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Legal and Conduct Risk in the Financial Markets, 3rd Edition by McCormick, Roger; Stears, Chris (22nd March 2018)

Part II The Financial Crisis of 2007–2011, 6 Market and Regulatory Failure

Roger Mccormick, Chris Stears

From: Legal and Conduct Risk in the Financial Markets (3rd Edition)

Roger McCormick, Chris Stears

Credit risk — Lending and credit

(p. 69) Market and Regulatory Failure

The issue clearly posed, and now extensively debated, is whether future regulation should enforce a greater institutional separation between classic bank services to the real economy (sometimes labelled ‘narrow’ banking or ‘utility banking’) and risky proprietary trading activities (sometimes labelled ‘investment banking’ and sometimes ‘casino banking’).1

A swap contract based on a notional principal sum of £1m under which the local authority promises to pay the bank £10,000 if LIBOR rises by one per cent. and the bank promises to pay the local authority £10,000 if LIBOR falls by one per cent is more akin to gambling than insurance.2

It is a tale from which nobody emerges well: not the maths whizzes who applied the Gaussian copula function to put a price on these collateralized debt obligations; not the risk assessors, who asserted there was only a one-in-a-billion chance of things turning out as they did; not the regulators, who could not understand what they were regulating; not the rating agencies, who were receiving money from the banks they were supposed to independently assess; not the bankers, who awarded themselves bonuses for taking ever larger risks; not the academic economists, almost none of whom predicted what was coming; not the world’s governments, who have put future generations in hock to pay for their incompetence; not even you or I, who on average have allowed our level of personal debt to reach 160% of our income, and who took such ignorant risks with our savings for the sake of an extra 0.5% interest.3

(p. 70) A.  Casinos and Utilities

6.01  One of the by-products of the Financial Crisis was a repeating chorus of demands for ‘better risk management’ and an end to ‘excessive’ or ‘imprudent’ risk taking. However, understanding risk and risk management requires an appreciation of the context in which the risk in question arises. The risk of death and destruction by bush fires, for example, is more material in California, Southern Australia and the South of France than it is in any part of the UK or Scandinavia. The context includes climate and relevant weather conditions (such as strong winds): at any given time they might combine (perhaps with human carelessness or recklessness) to produce a deadly effect. Concern about legal risk in financial markets tends to arise in the first place because of the nature of banking activity but the level of concern also varies from time to time due to events such as new case law or legislation or significant changes in transactional behaviour or other market phenomena. It is also affected by political developments, including pressure for bankers to be seen to be ‘punished’ for their misdeeds, changes in law that affect how banks may go about their business and the creation of new regulatory agencies whose methods, practices and approaches to ‘grey areas’4 and issues of interpretation may be difficult to predict.

6.02  Any consideration of the current context of financial market activity has to take into account the Financial Crisis and, in its aftermath, the Conduct Crisis. The Financial Crisis came as a surprise. Much has been written about its causes but it was not publicly predicted by anyone with any degree of precision.5 It had a huge impact on all kinds of commercial activity as well as considerable political consequences. Its most noticeable side effects include a heightened awareness of the risk management role (by whatever name called) in financial institutions and a more general concern about how society, whether through regulators or otherwise, can minimize the risk of a recurrence. Risk has come to dominate the political agenda, whether in relation to risk management functions, the appropriate incentives for risk takers (and disincentives for ‘undue risk taking’) the implications of ‘moral hazard’ and institutions considered ‘too big to fail’, the protection of depositors, the ‘socialization’ of risk or the stability of the financial system as a whole (and its protection from systemic risk). (p. 71) Legal risk as such has not grabbed the headlines but this is largely because the term is not common currency in the media. If, say, ‘increased regulation’ was substituted for ‘legal risk’ (since the former is an example of the latter) we would no doubt find the expression dominating conversation in political and financial communities, rather like the reactions to banks being accused of fraud (another example of legal risk, specifically, conduct risk). Legal risk looms in various phenomena that have been triggered by the Financial Crisis; in new laws, the threat of tougher regulation and increased litigation as well as calls for greater individual responsibility for future, improved risk management and, generally, as the Conduct Crisis has developed,6 more ethical behaviour within banks. Case law triggered by the Financial Crisis has also thrown new light on practices in the financial markets that, albeit with the benefit of hindsight, raise legal risk issues which may not have been fully appreciated prior to the Financial Crisis. In this Part of this book, we look at the relationship between the Financial Crisis and legal risk and how they have affected each other. This analysis includes a survey of the initial legal and regulatory responses. In Part II of this book, we consider the many legal and regulatory changes prompted by the Financial Crisis, and which have been implemented since 2012 (and up to the date of this edition of the book). In Part III of the book, we focus on the Conduct Crisis.

6.03  Although this Part of the book is essentially concerned with the general impact that the Financial Crisis has had, and is having, on legal risk, we begin with the reverse cause and effect discussion: how concerns over a particular legal risk resulted in changes to the law in the 1980s and the effect of those changes on certain kinds of financial transactions and, ultimately, a crucially important part of investment banking activity—derivatives trading.7 A glance at the recent past, and how we (in the UK) changed the law relating to swaps and other derivatives may perhaps inform our views as to directions that should be taken in the future.

6.04  According to the Turner Review, the origins of the Financial Crisis ‘entailed the development of a complex, highly leveraged and therefore risky variant of the securitised model of credit intermediation’ and ‘large losses on structured credit and credit derivatives’8 impaired bank capital and ‘created a crisis of confidence which (p. 72) produced severe liquidity strains across the entire system’. These liquidity strains of course produced what became known as the ‘credit crunch’. Derivatives, or certain versions of them, were thus regarded, by the FSA (the authors of the Turner Review) and by many others, as key contributors to the causes of the Financial Crisis. The de Larosière Report, for example, holds them at least partly responsible: ‘… the explosive growth of the Over-The-Counter credit derivatives markets, which were supposed to mitigate risk, in fact added to it’.9 They are associated with the ‘casino banking’ referred to in the Turner Review and worse still, depending on your point of view, ‘casino capitalism’.10 The reference to casinos is of course usually intended by those who make it to be a pejorative metaphor.11 In fact, the relationship between derivatives trading and gambling is a very close one. It was only in 1986, with the passing of the Financial Services Act,12 that the legal risk of certain kinds of derivatives contracts being regarded as void or unenforceable under the Gaming Acts of (p. 73) 1845 and 1892 was for most practical purposes removed.13 Prior to that change in the law, it was not always easy to get a clean legal opinion on the enforceability of derivatives contracts, especially if they did not have any genuine, underlying hedging purpose but were purely speculative. The problem of derivatives being caught by gaming laws is not confined to the UK. As Henderson observes, there is a:

near-universal existence of laws prohibiting or restricting gambling or rendering gambling contracts unenforceable. These laws often define gambling as an agreement to make a payment based on the occurrence of a contingent event, or a contract for differences. Both transactions are broad enough to include transactions in the form of derivatives within a strict reading of their terms.14

6.05  So the changes to the law that, broadly, gave legal validity to derivative deals done ‘by way of business’ (and, subsequently, removed the relevant 19th century legislation altogether) were of course welcomed by the markets. It is reasonable to conclude that UK public policy, expressed through legislation in the 1980s and the following two decades, was in favour of banks being able to enter into valid contracts for purposes that might otherwise have been regarded as gambling. If we now find that their operations sometimes resemble those of casinos, we can hardly claim to be surprised. The Financial Crisis-driven problems are due, at least in part, not to a failure to understand the nature of the changes to the law but to a failure to appreciate what ‘risk management’ of the consequences of these changes (on behalf of individual institutions and society as a whole) would actually entail. The need for ‘better risk management’ and concern about the ‘quality of corporate governance’ are, arguably, direct products of the more liberal regime that these changes have introduced. It is, as the Conduct Crisis continues to unfold, far from clear that we have found the answer to such concerns.

B.  The Origins of the Financial Crisis

6.06  As so often happens when a crisis hits, those affected tend to look back at the preceding period and condemn what they see (usually with hindsight) as inexcusable excess. This happened when the boom of the 1980s eventually ran out and it also happened as commentators looked back on the Financial Crisis. The following extract from Nick Cohen’s ‘Looking Back at the Ruins’15 sums up the way many feel about what happened in the UK:

(p. 74)

Those who did not have the £250,000 income they needed to be truly wealthy in 2007 had no need to feel hard done by. They could still take a mortgage of up to five, six, seven, eight times their income, add in credit card and bank loans and live as if they were wealthy in executive homes with Porsche Cayennes in their drives … Like other lenders, Northern Rock also gave mortgages on 125 per cent of the value of a property. The bank’s generosity had the advantage of allowing borrowers to pay off credit card bills and have money left over to kit out their homes

6.07  ‘Sub-prime’ loans were not confined to the USA. UK society had also got into the habit of living beyond its means. It was able to do this for various reasons, including the increasingly lax lending standards of lenders. They in turn could afford (at least for a time) to be lax because their exposures under the ‘sub-prime’ loans they were making could be sold off to (it would seem) gullible investors, using a variety of legally complex transactions involving securitization and derivatives. As a result, the response of society, as it looks back in anger at what has happened, includes casting a very suspicious eye over the way the derivatives market works.

6.08  Despite the opprobrium heaped upon derivatives, especially credit derivatives, in the wake of the Financial Crisis, the damage that has been done is due to human intervention rather than the mere existence of a transaction form,16 however akin to gambling it may seem. Derivatives are not ‘bad’ per se and nor is ‘financial innovation’.17 A derivative that is used to hedge genuine commercial or financial risks is a very valuable, and widely used, tool.

6.09  According to a survey of the world’s 500 largest companies carried out by ISDA in March and April 2009, 94 per cent of those companies ‘use derivative instruments to manage their business and financial risks’. These companies are not all gamblers (save to the extent that any commercial activity involves taking risks). The findings of the survey included the following:

  • •  foreign exchange derivatives are the most widely used instruments (88 per cent of the sample);

  • •  interest rate and commodity derivatives are the next most popular;

  • •  commodity, equity and credit derivatives are used mainly by specific sectors; for example, commodity derivatives are used mainly by utilities, companies involved in basic materials and financial service companies and credit and equity derivatives are mostly used by financial service companies.

6.10  Few would argue against the proposition that derivatives have their uses. In their less exotic forms they are part of the fabric of ordinary commercial and financial (p. 75) activity. A derivative that has, say, a single, well known corporate credit risk as its underlying asset is likely to be a perfectly understandable form of investment. A derivative or securitization product, such as a CDO (Collateralized Debt Obligation)18 that has a complex mix of very dubious credits as its underlying assets, on the other hand, looks more suspect. It may prove to be ‘toxic’, to adopt one of the expressions popularized by the Financial Crisis. However, it may not be ‘toxic’ at all, if it is bought by an investor who fully understands the risks and is able to manage them.19 Like almost any other ‘innovation’ or invention, it can be put to good or bad use. However, one of the disconcerting phenomena to emerge from the Financial Crisis was how many investors who were supposed to be ‘sophisticated’ and able to understand complex risks were, as it turned out, not very adept at managing such risks and, as their problems mounted, in need of taxpayer funds (in some cases, at least) to keep them ‘alive’.

6.11  The problems that led to the Financial Crisis were caused more by how particular kinds of derivatives were used, how they were combined with securitization techniques (the ‘slicing and dicing of risk’) and how such usage, it would seem, masked the seriousness of the underlying risks to those who acquired exposure to them via the resultant instruments.20 It appears that a ‘herd instinct’ developed that, put simply, led investors of all kinds (and others, such as regulators) to believe that a market phenomenon that had achieved such widespread popularity so quickly surely could not have catastrophic, even systemic, risks associated with it.

6.12  That bad decisions were taken by bankers, in various different contexts, is beyond dispute. But what of the regulators? Should they accept some responsibility for inappropriate reaction to those decisions (or, in some cases, for allowing them to (p. 76) be made, or implemented, at all). The accusation is simple: they knew (or should have known) what was going on and they did nothing about it. We may also feel that government intervention in banking activity (particularly in the US housing mortgage market) should come under suspicion as a significant cause. The accusation in that context is: they deliberately encouraged credit decisions to be skewed in order to further social engineering policies and in so doing caused normal, prudent underwriting standards applicable to a huge sector of bank lending to be fatally undermined. One might also add, in the case of the UK, that the government had become so awestruck by the success of the City of London that few in government circles felt able to second-guess the judgment of those in charge of major international banks that produced such a bountiful return in terms of jobs and taxes.21 But the primary responsibility must lie with the management of the banks. They designed and traded, to a large extent among themselves, a type of security (with various sub-variations) that proved, ultimately, to lead to the near-collapse of the financial system. No one forced them to do this, whatever one may feel about ‘regulatory incentives’. The failures of regulators and others do not excuse them from responsibility. The decisions to expose financial institutions to the risks presented by these instruments were the decisions of their own management. This carries enormous implications for risk management functions in financial institutions as well as for regulatory systems that assume that such functions are reliable.

6.13  What was the nature of the errors, how did they come about and what are the implications for regulation in the future? The following is a distillation of the key events in the causation chain that most commentators accept as a reasonably accurate account of the origins of the Financial Crisis (although different commentators may emphasize different links in the chain—this is not an area free of politics):

  • •  For various macro-economic reasons, such as US trade imbalances with China, the returns available to investors on conventional, ‘safe’ investments such as US Treasury bonds gradually became unattractive during the early 1990s.22

  • •  As a result, demand for more ‘exotic’ and ‘structured’ instruments that could offer higher returns started to grow.23

  • (p. 77) •  There was political pressure on US banks and other financial institutions to provide mortgage finance to sections of society in the US that had below average creditworthiness—so-called ‘sub-prime’ borrowers.24 Further, certain features of the US mortgage market, particularly the prominence of ‘limited recourse mortgages’, appeared to incentivize over-optimistic borrowing (and lending).25 And some of the practices of mortgage ‘originators’, such as allowing self-certification of income, accepting very generous valuations and unusually structured ‘teaser’ interest payment obligations, now look, in retrospect, very dubious indeed.26 It seems unlikely that those who invested in securitized products (as described below) that were based on transactions with these features would have done a considered risk assessment of the implications.

  • •  Derivative instruments offering attractive returns were developed that included a range of corporate credits as the underlying assets; these were then adapted to feature sub-prime mortgage assets as the underlying; it was possible to split the underlying risks into different ‘tranches’, with different categories of risk for each tranche; those who bought the instruments could thus opt for higher or lower risk of default, depending on their risk appetite and desire for higher yield; it was, however, extremely difficult to value such products, especially when the market for them started to dry up.

  • •  Banks in US and European markets were able to create special purpose vehicles (SPVs) that would purchase such derivatives using short term funding from the money markets; the capital adequacy and accounting rules allowed such activity to be treated as off-balance sheet for the banks notwithstanding various contingent funding commitments that they may have given to such vehicles.

  • •  The amount of ‘leverage in the system’27 created as a result of the use of the SPVs referred to above grew to enormous proportions and it was, effectively, outside the scope of the conventional regulatory system, creating risk that was largely unmeasured by the authorities.28

  • (p. 78) •  As Mervyn King, when Governor of the Bank of England, pointed out29 the banking system itself (certainly in the UK) became too big and over-leveraged. As a proportion of GDP, the UK banking system was five times the size of that of the US.

  • •  In some cases, derivative instruments were used as the underlying assets of other derivatives, thus creating so-called derivatives ‘squared’ (or even ‘cubed’)—or, to use the more technical language of the BCBS, ‘re-securitisations’.

  • •  The fact that assets represented by sub-prime loans could be passed on relatively easily by those who made (or ‘originated’) the original loan transactions resulted in a lack of rigour in the basic credit assessment process at the time those loans were made.30 The underlying loans were essentially treated as little more than the raw material for the derivative ‘products’ that were sold into the financial markets, generating, in the process, very handsome fees for those who did the packaging and selling. The availability of securitization, as a means of offloading risk, seemed to exacerbate the problem, if anything. McBarnet observes:

… the legal capacity to securitise itself stimulated a hunger for opportunities to create loans or other assets that could be securitised. Rather than securitisation being built on pre-existing assets with their own economic logic, the possibility of securitisation prompted the creation of assets—such as sub-prime loans—to securitise, regardless of their intrinsic economic logic. Small wonder that there was concomitant expansion of systemic risk.31

  • •  In the UK, various banks, notably, Northern Rock, Bradford & Bingley, Alliance and Leicester and HBOS, became increasingly reliant on wholesale markets to finance mortgage lending activity ‘and/or on their continuous ability to securitise and sell down rapidly accumulating credit assets … ’32 Mutual building societies in the UK started investing in ‘sub-prime assets’ (p. 79) bought from institutions like Lehman Brothers and GMAC. Looking beyond the UK, it is even asserted that the advance of mortgage finance was no longer restricted by capital considerations: ‘the deciding factor was whether the loans could be sold on as bonds and the demand for those was rapacious’.33

  • •  The ability to pass on the assets (or credit risk) was eased by the ability to obtain favourable credit ratings (eg, AAA) for the relevant derivative instruments due, some suspect, to creative structuring of the transactions that took advantage of loopholes in the credit rating process; the high credit ratings, together with the use of credit default swaps and credit enhancing ‘wraps’ (issued by, eg, insurers such as the AIG group or ‘monoline insurers’ such as MBIA and Ambac)—which insured against the default risk—also made it more acceptable for banks to keep the instruments on their books, but using short term funding.34

  • •  When the US housing market started to decline, the perceived value in derivatives based on sub-prime mortgages also declined; the willingness of money markets to continue financing arrangements such as those referred to above quickly disappeared; banks found that they were required to honour contingent funding commitments even if only for ‘reputational’ reasons and as a result many of the off-balance sheet arrangements became on balance sheet,35 triggering requirements for large new capital injections; institutions (such as Northern Rock) that had depended on the money markets for funding to a significant extent developed severe liquidity problems (and of course, in the case of Northern Rock this led to the first bank run in England for over a century); even those with lower direct exposures to such markets experienced difficulties as the money markets ‘closed’ due to a lack of confidence in the financial system generally caused by uncertainty as to which institutions had the more serious sub-prime exposures.

6.14  The above analysis is echoed in the Explanatory Notes to the G20 Communique issued at the London ‘Summit’ of 2 April 2009:

While market participants were unable to understand the nature of the risks they were exposed to, the regulatory system allowed them to increase leverage dramatically in the run up to the crisis. The tendency of the financial sector to over-expand during upswings was exacerbated by a number of factors: over-reliance on Credit Rating Agencies (CRAs) assessments of the credit risk and potential CRA conflicts (p. 80) of interest, inadequate accounting standards and capital requirements that served to reinforce rather than dampen financial market over expansion, and remuneration policies that encouraged excessive leveraging and risk-taking.

6.15  As the dominoes fell, the Financial Crisis unfolded. At times, the markets came very close to outright panic. As Wolf pointed out:36

… a panic may turn a solvent but illiquid bank into an insolvent one. The panic is then likely to spread throughout the banking system, partly because the insolvency of one bank directly affects that of others, but also because the same uncertainty about the true value of one bank’s assets also applies to those of the others.

6.16  The run on Northern Rock (which was only stopped when the UK government guaranteed all its deposits) was followed, at various intervals, by rumours of other institutions being in difficulties (especially those with similar business models). Eventually, the fall of Lehman Brothers in the autumn of 2008 triggered a general collapse in confidence that could only be remedied by very large, state-funded ‘bail-outs’ of many of the largest institutions (such as, in the UK, Royal Bank of Scotland) and some timely ‘rescue’ takeovers where the influence of the state was all too obvious.

6.17  As is often the case with complex causation chains it is hard to see from the description of any one event (or link in the chain) that appalling consequences would be likely to follow. Even the overall picture that emerges from the combination of events tends to derive much of its doom-laden hue as a result of being examined with the benefit of hindsight. The herd instinct, inherent in market behaviour of all kinds, underlies much of the activity.37 Banks compare their financial performance with their competitors. Their shareholders make the same comparison. If one bank refuses to accept the risky deals (or exotic balance sheet devices) being engaged in by others and as a result is out of line—and is not making as much money for shareholders—its management comes under pressure. Notwithstanding the many references to ‘innovation’ that one encounters in connection with financial market activity (claims of innovation having been a habit in the financial markets for decades), there is in fact a strong incentive to conform.38 Further, behaviour which might at the outset look to be an ‘aggressive’ (p. 81) gaming of the system, over time often becomes regarded as acceptable, even ‘standard market practice’. If the behaviour (a) is not illegal (b) makes money and (c) is common to all reputable competitors, it would (during the period leading up to the Financial Crisis) have taken a very strong-willed executive to refuse to follow suit (although the Conduct Crisis has recently started to change perceptions as to the need for an ethical perspective in addition to a purely legal analysis39). (It would have taken an even stronger-willed non-executive director, or major shareholder, to challenge the orthodoxy.) It is easy for the commentator, advantaged by hindsight, to say: ‘just because it’s legal, that doesn’t make it right’ (and many have made this observation) but, in the pre-Conduct Crisis era, to expect the market to be self-correcting on such things was unrealistic. Regulation, or some form of standard setting and adoption,40 was needed to set the rules (or, rather, re-set them). We may also have to accept that an ‘intrusive’ regulator is needed in order to check how individuals actually behave within whatever governance framework is deemed appropriate.

6.18  Amongst the most urgent of the tasks confronting policymakers in the aftermath of the events described above was framing regulatory responses that (a) would be practical (bearing in mind that the most effective responses would need to be internationally effective, at least in the principal financial centres) and (b) addressed the principal causes of the Financial Crisis (making it less likely that there will be any repetition of such events) and would not focus only on those areas where it is easiest to get international agreement (even though their relevance in the causation chain is marginal at best). There has been a very large number of responses and suggestions for reform. To some extent, these are not concerned only with the causes of the Financial Crisis, strictly speaking, but with avoiding the need for public funds to ‘bail-out’ financial institutions when they fail. (If they are successful in this, they may of course kill two birds with one stone.) There was also a clamour to limit speculative activity by deposit-taking institutions. This arises not so much because of the financial failure of ‘casinos attached to utilities’ but because the Financial Crisis raised public awareness of how speculative the behaviour can be—and, as a result, many bank customers felt uneasy about depositing their money with a ‘casino-type’ bank. The authors of these responses include Parliamentary Committees, regulatory bodies at national and supra-national level, government departments, various kinds of ‘think tank’ (p. 82) organizations and even religious leaders. A selection of the more significant responses (concentrating on those most directly relevant to the UK) is examined in the remainder of this Part of this book and in Part IV. The remainder of this chapter is concerned with particular aspects of market behaviour that featured in the causation chain and that have implications pointing to regulatory reform. They may also contain lessons to be learned by risk managers, including legal risk managers.

C.  ‘Originate and Distribute’

6.19  It is apparent from the description of the Financial Crisis set out in the preceding part of this chapter that one of the practices of financial market participants that led up to the Financial Crisis was the ‘packaging and selling’ of credit risk. In retrospect, many aspects of that practice look very bad indeed, both buyers and sellers of risk appearing irresponsible in many cases. However, the idea that banks might originate a credit exposure but then transfer the credit risk attached to it to a third party was, before the Financial Crisis, considered to be part and parcel of sound risk management. In an article (‘Market-based risk is changing banking’) published in the Financial Times on 8 May 2007, Thomas Huertas and Sally Dewar (at that time, the banking sector leader and capital markets sector leader respectively at the FSA) claimed:

From ‘hold what you originate’ the business model of banking is shifting to ‘underwrite to distribute, and buy what makes sense to hold’. Banks are shifting to market-based risk management …

Traditionally, banks originated loans to customers, which they held on their balance sheet until maturity. Banks still originate loans, but aim to reduce their exposure, either by selling participations in the loan to other investors—not all of them necessarily banks—by securitising the loans, or by buying credit protection in the derivatives market.

At the same time, banks are buying exposure to credits not only through purchases of participations in loans originated by others, but also through selling credit protection and buying collateralised debt and loan obligations (CDOs and CLOs) …

Regulation supports this move toward market-based risk management. Under Basel 2 and the Capital Requirements Directive, capital regulation is moving in the direction of economic capital. Capital is now assessed in line with risk, and the new capital regulation framework gives much more adequate recognition for credit mitigation factors such as derivatives and securitisation.

6.20  How times have changed! The above article was of course written before the implications of the ‘credit crunch’ had started to emerge.41 Excessive use of the (p. 83) ‘originate and distribute’ model (or ‘originate to distribute’, sometimes called OTD) referred to in the article is now widely seen as being at least partly responsible (albeit indirectly and when combined with securitization) for the Financial Crisis. In its Report on ‘Enhancing Market Stability and Institutional Resilience’ of 7 April 2008, the Financial Stability Forum42 commented (at paragraph 3, page 9) that:

Although securitisation markets and the OTD model of intermediation have functioned well over many years, recent innovations greatly increased leverage and complexity and . … were accompanied by a reduction in credit standards for some asset classes

and (later in the same paragraph) that:

… in some cases, risks that had been expected to be broadly dispersed turned out to have been concentrated in entities unable to bear them. For example:

  • •  Some assets went into conduits and SIVs with substantial leverage and significant maturity and liquidity risk, making them vulnerable to a classic type of run.

  • •  Banks ended up with significant direct and indirect exposure to many of these vehicles to which risk had apparently been transferred, through contingent credit lines, reputational links, revenue risks and counterparty credit exposures

  • •  Financial institutions adopted a business model43 that assumed substantial ongoing access to funding and liquidity and asset market liquidity to support the securitisation process.

  • •  Firms that pursued a strategy of actively packaging and selling their originated credit exposures retained increasingly large pipelines of these exposures, without adequately measuring and managing the risks that materialised when they could not be sold.

6.21  The ‘OTD’ theory did not work out in practice as well as regulators, pre-Financial Crisis, had expected. It led to a lack of transparency and contributed to the growth of what is now called ‘shadow banking’—leverage build-up outside (p. 84) the main regulated system. This is how the de Larosière Report, which states that OTD created ‘perverse incentives,’44 described the problem:

There was little knowledge of either the size or location of credit risks. While securitised instruments were meant to spread risks more evenly across the financial system, the nature of the system made it impossible to verify whether risk had actually been spread or simply re-concentrated in less visible parts of the system. This contributed to uncertainty on the credit quality of counterparties, a breakdown in confidence and, in turn, the spreading of tensions to other parts of the financial sector.45

6.22  John Plender, writing in the Financial Times on 5 January 2009 characterized the problem as follows:

This ‘originate and distribute’ model—in which banks turned conventional loans into fancy securities and sold them on to a pool of investors—reduced the incentive for banks to monitor the creditworthiness of those to whom they lent. It was a case of churn out the loans and let the devil take the highmost.46

6.23  The de Larosière Report noted that the above problems were exacerbated by the capital adequacy rules that ‘in fact encouraged’ using off-balance sheet vehicles and also by the ‘explosive growth’ in over-the-counter credit derivatives ‘which were supposed to mitigate risk but in fact encouraged it.’47

D.  Credit Rating Agencies

6.24  The principal credit rating agencies (CRAs) are Moody’s Investor Services, Standard and Poor’s, and Fitch Ratings (although there are others). According to the Moody’s website, it is ‘amongst the world’s most respected and widely utilized sources for credit ratings, research and risk analysis.’ Its ratings for debt securities cover obligations issued by governments, companies and public bodies. It also covers ‘structured finance obligations.’ The principal purpose of a credit rating is to assist a potential investor in assessing the risks of investing in a particular security. A highly rated instrument is thus thought to be a safer investment than one rated at a lower level (although, because it is thought to be ‘safer’, it may not provide such an attractive return). For this ‘system’ to ‘work’ it is of course important that the investing community has confidence in the agencies’ research capabilities and the relevant processes that lead up to a rating being given. Moody’s thus trumpets its status and reputation as follows:

A Moody’s rating provides a superior ‘passport’ to the global capital markets. Looking towards the twenty-first century, our commitment is to maintain the (p. 85) quality research that market participants need to understand and manage risk and to maintain access to the world’s major sources of capital.

Other CRAs would no doubt make similar claims.

6.25  As Benjamin observes, ‘Although not formally regulated, the credit rating agencies are tremendously powerful and their ratings officially recognized.’48 The financial markets, and their regulators, have become reliant on them. Agencies have ‘played a long and established role in capital markets, providing investors with an independent assessment of the relative probability of default of credit securities.’49 However, as analysis of the Financial Crisis and ‘what went wrong’ developed at national and international level, the rating agencies were increasingly being seen as having been too generous with their rating of many of the structured products that contributed to the collapse.

6.26  Both the Turner Review and the de Larosière Report took the CRAs to task for (i) over-rating structured credit products and (ii) having weak governance systems. There is at least a hint that the latter helped to lead to the former.

6.27  As regards the over-rating, the problem seems to have stemmed mainly from the fact that, traditionally, CRAs rated single entity, corporate bonds and their adaptation of methods used for that kind of instrument to structured products did not work well. The Turner Review50 attributes this ‘breakdown’ to three issues:

  1. (i)  the fact that ratings were being extended to instruments where there was limited historical experience,

  2. (ii)  the enormous complexity of many structured credit instruments, and

  3. (iii)  a misplaced confidence in the ability of mathematical modelling to define the risks.

6.28  The de Larosière Report, in substance, comes to the same conclusion as the Turner Review but also draws attention to the CRAs’ failure to take into account the lowering of underwriting standards on the part of those who originated the underlying credit assets. As regards governance, the Report says that, ‘conflicts of interest in CRAs made matters worse’.51 The conflict results from the fact that the issuer of any given security (in practice, a bank or bank-controlled entity) pays for the rating. Since the issuer, of course, wants a high rating—and the CRAs want the issuer’s business—there is room for scepticism as to how rigorous the processes might have been.52 De Larosière observes: ‘Issuers shopped around to (p. 86) ensure they could get an AAA rating for their products.’53 The Turner Review also expresses concern54 as to the effect of the competitive environment and whether ‘commercial objectives did not influence judgements on whether the instruments were being rated effectively’ and also makes the further point that there was a ‘danger that issuers were “structuring to rating” i.e. designing specific features of the structure so that it would just meet a certain rating hurdle’—a practice made possible by the fact that the CRAs let issuers know about the models they were using for rating structured products.55

6.29  CRAs were also criticized by the Treasury Select Committee Report into the Banking Crisis of 12 May 2009,56 which refused to accept the arguments advanced by their managers that they were well equipped to rate structured products, and expressed the view that they should take more lead time in arriving at such ratings and generally shared in the calls for more regulation and better governance.57

6.30  At hearings before the US Senate Permanent Committee on Investigations on 22 April 2010, Eric Kolchinsky, a former managing director of a Moody’s unit that rated sub-prime-backed securities, said that ‘he believed he saved the agency from committing fraud in 2007 when he insisted it change the way it rated the instruments because of clear deterioration in the housing market’.58 He said: ‘Despite the massive manifest errors in the ratings assigned to structured finance securities … it appeared to me that my manager was more concerned about losing a few points of market share than about violating the law.’ The committee’s report had commented that the CRAs’ intense competition with each other had brought them into an unhealthily close relationship with the banks that sponsored the issues of the securities that they were rating.


1  Turner Review, para 2.9.

2  Per Lord Templeman in Hazell v Hammersmith and Fulham London Borough Council [1992] 2 AC 1.

3  Robert Harris: from his review of ‘WHOOPS! Why Everyone Owes Everyone and No One Can Pay’ (by John Lanchester) in the Sunday Times ‘Culture’ Section of 24 January 2010.


5  Not everyone agrees with this. In an ‘open letter’ dated 10 June 2008 addressed to the President of the European Council and signed by various ‘elder statesmen’ from continental Europe (including Jacques Delors, Jacques Santer, Helmut Schmidt, Lionel Jospin and Michel Rocard) it was asserted that the Financial Crisis ‘was not, as some top people in finance and politics now claim, impossible to predict. For lucid individuals the bell rang years ago. This crisis is a failure of poorly, or unregulated markets, and shows us, once more, that the financial market is not capable of self regulation.’ On the other hand, Sir Howard Davies (a former Chairman of the FSA) writing in the Financial Times on 30 September 2008, poured scorn on ‘Harry Hindsight’ who claimed to have foreseen everything ‘though a diligent Google search has failed to unearth any warnings he personally gave’. According to Davies, ‘These are highly unusual, once-in-a-lifetime circumstances, and it is not reasonable to expect that all financial institutions could have positioned themselves to survive market conditions of this severity.’

6  See Part III for a discussion of the Conduct Crisis and Ch 15 on the regulatory developments with regards to individual accountability.

7  According to Benjamin, ‘Derivatives in general, and credit derivatives in particular, have become the most innovative form of financial position. They are to be found, either alone or in combination with other types of contracts, in all branches of financial practice.’ Financial Law (Oxford University Press, 2007) at 4.30.

8  In his book, Henderson on Derivatives (LexisNexis Butterworths, 2003), at p 106, Schuyler Henderson states that:

The most common form of credit derivative is the credit default swap between the protection buyer and the protection seller in respect of a single reference entity. In the typical structure, the buyer periodically pays a fixed amount to the seller in consideration of the protection acquired. The seller in a cash-settled credit default swap agrees that, on the occurrence of a credit event, delivery of a credit event notice and, if agreed by the parties, delivery of publicly available information confirming the occurrence of the credit event (the conditions to settlement) it will make the protection payment to the buyer. The protection payment is determined as the difference between a pre-agreed price (the reference price) and the current value of the reference obligation. In this context, a ‘credit event’ is typically the insolvency or some other default event of an entity (the ‘reference entity’) that has raised money on the debt markets—and which may be an entity to which the protection buyer (say, a bank that proposes to fund that entity) has a credit exposure (see Henderson at p 118). According to Henderson (writing in 2003), ‘The BBA [British Bankers’ Association] estimates that banks constitute 52% of the protection buyers’ market and 39% of the protection sellers’ market. Management of portfolio credit risk is, after the dealing market, the single most common use of credit derivatives.’ The 2007 market survey (looking at the year-end 2007 and published on 16 April 2008) carried out by ISDA indicated that the notional principal amount outstanding of credit default swaps grew by 37% in the second half of 2007 rising from US$45.5 trillion at 30 June 2007 to US$62.2 trillion at 31 December 2007. The notional growth (according to this survey) for the whole of 2007 was 81% (from US$34.5 trillion at the end of 2006).

9  de Larosière Report at para 16.

10  Sometimes equated, especially by certain senior French and German politicians, with ‘Anglo-Saxon’ capitalism.

11  The metaphor is almost irresistible. A good example is provided in Vince Cable’s article in The Times of 8 July 2009 (‘We’re the masters of the banking universe’) when he says: ‘if the directors of Barclays Capital, or its equivalent, want their bank to become the world’s biggest casino that’s up to them, but only if there is no question of the British taxpayer guaranteeing it … industries that fail or put too much risk on the rest of the economy are not in our national interest. Ask the millions who will lose their jobs and the thousands who will lose their homes because City gambling was allowed to get out of control.’ The attractiveness of the metaphor does of course tend to obscure causation issues such as why a failure to meet mortgage repayments should be due to ‘City gambling’. Another ‘gambling’ reference of this kind was made by Andrew Haldane (Executive Director (financial stability) of the Bank of England) in a speech given on 14 September 2009 (to the Association of Corporate Treasurers): ‘During the upswing, banks enjoyed windfall gains from bets at the race-track. This boosted their buffers. But when those bets turned sour, these same activities put at risk the banks’ day job—the provision of loan and deposit services to the real economy.’

12  The relevant section of the Act is s 412 (itself amended by the Gambling Act 2005, which repealed the sections of the Gaming Acts that caused the risk to arise).

13  See para 20.27. See also Morgan Grenfell & Co Ltd v Welwyn Hatfield Council and Islington London Borough Council [1995] 1 All ER 1 for an example of a court decision upholding a contract on the basis that it was not a ‘wagering contract’.

14  Henderson on Derivatives (LexisNexis Butterworths, 2003) at 12.8. See also McKnight, The Law of International Finance (Oxford University Press, 2008) at 11.7 and Benjamin, Financial Law (Oxford University Press, 2007) at 5.135–5.139.

15  An introductory piece to his collection of articles, Waiting for the Etonians (Fourth Estate, 2009).

16  For a detailed description of the transaction form, see McKnight, The Law of International Finance (Oxford University Press, 2008) at 12.10 and 12.11.

17  Nor do they have to be unduly complex. As Mervyn King has pointed out: ‘The principle of derivative instruments is simple, but if you want to make it complicated there are many lawyers, and investment bankers who will help you—at a (significant) price.’ The End of Alchemy (Little, Brown, 2016) at p 141.

18  For an analysis of these instruments, see Fuller and Ranero, ‘Collateralised Debt Obligations’ (2005) 09 JIBFL at 343. The concluding paragraph of this article reads: ‘A further significant shift is that of the investor base and the different levels of risk they wish to assume. Insurance companies and pension funds tend, for example, to purchase senior tranches, whilst the riskiest subordinated notes are generally acquired by banks or hedge funds, which, at least in theory, should be able to handle this kind of risk.’

19  Perhaps a good example of justifiable use of these ‘suspect’ methods is provided by an article in the Financial Times of 6 July 2009 (‘Banks reinvent securitisation to cut capital costs’ (Patrick Jenkins)) where it was reported that banks were using various new schemes to ease their capital requirements. One of these involved pooling assets from a range of customers into ‘a secured financial product that can be sold to other investors and rated by a credit rating agency, potentially reducing the capital allocated against the assets by between 10 per cent and 50 per cent.’ The stigma that attached to transactions of this nature following the role of securitized sub-prime products in the Crisis was not thought to apply because the assets were existing assets (not freshly ‘originated’) and also because of the greater transparency in the nature of the risk being transferred. Another scheme involved selling an ‘insurance product’ to a bank that had a ‘toxic portfolio’—an ‘efficient’ use of capital because insurance capital requirements are lighter than banks’. Some understandable scepticism was expressed about the desirability of ‘capital arbitrage’ of this kind.

20  For a telling allegorical tale of how derivatives can be destructive, see King, The End of Alchemy (Little, Brown, 2016) at pp 145–8.

21  The Government White Paper of July 2009, ‘Reforming Financial Markets’ (Cm 7667) noted (para 1.6) that over the previous nine years the financial sector had contributed over £250bn to the public finances through a combination of corporation tax and various other taxes.

22  See Turner Review at 1.1 (p 13). ‘In 1990 an investor could invest in the UK or the US in risk-free index-linked government bonds at a yield to maturity of over 3% real; for the last five years the yield has been less than 2% and at times as low as 1%.’

23  According to the Turner Review at 1.1 (p 14), ‘The demand for yield uplift, stimulated by macro-imbalances, has been met by a wave of financial innovation, focused on the origination, packaging, trading and distribution of securitised credit instruments’. This was ‘predicated on the belief that by slicing, structuring and hedging, it was possible to “create value …” ’.

24  See ‘Origins of the Financial Market Crisis of 2008’ by Anna J. Schwarz, Ch 3 of the Institute for Economic Affairs publication, Verdict in the Crash: Causes and Policy Implications (2009) (at p 46) and ‘The Financial Crisis: Blame Governments not Bankers’ by Eamonn Butler, Ch 4 of the same publication (at pp 53–5).

25  If a borrower went into ‘negative equity’ he could be discharged of his obligations by, in effect, offering up the mortgaged house to the lender who had the mortgage, even though the house, if sold, would not realise the amount lent. This kind of lending gave borrowers a ‘one-way option’. If the value of the house went up, they made a profit: if it went down, they could ‘hand the keys to the bank’ and ‘walk away’.

26  See Stiglitz, Freefall (Allen Lane, 2010) at Ch 4.

27  The Turner Review uses the term ‘total system leverage’, much of it not ‘measured on-balance sheet leverage’ but instead located in off-balance sheet vehicles such as structured investment vehicles (SIVs) and conduits. The off-balance sheet treatment ‘proved inaccurate as a reflection of the true economic risk, with liquidity provision commitments and reputational concerns requiring many banks to take the assets back on balance sheet as the crisis grew, driving a significant one-off increase in measured leverage.’ (1.1(ii) at p 20).

28  Tett describes the situation thus: ‘In part, the problem was one of data. The main yardstick used by regulators and central banks to judge if banks were healthy was whether they were meeting the terms of the Basel Accord. All banks needed to set aside capital worth 8 per cent of their assets, and by that measure the banks all looked extremely healthy. In early 2007 British banks had a capital ratio of 12 per cent, while the American ratio was just slightly lower–way above the minimum the regulators required … .What they didn’t know … .was that those capital reserves were only set against a relatively small portion of the banks’ true risk exposure, because so much risk was tucked out of mind into shadow banks, or only measured using very narrow and flattering tools.’ Fool’s Gold (Little, Brown, 2009) at p 191.

29  Mansion House speech of 17 June 2009.

30  According to the de Larosière Report, there is ‘empirical evidence’ suggesting a ‘drastic deterioration in mortgage lending standards in the US in the period 2005 to 2007 with default rates rising.’ (para 17). The Turner Review also comments (at p 29) that in the UK, ‘Though not to the same extent as in the US subprime market, mortgage credit was extended to social categories which would not previously have enjoyed access … The buy-to-let market grew from trivial to significant proportions.’

31  See ‘Financial Engineering or Legal Engineering? Legal Work, Legal Integrity and the Banking Crisis’ (at p 74) set out in McNeil and O’Brien (eds), The Future of Financial Regulation (Hart, 2010) at p 67.

32  Turner Review at p 35. This strategy was described as ‘fatally flawed’ by the Governor of the Bank of England, Mervyn King, in his evidence to the Treasury Select Committee examining the causes of the failure of Northern Rock.

33  Tett, Fool’s Gold (Little, Brown, 2009) at p 112.

34  The Turner Review notes (p 21) that ‘Investment banks increasingly funded holdings of long-term to maturity assets with much shorter term liabilities: the value of outstanding Repurchase Agreements (repos) tripled between 2001 and 2007, with particularly rapid growth of overnight repos.’

35  The Financial Times of 11 February 2008 reported that ‘Citigroup of the US and HSBC of the UK, the banks that had the largest SIVs, have both pledged to support their vehicles while they were restructured, resulting in each bank taking more than $40bn worth of assets on to their balance sheets.’ (‘StanChart withdraws Whistle jacket support’ (Paul Davies)).

36  Fixing Global Finance (Yale University Press, 2009) at p 16.

37  It was also the herd instinct, coupled with fear rather than the profit motive, that caused wholesale sources of funds to dry up so quickly in mid-2007 and, at street level, triggered the run on Northern Rock.

38  In an article in the Financial Times of 28 April 2008, Abigail Hofman (who had spent 18 years in investment banking) observed: ‘The sad truth is that the culture is one of lemming-like imitation. There is too much looking over the shoulder at rivals and not enough scrutiny of internal decisions. “It is not how we do” a senior US banker told me last summer, “it is how we do relative to our peers.” This attitude causes the problem in the first place. If X bank is making millions on an innovative product, Y bank feels pressure to do the same. There is a terror of stepping off the escalator even as it approaches the cliff.’ McBarnet also cites from a research interview: ‘One major bank’s head of compliance complained about the snake oil salesmen from the investment banks coming in and saying “Everyone’s doing this, why aren’t you?” putting enormous pressure on young directors.’ (See ‘Legal Work, Legal Integrity and the Banking Crisis’ (at pp 70–1) set out in MacNeil and O’Brien (eds), The Future of Financial Regulation (Hart, 2010) at p 67.)

39  See Part III for a discussion on the growing influence of ethical and moral judgement in the articulation of responsibility and thus, by extension, the creeping of such expectations into legal and conduct risk management for those operating with a ‘social licence’ or ‘with other people’s money’.

40  Such as that which is expected from the Banking Standards Board and is already evident in the publication of standards (and practice statements) by the FICC Market Standards Board.

41  Another indication of the ‘old thinking’ is provided by the following extract from the IMF Global Financial Stability Report of April 2006 (quoted in the Turner Review):

‘There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient.

The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks.’

42  This was an influential group of senior representatives from national financial authorities, such as central banks, international financial institutions, such as the IMF and the World Bank, and others founded by the G7 finance ministers and central bank governors in 1999. In April 2009, it was replaced by the Financial Stability Board.

43  In an article in the Financial Times of 23 April 2008 (entitled ‘A good name sliced, diced and traded’), John Gapper commented (critically) on the ‘originate and distribute’ policy of the Swiss Bank, UBS, and notes that its former chairman, Marcel Ospel, ‘and others in the credit derivatives market reasoned that banks could originate and trade debt, using swaps and options to transform it into securities. Banks would take less credit risk and use up less of their precious capital …’.

44  At para 17.

45  At para 16.

46  In an article entitled ‘Originative sin’.

47  At para 16.

48  Benjamin, Financial Law (Oxford University Press, 2007) at para 2.37.

49  Turner Review at p 77.

50  At p 77.

51  de Larosière Report at para 21.

52  Tett makes an interesting observation that at a conference of the European Securitisation Forum held in Barcelona in June 2007, ‘Some of the biggest delegations … came from … rating agencies, which were drawing fat profits from the CDO boom. Barcelona was the perfect opportunity to market their skills.’ Fools’ Gold (Little, Brown, 2009) at p 196. Stiglitz is particularly critical of the CRAs: ‘They raked in fees as they told the investment houses how to get good ratings and then made still more money when they assigned the grades.’ Freefall (Allen Lane, 2010) at p 93.

53  De Larosière Report at para 21.

54  See pp 77–8.

55  According to Tett, Fools’ Gold (Little, Brown, 2009) at p 119, if a banker had a new idea for a product it would be tested against the CRAs’ models to see what the rating would be. If it would be too low, the design would be ‘tweaked’ accordingly. This was known as ‘ratings arbitrage’ and ‘Officials at the ratings agencies knew perfectly well that this was going on’. Although there is evidence that the CRAs tried to resist the pressure, in practice they were outgunned by the banks, who had much greater resources at their disposal. Further, the income generated for the CRAs by this kind of activity was huge. Tett notes that ‘by 2005 Moody’s was drawing almost half its revenues from the structured finance sector.’

56  ‘Banking Crisis: reforming corporate governance and pay in the City’ (ninth report of session 2008–09).

57  See section 5 of the Report.

58  See Financial Times report of 23 April (‘Moody’s chief admits to failings in run-up to financial crisis’).