Financial Crisis - February 10, 2009

Financial crisis or regulatory crisis? An interview with Noël Amenc

Noël Amenc

In August 2007 EDHEC carried out a study1 that absolved hedge funds from blame for the subprime crisis. One year later, do your conclusions still stand?

I know it’s not politically correct to defend hedge funds, but any serious study and a review of the facts ought to prevent an exaggeration of their influence on the major financial crisis we are going through today.

As it happens, neither the prohibition on short selling nor the great decrease in leverage as a result of greater demands for collateral, which have been hamstringing hedge funds since late 2007, has stabilised the financial markets. In its latest report on financial stability, the International Monetary Fund (IMF) estimates that on average the losses of managers of alternative assets and hedge funds account for only 10% to 15% of the total financial sector losses of more than $1.4 trillion on such American debt products as packaged subprime debt and securitisations. So it is distressing to see that the constant search for scapegoats is causing pundits and policy makers to fail to see that it is the very logic of financial regulation, not the greed of this or that person, that is at the root of the crisis.

More broadly, it is the inability of investors to accept the volatility of financial markets that has led to the creation of high-risk products. This inability is as much the result of prudential regulations as it is of the attitudes of institutional investors and financial analysts, who are using the accounts as financial indicators of solvency and profitability, even though accounting is but a source of information that should be subject to specific treatment and adapted to the strategic situation, to the profession, and, more broadly, to the asset-liability management of the investors.

The notion that the fair value approach would make retreatment specific to financial or prudential analysis unnecessary creates confusion. In fact, those who devised and promoted the international financial reporting standards (IFRS) were excessively and dangerously ambitious to think that accounting information could become universal financial information. As early as 2005, in a report on the use of IFRS in the insurance industry and on the troubled co-existence of the standards and Solvency II, the new European framework of capital rules for insurance companies, we underscored the risks of this notion of accounting.2 The crisis has only strengthened our conviction.

In what ways is the regulation of investors to blame for the crisis?

First of all, which crisis are we speaking of? The first crisis is a stock market crisis that, at heart, isn’t that much different from earlier crises (the Internet bubble). In no way does it threaten the stability of our financial system, even though it does have very negative consequences on growth and on funded pension systems.

The second crisis is the credit crisis, and it is this crisis that is undermining the foundations of global economic stability. It is the result of regulation. Indeed, regulation has been unable to ward off systemic risk even though that is its very reason for existence. As a result of its pro-cyclical nature, it has even exacerbated it. Institutions were given room to get around the capital requirements linked to counterparty risk—by categorising securitised debt products as held for trading, by breaking down ultimate exposure to this risk into special vehicles for which they provided the collateral, or by relying on altogether ineffective outside ratings—and it was in many ways this room that led to excessive risk-taking in high-risk credit markets.

In addition, the “cyclicality” of prudential regulation forces financial institutions to sell off assets to respect solvency ratios that have fallen both because of the fall of their capital—the result of the depreciation of their assets—and because of the highlighting of such hitherto misread risks as the liquidity risks or counterparty risks of market transactions.

So the impact on holdings of risky assets of the sale of securities by hedge funds and of very pro-cyclical regulation cannot be compared. As a result of this pro-cyclical regulation, in fact, banks find themselves technically insolvent during lows in the economic cycle, and institutional investors are no longer able to take risks as a result of a framework that fails to take into account the duration of their liabilities and enjoins them to be able to cash out their portfolios at any time.

What do you think of the recent reforms to accounting standards undertaken to prevent a deterioration of the accounts of lending institutions? Does the mark-to-market valuation of instruments in markets with no real depth or liquidity not pose a great risk of exacerbating the crisis?

It quickly became clear that in illiquid markets the valuation of financial instruments, and of structured products and securitised debt in particular, could not reasonably rely on market prices that resembled distress-sale prices more closely than they did prices reflecting a balance between supply and demand. This problem led accounting standard setters and the regulators of financial markets to state that the valuation at fair value stipulated by both North American and European accounting standards was not always equivalent to a mark-to-market value but could also be determined by an internal model that might or might not input market parameters.

This so-called mark-to-model approach makes it possible to allow both for temporary difficulties with mark-to-market valuations and for the many structured products that are designed to be unique, tailored to each client, and for which there is no real market price.

Why did the international accounting standard setters make urgent changes to IAS 39 and IFRS 7?

The IASB (International Accounting Standards Board) acted under pressure from governments, most of all from the European Commission, which was threatening to suspend the application of IAS 39, which accounts for the bulk of the fair value accounting for the financial institutions that were being bailed out. As it happens, to reduce required regulatory capital, these institutions had put nearly all their securitised debt and structured debt products in their trading books; the market Value-at-Risk prescribed by the rules for bank capital didn’t, after all, take into account the counterparty and liquidity risks that are, in fact, the main risks of instruments, and the institutions were taking advantage of this loophole. The downside of this regulatory arbitrage is that classifying these instruments as held for trading (rather than as held to maturity or loans and receivables, as they should have been) is now forcing financial institutions to price at fair value, in the profit and loss account, the considerable latent losses caused by the deterioration of the credit and real estate markets.

The amendments to IAS 39 and IFRS 7 allow banks to make a posteriori reclassifications—and at 8 July 2008 values—of the financial instruments in their banking books and thus to reduce the losses and volatility posted in their profit and loss accounts. To the researchers at EDHEC, these changes seem not only untimely but above all dangerous.

Untimely because, were the crisis to worsen, they might not prevent financial institutions from having to book write-downs for the long-term depreciation of these reclassified assets. In addition, the return to accounting at historical cost is likely, as it did in the Japanese banking crisis of the 1990s, to delay the write-off of losses, the recapitalisation of financial institutions, and the swift recognition of market recovery.

Dangerous because changes to the rules for financial information are likely to heighten investor mistrust of published accounts, thus exacerbating the crisis of confidence that is at the root of the financial crisis we are experiencing.

Finally, it’s never a good idea for the regulators to save those who skirted the rules. The amendments to IAS 39 and IFRS 7 seem to stem from a “too many to fail” precept even more threatening to the credibility of regulation than the notorious “too big to fail,” a precept that will lead too many institutions to take too many excessive risks at the same time.

Late last year, EDHEC published a position paper3 on the fair value debate that is, in our view, a paper that will be returned to again and again. It seemed important to us to say that the accounting framework is unsatisfactory, especially in periods of great market illiquidity. Indeed, the excessive reliance on market values, even when they no longer exist, by accountants and analysts who in so doing want to be shed of all blame for the certification of results from an internal valuation model, is causing great problems for financial institutions and for companies in general.

Nonetheless, we think that these problems should lead not to a shrinking of the purview of fair value accounting but to changes in the way it is used. The reform for the occasion represented by the amendments to IAS 39 and IFRS 7 should not overshadow the real issue of reforms to international accounting standards.

Making allowances for dynamic risk management strategies, as well as improving the accounting treatment of macro-hedging or partial and incomplete hedging, practices penalised by current rules, are problems of the first order that should be swiftly resolved by the accounting standards setter, as current accounting rules encourage financial risk management behaviour that is less than optimal.

What is the impact of these reforms on the asset management industry?

Asset managers, much like institutional investors, are guarded about these changes that were effected without broad consultation. It is clear that as users of published accounts they would like to have information that is precise, clear, and as little susceptible to manipulation as possible. From their perspective, the amendments to IAS 39 and IFRS 7 are at odds with this desire. We have surveyed4 more than 800 professionals for their views of these amendments. The results are clear: a great majority of those surveyed believe that the IASB initiative poses more problems than it solves. It seems to them especially unlikely to restore confidence to the markets, the lack of which is currently the major problem besetting the asset management and investment industries.

It’s the way the accounting instrument is used that needs to be changed, not the instrument itself. Analysis of solvency should rely not on the short-term use of accounting magnitudes that have no forecasting value but on the quality of the long-term financial management of the institutional investors. It’s the aversion of clients to short-term volatility that led the financial industry to create financial instruments with attractive returns and very low volatility, instruments whose performance was nonetheless linked to extreme risks of great magnitude.

So, without breaking the accountant’s thermometer, how to reduce the pro-cyclicality of current regulation?

The real problem of regulatory pro-cyclicality has to do with rules for capital, not with accounting. EDHEC, in two position papers,5 argues that, although government intervention in the banking system was, in view of the great difficulties faced by the major banking institutions, indispensable, this intervention was above all the consequence of a misconception of what solvency margins are, a misconception that turns capital ratios meant to serve as cyclical buffers into downright guillotine blades.

The markets, influenced by rating agencies and by the simplistic discourse of policy makers, are demanding that banks have more and more capital at the very moment in which capital is hardest to find. In no way does this escalation correspond to a regulatory requirement. In Europe, Tier-I ratios for core bank capital are close to 8%, while the regulatory minimum is 4%. Because there is no clear definition of the way that prudential ratios, to ensure the stability of the banking industry, should rise and fall over the business cycle, the market, in a context of great uncertainty, is demanding more and more capital of banks, even though in a crisis bank capital, like the capital of any other company, is meant to be spent. Here, a simple decrease of one percentage point in the target ratio was all that would have been needed to make government intervention unnecessary.

But is it not dangerous to change the rules during a financial crisis?

In reality, market obligations exceed that which would be required by strict compliance with the 4% ratio and by additional capital determined by stress tests meant to ensure that events with dire consequences do not cause capital to fall beneath the regulatory floor. So, even though the British regulator noted on January 19 that stress tests yield target capital ratios of around 6% to 7%, suggesting that British banks are sufficiently well capitalised to withstand the foreseeable turbulence, the government is participating in yet another round of recapitalisation.

Between October and the end of last year, governments spent more than $350 billion to stabilise the financial system and restore at least some confidence in banks, which were nonetheless complying with minimum solvency ratios. Intervention as a result of bank failure was exceedingly rare. Although government bailouts, given the unfounded capital requirements prevailing in the markets, have managed to prevent a collapse of the banking system, stabilising the banks is no longer a sufficient response to the broadening of the economic crisis. An easing of the terms for extending credit will require not just new inflows of government money, but ultimately, perhaps, changes to rules for bank capital as well.

About Noël Amenc

Noël Amenc is professor of finance and director of research and development at EDHEC Business School, where he heads the Risk and Asset Management Research Centre. He has a masters degree in economics and a PhD in finance and has conducted active research in the fields of quantitative equity management, portfolio performance analysis, and active asset allocation, resulting in numerous academic and practitioner articles and books. He is a member of the editorial board of the Journal of Portfolio Management, associate editor of the Journal of Alternative Investments and a member of the scientific advisory council of the AMF (French financial regulatory authority).


  1. Amenc, N. 2007. Three Early Lessons from the Subprime Lending Crisis (August).

  2. Amenc, N., P. Foulquier, L. Martellini, and S. Sender. 2006. The Impact of IFRS and Solvency II on Asset-Liability Management and Asset Management in Insurance Companies (November). With the EDHEC Financial Analysis and Accounting Research Centre.

  3. Escaffre, L., P. Foulquier, and P. Touron. 2008. The Fair Value Controversy: Ignoring the Real Issue (November).

  4. Amenc, N., F. Ducoulombier, and P. Foulquier. 2008. Reactions to an EDHEC Study on the Fair Value Controversy (December). With the EDHEC Financial Analysis and Accounting Research Centre.

  5. Amenc, N., and S. Sender. 2008. Assessing the European Banking Sector Bailout Plans (December). Sender, S. 2008. Banking: Why Does Regulation Alone Not Suffice? Why Must Governments Intervene? (November).

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