Jane Diplock AO
Chairman, Securities Commission New Zealand
& Executive Committee, IOSCO

Institute of Finance Professionals New Zealand (INFINZ)
Finance & Treasury Forum 2009

Auckland
17 March 2009

New Zealand's capital markets and the global financial crisis

Good morning. It is a special pleasure to be participating in your forum and I welcome the opportunity to talk to you all today.

We are experiencing unprecedented times. The immensity of challenges which face those working in the financial markets is clear to us all. The impact of the global financial crisis is far-reaching. As I open the Blackberry this morning Standard & Poor's newsletter is headed "The worst may be yet to come" - confidence is shattered. All of us here today are affected either through constrictions on liquidity or a lack of access to credit as borrowing becomes more expensive. Ultimately it touches the lives of most people one way or another. Repercussions have already spread to the real economies with the world in the grips of a global recession. It will therefore not only fall on those in the finance sector itself to contribute towards solutions for a better future. The effort required is a collective one.

Today I'd like to discuss issues relating to the global crisis and its effects on New Zealand's capital markets. I'll talk about the international response and what's being done here in New Zealand.

A tremendous amount has already been said about this credit crisis that started in the US and very rapidly has become a global financial crisis. You will recall that from mid June 2007 onwards, it became apparent that many institutional investors were exposed to potentially large losses through their investment in residential mortgage-backed securities (RMBSs), collateralised debt obligations (CDOs) and other forms of securitised and structured financial products linked to US sub-prime mortgages. Uncertainty over the extent of those losses and how they would flow through complex lending chains pushed some banking institutions and hedge funds into a liquidity crisis. Their urgent responses sent shockwaves through debt and equity markets in the US and elsewhere.

Recently we have witnessed huge falls in stock markets worldwide, we hear of more and more companies posting and forecasting unprecedented losses and announcing job cuts. The largest such loss being announced by AIG of $US61.7 billion has prompted the announcement and consideration of a further bailout plan. HSBC has had to face massive losses in the US, prompting it to seek more funding through an estimated £12.5 billion rights issue. The International Monetary Fund has forecast a grim growth of an average of 0.5% in the world economy while rates in UK are now at their lowest level, 1%, in the Bank of England's 300-year history.

Various short-term measures, such as bans on short-selling, were put in place in many jurisdictions. The enormity of the crisis has taken everyone by surprise. In the very latest developments we have seen the crisis threaten the underlying foundations of the entire financial system.

The under-regulated parts of the market and unregulated products - which are the largely opaque areas - contributed to the volatility of the global markets.

It was very evident that a coordinated and collective response was imperative and from the beginning of the crisis there has been a flurry of work from across the full spectrum of the international global financial regulatory framework.

Political leaders have addressed the challenges arising from this crisis, with state-supported bank bail-out packages, fiscal-stimulus packages worldwide, co-ordinated reduction in interest rates, and the special G20 and APEC summits to address the crisis.

Various international bodies including the International Organisations of Securities Commissions (IOSCO) and the International Accounting Standards Board (IASB) are working within their remit with their member nations and others to co-ordinate efforts to understand the crisis and find solutions. These international organisations, I believe, can play an important role in looking at events globally, coordinating and facilitating member nations to find solutions that work beyond their individual jurisdictions.

I have had the privilege of the chairing the Executive Committee of IOSCO which is the international standards setter for securities regulation. Its 109 members regulate more than 90% of the world's securities markets. As the global standards setter it leads the thinking on ways to address the challenges for securities regulators amid today's capital market instability.

Even before the crisis IOSCO was already examining ways to address some of the regulatory gaps which have now been starkly exposed.

One of these is the area of credit rating agencies. They have certainly attracted significant attention during the crisis with questions raised about the integrity of the processes they used and the reliability of the ratings for complex financial instruments. A perception of conflict of interest was created by the fact that they provided advice on how to structure these financial products to obtain certain ratings and then went on to rate them. IOSCO, in updating its Code of Conduct for Credit Rating Agencies, suggested refinements to enhance the quality and integrity of rating processes, avoid conflicts of interest, and clarify the responsibilities of CRAs to the investing public and to securities issuers.

IOSCO has identified key measures which it believes will contribute to improved international monitoring of credit rating agencies and address the issues that have contributed to the failures in the market for structured finance products. In particular, IOSCO favours a consistent global regulatory approach to monitoring the activities of CRAs.

This week IOSCO has released a report listing those rating agencies which are complying with this revised Code of Conduct.

In November last year IOSCO wrote an open letter to the G20 Leaders Summit setting out the views of global regulators in relation to the steps needed to address the ongoing financial crisis, the role to be played by securities regulators and the work it had already done in response to the crisis and in the wider development of sound securities regulation. To assist the G20, IOSCO set up three new taskforces to look at short selling, unregulated financial markets and products and unregulated financial entities.

The taskforce on short selling recognizes that there are great differences in the regulation of short selling across jurisdictions and is soon to publish a report for public consultation that sets out general principles on the regulation of short selling.

The taskforce on unregulated financial entities is examining issues surrounding entities that are unregulated, including the development of recommended regulatory approaches to mitigate risks associated with their trading and traditional opacity. It is looking at the risks posed by hedge funds to capital markets, and the current level of regulation of hedge funds. An important issue is how hedge funds should be regulated given the different approaches across jurisdictions.

A taskforce on unregulated financial markets and products is examining ways to introduce greater transparency and oversight to unregulated market segments, such as OTC markets for derivatives and other structured financial products.

Another focus for IOSCO has been international financial reporting standards and the accountability of the standard setter to the community of national authorities responsible for reporting by public companies. An IOSCO technical committee is closely monitoring the International Accounting Standards Board (IASB) work that is focused on off-balance sheet reporting and on fair value accounting in the context of inactive markets.

I would like to mention here that I have the privilege of being a member of the Financial Crisis Advisory Group set up in December by the IASB and the United States Financial Accounting Standards Board. This Group will be reporting back to those boards mid year about standards setting implications of the global financial crisis and potential changes to the global regulatory environment.

Of particular interest to the Group are issues around fair value accounting (raised in the US Congress in the past few days) and mark-to-market and the role they played in the financial crisis; consolidation and de-recognition of assets related to special purpose vehicles; and financial instruments. Also questions of financial institutions being encouraged to make greater capital provisions during good times in order to be better resourced in downturns, and whether this might be encouraged by prudential requirements or accounting treatments, have been strongly debated.

It is my personal expressed view that restoring investor confidence should be the number one priority for standards setters when considering any changes to reporting standards.

There had been a belief, as outlined by Alan Greenspan in his evidence before the US Congress, that certain unregulated parts of the market would discipline themselves. Clearly, that did not happen and will not happen.

But the real challenge in difficult times is to ensure that a measured and balance approach is taken. It is absolutely critical to the development of capital markets and the ensuing growth of economies that we facilitate these markets. So we must not take the course which would lead to over-regulation.

What we need is improved liquidity and well functioning markets - investor confidence is the key to this. Transparency and sound and balanced financial regulation are also important means of achieving this.

Which brings me to the New Zealand situation: As you know, while the turmoil here was initially largely the result of domestic concerns, after August 2007 when the sub-prime effects were being felt in the US and UK, credit to all banks began to be constrained. Inter-bank lending was reduced. Few New Zealanders were directly exposed to the securitized products which caused turmoil in other parts of the world; however it was the reduction in liquidity that more generally affected this market. This, combined with declining economic conditions and a falling New Zealand property market, influenced the markets in New Zealand.

We did have our own crisis in one segment of the capital market, with the collapse of a number of finance companies from early 2007. While this represents in dollar terms, a limited part of the capital market, the failures in this sector severely damaged confidence of the investors affected and had an impact on investor confidence more broadly.

With the global financial crisis and recession taking hold New Zealand is facing difficult times. The Government is concerned about the impact of the international crisis on the New Zealand economy and we know that strong and sustainable capital markets are fundamental to the growth of the economy, but our markets are under stress and investor confidence has taken a real hit.

So how do we deal with these challenges which we are all faced with? As well as economic stimulus measures, the Government has acted on a number of fronts with the deposit guarantee scheme, the Capital Markets Development Taskforce, and more recently the Job Summit - all three of which the Securities Commission has been involved with in one way or another. As the main regulator of securities markets in New Zealand the Commission itself has a vital role to play because it is able to facilitate, develop and implement changes that will support the growth of the capital markets.

I will move onto the Commission's approach shortly, but starting first with the Government initiatives:

Last October, with international financial market turbulence affecting the ability of funding institutions both in New Zealand and overseas, the Government quickly followed Australia's move to introduce the deposit guarantee scheme. This aimed to ensure continuing depositor confidence in New Zealand. It is similar to the Australian scheme and those schemes now offered by other countries.

There are two schemes, according to whether they are retail or wholesale investors. The retail scheme covers all deposits of approved institutions. It is for all depositors with New Zealand banks and for New Zealand depositors only, with non-bank deposit takers, with a one-million-dollar limit for each investor per institution. This scheme expires in 2010. The wholesale scheme is subject to approval by individual issue and is available to both New Zealand and overseas lenders. There is no set limit on the amount of deposits, nor is there any expiry date at this time.

The Securities Commission has made rules (by exemption) for institutions disclosing coverage under the scheme and these involve three guiding principles. They are, first, that messages are consistent and straight forward - in other words, there is no marketing hype. The second is that readers must be referred to a single authoritative source of detailed information, that is, the Treasury website. And finally there must be nothing misleading about the information provided.

The Capital Markets Development Taskforce is an industry-led taskforce set up by the Government last year to produce a blueprint and action plan to develop New Zealand's capital markets. In doing so it is looking at the current state of our capital markets, the international context, future risks and opportunities and key changes necessary to deliver the best possible financial system for New Zealand.

The Commission is supportive of this initiative and is working closely with the taskforce in finding ways to implement recommendations put forward in their interim report published in November. Those recommendations are aimed at improving access to capital for businesses and reducing the costs of raising capital.

The approach is three-pronged - changes to the Securities Act, exemptions and changes to Listing Rules:

As I have already said, a healthy capital market is essential for economic growth and underpinning this is a fair and efficient regulatory regime. The Commission has adopted short to medium term priorities that focus on the immediate challenges in our market and our economy and that aim to restore and maintain investor confidence in our markets and our regulatory environment. We approach this on both the domestic and international fronts.

As New Zealand firms come under stress as a result of the economic conditions it will be important to ensure that unnecessary or duplicative regulations do not impede access to funds.

Other legislative work being undertaken in the interests of developing market liquidity includes reviewing securities regulation to simplify and clarify disclosure requirements, and wider review of the Securities Act.

On the international front we use make use of opportunities to improve confidence in New Zealand capital markets. In the current financial crisis it is increasingly important that potential investors offshore - who may provide key investments in New Zealand companies - are reassured about the market and the regulatory environment into which their investments will be placed. And we have a good story to tell about the stability of our financial system and the quality of our regulatory regime. With this in mind we use every opportunity, together with agencies such as the Ministry of Foreign Affairs and Trade and New Zealand Trade and Enterprise, to raise awareness of New Zealand as a sound destination for overseas investors, and to encourage and facilitate investment in New Zealand. This has been largely made possible through our involvement with IOSCO.

The Job Summit in February primarily examined how unemployment resulting from the recession can be curbed. We all know the constrictions that lead to decisions on job cuts, so appropriately major sessions were about business financing and keeping businesses liquid and productive. I was pleased to be able to contribute to the Summit and provide two of the working groups with an explanation of the relevant work we are doing in New Zealand and internationally, which is ultimately aimed at restoring investor confidence in our markets and regulatory environment. The working group which I participated in focussed on issues related to capital raising and funding.

Finally I'd like to mention some other work by the Commission that supports our aim of promoting investor confidence which is so sorely needed at this time.

Recent events have exposed the significance of the role of finance advisers but this important sector was unregulated. This of course is all changing with the passing of the Financial Advisers legislation in September which aims to give New Zealanders confidence in a competent and trustworthy financial advisory industry. The Commission is working with other agencies, the industry and training sector on implementing the regime and hopes to have it in place by the end of next year.

Our considerable ongoing work on finance company enforcement acts as a deterrent to bad practices and market misconduct and may provide a measure of redress for affected investors.

We are also continuing our long-term efforts to assist financial literacy and generally raise public awareness and understanding about investing so that people can make confident investment decisions.

Finally then, it would appear that fundamentally the global financial crisis is taking us into uncharted waters. In the global arena we have witnessed bailouts and other measures aimed at restoring the banking system. But these have yet to be properly tested. New Zealand is clearly subject to turmoil as are other countries, and a number of challenges lie ahead.

On the matter of the last question, this issue is addressed by Carmen Reinhart and Kenneth Rogoff in their paper prepared for the American Economics Association meeting in January. In a paper entitled "The Aftermath of Financial Crises" they compare the run-up to the 2007 US sub-prime crisis with previous banking crises of the last 50 years. To quote from their report:

"An examination of the aftermath of severe financial crises shows deep and lasting effects on asset prices, output and employment. Unemployment rises and housing price declines extend out for five and six years respectively. On the encouraging side output declines last only two years on average. Even recessions sparked by financial crises do eventually end, albeit almost invariably accompanied by massive increases in government debt."