Howard Davies' Take on the Market Turmoil

The former British financial regulator weighs in on the debt crisis and predicts what might happen with interest rates

European stocks rebounded on Aug. 17 after the previous day's heavy losses, with major indices up 1% to 3%. The U.S. Federal Reserve's decision the same day to cut one of its interest rates in a bid to ease the liquidity squeeze seems to have, at least temporarily, calmed the world's jittery financial markets. But after a week of tumultuous market volatility across the globe and a concession by the Fed's own Chairman Ben Bernanke that "the downside risks to growth have increased appreciably," it's no wonder that investors are still nervous.

BusinessWeek's London correspondent Kerry Capell spoke on the morning of Aug. 17, prior to the Fed's move, to Howard Davies, director of the London School of Economics, about what the future holds. Davies was formerly the chairman of the Financial Services Authority, the British equivalent of the U.S. Securities & Exchange Commission, and a deputy governor of the Bank of England. He currently sits on the board of Morgan Stanley (MS) and formerly sat on the board of Total (TOT).

In this wide-ranging discussion, Davies offers his views on everything from the genesis of the current crisis to future risks.

With the market volatility showing little sign of abating what do you believe will happen with interest rates?

The expectation that people had until a few weeks ago was that interest rates would carry on rising. But at the moment, the likely consequence of this market turmoil in terms of interest rates is for the U.S. Federal Reserve to lower. The debate now is whether or not the Fed will step in sooner than September. It will be a bold central bank that raises rates in this environment.

On Aug. 2, European Central Bank President Jean-Claude Trichet signaled that the ECB remains on track to raise its benchmark rate by a quarter-point to 4.25% in September, saying the bank would show "strong vigilance" on inflation. Is a rate rise still likely?

The ECB probably will not raise rates in September as previously expected. As long as the market volatility continues, the risk of raising rates and creating even more market turmoil is pretty high. As for the Bank of England, last week's improved inflation figures and the current market conditions argues for the BoE sitting tight. As long as what's going on in the financial markets doesn't change Britain's inflation prospects, we will probably not see any reduction in interest rates from the BoE.

Given the concerns over leverage in the global economy, where do you think the next shocks might emerge?

The debt markets have frozen, in that people can't borrow. This is impacting short-term debt financing. The core of the problem is some U.S. institutions have lent money to people who can't pay it back. The U.S. had small interest rate rises coupled with the collapse of the property markets in speculative locations such as Florida and Texas, where there are high levels of consumer indebtedness related to property. So the countries that might be affected are those with similarly high levels of consumer indebtedness, as this may put similar pressures on other financial institutions that have overextended themselves in terms of credit. You might look to Britain, Ireland, Australia, and Spain, all of which have had very racy property markets.

But while there has been some potentially risky borrowing in Britain it is not on the same scale as in the U.S. Yes, foreclosures and defaults have gone up, but they are still at a low level historically.

How worried are you that this could spiral out of control?

There is an issue about mortgage debt and property prices, and we would be vulnerable in Britain to a change in sentiment in the property market that could produce more defaults, which in turn could feed this problem through to the real economy. But in Britain, recent figures on property prices have been quite strong.

But no doubt, the BoE will look quite carefully to see if there is a freeze in property market, which could be quite troublesome.

In addition, there is a problem of financial stability. There is undoubtedly an x factor. Everyone is running for cover. Financial institutions are saying "we can't fund, so any liquid we have we will sit on." Banks not lending, to preserve their own liquidity, is currently the most dangerous thing. There is a completely different psychology going on, a real battening down of the hatches. But everyone protecting their own position can lead to real problems in the markets. This is why we are on edge.

There will be losses in private equity and this routes through to the equity market in general, where there has been a premium in a lot of financial firms. This is due to the expectation that there will be a new wave of consolidation in the European financial sector. But all of that has gone away because now private equity can't fund those deals. Even some of the announced deals might not happen. So bank shares have declined due to the expectation that more consolidation is unlikely, and this is driving down the market.

Is speculative mortgage lending a real problem for British financial institutions?

There are only small pockets of speculative lending, conducted by much fewer and smaller players than in the U.S. It's true that income multiples have gone up in relation to borrowing. Until a decade ago, you could borrow as much as you liked as long as it was 2.5 times your income. Now banks are willing to lend at 4.5 or sometimes even 5 times income. Exposure to this end of the market is a concern for big banks in Britain, as it may be a big part of their portfolio. But it is important to remember that it is by no means all of it. The major British mortgage lenders are highly diversified, more so than the troubled U.S. institutions.

Do you think European bankers and policymakers have been more active in managing this current crisis? We've had French President Nicolas Sarkozy calling for more transparency of the financial markets and the European Union claiming it intends to launch an investigation into the role of the credit agencies in the current debacle.

The ECB clearly decided that there were liquidity problems in the European banking sector which were associated with rumors in the markets related to mortgage holdings. It looked as though their judgment was that these market anxieties were producing a liquidity problem that should be nipped in the bud. It was a bold preemptive move. It hasn't solved all the problems but it has taken the pressure off some of the financial institutions caught up in the rumors.

As for Sarkozy, in my opinion this is pure politics. It's typical of the French attitude that we must try to regulate market volatility. As far as the rating agencies are concerned, the European Commission has been looking at the regulatory environment for these agencies for a while. This is not a case of the Europeans being in the lead, as there is already regulatory oversight of the agencies in the U.S. and there has even been recent legislation to tighten it up.

There is nothing similar in Europe, where these agencies are not regulated. There has been some concern in the European Commission that we should do something comparable [with regards to rating agency oversight] as they do in the U.S. So far, the Europeans couldn't see a case for it. Now, somewhat opportunistically, they are saying there may be one after all.

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