European regulatory measures designed to make the financial system safer don’t actually eliminate risk, they simply move it to nonfinancial companies, warns Mark Morris, the finance chief for Rolls-Royce, the British aero-engine maker. And there could be a negative impact on the economy, he says.

Speaking at a conference organized by The Economist Group (a minority owner of CFO), Morris criticized European regulators for seeking to deal with over-the-counter derivatives risk in the financial sector by requiring some contracts to be centrally cleared or to have collateral posted.

The European market infrastructure regulation, known as EMIR, took effect last August but requires the European Commission to enact a series of technical standards before the rules can be fully implemented. Most are expected to be finalized by mid-2013.

“In essence, you can’t destroy risk,” Morris said. “It morphs into something else. If you take market risk and go into a foreign exchange [hedging] transaction with a bank, you’re replacing it with counterparty risk. If you try to replace the counterparty risk by using central clearing or some form of posting of collateral, what you’re doing is you’re replacing counterparty risk with liquidity risk.”

He argued that the regulatory environment was based on a misconception. “Derivatives did not create the financial crisis. You might argue they may have amplified it,” Morris said. He insisted that standardizing derivatives contracts or forcing counterparties to post collateral “creates a whole host of other risks that just pushes back into the nonfinancial system.”

In other words, while regulators regulate the financial universe, they’ve simply thrown some risk back over to an environment they don’t regulate. “That doesn’t mean the risk has gone away,” Morris said.

He added, “The market has in effect created the OTC derivative space because that’s what nonfinancial companies want. We’re now being told we can’t have these tools anymore; we can have these standard tools. We’re saying, we don’t want these standard tools.”

Companies such as Rolls-Royce that practice long-term hedging — perhaps as long as 10 years — have significant mark-to-market movements. “We would be posting vast sums of collateral which will use huge liquidity reserves so we can’t invest in the real economy,” Morris warned. “It’s [raising] investment barriers, which is the very thing we’re not looking for as we want growth to kick-start the economy.”

Andrew Sawers is editor of CFO European Briefing, a CFO online publication.

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