The financial crisis and the future of
financial regulation
Related information
Slides:
The Economist’s Inaugural City Lecture
Speech by Adair Turner, Chairman, FSA
The Economist's Inaugural City Lecture
21 January 2009
It is stating the obvious to say that over the last 18 months, and even more so the last four, the world
financial system – and particularly but not exclusively the world banking system – has suffered a
crisis as bad as any since the stock market crashes of 1929 and the various banking crises that
followed. As a result, banking systems in many countries are suffering from an impaired ability to
play their vital role in credit extension to the real economy and a process of deleveraging threatens
severe adverse effects on real economic prospects. The crisis therefore presents the financial
authorities – central banks, regulators and finance ministries – with two challenges:
• The first and most urgent is to design short-term policies so as to at least limit the adverse
impact of deleveraging and deflation on the real economy. We cannot make that impact nil,
but we do know how to avoid the policy mistakes which turned the initial problems of 1929-
30 into the Great Depression. Fiscal and monetary policies need to be carefully designed,
and – as we approach a zero interest rate and consider quantitative easing options – need to
be increasingly coordinated. And there are a wide range of policies which can be taken to
free up financial markets – measures which Ben Bernanke last week labeled “Credit Easing”
– funding guarantees, liquidity provision, tail risk insurance, direct central bank purchases of
assets, and regulatory approaches to capital regulation which avoid unnecessary pro
cyclicality in capital adequacy requirements. The measures announced by the Chancellor of
Exchequer on Monday were designed as an integrated package, which will have a
significant impact. And if more measures are acquired they can and will be taken.
• It is not, however, on this challenge of short-term economic management – where the lead
must be with the fiscal and monetary authorities – that I’m going to talk tonight. But instead
on the second challenge: how to design the future regulation and supervision of financial
services so that we significantly reduce the probability and severity of future financial
crises? Last September, when I took over as Chairman of the FSA, the Chancellor asked me
to conduct a review of our regulation and supervision of the banking system, and I will
deliver that Review in March, alongside the publication of a comprehensive FSA Discussion
Paper. That paper will set out the changes the FSA has already made, those where we have
proposals in principle but need to consult on details, and those where we have defined our
objectives but now need to play our role in achieving international agreement.
Those proposals for regulatory change need to be grounded in analysis of what happened – why this
crisis occurred. Tonight therefore I will concentrate on that analysis. I will then draw out some
issues and possible implications relating to the future shape and size of the banking and credit
mediation markets. I will finally and briefly outline three changes which we know are in principle
essential.
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What happened and why?
So what happened? Why did this extreme crisis occur? I think with hindsight – and it is only with
hindsight – a fairly compelling and broadly agreed explanation of what has occurred can be set out.
At the core of the crisis was an interplay between macroeconomic imbalances which have become
particularly prevalent over the last 10-15 years, and financial market developments which have been
going on for 30 years but which accelerated over the last ten under the influence of the macro
imbalances.
Macro-imbalances. First, the macro side. The last decade [Exhibit 1] has seen an explosion of world
macro-imbalances, with very large current account surpluses piling up in the oil exporting
countries, China, Japan and some other east Asian developing nations, and large current account
deficits piling up in the USA, but also in the UK, in Ireland, Spain and some other countries. A key
driver of those imbalances has been very high savings rates in countries like China; since these high
savings are in excess of domestic investment, China and other countries must accumulate claims on
the rest of the world. But since, in addition, those countries are committed to fixed or significantly
managed exchange rates, these rising claims take the form of central bank reserves, typically
invested not in a wide array of equity, property or fixed income assets – but almost exclusively in
apparently risk-free or close to risk-free government bonds or government guaranteed bonds.
This in turn has driven a reduction in real risk free rates of interest to historically low levels
[Exhibit 2]. In 1990 you could invest in the UK or the US in risk-free index-linked government
bonds at a yield to maturity of over 3% real; for the last five years the yield has been less than 2%
and at times as low as 1%.
These very low medium- and long-term real interest rates have in turn driven two effects:
• First, they have helped drive rapid growth of credit extension in some developed countries,
particularly in the US and the UK – and particularly but not exclusively for residential
mortgages [Exhibit 3] – with this growth accompanied by a degradation of credit standards,
and fuelling property price booms which for a time made those lower credit standards
appear costless.
• And secondly, they had driven among investors a ferocious search for yield – a desire among
any investor who wishes to invest in bond-like instruments to gain as much as possible
spread above the risk-free rate, to offset at least partially the declining risk-free rate. Twenty
years ago a pension fund or insurance company selling annuities could invest at 3.5% real
yield to maturity on an entirely risk-free basis; now only 1.5%: any products which appear
to add 10, 20 or 30 basis points to that yield without adding too much risk look very
attractive.
Financial sector innovation. The fundamental macro economic imbalances have thus stimulated
demands which have been met by a wave of financial innovation, focused on the origination,
packaging, trading and distribution of securitised credit instruments. Simple forms of securitised
credit – corporate bonds – have of course existed for almost as long as modern banking. In the US,
securitised credit has also played a major role in mortgage lending since the creation of Fannie Mae
in the 1930s; and securitisation had been playing a steadily increasing role in the global financial
system and in particular in the American financial system for a decade and a half before the mid-
1990s. But it was from the mid-1990s that the system entered explosive growth in both scale and
complexity:
• With huge growth in the value of the total stock of credit securities [Exhibit 4]
• An explosion in the complexity of the securities sold, with the growth of the alphabet soup
of structured credit products.
• And with the related explosion of the volume of credit derivatives, enabling investors and
traders to hedge underlying credit exposures, or to create synthetic credit exposures. [Exhibit
5]
All of these developments, in different ways, seeking to satisfy the demand for yield uplift, and all
predicated on the belief that by slicing and dicing, structuring and hedging, using sophisticated
mathematical models to understand and manage risk, we can “create value” by offering investors
combinations of risk and return which are more attractive than those available from direct purchase
of the underlying credit exposures.
This explosion was supported by and in itself drove big increases in the leverage of major financial
institutions – in particular investment banks and the investment banking activities of some large
universal banks. [Exhibit 6]
And as it developed the rapid growth began to drive and to be driven by one of those self-fulfilling
cycles of falling risk aversion and rising irrational exuberance to which all liquid traded markets
seem at times to be susceptible:
• Credit spreads on a wide range of securities and loans falling to clearly inadequate levels.
[Exhibit 7]
• The price charged for the absorption of volatility risk falling because volatility seemed to
have declined. [Exhibit 8]
• And these falling spreads and volatility prices driving up the current value of a range of
instruments, marked to market value on the books of banks, investment banks and hedge
funds – fuelling in turn higher apparent profits and higher bonuses, and as a result
reinforcing management and traders certainty that they must be doing the right thing.
Until we reached the point where people began to fear that the music was about to stop – but where
others felt, in Chuck Prince’s words, that they had to keep dancing till the band stopped, which it
did in summer and autumn 2007.
A cycle therefore of irrational boom and then bust; and therefore in some ways no different from
other cycles which we have seen in markets in the past: in equities, in property, in South Sea project
participations, in tulips. But what makes this one different – and potentially more economically
destructive to the real economy – is that it is the first major global boom and bust of securitised
credit instruments. Because at the core of this story is the development of a new model for
delivering credit intermediation – the originate and distribute model of securitised credit. And one
of the crucial questions we therefore have to ask is whether this originate and distribute model is
inherently riskier than the one that it has partially replaced – or whether, provided we regulate it
more effectively, it is capable of being a more stable system, or indeed of delivering the positive
benefits of increased financial stability which its advocates originally proposed.
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So before talking about the response to the crisis, I will make four observations relating to the
growth and the implications of the securitised credit intermediation model:
Securitised credit: initial proposition and subsequent
evolution
First, as already said, securitised credit has a history going back many decades. But it really began
to take off in the 1980s, and it is interesting to revisit the arguments made in its favour at that time.
One argument was greater liquidity for end investors (an issue I’ll come back to), but another
crucial argument was that securitisation would reduce risks for individual banks by passing credit
risk to end investors, reducing the need for unnecessary and expensive bank capital [Exhibit 9].
Rather than a regional bank in the US holding a dangerously undiversified holding of credit
exposures in that particular region, which created the danger of a self-reinforcing cycle between the
decline in a regional economy and the decline in the capital capacity of regional banks – much
better to package up the loans and sell them through to a diversified set of end investors. And
indeed it was argued that securitised credit intermediation could reduce risks for the whole banking
system, since while some of the credit risk would be held by the originating bank and some by other
banks acting as investors, much would be passed through to end non-bank investors. Credit losses
would therefore be less likely to produce banking system failure.
But that is not what happened. Because when the music stopped – as these figures from the IMF
Global Financial Stability Report of April, 2008 make clear [Exhibit 10] – the majority of the
holdings of the securitised credit, and the vast majority of the losses which arose, did not lie in the
books of end investors intending to hold the assets to maturity, but on the books of highly leveraged
banks and bank-like institutions.
Because what increasingly happened [Exhibit 11] was that the credit securitised and taken off one
bank’s balance sheet, rather than being simply sold through to an end investor, was:
bought by the propriety trading desk of another bank;
or sold by the first bank but with part of the risk retained via the use of credit derivatives; or
used as collateral to raise short-term liquidity – creating a complex chain of multiple
relationships between multiple institutions, each performing a different small size of the
credit intermediation and maturity transformation process, and each with a leveraged
balance sheet requiring a small slice of capital to support that function.
Some banks were truly doing “originate and distribute”: but the trading operations of other banks
(and sometimes of the same bank) were doing “acquire and arbitrage1. The new model left most of
the risk still somewhere on the balance sheets of banks and bank-like institutions but in a much
more complex and less transparent fashion.
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Changing forms of maturity transformation
My second point is that in this story, what happened to maturity transformation and to assumptions
about liquidity was particularly important. One of the key socially valuable functions of the banking
system is to deliver maturity transformation, holding longer term assets than liabilities, and thus
enabling the non-bank sector to hold shorter term assets than liabilities. This absorbs the risks
arising from uncertainties in the cash flows of households and corporates, and results in a term
structure of interest rates more favourable to long-term capital investment than would pertain if no
such maturity transformation were being performed.
It is a very important function of undeniable social value, but also one which creates risks. If
everybody wants their money back on the contractual date, no bank could repay them all. Therefore
we have insurance via lines from other banks, liquidity policies to measure and limit the extent of
maturity transformation, and ‘lender of last resort’ facilities provided by the central bank. A
complex balancing act of individual bank practices, regulatory policies and central bank facilities
and discretion, but at least one we know is of central importance.
But one of the striking developments of the last several decades has been that a growing part of this
maturity transformation has been occurring not on the books of regulated banks with central bank
access, but on the off-balance sheets of banks, and on the balance sheets of shadow banks or near
banks. SIVs and conduits performed large-scale maturity transformation between short-term
promises to noteholders and much longer term instruments held on the asset side. Investment banks
funded holdings of long-term to maturity assets with much shorter term liabilities. And while
mutual funds with long-term assets and immediately available redemption were not banks since
their liabilities to investors did not have certain capital value, the implicit promise not to “break the
buck” meant that their behaviour in a liquidity crisis – selling assets rapidly to meet redemptions –
could reinforce the liquidity crisis elsewhere.
While it is difficult to get the aggregate figures, it therefore seems highly likely that the aggregate
degree of maturity transformation being performed by the financial system in total has increased
substantially over the decades. And it is certainly clear that a wide range of institutions – both banks
and near banks – have been relying on “liquidity through marketability” to assure themselves that
their maturity transformation activity is safe. “Liquidity through marketability” – i.e. I can count
this as a one-day asset because I can sell it within a day in a liquid market – has always been an
important concept. Instruments which have long contractual tenor but which can be sold or
discounted to generate immediately funds have been a key element in bank liquidity management
since the days of Bagehot. But the extent to which the bank and near-bank system in total has relied
on “liquidity through marketability” has increased dramatically over the last three decades and
particularly in the years running up to the crash. The system in total has become significantly more
reliant on the assumption that a very wide range of assets could be counted as liquid because they
would always be sellable in liquid markets2.
And while some of these developments – in particular the growth of SIVs, and investment bank
balance sheets and mutual funds – were most prevalent in the US and less important elsewhere, the
impact in a global funds market was felt throughout the world. Northern Rock and Bradford &
Bingley were directly or indirectly dependent on the maturity transformation function of US
mutual funds and SIVs, enabling them to access the funds of short-term US investors to provide
long-term UK mortgages , with the macro-imbalances I mentioned earlier, including the feature that
while the US was a huge net recipient of Asian central bank investment, it was simultaneously on
the private-sector side, a large net investor in, among other things, British residential mortgage
backed securities [Exhibit 12]
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Irrational exuberance in credit prices more harmful than
in equities?
So we have had the huge growth in securitised credit intermediation and a related increasing
reliance of the total system on liquidity assured by marketability. That raises the question of
whether a system of securitised credit intermediation is inherently more risky, at the systemic rather
than the idiosyncratic level, than a system of on-balance sheet intermediation.
In a securitised system, credits become marketable instruments, tradeable in liquid markets. And we
know from history that all liquid markets – markets where you can buy something one day in the
hope of selling it the next day for profit – can be susceptible to swings in sentiment which produce
significant divergence from rational equilibrium prices. The historical record of such irrational
swings has been extensively documented by economists such as Kindlebeger, Minsky and Shiller:
and the root causes of these swings in human psychology and in the incentives facing institutions
and individual traders are increasingly well understood. Internet equity prices in 2000 were driven
irrationally high by irrational exuberance, and subsequently fell. Bond yields were driven
irrationally low and prices irrationally high by irrational exuberance between 2002 and early 2007,
and the yields subsequently soared, the prices collapsed.
But while the former boom and bust in equity prices had surprisingly small consequences for the
real economy, the latter boom and bust is likely to have a much bigger one. And that contrast may
be inherent. It may well be that the world economy has greater ability to absorb without dire
consequences severe cases of irrational exuberance and then depression in equity prices, than in the
prices of a broad range of credit instruments, held to a significant extent on the trading books of
banks, shadow banks or near banks. Banks are highly leveraged: they perform maturity
transformation which exposes them to liquidity risk: and they are involved in a process of continual
rollover of new credit supply to the real economy without which economies will contract. Irrational
swings in the prices of credit securities held by banks, and thus in their capital resources, are
therefore likely to be far more economically significant than irrational swings in the prices of equity
investments held by end investors.
It is therefore possible that the growth of the securitised credits intermediation model has increased
some aspects of systemic risk in ways which are not just the result of poor execution – bad
remuneration practices, inadequate risk management or disclosure, failures in the credit-rating
process – but absolutely inherent.
But if that is true, it would be precisely the opposite of what many clever, hardworking and well-
meaning people believed about the securitised credit markets only two years ago. The IMF’s Global
Financial Stability Report of April 2006 stated that [Exhibit 13] ‘the dispersion of credit risk by
banks to a broader and more diverse set of investors, rather than warehousing such risk on their
balance sheets, has helped to make the banking and overall financial system more resilient’. It
noted that this dispersion would help to “mitigate and absorb shocks to the financial system” with
the result that “improved resilience may be seen in fewer bank failures and more consistent credit
provision”. And many other economists argued that in addition to increasing financial stability, the
development of securitised credit, structured credit, and of credit derivatives, by creating or
completing markets which had not previously existed, must have increased economic allocative
efficiency.
The core issue which we now need to face is whether in that analysis we significantly overstated the
allocative efficiency benefits which could possibly have arisen from this completion of markets,
even if they had operated rationally, and significantly underestimated the inherent dangers that any
liquid-traded market will at times be susceptible to irrational exuberance followed by irrational
despair.
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The growth of the financial sector: fundamental benign
effects, illusory profits and rent extraction.
My fourth and final observation about the growth of the securitised credit markets is that it is
striking that it has been accompanied by a quite remarkable growth in the relative size of wholesale
financial services within the overall economy. If, for instance, we look at debt as a percent of GDP –
an income measure of leverage – [Exhibit 15] we do indeed see a growth of household debt as a
percent of GDP, and to a smaller extent of corporate debt as a percent of GDP, but what is really
striking is the extent to which the debt of financial companies as a percent of GDP has grown, both
in the US and in the UK.
On a consolidated basis of course – i.e. stripping out claims between financial institutions –
financial sector assets and liabilities can only grow pari passu with non-financial sector liabilities
and assets. So what this disproportionate growth represents is an explosion of claims within the
financial system, between banks and investment banks and hedge funds – that multiplication of
balance sheets involved in the credit intermediation process which I suggested earlier has
accompanied the increasing complexity of securitization.
This huge growth of intra-financial system leverage has a relevance to the urgent issue of short-term
macro-economic management. The more that we can ensure that bank deleveraging takes the form
of the stripping out of inter-trader complexity, and the less it takes the form of leveraging vis-á-vis
the non-bank real economy, the better. But for this evening my focus is on why this growth has
occurred, why indeed many other measures of financial system importance – output as a percent of
total GDP, profits as a percent of total corporate profits, as financial sector market cap as a percent
of total equity market capitalisation [Exhibit 16], show a similar long-term trend, with a strong
acceleration in the last five years up to 2007.
For this growth appears to be at variance with one of the other arguments made for securitisation,
that it would be a more cost efficient system – delivering the service of credit intermediation to the
real economy at a lower total cost. So why has the wholesale financial services industry instead had
to grow so significantly?
Well, there are some underlying and entirely benign factors which do tend to increase the relative
importance of financial services (retail and wholesale combined) as incomes grow. The wealthier
people become, the more lifecycle consumption smoothing that occurs, and the more diverse they
become in their preferences for consumption at different points in their life cycle; as a result there is
a simultaneous increase in demand for both savings and borrowing products. And the more complex
and globalised the world economy becomes, the more complex are the functions which the world’s
banks have to perform in intermediating credit and other flows, and in themselves managing and
helping corporates manage, the risks that arise from global operations, and fluctuating exchange
rates, interest rates and commodity prices. In general, income per capita and financial sector value
added as a percent of GDP are somewhat correlated, across at least a range of income per capita
levels, for inherent and benign reasons.
But it is also possible that the importance of financial services as a percent of GDP has been
swollen by two other factors – one of which is illusory and short term, and the other harmful and
longer term.
• The illusory one arises from mark to market profits in a rising market. If the bank and near-
bank system in total holds a net long position in those assets which we mark to market –
which it does – and if irrational exuberance can push the price of those assets to irrationally
high levels (which I think it clearly did in the years running up to early 2007) then mark to
market accounting will swell declared profit in an unsustainable way, but in a way which,
reflected in bonuses, may reinforce management and traders’ determination to do more of
the clever stuff, which is delivering those profits.
• The possible long-term and harmful possibility is rent extraction. For there must be a
suspicion that some and perhaps much of the structuring and trading activity involved in the
complex version of securitised credit, was not required to deliver credit intermediation
efficiently, but achieved an economic rent extraction made possible by the opacity of
margins and the asymmetry of information and knowledge between end users of financial
services and producers. Simply put, wholesale financial services, and in particular that
element devoted to securitised credit intermediation and to the trading of securitised credit
instruments – grew to a size unjustified by the value of its service to the real economy, and is
now going through a downsizing, part of which is cyclical, but part a permanent one-off
adjustment to a more economically efficient size.
Now of course, if you are an extreme Chicago school economic liberal, what I have said cannot be
the case. If the industry grew dramatically in the decade to 2007 that must be because it was
performing value added services: if complex product innovations were able to sustain themselves
economically, they must have been socially useful innovations. But after what has happened, I think
we know that that is not the case. I think we know that imperfections and irrationality in financial
markets which are not fixable just by disclosure, but are inherent, mean that financial innovation
which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals
and institutions which innovated, very large returns.
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Not all innovation is equally useful. If by some terrible accident the world lost the knowledge
required to manufacture one of our major drugs or vaccines, human welfare would be seriously
harmed. If the instructions for creating a CDO squared have now been mislaid, we will I think get
along quite well without. And in the years running up to 2007, too much of the developed world’s
intellectual talent was devoted to ever more complex financial innovations, whose maximum
possible benefit in terms of allocative efficiency was at best marginal, and which in their
complexity and opacity created large financial stability risks.
Implications and what to do next
So if that’s what happened, and some of the reasons why it happened, what are the implications for
the possible future shape of the financial system, and what are the implications for how we should
manage the future financial system?
One implication is that there is a very important macro element to the required response.
Major macro-economic imbalances – large surpluses and deficits – were an important underlying
driver of what occurred, and their more effective management is important not just to a more stable
global system in the long term, but to the challenge of limiting the severity of the immediate
economic downturn. The fundamental problem of potentially asymmetries between the policy
responses of deficit countries and surplus countries, which lay at the root of the mismanagement of
the gold standard in the 1920s and early 30s, and which Keynes warned of ahead of Bretton Woods,
remain a crucial issue today. Without more Chinese consumption to balance more Americans
saving, the deflationary impact of the crisis could be prolonged.
And looking to the long-term, as we think about what is needed to avoid future crises, it is clear that
better analysis of and response to macro-prudential problems – problems which lie at the interface
between macro-economic policy and financial system regulation – will be vital. The FSA has been
more open than I think any institution involved in this crisis in admitting that it made mistakes in
the institution specific supervision of northern rock. But I think the best judgement is that better
institution specific supervision of Northern Rock would have made only a very small difference to
the shape and impact of this global crisis.
The far bigger failure – shared by bankers, regulators, central banks, finance ministers and
academics across the world – was the failure to identify that the whole system was fraught with
market-wide, systemic risk. The key problem was not that the supervision of Northern Rock was
insufficient, but that we failed to piece together the jigsaw puzzle of a large UK current account
deficit, rapid credit extension and house price rises, the purchase of UK mortgage-backed securities
by institutions in the US performing a new form of maturity transformation, and the potential for
irrational exuberance in the market price of credit. We failed to realize that there was an increase in
total system risk to which financial regulators overall – authorities, central banks and fiscal
authorities – needed to respond.
Regulators were too focused on the institution-by-institution supervision of idiosyncratic risk:
central banks too focused on monetary policy tightly defined, meeting inflation targets. And reports
which did look at the overall picture, for instance the IMF Global Financial Stability Report which
I quoted earlier, sometimes simply got it wrong, and when they did get it right, for instance in their
warnings about over rapid credit growth in the UK and the US, were largely ignored.
In future, regulators need to do more sectoral analysis and be more willing to make judgements
about the sustainability of whole business models, not just the quality of their execution. Central
banks and regulators between them need to integrate macro-economic analysis with macro-
prudential analysis, and to identify the combination of measures which can take away the punch
bowl before the party gets out of hand. We also need to create deliberate mechanisms to increase the
likelihood that major analytical institutions such as the IMF challenge the conventional wisdom
rather than go along with it. And we need to ensure that when the IMF or other international
surveillance bodies do issue warnings, that big powerful countries, and not just weaker developing
countries potentially dependent on IMF support, feel that they have to respond.
Alongside that more effective macro-prudential analysis, however, we also need more effective
approaches to the regulations which govern the financial system. That regulation needs to be
designed in the light of how the system we are regulating is likely to evolve. Two questions can help
frame our thinking about the future: what is going to happen, and what should happen, to the
originate and distribute securitised credit model: and what will and should be the institutional
relationship between “narrow banking” – deposit taking, extending loans, and providing payment
services – and more complex treasury and trading activities?
On the originate and distribute, securitised credit model, I argued earlier that, especially if it
involved a substantial holding and trading of securitised credit instruments on the balance sheets of
banks involved in maturity transformation, it created significant and inherent risks. But it does not
follow that the originate and distribute model will now or should now largely disappear. Some of
the arguments which were advanced in favour of this model can be good ones: taking regionally or
sectorally concentrated credit risk off bank balance sheets and distributing it to diversified investors,
could be beneficial. Many forms of credit, for instance residential mortgages, are best credit
assessed via quantitative scoring techniques, rather than by individual bank officer judgement, and
can therefore be turned into securities, the risk of which can be well captured in credit ratings. And
while we are now facing a crisis of the securitised credit model, we must remember that the past has
had many examples of credit crises in good old fashioned on balance sheet banking – the British
secondary banking crisis of 1973 to 74, the US savings and loans debacle of the 1980s, the Japanese
and Swedish banking crises of the 1990s.
It is therefore, I believe, highly likely that the future system will and should involve a combination
of traditional on balance sheet credit intermediation and securitised intermediation, and that a
combination of better regulation and market response to the crisis, should and will produce a safer
version of the originate and distribute model – less complex, more transparent to end investors,
with less exclusive reliance on credit ratings and more independent judgement, and with less
packaging and trading of securitised credit through multiple balance sheets. The securitised
originate and distribute model will change significantly but it will still play an important role in
national and global credit intermediation.
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Narrow banking and investment banking. The somewhat related issue is then, should the different
functions of classic on balance sheet banking – deposit taking, loan extension, and payment services
provision – and more complex and risky investment banking activities be done in the same
institutions or in separate firms. The actual trend of the last year has clearly been for these functions
to be combined to a greater extent than before – as Bear Stearns has folded into JP Morgan, Merrill
Lynch into Bank of America, and part of Lehmans into Barclays, and as Morgan Stanley and
Goldman Sachs have become bank holding companies with access to the Fed discount window and
covered by the implicit assumption that the US government would consider them too important to
fail.
But even while this is been the de facto trend, several commentators have argued that regulation
should be designed to produce the precisely opposite result – a separation of “narrow banking” from
risky investment bank trading activities, a re-imposition in the US of the Glass Steagall separation
of commercial and investment banking, and the introduction of that separation for the first time into
European bank regulation.
At times this vision is expressed in terms close to a nostalgic elegy for a past age of innocence and
stability: with Captain Mainwaring back behind the desk in the branch at Walmington-on-Sea
casting a censorious eye over any householder or small-business man silly enough to want to take
on too much credit, while the wide boys of the City and Wall Street are free to speculate but well
away from sober middle England. But there is a very important issue here; we need to think
carefully about how to insulate the vital functions of deposit taking, maturity transformation, and
credit extension, from adverse impacts arising from the potential irrationality of liquid traded
markets; we need to control the extent to which large universal banks can take the benefits of stable
retail funding, deposit insurance and too big to fail status, and use them to fund activities of little
economic value and/or of high risk, such as unnecessarily large proprietary trading.
I am not convinced, however, that this can or should take the form of any absolute separation
between institutions which do to narrow banking and those which perform investment banking
activities. The desire for this distinction fails, I think, to reflect the fact that the originate and
distribute model can have some advantages, and the fact that in between narrow banking as
performed by say a building society, and pure proprietary trading performed by say a hedge fund,
there are a wide range of functions essential to the provision of finance to major corporates, to the
lubrication of global capital flows, and to the management of risk naturally arising in a world of
fluctuating exchange rates, interest rates and commodity prices, which mean that global banks
involved in deposit taking, and credit extension are also involved in complex treasury and market
making activities.
A crucial issue for regulators is therefore going to continue to be how we regulate the very large and
very complex systemically important banks which are too big to fail and which are involved both in
narrow banking and in complex treasury and trading activities. The Group of 30 Report Financial
Reform: A Framework for financial stability, published last Thursday, suggested that “large
systemically important banking institutions should be restricted in undertaking proprietary
activities that present particularly high risks”. The precise ways in which we achieve this end need
to be carefully considered, and the crucial change may be simply the better treatment of trading
book capital, which I will come to shortly: but the issue certainly needs to be addressed.
So let me turn finally to the key elements of the regulatory response required to reduce the
probability and severity of future financial crises, whether arising from classic on balance sheet
banking or from the securitized model of credit intermediation. The response needs to be
multifaceted, and there are many facets which I am not going to discuss tonight, but which will be
covered in the Review and Discussion Paper to be published in March. These include actions
relating to remuneration and incentives, to rating agencies, to counterparty risk in derivatives. They
also involve consideration of the appropriate balance between mark to market and accrual
accounting principles in published accounts. And, very importantly, we need to address issues
relating to the regulation of large cross-border financial institutions, the realistic scope for global
supervisory coordination, appropriate structures for local operations (subsidiaries or branches) and
the appropriate balance of responsibility between home and host supervisors; the events of the last
year – the Icelandic bank and Lehmans failures in particular – have taught us that we live in a
world of global finance and global banks, but where, when disaster strikes, bankruptcy procedures
and fiscal support are national, and we need to be clear about the implications of such a world.
But while all these issues are all important, there are three regulatory responses which I would like
to highlight as the most fundamental and where what we need to do is in principle now clear.
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New approaches to capital adequacy
The first is new approaches to the regulation of the capital adequacy of banks. These have of course
been extensively revised by the introduction of Basel 2, which has aimed to achieve greater
sensitivity of capital levels to the different risks which banks are running, and there are certainly
benefits to the Basel 2 approach on which the future system should build. It is important to realize
that the crisis developed under the Basel 1 regime not Basel 2, and that Basel 2 would have
addressed some of the problems which led to it – for instance the failure to distinguish between the
capital required to support mortgages of different credit quality. But it is also clear that we will
need to adjust Basel 2 in a number of ways. The general direction of travel will be towards higher
levels of bank capital than have been required in the past, and in particular capital which moves
more appropriately with the economic cycle and more capital required against trading books and
the taking of market risk.
• On the economic cycle, there has been considerable commentary on the procyclical nature
of Basel 2 risk-sensitive capital measures, and it is inevitable that any system which is risk
sensitive, unless deliberate countervailing adjustments are made, will be to a degree
procyclical i.e. capital requirements will rise as we head into a recession and credit quality
declines. But it is important to note that the degree to which Basel 2 is procyclical in relation
to the banking books – credit extension on balance sheet – depends crucially on how it is
implemented and can be significantly reduced if banks use appropriate through-the-cycle
approaches to estimation of probability of default and loss given default. It is therefore
important to ensure that the detailed implementation of Basel 2 does not introduce
unnecessary and unintended procyclicality, and the FSA on Monday issued a clarification of
our approach designed to ensure this.
Looking forward, however, we need to go beyond the avoidance of unnecessary
procyclicality and to create a system which introduces significant counter cyclicality,
requiring banks to build up substantial capital buffers in good economic times – ratios well
above absolute minimum levels – so that they can run them down in bad. Such an approach
makes sense from a micro-prudential point of view, reducing the risk of bank failure. But it
is also desirable from a macro-prudential and macro-economic perspective: it will tend to
place at least some restraint on over-rapid expansion in the boom, and it will reduce the
danger that impaired capital makes it more difficult for banks to lend in recessionary times,
thus making the recession worse. Ideally, such a regime must be agreed at international
level, and the FSA is working closely within the Basel Committee on Banking Supervision
and the Financial Stability Forum to design the details. There are many of those details to be
worked out; whether the buffer requirements will be defined in formulaic terms, as in the
Spanish dynamic provisioning system, or by regulator discretion; and how to deal with the
complexity of different economic cycles in the different countries in which a cross-border
bank may operate. But the principle is clear.
• And equally it is clear that in respect to the trading books of banks, we need to remove
procyclicality and to increase capital requirements not just marginally but by several times.
The present system of capital regulation of trading books is from a prudential point of view
seriously deficient. Its reliance on value at risk (VAR) measures derived (usually) from the
observation of the last year’s movements in market prices is clearly procyclical: if volatility
goes down in a year, the measure tells banks that risks looking forward have reduced, and
thus fails to allow for the fact that historically low volatility may actually be an indication of
irrationally low risk aversion and therefore increased systemic risk. It fails to allow
effectively for the low probability tail events which are crucial to extreme idiosyncratic and
even more so to overall systemic risk. And, overall, the level of capital required against
trading books has been simply too low relative to the risks being taken, given what we now
understand about the systemic dangers of relying on liquidity through marketability, and
about the susceptibility of securitised credit markets to irrational exuberance, sudden
liquidity disappearance and rapid price collapse. Major banks with a large percentage of
their balance sheets devoted to trading activity, have been required to hold only very thin
slices of capital against it [Exhibit 16]. That will change radically given the proposals
already issued by the Basel Committee, and these changes in themselves are likely to result
in a significant contraction in the scale of future trading books.
And, looking forward, the FSA believes that a fundamental review is required of how
trading books are defined and how risks in trading books are estimated. VAR-based
approaches were originally developed to model the risks in trading in markets likely to be
continually and deeply liquid (e.g. government securities, major currency FX swaps and
interest rates derivatives), and were adopted by regulators in the mid-1990s when a high
proportion of bank trading was concentrated in such highly liquid instruments. Over the last
decade and a half, however, trading books have expanded rapidly to encompass the holding
of many debt securities whose markets are imperfectly liquid even in normal times and
which became suddenly illiquid when the downturn occurred; this booking of potentially
illiquid assets in trading books was indeed in part driven by the lower capital charge there
incurred. The FSA will be proposing to the Basel Committee that a fundamental review of
the division between the trading and banking books and of the appropriate use of VAR to
measure risk is now required.
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New approaches to liquidity
New approaches to the management and regulation of liquidity are equally important. Indeed, we
need to ensure that the regulation of liquidity is recognised as being at least as important as capital
adequacy, a sense which was to a degree lost over the last several decades, with intense regulatory
focus and international debates on capital adequacy, but less focus on liquidity – no Basel 1 or Basel
2 for liquidity to match the equivalents for capital.
That lack of a defined international standard has reflected the extreme complexity of the liquidity
risk, which makes it difficult to achieve effective regulation through generally applicable
quantitative ratios equivalent to capital adequacy ratios. Many developed economies did in the past
require limits to defined ratios, such as loans to deposits; but it is less clear today that deposits are
inherently more sticky than other categories of funding in a world of internet retail deposits and
wholesale depositors (corporates, local authorities, charities, etc) with multiple options to redeploy
spare funds.3 And the emergence of the originate and distribute securitised credit model has been
accompanied by increasing options to manage liquidity through secured funding (e.g. repos), and an
increased reliance on liquidity through marketability, making bank liquidity risk assessment
crucially dependent on assumptions about the liquidity of specific asset and secured funding
markets, which it is difficult to reduce to simple quantitative rules.
Measuring and limiting liquidity risk is, however, crucial and reforms to regulation need to include
both far more effective ways for assessing and limiting the liquidity risks which individual
institutions face and a better understanding of market-wide liquidity risks. The FSA’s Consultation
Paper on Liquidity published in December, therefore proposes a major reform of our liquidity
supervision. It will put in place:
• Significantly enhanced reporting requirements focused on a detailed mismatch ladder
analysis and applicable to all banks and building societies.
• Regulations which will require all banks to focus on the combined liquidity effect of their
holdings of liquid assets, the maturity (on both a contractual and behavioural basis) of their
assets and liabilities, and the term, diversity and reliability of funding sources.
• For simpler mortgage banks and building societies this will be underpinned by a
quantitative “buffer ratio” rule, which will restrain reliance on wholesale funds.
• And for larger banks it will be achieved by a regime which requires the development
by each bank and review by supervisors of a detailed Individual Liquidity
Assessment, on the basis of which we will give Individual Liquidity Guidance,
including the required level of a liquid assets buffer, which will be defined on a
standardised basis but whose required level will be tailored to individual
circumstance.
At the core of the assessment and guidance will be stress-test scenarios, rather than
models which seek to infer the probability distribution of risks from the observation
of past fluctuations. This reflects the fact that liquidity risk assessment is inherently
concerned with low probability but extreme events. And crucially the stress tests
will need to cover potential market-wide stresses as well as idiosyncratic stresses,
reflecting the lesson of the financial crisis that market-wide collapses in the liquidity
of specific asset or funding markets can have huge impacts which analysis of
individual specific risks will not capture.
This new regime and the related reporting requirements will greatly enhance our ability to
understand emerging liquidity risks in individual institutions and across the whole economy, and to
conduct sectoral analysis which can identify outlier business models and management practices.
On the basis of this increased understanding, we will keep under review the appropriate balance of
quantitative rules, stress test based analyses, and discretionary guidance. We anticipate that the new
regime will result in major changes in the extent and nature of maturity transformation in the
overall banking system, with banks holding more liquid assets and a greater proportion of those
assets held in government securities, an incentive for banks to encourage more retail time deposits
and less instant access, less reliance on short-term wholesale funding, and, as a result, a check on
rapid and unsustainable expansion of bank lending during favourable economic times.
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Regulation by economics substance: shadow banks and
near banks
The third key priority is to ensure that in future financial activities are always regulated according to
their economic substance not their legal form. One of the striking features of the years running up to
the crisis, as I stressed earlier, was that a core banking function – maturity transformation – was
increasingly being performed by institutions which were not legally banks, but the off balance
sheet vehicles of banks, (SIVs and conduits), investment banks and mutual funds. To different
degrees in different countries these ‘near banks’ or shadow banks escaped the capital, leverage and
liquidity regulation which would apply to banks. In the case of SIVs they also escaped the degree of
disclosure and accounting treatment which would have applied if the economic activities were
performed on balance sheet. In future it is essential that if an economic activity is bank-like and
poses a significant risk to consumer or financial stability, regulators can extend banking-style
regulation. And essential that accounting treatment reflects the economic reality of risks being
taken.
Applying these principles will have more implications for legal powers and regulatory structures in
some other countries – and in particular in the US – than in the UK. European approaches to the
bank capital adequacy have always applied to investment banks: the requirements set down for
trading book capital were in retrospect inadequate, but in Europe investment banks did not lie
outside a regulatory boundary. In the US, with a fragmented regulatory structure, there is a greater
need to look at structures and powers. But, across the world, regulators need to continually assess
how evolving industry structures and institutional roles are changing the nature of risk, both for
individual institutions and for the whole system, and if necessary to adapt the coverage of
prudential regulation over time.
This will at times require judgements about the appropriate treatment of institutions which have
some of the risk characteristics of banks but not others. Two examples:
• The first is mutual funds taking consumer investments which are liquid in nature (immediate
or very short redemption) and investing in long-term securities. These are not banks, the
crucial distinction being that the liquidity of the promise to savers is not matched by
certainty of capital value at redemption. But if they have made assurances that they will
maintain a stable net asset value, that they will not “break the buck”, they may in a liquidity
crisis act in a fashion which exacerbates that crisis, selling rapidly to meet redemptions and
fuelling the deflationary cycle. That is why the G30 report recommends that “money market
funds which want to continue to offer bank-like services… and assurances” should be
reorganised as special purpose banks and regulated as such. This is a pressing issue for the
US but not the UK: for a variety of reasons mutual funds of this character have not
developed here. But if they ever did develop in future, we would need to keep under review
at what point bank-like characteristics justify bank like regulation.
• The second is hedge funds, whose asset managers are present in the UK, and who are
regulated as asset managers by the FSA, though the actual legal fund is usually registered
offshore and not subject to prudential regulation. Here the issue, now being considered by
fora such as the Financial Stability Forum, is whether the funds themselves should be
regulated and subject to prudential limits on leverage or liquidity. The argument against is
that these institutions are not banks: they do not deal directly with the general population but
with professional sophisticated investors; leverage levels are in general (though with some
exceptions) far lower than those of banks (typically two or three not twenty); and they do
not perform contractual maturity transformation, since they have the power to limit the
speed of redemptions via redemption gates. In general (again with some possible exceptions)
they neither have the scale nor the characteristics which would require that individual hedge
funds be treated as systemically important and thus too big to fail. But in aggregate, they
may nevertheless play a role with systemic effects which regulators and central banks need
to understand, but which currently we lack the data to analyse effectively. Rapid
deleveraging by hedge funds has probably over the last six months played a non-trivial role
in exacerbating financial instability. It is for these reasons that the G30 report suggested that
regulators should have the power to gather detailed information from hedge funds, so that
we and central banks are better able to judge their evolving systemic importance: and
recommended that “for funds above the size judged to be potentially systemically
significant, the prudential regulator should have the authority to establish appropriate
standards for capital, liquidity and risk management”. That halfway house on hedge funds –
information and the power to respond to future developments in size, concentration,
leverage levels, and practices – would be in line with the principle of focusing on economic
substance not legal form.
Conclusion
To conclude, let me return to my opening thought. We are in the middle of an economic downturn
which, to a far greater extent than any since the 1930s, is the result of developments which were to
a degree internal to the global financial system. Developments in the banking and the near-bank
system, which had been lauded as improving allocative efficiency and financial stability, have in
fact caused serious harm to the real economy. The changes which we need to make to create a
sounder system for the future will be profound. Their guiding principle should be that they should
create a banking system focused on the delivery of the value-added functions of banking which are
so essential to a market economy.
1 Even the banks which were largely doing “originate and distribute” would often however have to
warehouse significant quantities on balance sheet before packaging and distributing, and could be
left with liquidity strains and future potential losses if liquidity suddenly dried up (e.g. Northern
Rock)
2This assumption seems also at time to have been based on a misunderstanding of the inference that
could be drawn from a credit rating, with high ratings treated as carrying the inference of liquidity,
rather than simply lower credit default.
3Loan to deposit ratios limits continue however to be used in some emerging economies. A number
of emerging economies e.g. India, also continue to use reserve asset ratios as monetary policy
instruments, with significantly liquid balance sheets a resulting byproduct.