Former IMF managing director Jacques de Larosiere yesterday lashed out at rating agencies for their failure to identify risks before the recent turmoil in financial markets. He also lambasted markets for “not listening to loud and clear warnings” from economists and others about the impending crisis.
“If rating agencies cannot provide an adequate picture of looming potential risks, isn’t there a case for more preventive action through regulation, or at least through disclosure?” de Larosiere asked, in an address to the Institute of International Finance. The issue cannot be brushed aside with claims that “markets are always right,” he argued.
The crisis was the result of “a combination of abundant liquidity, which led to low interest rates and therefore to excessive appetite for high yield assets, of too-low and indiscriminating spreads, and of insufficient understanding of the true risks involved”, de Larosiere said.
The crisis was “predictable” and the warnings from economists “loud and clear”. “But, as usual, no-one really listened. And, as always, when the trigger comes – after the realization that defaults are rising, which has been the case in the US sub-prime mortgage markets – the markets are surprised, and overreact.”
The financial world had in recent years “lowered risk assessments and encouraged credit laxity”. Global monetary policy has allowed liquidity to increase in such a way that “the possibility of scarce money was not even a consideration in the mind of most market players. This is always dangerous,” said the former head of the Bank of France.
In a scramble for higher yields, financial institutions sold their initial credits to special investment vehicles, de Larosiere noted. “One danger of this wave of securitization is that some banks tend to become less vigilant on the quality of their loans, and more interested in the quantity of credits to be packaged at remunerative conditions.”
The “biggest danger” lies in the proliferation of off-balance-sheet special purpose vehicles not exposed to normal liquidity risks. Disintermediation has created “virtual or synthetic banks” that take on the same risks as real banks – but with very weak capital, no deposit base, and no comparable regulation.
Rating agencies had failed to incorporate the relaxation of lending criteria for sub-prime borrowers into their analysis, de Larosiere argued. And rating agencies had been used as “proxies for regulating markets”, a role they are unable to play.