The Treasury Select Committee says recent market turbulence has been a result of reckless behaviour by UK financial institutions and deficient warnings from the Bank of England and the FSA.
In its Financial Stability and Transparency report, the TSC says the search for yield in the benign macro-economic and low interest rate environment of the past few years encouraged many investors to invest in products they did not always understand.
It says these complex products have introduced increased opacity into the financial system which is demonstrated by continuing uncertainty over the scale and distribution of losses in the banking sector resulting from exposure to sub-prime mortgages.
Chairman John McFall says: “The ‘best and the brightest’ at our top investment banks have expended great energy designing ludicrously complex financial products, which you need a Nobel Prize in physics to understand.
“Whilst financial innovation and securitisation have brought real benefits and allowed for risk dispersion through the system, it has come at a cost. Product complexity has introduced increased opacity into our financial system, making it almost impossible to determine where risk lies and making it much more difficult to achieve financial stability.”
The TSC also blames the Bank of England and the FSA for having deficient warning systems and recommends that in future the authorities clearly highlight the two or three most important risks in a short covering letter to financial institutions, for discussion at board level. It says the Bank and FSA should seek confirmation from those institutions that the warnings have been properly considered and publish commentaries on the responses received.
McFall says: “The Bank and FSA can no longer hedge their bets, throwing potential risks out into the ether and then washing their hands of the consequences. We must ensure that in the future such warnings are heeded and acted upon by those at the top of financial institutions.”
The report says the credit crunch has highlighted inherent and multiple conflicts of interest in the credit rating agencies’ business model, as well as flaws in their rating methods. The TSC calls for agencies to tackle these perceived conflicts of interest urgently if they want to regain trust and confidence.
McFall says: “The rating agencies have not emerged from the current episode of market turbulence smelling of roses. We need to have a serious debate about a root and branch reform of their business model to tackle perceived ‘conflicts of interest.’ If the rating agencies procrastinate on reform then we will have to seriously consider whether new regulation is necessary.”
Liberal Democrat Shadow Chancellor Vince Cable says: “The committee is right to highlight the deficiency of current financial warning systems. The existing arrangement, where warnings from the Bank of England and the FSA are brushed recklessly aside, cannot continue. It is vital that action is taken quickly, particularly in respect to credit rating agencies who carry responsibility for the breakdown in securitised markets.
“The fact that financial institutions no longer trust each other is mainly due to misleading credit ratings. If confidence is to be restored without heavy-handed regulation then the financial services industry has got to clean up its act very quickly.”