The Future of Financial Regulation Howard Davies Director

The Future of Financial Regulation Howard Davies Director The London School of Economics OXONIA lecture 15 January 2008

Global Committee Structure - A Regulator’s View G-7 (Gov’ts) IMF World Bank (Gov’ts) OECD (Gov’ts) WTO FATF (Money Laundering) Financial Stability Forum Bank for International Settlements (Central Banks) G-10 (Central Banks) CGFS Basel (Banking) CPSS IOSCO (Securities) Joint Forum IASB IAASB (Audit) IAIS (Insurance) PIOB IASC Monitoring Group IFIAR (Audit) Source: “Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007”

European Committee Structure FSC Financial Services Committee (Finance Ministries + observers from regulatory level) Regulatory Level (Competent Authorities) European Parliament European Commission Council Working Groups (Legislative) Govermment Level Council of Ministers (ECOFIN) EFC Economic and Financial Committee Co. Re. Per Ambassadors (legislative) ESC European Securities Committee ARC Accounting Regulatory Committee EIOPC European Insurance and Occupational Pensions Committee CESR Committee of European Securities Supervisors CEIOPS Committee of European Insurance and Occupational Pension Supervisors EBC European Banking Committee EFCC European Financial Conglomerates Committee CEBS Committee of European Banking Supervisors IWCFC EGAOB Interim Working European Group Committee on Of Audit Financial Oversight Bodies Conglomerates AURC Audit Regulatory Committee 3 L 3 Committee Central Bank Level Outside Commission Committee Framework ECB Banking Supervision Committee of the ECB Source: Adapted with permission from a chart originally devised by John Sloan.

Seven Questions: 1. 2. 3. 4. 5. 6. Did the Fed do it? Is it all over for Anglo-Saxon capital markets? Is it all over for the sub-prime market? Can the ratings agencies survive? Do we need a new approach to liquidity? Is the UK’s Tripartite model fundamentally flawed? 7. Does the crisis reveal gaps in the global regulatory system?

1. Did the Fed do it?

2. Is it all over for Anglo-Saxon capital markets?

3. Is it all over for the sub-prime market?

Mortgage Origination by Product (%) Notes: 1. Total mortgage origination excludes seconds and home equity lines of credit 2. For relative growth versus 2001, 2007 annualized based on 9 months of date

Historical US Home Prices S&P/Case-Shiller Composite-10 Home Price Index (19912007) Index Value Source: Standards and Poor’s

Subprime Mortgage Pool Securitization Capital Structure Containing Subprime Loans PRINCIPAL PAYMENTS 100% Mortgage pool losses are allocated sequentially from the bottom of the capital structure to the top Principal payments are made sequentially from the top of the capital structure to the bottom 28% 20% 11% 7% 0% Note: Ratings are Rating Agency defined LOSSES

ABS CDO Securitization Capital Structure Containing Subprime Loans Subprime Mezzanine CDO Containing BBB Subprime Bonds 100% 11% SUPER SENIOR CUMULATIVE LOSSES AAA 8. 6% AAA 28% 20% 11% 7% 0% 40% AA A 11% 7% BBB 7% Equity 0%

Recent ABX BBB Price History Price Note: ABX BBB – Standardised basket of 20 home equity; ABS reference loans from home equity deals (issued within 6 months prior to index issue date Source: Markit Partners

4. Can the ratings agencies survive?

Bank of England’s Suggestions for Improvement 1. Agencies could publish the expected loss distributions of structured products, to illustrate the tail risks around them Agencies could provide a summary of the information provided by originators of structured products 2. • 3. Information on originators’ and arrangers’ retained economic interest Agencies could produce explicit probability ranges for their scores on probability of default Agencies could adopt the same scoring definitions Rating agencies could score instruments on dimensions other than credit risk 4. 5. • E. g. market liquidity, rating stability over time or certainty with which a rating is made. Source: Financial Stability Report October 2007, “Role of Ratings Agencies”

5. Do we need a new approach to liquidity?

6. Is the UK’s Tripartite model fundamentally flawed?

Non-Central Bank Unified Financial Regulators Source: How Countries Supervise their Banks, Insurers and Securities Markets 2007: Central Bank Publications

Central Banks in Regulation Central Bank as Banking Supervisor only Central Bank with Banking and other responsibilities Central Bank with no direct supervision responsibilities Central Bank as unified regulator Source: How Countries Supervise their Banks, Insurers and Securities Markets 2007: Central Bank Publications

7. Does the crisis reveal gaps in the global regulatory system?

Global Committee Structure - A Regulator’s View G-7 (Gov’ts) IMF World Bank (Gov’ts) OECD (Gov’ts) WTO FATF (Money Laundering) Financial Stability Forum Bank for International Settlements (Central Banks) G-10 (Central Banks) CGFS Basel (Banking) CPSS IOSCO (Securities) Joint Forum IASB IAASB (Audit) IAIS (Insurance) PIOB IASC Monitoring Group IFIAR (Audit) Source: “Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007”

The Future of Financial Regulation Howard Davies Director The London School of Economics OXONIA lecture 15 January 2008