in the face of alternative uses for land and water)

– Should financial institutions (during their period of government “influence”) be given a new goal of facilitating the transition to a low carbon world that ensures sustainable use of natural resources (note: capital flows of USD 50 billion would be 10% of total private capital flows and 35% of commercial bank flows to emerging markets based on the IIF’s estimates for 2009)?

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A Closing Comment

APPENDIX

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A Simplified Version of a Bank Banks intermediate credit by turning deposits into loans

This leads to credit risks (loans may go bad), liquidity risks (depositors may demand money back), interest rate risks (spread between loans and deposits), operational risks (e.g. poor due diligence) and market risks (to the extent banks invest on their own account)

Banks must pay for their funds and make money with the returns they generate on their assets. In addition, banks have general administrative costs.

Banks in the US face two key regulatory constraints. A capital requirement that requires 10% of “risk weighted” assets to be covered by equity and a leverage ratio that limits nominal assets to 20x equity.

Assets– Cash 50

– Securities 450

– Loans 1500

Total 2000

Return Rates– Cash 0

– Securities 4%

– Loans 8%

Liabilities– Deposits 1500

– Borrowings 400

Equity 100

Total 2000

Cost Rates– Deposits 2%

– Borrowings 2%

– Cost/Income Ratio 65%

Return on Equity = 10 / 100 = 10%

Leverage Ratio = 2000 / 100 = 20

Risk Weighted Assets = (450 * .1 + 1500 * .5 ) = 795 Capital Ratio = 100 / 795 = 12.6%

Income– Securities 18

– Loans120

Expense– Deposits -30

– Borrowings -8

– General Admin -90

Total 10

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Turning a Bank into a Growth Stock Banks have recently focused on Return on Equity and sought ratios around 25%

In order to get there banks need to increase their income through increasing assets (in this case 2000 of loans but could also be an even higher number of securities)

In order to fund this increase one could increase equity (but this dilutes current shareholders and requires event greater income increases) or gathering deposits or issuing debt (each of which has a cost).

In either case, there is a limit on asset growth due to the leverage ratio and capital requirements

These can be worked around particularly if the loans can be rated highly or moved off balance-sheet. Assets

– Cash 50

– Securities 450

– Loans 3500

Total 4000

Return Rates– Cash 0

– Securities 4%

– Loans 8%

Liabilities– Deposits 1500

– Borrowings 2400

Equity 100

Total 4000

Cost Rates– Deposits 2%

– Borrowings 2%

– Cost/Income Ratio 65%

Return on Equity = 26 / 100 = 26%

Leverage Ratio = 4000 / 100 = 40 (but assets can be moved off-balance sheet via securitisation)

Risk Weighted Assets = (450 * .1 + 4000 * .5 ) = 2045 Capital Ratio = 100 / 2045 = 4.9% (too low!)– But if assets can be rated higher, risk weights reduce. Revised Capital Ratio (450*.1 + 2000*.1 + 1500*.5) = 100 /

995 = 10.1

Income– Securities 18

– Loans280

Expense– Deposits -30

– Borrowings -48

– General Admin -194

Total 26

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How a Bank Gets into Trouble With the additional assets and leverage a bank has more weak spots.

If the assets turn out to be worth less than originally thought then capital can be an issue (i.e. reduction in assets must be covered by reduction in equity but there is only a think equity buffer).

– E.g. if the loans turn out to be worth only 3350 instead of 3500 (i.e. reduction in value of 4.5%) then the equity is wiped out and the bank must raise more funds

If the assets were funded through borrowing more than deposits then liquidity can be an issue (i.e. if the returns on the assets are not sufficient to cover the borrowing costs then additional assets must be sold).

– E.g. if the additional loans only return 6.5% instead of 8% then income is reduced by 30 and the bank has a loss and cannot cover its cost of funds

If depositors lose faith in the bank and demand their money back at the same time then liquidity is an issue (e.g. only 50 in cash and marketable securities on hand to cover 1500 in deposits) or if the cost of funds suddenly increase due to concerns about solvency then liquidity also may become problem (cost of borrowed funds increase to 3.1% turns income negative)

– These are always a problem for a bank but may be made more acute through the additional leverage

Assets– Cash 50

– Securities 450

– Loans 3500

Total 4000

Return Rates– Cash 0

– Securities 4%

– Loans 8%

Liabilities– Deposits 1500

– Borrowings 2400

Equity 100

Total 4000

Cost Rates– Deposits 2%

– Borrowings 2%

– Cost/Income Ratio 65%

Income– Securities 18

– Loans280

Expense– Deposits -30

– Borrowings -48

– General Admin -194

Total 26

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Where the Losses Occurred and connection to UBS UBS losses were concentrated in Super Senior Tranches of CDOs that were either

still in a “warehouse” for distribution as part of the “originate to distribute” model or were on the balance sheet as part of a “carry trade” proprietary investment strategy

Source: Swiss Federal Banking Commission 18 Oct report - Subprime Crisis: SFBC Investigation into the Causes of the Write-downs of UBS

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UBS Transaction with Swiss National Bank

Supports the stability of both the Swiss financial system and UBS

Accelerates UBS’s risk and balance sheet reduction in an extremely difficult market environment

Ensures orderly liquidation of distressed assets over time with the funding structure of the entity and the ownership by SNB

Provides UBS's clients with an opportunity to renew confidence

Substantially protects UBS’s shareholders from the impact of troubled fixed income markets

Material de-risking through transaction with the SNB

Practical, commercial solution at economic terms

Caps UBS’s future potential losses at USD 6 billion on the transferred assets of up to USD 60 billion

Secures their long-term funding through SNB loan

Removes assets from UBS’s balance sheet, reduces RWA and balance sheet size

Capital raise eliminates doubts about strength and reliability

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Transaction details

UBS SNB

Assets

Cash

UBS provides 10% of asset value (up to USD 6 bn) of equity capital, then sells to SNB for USD 1. In return UBS is granted an option to participate in 50% of the equity value exceeding USD 1bn

Non-recourseloan

< USD 54bn

Equity< USD 6 bn

Assets< USD 60bn

New Fund

Loan

Principal +

interest

UBS sells up to USD 60 billion of currently illiquid securities and other assets from its balance sheet to a separate fund entity.

– Assets include previously disclosed risk concentrations related to the US real estate market [but exclude monoline or leveraged finance positions]

After the sale to the fund, UBS’s net exposure to risk concentrations will be close to zero

The entity will be controlled by the Swiss National Bank – assets will be removed from UBS's balance sheet.

Financing of the entity will be provided through:

– UBS will contribute equity funding of up to USD 6 billion. Its equity interest will be sold to SNB for USD 1.

– Loan of up to USD 54 billion by SNB. Loan is non-recourse to UBS (assuming no change in control).

Terms of the transaction allow:

– UBS has the option to repurchase the equity once the loan is fully repaid for a purchase price of USD 1 billion plus half of the equity value exceeding USD 1 billion.

– If – over the life of the transaction – the fund equity declines in value, the SNB will be able to participate in the appreciation of the UBS share (based on max 100 million UBS shares).

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Further strengthening of capital base

Strong Tier 1 and total capital ratios at 10.8% and 14.8% estimated for 3Q08

RWA increased by CHF 13bn driven by currency effects and market risk

The impact of the transaction and related capital measures expected to produce a year end Tier 1 ratio of approximately 11.5% before any other fourth quarter effects

1Q08 2Q08 3Q08E

Tier 1 Capital (CHF bn) 22.9 37.5 36.3

Tier 1 Capital Ratio 6.9% 11.6% 10.8%

Total Capital (CHF bn) 35.6 50.7 49.7

Total Capital Ratio 10.7% 15.7% 14.8%

RWA (CHF bn) 333 323 336