Securitisation and the global economic crisis

In the current pantomime of financial regulatory turmoil, the villain of the piece is easily cast - securitisation. Even the relative obscurity of the word has added to its perceived villainy. A difficult word to pronounce for the uninitiated, it has been booed and hissed at by politicians of all sides. The Turner Review, published on 18 March, firmly places securitisation - at least in its more complex forms - at the heart of the current banking crisis. Does it deserve its reputation?

Current criticisms

Will the suggested remedies work? Politicians and experts talk of the need for increased transparency, greater accountability, and a closer alignment of interests between investors, shareholders, banks and executives.

"Complex securitisation reduced transparency" is an accusation levelled by the G20 participants. But greater transparency would not necessarily have had any effect on investors' exuberance in the search for yield. That search has led certain investors to overlook the dangers of riskier investments, to focus too much on a hoped-for handsome reward and to avoid taking the time to understand properly the investments they were buying.

The concept of transparency in this context is, at its heart, again simple. It requires that the underlying financial story is told, warts and all. Significant regulatory intervention in the field of transparency has been happening for many years. Issuers of financial products to the public markets are already under strong legal obligations to explain in great detail the nature of the financial products, such as commercial mortgage-backed securities, and the nature of the underlying assets.

So a more detailed assessment of the risks by investors is required. They must not rely simply on credit rating agency analysis. Investors have been heard to complain that they do not have time to properly examine new investment opportunities. Whatever else they do, they must do this.

Good old-fashioned banking

Transparency is also used as a byword for simplicity. A return to "good old-fashioned banking" is advocated by many. This makes a good soundbite for the politician but would represent startling naivety were it seriously to be pushed as the way forward. Does anyone really expect a return to the days of the bank manager lecturing his first-time buyers?

The boundary between 'normal' banking and more esoteric investment banking was broken down in the 1990s by the repeal of the Glass-Steagall Act in the US. Although some voices speak up in favour of aspects of this model, there are few in positions of influence who are suggesting that restoring the distinction is the way forward. Securitisation is just one part of the huge range of complex financial products available to international investors. Lord Turner is clear in his report that the future for financial markets will include, in his view, a "significant role for securitised credit" and that this will involve banks which operate across the traditional Glass-Steagall divide. Securitisation is needed, and is here to stay.

And complexity will not disappear. The challenge is to design a regulatory system which recognises this complexity and addresses the risks in a structured rational way. The regulatory response must, however, be flexible. It must be able to treat differing banking activities in different ways. It would be dangerous and short-sighted for the regulatory reforms to stifle innovation because of a lack of understanding. There would be no better way to delay the return to prosperity.

Lessons

The lessons to be learned here are threefold. First, we cannot turn the clock back. Bankers, regulators and investors must work together to appreciate and evaluate the risks inherent in complex financial transactions - there will always be a degree of risk. Second, calls for transparency and the like must be used properly and lead to informed choices. Buzz-words alone will not achieve the alignment of interests between banks and investors. And finally, those involved in the evaluation of risk must be educated to understand that the buck may stop with them - not every risk can be offloaded to someone else.

Posted by Christian Lambie, international capital markets partner at Allen & Overy. See Legal Village tomorrow (1 April) and the 2 April edition of Legal Week for more on the G20.