Closing Keynote Session:
“Coming Up on the Radar – Systemic and Counterparty Risks in the Next Phase of the Crisis”

Notes for Intervention:  Malcolm D. Knight, Vice Chairman, Deutsche Bank Group
May 12, 2009, Beijing

It is a great privilege to participate in this year’s Asian Bankers Summit here in Beijing. The topic of this Closing Session: “Systemic and Counter-party Risks in the Next Phase of the Crisis” -- is certainly apt and timely. What has this crisis taught us about managing both systemic and counter-party financial risks, not only while the present turbulence persists, but also over the longer term, as we work to build a more stable global financial system?

1. The Macroeconomic context:  the severity and duration of the global recession

• The global financial crisis has now persisted since the summer of 2007 and has now metamorphosed into a severe global recession.  Thus it is essential to address these questions in a broad macro-economic context.


• If one strips away the details, the basic picture is that during the credit boom of 2002-07 residents of the US and a number of other advanced countries borrowed heavily to both consume more and invest more – and, of course, the investment was concentrated in residential real estate.  Simultaneously, banks in these countries borrowed more and lent more to expand their businesses in securitizations backed by residential mortgages and in proprietary trading, and also to extend credit both domestically and internationally.  


• With the onset of the crisis in the summer of 2007 the household sectors in several key advanced countries were left highly over-leveraged.  Simultaneously, with the collapse in the valuations of complex structured credit products (particularly those based on asset pools consisting of sub-prime residential mortgages), a number of large internationally active banks experienced serious deteriorations of their holdings of capital – it became evident that the large banks, too, were over-leveraged. 


• Since early 2008 households in the advanced countries have been trying to bring down their leverage by reducing consumption relative to disposable income.  Simultaneously, banks and other financial institutions are continuing to deleverage to rebuild their capital adequacy.  Both these actions are essential to eventually restoring financial stability, but both have had the effect of depressing output and employment in the “advanced” countries, thus sharply weakening their demand for imports.


• Despite these adverse conditions, the Chinese authorities have thus far succeeded in expanding domestic investment in productive infrastructure and other domestic spending as a major offset to the weakening of global demand.  Thus China’s policy actions are a boon both to China itself, and to the global economy. 


• But, the “bottom line” is that, despite China’s welcome initiatives the present global recession is likely to be more severe, prolonged, and internationally synchronized than any recession since 1945. 

2. The immediate future: Managing systemic risks and counterparty risks

  (i) Systemic risks

• The global recession, then, provides the adverse macro-economic context in which financial institutions and investors must address both systemic risks and counterparty risks.  For the immediate future, I believe that both the authorities and private financial market participants need to address four key systemic risks:
  (1) a further substantial deleveraging by both households and banks.
  (2) continued stress on both market liquidity and funding liquidity in global financial markets.
  (3) continued weaknesses in corporate risk management.
  (4) infrastructure risks.


• Let me say just a few words about each.


• While financial market conditions have improved in the past three months, deleveraging by households and financial institutions is continuing in the advanced countries, and is likely to persist for some time. 


• In their attempts to mitigate the heightened systemic risks from continued private sector deleveraging, policymakers have little choice but to use their policies to take on the leverage that is being ‘shed’ by the private sector.  They do so by taxpayer-funded capital injections into financial institutions and substantial debt-financed fiscal stimulus.  Such actions, while necessary, will create fiscal risks of their own over the medium term.  Indeed, several countries are already close to the limits of their fiscal capacity to provide capital to banks and to underpin domestic demand.


• In today’s global financial system, market liquidity and funding liquidity are much more closely interconnected than they used to be, and both have dried up since mid-2007.  Thus, in current circumstances, all types of corporations -- and indeed also policymakers in emerging market economies -- need to maintain very strong liquidity positions, build up their capital positions systematically, and be particularly vigilant of their rollover (refinancing) risks.  And, of course, banks need to continue to build capital through retained earnings, to limit their maturity transformation and to manage credit risk closely.  To some degree, the steeply-sloped yield curves that are the result of bringing monetary policy interest rates to historically low levels in the advanced countries will help financial institutions to gradually rebuild capital over time through retained earnings.


• Although many financial institutions have taken steps to strengthen their risk management, at least two major areas still require further work.  First, credit underwriting and credit monitoring still need to be strengthened.  Second, a fundamental restructuring of corporate remuneration systems must be implemented, so that the remuneration of risk-taking units in each financial institution is better aligned with its long-run risk-adjusted profitability.  We still have a system that compensates profitability unadjusted for risk, with the addition of arbitrary ceilings on “performance related” compensation.  This is obviously an untidy ‘interim solution’ which does solve the fundamental incentive problem in financial risk management. 


• There have been useful recent proposals in this area -- for example, by the Financial Stability Board (the former FSF) and the European Commission.  But as yet there is no international consensus on how to go forward to align compensation incentives with better risk management.


• As regards the systemic risks embedded in key financial infrastructures, two immediate issues come to mind.  First, the infrastructures of over-the-counter markets that are key to pricing risk – for example, the credit default swap market -- need to be reinforced to mitigate the large systemic risks that could be caused by the failure of a key counterparty (e.g., an AIG or a Bear Stearns).  This requires early implementation of central counterparty clearing in this market.  Much progress has been made here and this should happen in the next few months.  Second, as current anxieties about an influenza pandemic emphasize, more must be done to risk-proof the communications, messaging, accounting and information technology infrastructure without which the financial system cannot function.


• Clearly, all these key “short-term” systemic risks must be managed with great vigilance at the present time.

(ii) Counter-party risks.

• What are the key near-term challenges in the management of counter-party risk?  The current crisis is demonstrating that not only private financial sector institutions, but also the authorities need to be particularly vigilant to the evolution of counterparty risks.  Let me just mention the two types that I think are currently of most concern.


• First, of course, is the counterparty risk that is embedded in the complex structured credit products that are held widely throughout the global financial system though, happily, they appear to be of limited significance to institutions here in China.  These are the famous “toxic assets” -- now referred to as “legacy assets” in the United States – that are still causing major dead weight loss to the system.  The loss in value of these instruments is the main factor that has led to the severe capital deficiencies of many banks.  Since they typically have to be fair valued because they are in trading books, the toxic assets have been marked down progressively as the global economy has deteriorated.  My hope is that most large financial institutions are now marking these toxic assets at reasonable levels, though much more transparency in their valuations would be desirable.  Hopefully that will be a byproduct of the current US “stress testing” exercise and similar exercises in other jurisdictions.


• Second, there are the counterparty risks in the ‘whole-loan’ books of global banks.  These assets are on accrual so a deterioration in obligors’ loan servicing capacity comes through provisioning and impairments.  The accounting and management of these tend not to be forward looking.  With the global economy continuing to weaken, impairments to loans for autos, consumer credit and commercial real estate will likely be the next ‘shoe to drop’ in terms of counterparty credit risk.  Clearly, high vigilance is needed in monitoring these loans -- including here in China -- where the rapid credit growth the authorities are encouraging to address the recession must not be allowed to create excessive NPLs in the future.

3.  Rebuilding a more stable and resilient global financial system to better manage systemic and counterparty risks over the longer term.

• If regulators and market participants strengthen their management of counterparty risk in the near term, these enhancements will also serve them well in the long term.  But what can we start to do now to reform the architecture of regulation so that it can deal more effectively with system-wide risks over the longer term?


• Let me outline the key steps in establishing a framework for stabilizing and then reforming the global financial system. 


• Step One: Regulatory guidelines should be revised to require greater transparency and disclosure of the valuations of financial instruments (particularly those held on the books of systemically important institutions) and firms’ financial performance in order to strengthen market discipline.


• Whether fuller disclosure earlier on in the present crisis could have prevented it from “morphing” into a global recession, no one can say.  But greater transparency in the future will certainly reduce the uncertainties about counterparty risk that caused the enormous distortions in the interbank markets that undermined the core of the global financial system. 


• This area is quite technical, but in my view the key recommendation is that all jurisdictions should, as soon as feasible, adopt a single universally-accepted set of high-quality accounting standards, including internationally consistent guidance on accounting valuations and auditing standards. 


• Though China’s financial system is less affected by the crisis than most others, increased transparency will also be crucial here.  Banks are the chief source of financing for regional government and private sector investment in productive capital in China, and credit continues to grow rapidly.  Thus transparency to allow all market participants to monitor credit flows, low quality, and loan servicing performance will be essential to limiting financial system-wide risks in the future.


• Step two – needed in advanced and emerging market countries alike -- is to ensure that, over time, banks build up much stronger “shock absorbers” of high quality capital and liquidity so that they can survive the global recession and restart lending as demand for goods and services and for credit begins to rise again.  Since the fiscal capacity to inject capital is reaching its limits in some countries, this should be done gradually through stock offering and retained earnings. 


• In China, the authorities will need to remain vigilant to ensure that banks have sufficient capital and liquidity to support strong loan growth.
• But even if financial institutions act more effectively to mitigate risks that are priced in by credit markets, they are unlikely to take full account of financial system-wide risks – the risks that individual financial institutions do not systematically “price in” to their risk management, owing to competitive pressures.


• Thus Step Three is that each financial jurisdiction needs to establish an agency (in the case of many countries it will be the Central Bank) with the authority to act as the financial system risk regulator – the ‘macro-prudential’ regulator.  The responsibilities of this agency should be to: identify systemically-important institutions, markets, and infrastructures in its jurisdiction;  subject these entities to the levels of regulation and supervision that it considers appropriate;  monitor financial system-wide risks and require systemically-important financial institutions to take remedial measures (such as, e.g., increases in capital buffers as systemic risk rises in the upswing of the credit cycle and running them down in the downturn);  and establish a Special Resolution Regime for systemically-important financial institutions with the goal of preserving the integrity of the financial system,  but not necessarily to prevent the failure or merging of the institutions providing systemically-important functions. 


• And whether this “macro-prudential” function is performed by the central bank or a separate agency, the experience of this crisis has surely taught us that central banks must take on increased responsibility for financial system stability.  They must use all the policy instruments at their disposal to mitigate financial system risks, while continuing to achieve their key monetary policy objective.


• Step Four, perhaps most important of all, is to ensure that financial regulation is harmonized internationally.


• An integrated global financial system demands internationally consistent regulation and harmonized supervision, particularly for large cross-border financial institutions.  Otherwise, inconsistencies and gaps in regulation and supervision can aggravate competitive pressures and open the door to regulatory arbitrage, weaker risk management, and other activities that undermine the stability of the financial system. 


• Let me give just a few examples of what this means.  It means that key regulatory measures to control risk taking should all be consistent across national financial jurisdictions.  These include such safety and soundness standards as minimum risk-weighted regulatory capital requirements, the definition of what instruments constitute a firm’s reserve of capital, the capital cushions that financial institutions should hold above the minimum regulatory requirements, criteria for managing liquidity risk, loss recognition, and provisioning.  In sum, consistency in this domain across jurisdictions is critical to limit the scope for regulatory arbitrage in the international dimension, which has been a key cause of our current troubles. 

Conclusion: 

• Managing the ongoing financial turbulence and laying the foundation for building a new global architecture of financial regulation requires a comprehensive program of measures. 


• I would stress three things.  First, we need to begin implementing these measures immediately.  Second, it will be essential to ensure that their design and implementation are fully coordinated internationally.  Third, it is clear that China will play an important role in this process, both because it is such a large contributor to the global economy and because a number of the policy measures that the Chinese authorities may want to take, for domestic reasons, will be complementary to those that need to be taken in other countries, and would also be appropriate from a global perspective.

Thank you.

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