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European Commissioner for Internal Market and
European Parliament's Plenary Session
Mr President, Honourable Members,
The US sub-prime mortgage crisis and its potential impact on Europe have been occupying our attention in recent weeks. The European mortgage market has different characteristics than that of the US, – so problems on anything like a similar scale are less likely to arise in Europe in the near future. Sub prime lending in the EU is very limited compared to US and we have safeguards in place such as lending rules and limits on loan to value.
The recent turmoil has, however, clearly demonstrated the interconnectivity and globalisation of financial markets. Risks have been spread widely. This is positive. Contagion, however, is an issue. Some European banks and asset funds are exposed to sub-prime related securities. There have been some real problems, notably via the liquidity squeeze of the asset-backed and commercial paper markets.
What can Europe learn from this crisis? It is too early to draw firm conclusions. There is too much uncertainty in the market. It is also important to react sensibly, taking the necessary time to assess the situation. Fast policy reaction is likely to be a bad reaction.
The following issues emerge from our preliminary thinking:
1. The interconnectivity of markets shows how important it is to have a globally convergent approach to regulation, with sound prudential rules and proper investor protection standards. It makes the Commission's regulatory dialogues with the US and other jurisdictions even more critical. High standards of regulation are necessary throughout global financial markets - given the spill-over effects.
2. Questions about mortgage lending in the US inevitably arise. While I support the notion of facilitating access to the housing market for people who would not normally be able to buy a home, with hindsight the adequacy of regulation and consumer protection will inevitably be debated. Repair is underway, but the problem will take time to resolve. One of the lessons from the crisis is the importance of lifetime financial education for citizens whilst ensuring that responsible lending is enforced. In the EU, we are already looking at these issues within our ongoing work on consumer and mortgage credit and consumer education.
3. The transfer of mortgage loans and their risks to other parties has been at the centre of this crisis. Sometimes these risks have returned to the originating bank, when their financial vehicles could not sell off or finance the bank-originated securities.
We certainly need to look closely at the mechanisms at play (i.e. the role of conduits and special purpose vehicles) and their relevance for European banks. The problems of valuation of complex securitised products and market clearing mechanisms in stressful market situations also need further analysis. The recent market crisis has also highlighted the importance of reputational as well as liquidity risks as important drivers to properly assess banks' risk exposures to complex transactions.
4. What about Basel II – the new capital requirements Directive for Banks? Basel II provides improved opportunities to banks and investment firms to properly assess risks and to correctly calibrate their regulatory capital. So will Solvency II, which is Basel's broad equivalent for the insurance sector. However this does not mean we should be complacent. There will be implications that will require careful examination by regulators. For example more work will be needed on the capital calibration of complex products and on banks' ability to identify potential problems in crisis conditions, including potential concentration of risk in certain areas.
5. Many hedge funds have been particularly active in the structured credit markets. Many of those hedge funds – and their wealthy private or institutional investors – may have incurred losses, some heavy, in recent months. That is the way markets go.
Sophisticated players in hedge funds know this. Financial markets function on risk. I do not criticise those who make fortunes when times are good. I am not going to shed any tears now if there are losses. However, the crucial thing is that hedge fund failures do not appear to have spilled over to the wider financial system. Investment fund rules (UCITS) have held up. Our prudential framework and bank risk controls have – as we expected – prevented hedge fund failures from triggering wider systemic disruption.
As much as some people want to demonise hedge funds they are not the cause of the difficulties in the market
Let us not forget where the present crisis has its roots. Poor quality lending, compounded by securitisation of these loans in off balance sheet vehicles that few understood the risks associated with. These are issues that prudential authorities and supervisors will need to focus on in the time ahead.
6. What was the role of Credit Rating Agencies in this crisis? I had already expressed criticism about how slow they were in downgrading their credit ratings for structured finance backed up by sub-prime lending. How robust was their methodology? How well were they explained? Were the limitations in the ratings of structured products vis à vis standard corporate ratings explained and understood?
Potential conflicts of interest of Credit Rating Agencies is another concern. On the one hand because they act as advisors to banks on how to structure their offerings to get the best mix of ratings. On the other, credit rating agencies provide ratings that are widely relied upon by investors. They also concern regulators, given their importance for the calculation of banks' capital requirements.
It has been alleged that there was unwarranted rating inflation for structured products. The role of credit rating agencies needs to be clearer. What they do. What they don't. The extent to which they can be relied upon. The extent to which they can't. I am following up on these issues with CESR and I intend raising them also with our international partners.
What we need are clear, robust methodological rules and principles, rigorously applied, and a much deeper understanding by investors of the uses and limitations of ratings and their reliability or otherwise. The scope for conflicts of interest to influence ratings must be firmly addressed. Of course adequate due diligence from other market players is also essential. Where was it? Were firms, and the professionals they employ, constantly and objectively assessing the quality of the instruments they were buying and selling and the risk implications of the structures of those instruments? Or were they just assuming? Did they stop and consider the validity of the underlying assets, the fraud risks, the track records of the originators and the trends in the markets? Did they question the ratings themselves and did they have access to the necessary data – both qualitative and quantitative to do so? I hope that the Boards of all financial firms will examine their actions and draw appropriate conclusions. We believe that "light touch", principle-based regulation is the best approach for the financial sector. It has proven its value. But we need to remain vigilant and draw lessons. All parties need to take their responsibility – and take it seriously.