THE IMPORTANCE OF THE FINANCIAL SERVICES

INDUSTRY:

by
René Karsenti,
Executive President, International Capital Market Association (ICMA)

KSDA SEMINAR, SEOUL, KOREA: 11 JUNE 2008

Check against delivery

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In my address to you today on the importance of the financial services

industry, I would like to focus on four themes: first of all, the
development of the international capital markets; second, the reasons for
the recent global market turbulence, and the likely response; third, the
role of self-regulatory organisations in helping to make capital markets as
efficient as possible; and fourth the relevance of our experience of the
development of efficient capital markets in Europe to the Asia Pacific
region.

The development of the international capital markets

After the devastation of the Second World War, we saw the first attempts
to restore the international markets. Out of these humble beginnings, the
infrastructure of these markets steadily improved through the 1970s
before getting a huge boost from the dogmatic deregulation and
liberalisation policies of Mrs Thatcher and President Reagan. Capital
started flowing more and more freely among the OECD countries and
certainly contributed to the creation of a much more integrated economic
and financial system. The collapse of the Soviet empire in the early 1990s
finally opened the gates to the rest of the world and to the globalisation of
capital markets, not to mention the unification taking place in Europe, and
culminating in the establishment of the euro as the common currency.

The development of the international capital markets has also involved a

journey for me personally. I was lucky enough to be a member of the
team at the IBRD that put together the now famous World Bank-IBM swap
in August 1981, which was the first ever public use of a swap. At the
World Bank in October 1989, we pioneered the first dollar global issue.
Then came the first public securitisation of assets for the IFC in 1991.
Later, at the EBRD, I was directly involved in the opening up of new
emerging markets through debt issuance in eastern European countries.
When I joined the EIB, we were intimately involved in market innovation
relating to Economic and Monetary Union in Europe. Indeed, in 1997, in
anticipation of EMU, the EIB issued the first ever euro denominated bond
and in 1998, the first ever euro global bond. The euro has also stimulated
the creation of a European corporate bond market.

There have been other important developments in the capital markets,

such as the development of methods to separate credit from other risks.
The market for credit derivatives has expanded very significantly during
this decade. And there has been a change in the make-up of the key
intermediaries in the international capital markets. The natural process of
growth in a competitive world has already led to the merger or
disappearance of many once well known names. The banks and securities
houses that now dominate our landscape are much larger and better
capitalised than ever before.

At the International Capital Market Association, where I am Executive

President, we have just celebrated our 40th anniversary. Since ICMA’s
inception, we have seen sweeping changes both in technology and
communication, which allows the world to run integrated and
interdependent capital markets in dimensions we could not possibly have
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imagined four decades ago. ICMA and its members have consistently
applied all their efforts to improve the framework of international
securities markets and can point towards many achievements with pride.
The latest turbulence in global financial markets has reminded us all that
ICMA and its members have a responsibility to continue their activities in
support of truly integrated financial markets and to ensure that an
efficient and robust regulatory infrastructure, which respects free market
principles, is in place to support them.

Market turbulence and the response

That leads me to my second main theme, which is the market turbulence

since last August and the expected response from the industry and from
regulators. Clearly, since last August we have been in a period of what
many would consider as a long overdue reassessment and repricing of
risk, after immediate and intensive corrective action to preserve liquidity
in financial markets. The market turbulence also illustrates the
consequences of a period of over-consumption and over-production of
complex financial products, which was combined with serious difficulties in
monitoring the associated risks. Indeed the benefits which should
normally derive from financial innovation, such as complex securitised
products, have in fact been associated with a new configuration of risks.

Over the years, we have observed the eagerness of certain financial

intermediaries to shift to the “originate-to-distribute” model, while
weakening their due diligence process, and an immense investors’
appetite to increase their returns by assuming complex risks that were not
always fully understood. The situation was compounded by the
outsourcing of important internal due diligence responsibilities to credit
rating agencies and other third parties. At the same time the use of such
new complex instruments was not supported by sufficiently adequate and
comprehensive risk monitoring functions; it also involved a global
distribution which included investors located in jurisdictions lacking
sophisticated oversight.

The market turbulence has highlighted, I believe, the need substantially to

enhance best practices in three main areas: risk management,
transparency and due diligence processes for structured products; the role
and methodology of rating agencies; and valuation of complex
instruments. I would like to talk briefly about each of these three issues
in turn, and then give you an overall assessment.

(i) Risk management, transparency and due diligence

On risk management, the authorities consider that larger and more robust
liquidity buffers are necessary. They are also proposing to make specific
proposals – to be implemented over a period of time – to: raise Basel II
capital requirements for certain complex structured credit products;
introduce additional capital charges for default and event risk in the
trading books of banks and securities firms; and strengthen the capital
treatment of liquidity facilities to off-balance sheet conduits.
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During the market turbulence, there has been an intense focus on the
need for transparency and due diligence for structured products. Work is
being done in several areas to enhance transparency. Transparency is
important in the case of the originate-to-distribute model as the risk is
widely spread – and sometimes blended and disguised – and it is difficult
to know where the losses lie. For its own part, the market believes that
lack of transparency is not one of the main causes of recent market
turbulence, and that there is a high level of transparency available to
investors in securitisation markets already. But the industry recognises
that improvements should be made, where this is practicable.

There are two issues about the due diligence processes. One is the
suspicion that originators may not be as active in due diligence about the
risk of default as they should be, as they immediately pass the risk on.
The other is that investors, seeking to increase their return, have
assumed complex risks that they do not always fully understand.

(ii) Credit rating agencies

The due diligence process has mainly in practice been outsourced to credit
rating agencies who may not have had the required expertise, staff or
historical data to be able to make an accurate assessment. Indeed, the
role and methodology of rating agencies have been under intense scrutiny
lately, both at European and at global level. The focus has been on: the
quality and integrity of the ratings process; independence and avoidance
of conflict of interest within credit rating agencies; and ensuring that
credit rating agencies meet their responsibilities both to the investing
public and to issuers. At the end of last month in Paris, Michel Prada,
head of the French AMF and outgoing Chairman of the IOSCO Technical
Committee, said that he personally was in favour of an international body
to monitor the role of the credit rating agencies.

(iii) Valuation of structured products

One of the most difficult issues arising during the period of market
turbulence has been how to value securities, which are normally valued by
marking them to market, when there is no longer a market. Valuation is a
matter for individual market firms and their auditors. But an industry
working group has been examining the issue more generally. In normal
markets, mark-to-market accounting has proved very useful in promoting
transparency and market discipline. But when there is no liquidity in
secondary markets, or liquidity is severely restricted, some market
participants consider that marking to market has the potential to
complicate valuation by creating self-reinforcing effects – for example, by
forcing firms to sell assets and mark them down further in a vicious circle.

(iv) Assessment

I can summarise this second part of my speech as follows: The originate-

to-distribute model was expected to produce important benefits in
financial innovation whilst diversifying risks and revenue streams and
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contributing to cost efficiencies. It was assumed that it would help to

avoid banking crises in which very large amounts of risk are concentrated
on banks’ own books. And indeed, it is fair to say that the distribution of
credit risk from banks to investors through the use of structured products
has generated significant benefits for financial system and the global
economy. But the originate-to-distribute model will only work effectively
if all market participants maintain high standards of risk management and
disclosure. It is clear that the trust between all the parties involved has to
be restored in order for the model to survive. A great deal of work is
being done to address the shortcomings in market practices that occurred
in the run-up to the market turbulence which we have been experiencing.

The role of self-regulation

In these turbulent times, I think that self-regulatory organisations like

ICMA have an important role to play. Self-regulation is my third theme.
ICMA has been involved from the beginning and is having an important
role to play in bringing the market together – in meetings and conference
calls of our committees and working groups – to discuss the appropriate
responses and how we can best help our members. We have also created
opportunities to strengthen the dialogue between our members and
central banks and regulators. Our own view is that market-led initiatives
are the preferred response. But if the market does not take a lead, there
is a risk of regulatory action by the authorities.

In more normal times, self-regulation of financial markets also makes a

valuable contribution to regulatory systems around the world, as it
provides a mechanism whereby the expertise and practical experience of
the industry contributes to the development and implementation of
regulatory policy. Self-regulation is particularly important when
regulators are dealing with market issues and the conduct of market
participants, since self-regulatory organisations (or SROs) are close to the
market and can therefore be flexible and responsive to market
developments. In addition, rules that are informed by industry expertise
should obtain greater industry support and result in a higher level of
voluntary compliance.

Self-regulation can also contribute to increased market efficiency because

it expands regulatory resources at a lower cost to taxpayers than other
forms of regulation while also giving consideration to the need for
efficiency and competitiveness. And SROs have a strong incentive to
ensure that public confidence in the self-regulatory system is maintained,
since a breakdown of such confidence could compel regulators to take
actions that might threaten their members and SROs’ own autonomy or
even its continued existence. In summary, self-regulation and regulation
should be complementary. If the market meets standards of best
practice, there is less need for the authorities to impose new regulations.
When a market failure is clearly demonstrated then regulation should be
introduced.

ICMA has demonstrated the role of self-regulation over many years

through our Primary Market Handbook and Secondary Market Rules and
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Recommendations. There are also several recent initiatives by ICMA

which demonstrate the role of self-regulation: for example, ICMA’s
Standard of Good Practice on Bond Market Transparency for Retail
Investors; and ICMA’s Voluntary Code of Conduct on Disclosure in the
Asset-Backed Commercial Paper Market.

The importance of the Asia Pacific region

At ICMA, we take a particular interest in the capital markets in the Asia

Pacific region. This is my fourth and final theme. The Asia Pacific region
has of course long been the home of thriving capital markets – from here
in Seoul to Hong Kong and Tokyo and Singapore and Sydney. Almost all
the region’s markets have grown significantly, and in recent years the
Chinese markets have joined the field as big players.

But so far these remain largely separate, national markets. Many market
participants believe that they could benefit from more standardisation and
integration. These are exactly the same objectives that ICMA has helped
to foster in Europe. ICMA has been organising and coordinating different
domestic and cross-border projects in the Asia Pacific region, working with
local and national associations. For example, in January we signed a
Memorandum of Understanding with the Japan Securities Dealers
Association, having agreed to cooperate in various areas, such as capital
markets regulatory issues; and we held a large joint conference with the
JSDA to present the Japanese market in London. In Singapore, we have
given seminars on the primary market, because institutions like the
Monetary Authority of Singapore and the Government of Singapore
Investment Corporation and other market participants wanted to hear
about our experience in Europe. In Malaysia and Indonesia, ICMA is
involved through our collaboration with the International Islamic financial
Market, based in Bahrain. In both the primary and secondary markets,
sukuk are one of the fastest growing segments of the global bond market.

We are very willing to transfer our knowhow and experience in Europe to

Asia. Our experience in Europe is directly relevant, both in terms of
helping to create a Single European Market in financial services among 27
countries in Europe, and also in integrating the countries of central and
eastern Europe following the fall of the Berlin Wall. But it is important to
add that, in achieving financial market integration, Europe has had one
one major advantage over Asia: the euro.

Even so, it seems to me that there are a number of steps that you can
take to promote financial market integration in Asia: first, tackle the
financial infrastructure, including trading platforms and stock exchanges;
then set the regulatory framework; then coordinate monetary policy; then
establish codes of conduct and best practice among participants in the
financial services industry.

The European experience of establishing a self-regulatory framework can

also, I believe, be useful in the Asian capital markets. We have a model
of experience in Europe which we are willing to share, while recognising
the specificity of Asian markets. In Europe, we have worked with
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fragmented markets in different languages, with different infrastructure

and regulations. Another important element that can accelerate market
development is a strong local investor base together with top quality
issuers. If investors, issuers, the market infrastructure and regulators all
play their parts, I believe that the long-wished for dream of a pan-Asian
capital market could become a reality.

Conclusion

In conclusion, I have spoken about the development of the international

capital markets as an example of the importance of the financial services
industry. I have spoken about some of the difficult issues that have given
rise to the recent market turbulence, and the expected response from
regulators and the industry. I have spoken about the role of self-
regulatory organisations like ICMA in helping to make capital markets
more efficient. And I have drawn attention to the relevance of our
experience of the development of efficient capital markets in Europe to
the Asia Pacific region. I hope that here in Asia you will be willing to learn
from our mistakes, but also to benefit from some of our achievements.