Barbara G. Stymiest
Chief Operating Officer
RBC Financial Group
International Economic Forum of the Americas Montreal
June 9, 2008
Good morning, ladies and gentlemen. It is a pleasure to be with you here today.
We've been living through the credit crunch for more than 10 months now. And for about 9 of those months, many of us in the banking realm have been asked to comment on the beginnings, evolution and potential end to this turmoil.
I do not purport to offer you the definitive word here today, as more analysis will have to occur before there is a complete picture of what happened, what went wrong and what was done right.
What I do want the room to consider is my belief that we're at a delicate juncture. We're at a point in time when people are starting to reflect and make significant decisions about their roles in this new environment and they need to do this carefully.
The question posed today is the roles of central banks and financial institutions in managing the repercussions of previous crises and their respective roles in preventing the crises of tomorrow.
My answer, as I will outline, is that although we each have different stakeholders, financial institutions, central banks and regulators have a shared responsibility. Our actions and reactions to events occur in very separate and distinct spheres, but we do not have mutually exclusive responsibilities; they are symbiotic, shared interests.
But before we get to roles, please allow me the opportunity to step back and walk you through the past 10 months of the credit crunch.
I'm speaking to you today as both a witness and a participant. As Canada's largest financial institution, and the largest capital markets player in the country, as well as the fifth largest financial institution in North America and one of the world's top 20 banks, it was inevitable that we would be a part of this story.
The story of the credit crunch really began with the bursting of the last bubble. In the aftermath of the dot-com crash, and the seismic shock created by the tragic events of September 11th, borrowing became remarkably cheap - in the United States and in many countries around the world.
This was also a time when the global financial system was flush with liquidity and had a seemingly insatiable demand for financial assets. That demand found its focal point in the U.S., which by 2005-06 was absorbing a remarkable 60% of global capital flows, from Europe and Asia as well as the recycling of petro-dollars from the Middle East.
The U.S. markets, where rules-based regulation had over a long period of time fostered market participants' compliance with the letter, though perhaps not the spirit, of the law, offered more inefficiencies to take advantage of than other markets, such as Canada.
These inefficiencies are rooted deep in the American past, in the forging some 80 years ago of restrictions against nationwide banking. The McFadden Act created a core banking system that was fragmented and insufficiently diversified - a system dominated by small- to mid-sized lenders, many with under-developed risk management and treasury operations with a funding model heavily reliant upon securitization rather than the model favoured by most other countries: matched funding via retail and commercial deposits.
The securitization model empowered a fragmented banking system to get loans off the books and onto the market as a way of freeing up capital for further loan origination.
Over time, this movement away from classic deposit funding further exposed the U.S. banking system to the fault lines underlying the capital markets.
In the low-interest-rate dawn of this current decade, mortgage lenders saw what they thought was a sure thing - an untapped market of consumers who now could better afford to take on bigger loans.
The growth in mortgages accelerated. Housing prices rose. With banks keen to move assets off their balance sheets - and investment banks eager to assist - financial products grew more sophisticated. The demand for high-yield products gave rise to new types of structured vehicles (like CDOs) which found their way to markets and investors through unregulated channels. Mortgage brokers found even more credit-challenged consumers to take on new loans or perhaps lowered their standards, as the rewards were too rich to ignore. Some people have called this the moral hazard.
Competition pushed mortgage rates to artificially low levels. Securitized products were being released into a world where there was no natural counterpoint to ensure that lending standards were respected. Traditional checks and balances were eroded.
This financial alchemy in which the sum of securitized parts was greater than the whole began to insinuate itself into the markets - magically satisfying the demands of many originators to remove "undesirable" poorly documented sub-prime assets off their balance sheets while supplying the investor with a "highly rated" security.
For their part, many banks believed that spreading risk to the four corners of America and around the globe inoculated them against the risk of a catastrophic collapse in the securitization market. And many policy makers believed this too.
In this "originate to distribute" model, the accounting income that would have been recognized over the life of loans was substantially booked as up front fee income. And the residual interests of the originators, the money centre banks and investment banks, were subject to complex marking-to-model practices, based on what we now recognize as faulty assumptions.
As an aside, the originate-to-distribute model has many benefits. Investors get more products to choose from that match their risk tolerance. Borrowers benefit from wider access to funds and cheaper rates. And originators get improved capital efficiency and increased funding options. In the months ahead, doubtless this model will be challenged, but these points are crucial to a full evaluation.
Many believed ratings agencies would act as de facto regulators, watchdogs by proxy. But the rating agencies were poorly equipped to serve that function, at least as it pertains to the complex investment vehicles at the root of subprime. Moreover, observable signs of increasing delinquencies came late and could not easily be interpreted in terms of expected losses.
As with all bubbles, we see now that it was based on folly and fantasy - on the fanciful notion that home values could only rise, or alternatively, not fall dramatically, that safety and security in the financial markets could be assured simply by appearing to distribute risk more broadly.
The last ten months have proved many wrong, and it has been a costly and, in some cases, humiliating lesson. Disappearance of markets and sharply increased doubts about valuations both of structured products and the underlying assets are continuing to affect the credit markets. Although some markets are starting to function again, there is still a long way to go. The securitization market, in particular, remains mostly frozen. Banks are relying on the short end of the curve for much of their funding, which has been facilitated by the influxes of liquidity provided by the central banks, but challenges remain in the mid- to longer end. While concerns over the fundamental solvency of financial institutions have largely abated, what we're now faced with is a mismatch of supply and demand in bank funding that continues to affect banks in material ways.
As I said a few moments ago the banks were very active in using the securitization market to move assets off their balance sheets but, concurrently, they were also forced to drive volumes and balances to maintain their profitability in a low interest rate environment, with narrow spreads. In many cases, this growth in assets exceeded the growth rate in relationship deposits thus driving higher levels of external borrowing at a much higher cost. This trend is clearly not sustainable.
There is now significant pressure on banks to deleverage their balance sheets, especially when you consider the banking system has had a significant increase in leverage caused by the net reduction in capital bases (losses of $380B exceed capital raises of $257B), as well as some banks being forced to buy-back assets from securitized vehicles which they sponsored.
This story is not yet at an end. The excess liquidity that drove the subprime market has disappeared and its absence has affected many other financial instruments. We have seen failures of single names like Northern Rock and Bear Stearns and some bank CEOs are being relieved of their duties (like Citi, UBS, Merrill and very recently Wachovia). We still have yet to fully understand the impact of this credit disruption on the banking system and the follow on effects on the general economy. More specifically, what the impact will be on the consumer as the economy slows and this deleveraging continues.
Today, all parties are considering the question of what a post-recovery environment will really look like. In the meantime, bank treasurers, such as ours, are being rewarded for having established well diversified programs for access to term funding and capital.
Beyond the funding issue, it's safe to say that banks have entered into a more cautious phase defined by increased transparency, a measure of internal austerity and reduced exposure to, and improved monitoring of, risk.
Let me emphasize: neither government nor industry should be expected to hold people's hands on every major financial transaction.
We need to remind ourselves of the old-fashioned principles and basic fundamentals that have made our industry such an enduring and successful feature of the global finance landscape. In the coming months and years, as a recovery takes hold, financial institutions defined by long-term business strategies, strong balance sheets and especially by disciplined risk management principles will be rewarded.
Some of you may know that UBS recently published a Shareholder Report on its write-downs which has been well read across the industry. Despite the incongruity between its write-downs and its principles, it made clear that, "… business management is accountable for, and is expected to manage, all risks arising from their business and function and to ensure that risk and profit objectives are balanced. The identification of business risks associated with a business strategy is the responsibility of the business Senior Management."
I mentioned earlier that we at RBC were a part of this story and while we are not happy with the size of our write-downs, they are, relatively speaking, modest compared to many other players.
To what do we credit this reality? It's very simple: good business strategy, clear accountabilities for risk-return tradeoffs and sound risk management. I believe that this is the defining narrative in this story. The landscape for financial institutions has changed dramatically from the days when we were simple lenders and deposit takers. Those financial institutions that managed this transition to their risk profile well are set to handle the crises of the future, as their risk and control infrastructure is better prepared to keep pace with business growth. Where businesses forge ahead with innovation, a well-managed risk infrastructure will quickly close the gaps between old and new.
RBC's ability to manage risk well is a core competency, and is supported by a strong risk management culture and an effective risk management approach to business innovation.
The tone is set at the top to ensure that the principles, policies, processes, authorities and limits appropriate to the type and nature of RBC's businesses are in place to support effective enterprise-wide risk management framework.
Collaboration between the businesses and with our control functions is a key component of RBC's enterprise wide risk management. RBC has a structured approach to defining the amount and type of risk we are able and willing to take as an organization.
It starts with identifying regulatory constraints that limit our ability to accept risk. This helps us define our risk capacity, which is the maximum amount of risk we can accept. Knowing our risk capacity, we then establish and regularly confirm a set of self-imposed constraints and drivers where we have chosen to limit or otherwise influence the amount of risk we undertake. This is our risk appetite.
Risk appetite is then translated into risk limits that guide our businesses in their risk taking activity. Continuous measurement and monitoring is used to confirm that our risk profile - the actual exposure as compared to our established risk limits and tolerances - remains within our risk appetite.
This means that we have a consistent discipline across the enterprise to manage risk. The details need to be tailored to specific situations, and for new innovations, but the fundamental structure is the same.
Some institutions chose not to participate in certain markets. They managed their risk to near-zero. But there was no reward. Other institutions participated actively in new markets, but didn't close the gap between reward and sound risk management. And yet others, like RBC, participated in these markets and adapted their risk management practices to close the innovation gap.
Striking the right balance between risk management and business innovation is a delicate affair, but ultimately our shareholders benefit when we get it right.
Turning from risk management at financial institutions to the domains of the central banks and regulators.
The Bank of Canada, as our nation's central bank, has five main areas of responsibility, one of which, monetary policy, has a direct influence on the general economy. The setting of overnight interest rates, the targets for inflation and the provision of liquidity all contribute to the smooth and efficient operation of the financial system.
Financial institutions earn returns for their shareholders and are dependent on the overall health of the economy. Banks need consumers to be confident in the economy in order to spend; similarly, we need business to borrow, spend and invest in order to get returns to the economy in a greater order of magnitude. Furthermore, capital markets businesses earn returns by serving clients who are issuers and investors by facilitating capital raisings, both traditional debt and equity as well as structured products to meet the complex needs of their clients. To play this role, capital markets players must be able to originate, distribute and trade and this can only be done in well functioning, liquid markets.
All of this to say that central banks and financial institutions have a shared interest in the operation of the markets. Our interests are aligned.
Central banks have been very effective players through this most recent period. Their focus on injecting liquidity into the financial system has helped ease the strain on markets. The Bank of Canada, as lender of last resort, has called for an increased range of instruments to use as collateral. These calls should be heeded, in fact, the House of Commons may be voting on this matter late today.
Where it concerns regulation, we need to consider - and in my view largely resist - calls for increased regulation, a clamour that is in full throat among some politicians and certain economists. Some demand a worldwide regulatory architecture, arguing that global finance cannot rely on a patchwork of domestic oversight. Others seek a more rigid and demanding national system of regulation.
It must be said right up front that the financial system is fundamentally sound. But, like any system, it is vulnerable to excesses. In this instance, excesses in the housing market, the originate-to-distribute model and leverage all played a part in allowing this most recent bubble to inflate.
Given that the system is sound, any reform should be targeted at the excesses, rather than broadly across the system. What's more, gazing into the rearview mirror to establish new rules for going-forward is a perilous proposition. Humans have a very natural inclination to never want to make the exact same mistake again. The risk is that by over-reacting to one particular set of circumstances, we set the stage for a whole new set of problems in the next cycle.
To over-regulate risks creating a shadow market to which markets shift to avoid overly burdensome rules. To under-react risks losing the confidence of investors. Striking the right balance is the key to the success.
I believe we must be guided by the recent words of Sir John Bond, the former Chairman of HSBC, who said: "Sensible regulation is fine, but not all regulation is sensible."
In terms of the United States, it appears that the time is ripe for a de novo review of the regulatory framework - in particular, a change in structure away from the fragmentation in the marketplace. This is not a recommendation to simply add new regulations onto the existing structure.
The vagaries of a banking system with many smaller participants relying heavily on a market-based system of funding could be mitigated by an evolution to fewer nationwide banks backed by FDIC charters - and therefore not be as affected by the whims and fluctuations of capital markets. Meanwhile, the volatility inherent in the operations of the monoline mortgage lenders could be diminished by absorbing more of them into the banking fold.
Does this scenario sound familiar? It should. It's Canada's.
Increased regulation has the charm of appearing to be a quick fix. But the truth is that where this crisis is concerned - a broad crisis over many countries and asset classes - there is no quick fix. And this will not be the last crisis we face.
One of the lessons that reverberates from recent events is that more and continuous communication between home and host banking regulators is essential in a globalized world. Dialogue promotes better compliance and heightens efficiency. In an environment where corporate overhead and public regulatory expenditures are continually under scrutiny, collaboration among regulators will contribute to more streamlined and effective compliance regimes. This will bring us closer to the shared goal of a more efficient and sounder international financial system with more protection for consumers and investors.
As a result, the notion of some sort of global regulatory regime seems a non-starter in practical terms, leaving alone any merits of its theoretical underpinnings. It makes more sense to focus on existing and successful examples of international co-operation, such as the Financial Stability Forum, a body whose creation was spearheaded in large part by our former Prime Minister, Paul Martin. Their recent recommendations in respect of risk management, valuations and disclosure as well as recommendations to strengthen prudential oversight and the authorities' responsiveness to risks are critical.
But even these recommendations must be examined in consultation with all parties. Our experience over the past ten months bears this out. We should be cautious about moving ahead precipitously with any type of prescriptive regulatory response that may be disruptive, overreaching and ultimately unnecessary down the road. And from the perspective of Canada, we need to be particularly careful considering that we have one of the best financial services sectors in the world.
The crucial thing to take away from what happened is not simply that bubbles happen and are damaging - it's that the global markets in the modern era are highly resilient and that the complex interdependence between various markets is not transparent and contagion fallout is a risk that needs to be managed. This demands a co-ordinated response by the various central banks. Although this is arguably the most severe crisis we have ever experienced, we will make it through, as we have made it through others. And over the long term, the ability to defend against the impact of such crises can be improved by the banks themselves, as well as by the policymakers and regulators. We all share the same interests and responsibilities.