Sunday, January 27, 2008

Davos Session on Evaluating Financial Risk: To Whom Should Credit Go?

· Walter B. Kielholz · Malcolm Knight · Raymond W. McDaniel Jr · Guillermo Ortiz
Moderated by
· Maria Bartiromo
Friday 25 January

The continued unravelling of the global credit market is raising questions about the role of market participants, including investment banks that distributed but did not originate the credit securities that went sour, the regulators who were not on top of the situation, and the rating agencies whose ratings of the credits turned out to be faulty. How soon the situation will sort itself out is anyone’s guess, as panellists agreed that the full extent of the losses suffered by banks is still not known.

Malcolm Knight, General Manager and Chief Executive Officer, Bank for International Settlements (BIS), Basel, noted that the total exposure globally to sub-prime loans is between US$ 250 billion and US$ 600 billion – far more than the amount disclosed by major financial institutions so far. Until there is more clarity, the painful process of de-leveraging or asset price deflation, which is taking place now, will continue.

He suggested that had banks already been under the Basel II rules, they might not have gotten into trouble, as the rules would have required them to set aside capital against off-balance sheet items such as the many structured products into which they bought.

Walter Kielholz, Chairman of the Board of Directors, Credit Suisse, Switzerland, said that, for four to five years, financial institutions have believed there is too much of an appetite for risk in the market, but not much was done as banks were under pressure to deliver returns.

Guillermo Ortiz, Governor of the Central Bank of Mexico, who confessed to "having been through more crises than I care to remember", observed that a factor common to all crises is the lack of transparency. Another potential risk, he warned, could come from insurance companies that provide credit protection. Spreads for credit default swaps have widened considerably.

Raymond W. McDaniel Jr, Chairman and Chief Executive Officer, Moody's Corporation, USA, accepted that the rating agencies were partly responsible for the credit mess. He said: "In hindsight, there was a failure in some key assumptions that were supporting our analytics, our model, and those key assumptions failed in part because the information quality, both the completeness and veracity of the information, was deteriorating in a way that was too much underappreciated by Moody’s and probably the other agencies."

He said Moody’s needs to learn from the experience and review its assumptions and methodology, as well as raise market awareness of what a rating agency does or does not do.

Panellists noted the big disconnect in the way the Collateralized Debt Obligations (CDOs) were originated, sold and regulated. They were originated by institutions not under the oversight of the banking regulators, sold by banks that did not originate the assets, and bought by investors who were not experienced in monitoring any deterioration in the value of the securities.

Knight opined that a "Balkanization" of regulations contributed to the problems. He noted that there are as many as 53 insurance regulators across the different markets in the US...

From the FT:

[Malcolm Knight] called for more global co-ordination to match the increasing integration of the financial system.

In rare public comments, Malcolm Knight, chief executive of the Bank for International Settlements, highlighted the discussions taking place with increasing intensity among world leaders and regulators over how to respond to the credit crunch.

At the World Economic Forum in Davos, Mr Knight said the “major challenge” for regulators was the “the Balkanisation of regulation – fragmented across market segments, across national jurisdictions and yet we want to have a global financial system”.

His comments echoed other ministers and officials, who are informally discussing at Davos the regulatory response to the financial turmoil.

Gordon Brown, the UK prime minister, called for greater transparency within banks and other financial institutions and for the IMF itself to take on the role of providing an early warning system for the global economy.

Leaders of NYSE Euronext, the US-European exchange group, said on Friday that global regulators were considering telling banks that they must disclose basic data about over-the-counter contracts such as collateralised debt obligations and credit default swaps, many of which have fallen sharply in value in the wake of the subprime crisis.

[Also] The level of leverage in the world’s financial system now appears to be rising, partly as a result of growing activity by hedge funds and private equity groups, [Malcolm Knight] warned on Friday.

Meanwhile, there are now some increasingly “crowded” trades in parts of the the foreign exchange market, including the so-called “carry trade” – which involves borrowing heavily in currencies such as the yen and investing the money in higher yielding assets.

These two factors could potentially create some nasty jolts to the financial system in the future, particularly given the economic wider imbalances which are now building up in the world, warned Malcolm Knight, general manager of the Bank for International Settlements in Basel.

“There is rising leverage in the financial system...and we have some very crowded trades in some areas of the foreign exchange markets,” Mr Knight said, speaking at the World Economic Forum in Davos. “Together these could create the potential for a very rapid repricing in financial market.”

Mr Knight’s comments are likely to be closely watched in financial markets, since the BIS acts as a meeting point for the world’s central banks and has historically had more freedom to air its concerns. It is also the official organisation which attempts to measure the extent of carry trades, something Mr Knight believes to be almost impossible.

His remarks came amid intense behind-the-scenes discussions between senior bankers and regulators on Friday about the risks which could potentially destabilise markets in the coming months.

Mr Knight did not specifically identify the yen as a threat on Friday. However, the BIS is understood to have been monitoring the yen carry trade very closely in recent weeks, amid signs that hedge funds and other investors have recently been borrowing heavily in yen.

But Kenneth Rogoff, Harvard professor and former chief economist of the International Monetary Fund, was more explicit. He said: “The most puzzling currency is actually the yen.”

Some bankers believe that pressure to unwind the carry trades would occur if the yen strengthened to around ¥111 to ¥114 to the dollar; the yen was on Friday trading at around ¥121 to the dollar. In 1998 it swung from ¥147 to around ¥115 in a matter of days, when the carry trades unwound, triggering jolts to the financial markets around the world.


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