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The future of finance
Adair Turner
14 July 2010
Speech by Adair Turner, Chairman, FSA
The Future of Finance Conference in London
What do banks do: Why do credit booms and busts occur and what can public policy do about it?
This conference, and the book which it is launching, is dedicated to the ‘future of finance’. Finance plays a crucial role within a market economy, but that role has continually evolved during the 200-year history of modern market economies. And one striking thing about the last 40 years, which clearly distinguishes the period 1970 to 2010 from the mid-20th century, is that the complexity of finance and its scale relative to the real economy has dramatically increased (Slide 1).
•Debt to GDP ratios have increased dramatically in the household and corporate sectors, but even more so within the financial sector.
•The value of trading activities – whether in foreign exchange or debt, or equities, or commodities, has increased hugely relative to related real economy variables.
•And the complexity of the wholesale financial markets has greatly increased, with the emergence of interest rate and credit derivatives, and structured credit products, which did not even exist 30 years ago.
After a mid-20th century of relative financial repression – a reduction in the relative role in finance – we have seen financial deepening and increased complexity. And the predominant pre-crisis conventional wisdom was that this deepening and increased complexity had been beneficial, increasing both allocative efficiency and system stability. Financial deepening and liberalisation were seen as an integral part of the package of ‘structural reform’ which would deliver improved economic performance.
But these confident assertions are not clearly supported by the facts. It is not clear that financial deepening beyond that already achieved in the developed world 30 years ago has significantly increased allocative efficiency and growth. Looking at the highest level, at overall correlations of financial intensity and GDP growth, there is no clear relationship. The period of relative financial repression from 1935 to 1970 delivered growth almost as good as the subsequent 40 years of financial deepening and liberalisation. It may be true that specific elements of increased financial intensity and sophistication in certain circumstances deliver increased allocative efficiency, but that needs to be illustrated at the specific level, it is not proved by high-level correlations.
As for the claims of increased stability – clearly they have turned to dust in the financial crisis of 2007 to 2008. And in the wake of that crisis, it is easy to identify numerous specific features of the new financial system which created greater risk, such as: (Slide 2)
•Overly complex structured credit products, with deeply embedded options which many investors did not properly understand.
•Bonus structures which created incentives for excessive risk taking.
•Conflicts of interest and poor practices in credit rating agencies.
•Over-reliance on apparently sophisticated mathematical models to measure and manage risk.
•Poor corporate governance and risk management processes.
•And the explosion of uncleared counterparty exposures, which created a cat’s cradle of intransparent relationships between multiple financial institutions.
Fixing these and other obvious deficiencies in our financial system must form an important part of the new regulatory agenda.
But fixing these problems will not be a sufficient response. And we will not design a sufficient response unless we ask fundamental questions about what a financial system does and what it should do, and about why financial markets and institutions, in particular banks, are so vulnerable to instability.
And what that fundamental analysis shows is that the roots of instability lie not, or not just, in specific faulty features of the current system – in bad incentives, poor risk management, over-complex products or over-reliance on ratings – but in too much credit, too easily available at too low a price – and that the fundamental problem is that bank lending, financial markets and property markets interact in ways which drive destabilising credit and asset-price cycles.
Our regulatory response will not therefore be effective unless: in the long run, it reduces leverage in the financial system and constrains it in the real economy; and it puts in place new policy tools to take away the punchbowl of excessive credit and property price inflation before the party gets out of hand. The transition to that sounder system needs to be managed with care – too rapid a progress to higher capital and liquidity standards could slow recovery – but we need to be clear that long-term reform of the financial system will have at its core changes that mean that credit is not as easily available as in the pre-crisis years.
Financial systems and markets in aggregate perform four functions (Slide 3). They provide payment services; they provide insurance services; they create markets in immediate and short-term futures contracts, such as in foreign exchange or commodities; and they intermediate between providers of funds and users of funds, savers and borrowers, and as a result play a crucial role in the allocation of capital within an economy. There are risks involved in all of these functions. But it is primarily in the fourth function, and sometimes in the third function, that the greatest risks to financial stability arise, and I therefore focus entirely on the third and fourth functions both in my chapter for the book and in my remarks today.
The financial intermediation function links providers of funds to users of funds. (Slide 4) Sometimes the link is a ‘matched’ one with, for instance, a householder directly buying the equity or bond of a business or a government so that the asset the fund provider owns looks exactly the same as the liability the fund user owes. And the financial system helps lubricate that process through market-making and through research and distribution.
But the really crucial intermediation activities, and those which introduce the greatest risk, are those which create unmatched assets and liabilities, so that the provider of funds can hold an asset which looks different in risk, return and maturity from the liability the fund users owes. This is achieved by four transformation functions (Slide 5):
•Pooling – which enables a householder, for instance, to hold an indirect claim on many different SME loans, rather than be exposed to a specific risky SME.
•Maturity transformation, which can be delivered in two different ways:
- contractually on bank balance sheet, with householders holding on-demand deposits but borrowing 20 year mortgages; or
- via liquid traded markets, with individuals able to hold equities for a day, even though the fund user enjoys perpetual equity finance.
•And finally risk/return tranching, with moderately risky bank loans funded with a mix of very low-risk deposits and high-risk bank equity.
My chapter explores the value added which these transformations deliver and the risks which they create.
It identifies five interacting factors which help explain why banking crises occur and cause harm, and why the latest was so severe.
•First, the fact that all financial markets are inherently vulnerable to divergence from equilibrium values; and that as a result increased financial trading activity creates increased risks, even if it delivers some benefits.
•Second, that credit contracts introduce very specific vulnerabilities in our economies, and that the greater the role of credit contracts, i.e. the greater the level of leverage in the real economy and in the financial system itself, the more vulnerable the system is to shocks and self-reinforcing cycles.
•Third, that fractional reserve banks introduce specific vulnerabilities into the economy because of their specific ability to create credit and money and because of their maturity transformation function.
•Fourth, that different types of credits perform quite different functions within the economy, with credit extended to finance existing assets, in particular to finance property, quite different in nature from credit extended to finance new investments, and peculiarly susceptible to volatile supply and pricing.
•Fifth, that the growth of securitised credit, while theoretically having the potential to disperse and reduce risks, in fact interacted with the specific risk characteristics of banks to make the whole system less stable.
The essence of why the financial system proved so unstable, and why the latest financial crisis was so great, lies therefore, I argue, in the interaction between the specific characteristics of credit contracts, of banks, of real estate finance, and of liquid traded markets.
The regulatory reform agenda must therefore address these interactions. At its core should be two elements:
•much higher capital and liquidity requirements across the banking system and in particular for large systemically important banks, addressing the ‘Too Big to Fail’ (TBTF) but not believing that fixing TBTF is sufficient in itself to make the system more stable; and
•the development of macro-prudential policy tools, which lean against the wind of excessive credit creation and of asset-price cycles.
The details of my argument are set out both in my chapter for this book and in another recent lecture.1 For this morning, I will simply set out the key arguments on the each of my five points and then explore the implications for policy.
1. Liquid financial markets inherently vulnerable to instability
One key driver of potential instability is that financial markets are inherently susceptible to momentum and herd effects, to over-shoots, to self-reinforcing irrational exuberance and then irrational despair. Charles Mackay’s classic work on the Madness of Crowds, Charles Kindleberger’s on Manias, Panics and Crashes – have documented that inherent susceptibility, from the Dutch tulip mania of 1635-37 to the Wall Street boom of the 1920s.2,3 , And we have an increasingly rich theoretical understanding of why these over-shoots occur. The behavioural economics of Daniel Kahneman and others provide explanations from psychology and evolutionary biology, with people acting in instinctive or emotional ways which, even at the individual level, might reasonably be described as irrational, with ‘animal spirits’ sometimes a key driver of market dynamics.4,5 , But theories of imperfect principal/agent relationships and decision making under conditions of imperfect information and inherent irreducible uncertainty, also explain how even the most rational of people might participate in a collectively irrational boom, calculating that they will be among those clever enough to get out just in time.6 Paul Woolley’s chapter in this book explores these principal/agent relationships and their implications.
But while all liquid financial markets are susceptible to unstable divergence from equilibrium values, it is clear that some booms and busts matter more than others, and that in particular, booms and busts in credit pricing and credit supply are far more important than those in specific commodities or in equities.
•The internet boom and bust of 1998-2001 (Slide 6) was large enough to move equity indexes in a dramatic fashion and to create wealth gains and losses which were significant relative to US GDP, but the bust had only a slight impact on US or global growth.
•The fall of corporate bond spreads to a low point in spring 2007 (Slide 7) followed by huge rises in 2007-09, by contrast, reflected a credit boom and bust which tipped the whole developed world into severe recession.
•And throughout modern economic history, in the 19th century banking crises and in the many banking collapses of the 1930s, and in the numerous crises of the past 30 years, it was volatility in credit supply within the economy, surges and sudden stops of credit – whether to governments, to other banks, or to the non-bank private sector, which have had a peculiar ability to cause real economic harm. As IMF figures illustrate, (Slide 8) banking crises are far more likely than other financial crises to cause severe recessions.
2. Credit contracts introduce specific vulnerabilities
The explanation for the greater impact of credit related crises lies in the specific character of credit contracts. Four features are important (Slide 9): specificity of tenor, specificity of nominal value, the irreversibility and rigidities of default and bankruptcy, and the credit/asset price cycle. I will come back to the credit/asset price cycle later; for now, a brief comment on the first three features.
•Specificity of tenor: The fact that a debt contract has to be repaid at a particular date, and that at any time there are large debt repayments due next month or next year, means that a continual supply of new credit is essential to the working of the economy in a way which is not true of equity finance. Equity prices can collapse, and firms may be unable to raise new equity, but they are not also required to repay existing equity; and economies could operate for sustained periods of time with no new primary equity issues: they cannot operate without new lending to refinance old. Credit is different because if the financial machine suddenly stops lending, the economy can go into reverse.
•Specificity of nominal value: Debt contracts in nominal value money terms – is an equally important feature, harmless as long as generalised inflation is maintained at a relatively stable and predictable level, but potentially destructive in the face of unanticipated inflation or deflation. Unanticipated inflation and hyper-inflation can destroy financial wealth and social cohesion, but it is unanticipated deflation, such as that of 1930-33 in the US, which has arguably even greater capacity to wreak real economic harm through its impact on the real value of debt, via the mechanisms which Irving Fisher set out in his classic article on Debt Deflation.7
•The third key factor is the rigidities of default and bankruptcy, which generate economic costs even in the absence of debt-deflation or financial crisis, but which if combined with either debt-deflation or banking crisis (banks as well as corporates going bankrupt) can have an enormously destructive effect. As Ben Bernanke points out in one of his Essays on the Great Depression, the existence of debt default and bankruptcy are direct contradictions of any theory of smoothly adjusting economic relationships. ‘In a complete markets world, bankruptcy would never be observed’, Bernanke notes ‘because complete state contingent loan agreements would uniquely define each party’s obligations in all possible circumstances.8 As firms approach default, economic rationality and perfect information would dictate a smoothly operating write-down of debt claims or translation of debt claims to equity claims. The fact that instead we have large legal and administrative costs, and fire sales of assets, illustrates how far from the ‘Arrow-Debreu nirvana’ of complete markets our real world economy actually is, and it makes credit crunches hugely disruptive.
3. Fractional reserve banks introduce further specific risks
But it is not just credit which is different: bank credit is even more specific. The characteristics of credit mentioned above – specificity of tenor and nominal value, the rigidities and irreversibilities of default and bankruptcy, and the potential for credit driven asset price cycles – apply to non-bank credit securities as well as to bank intermediated credit – and indeed one crucial issue to which I will return later is whether a non-bank system of credit extension introduces some specific drivers of instability which are not present to the same extent in a bank-based credit system. But it is certainly the converse case that bank credit intermediation introduces specific risks not present in the non-bank case.
Essentially, what leveraged fractional reserve banks do is to increase the range of potential contracts available to both users and suppliers of funds, by making it possible for suppliers to hold assets with different combinations of risk, return and maturity from those which users of funds face in their liabilities:
•they maturity transform (Slide 10) – enabling providers of funds to hold deposits of much shorter tenor than the maturity of the loans advanced to users of funds; and
•they tranche by risk and return (Slide 11) so that moderately risky loan assets are funded with a mix of close to zero risk deposits, moderately risky senior debt, and high risk equity.
Those transformation functions appear to deliver significant economic benefits, at least at some stages of economic development. Economic historians of 19th century Britain have often argued that Britain’s more developed banking system was one of the factors driving superior economic performance, facilitating the mobilisation of savings which would have been more difficult if savers had been linked to users of funds through untransformed contracts, in which the risk, return and maturity of the issuers’ liabilities had to match precisely the aggregate risk, return and maturity of the savers’ assets. Walter Bagehot certainly believed so, (Slide 12) arguing in Lombard Street that Britain enjoyed an economic advantage over France because the UK’s more advanced banking system fostered the productive investment of savings rather than leaving them ‘dormant’. ‘Much more cash’ he wrote, ‘exists out of banks in France and Germany and in the non-banking countries than can be found in England or Scotland, where banking is developed. But this money is not… attainable… the English money is “borrowable money”’.9
But these benefits of leveraged and fractional reserve banks also bring with them very significant risks.
•Banks facilitate greater leverage in the real economy and they are leveraged themselves, increasing the dangers that arise from the specific characteristics of credit rather than equity contracts.
•And they introduce maturity transformation risks, and related confidence and contagion risks, rooted in the simple fact that banks create a set of contractual liabilities which legally have a right to simultaneous execution, but which banks could never simultaneously honour, given the contractual tenor of their assets. Banks are therefore inherently risky institutions, which can only be made safe through the combined effect of capital and liquidity regulation and central bank liquidity insurance.
•Finally, banks have a particular ability to drive credit and asset price cycles – the fourth specific feature of credit instruments to which I will now turn within a consideration of the different economic functions of different credit categories.
4. Different categories of credit deliver different value and create different risks
Over the last 40 years, household and corporate sector sterling denominated debt in the UK has grown from about 22% to 125% of GDP (Slide 13). The vast majority of this debt has been lent by banks, and has been largely matched, though not entirely, by the growth of bank deposits, with bank credit and bank money created in a self-reinforcing fashion. Banks have thus delivered more leverage to the real economy. But with two thirds of the loan assets long-term mortgages, and with deposits primarily short term, they have also delivered much more maturity transformation. Both increased leverage and increased maturity transformation create risks for the economy, but can also deliver benefits. The challenge for prudential regulation is to preserve the benefits while constraining risks to an acceptable level.
In many debates about credit extension, and about the impact of new prudential regulations which may restrict it, it is assumed that credit contracts primarily perform the function of linking savers with businesses investing in productive assets (Slide 14). More credit supply and cheaper credit supply is assumed to be good for business investment, enabling more investment projects to exceed the cost of capital. Capital and liquidity regulations, which restrict credit supply or increase its price, are therefore often assumed to produce harmful effects on growth through their impact on investment. And it is certainly essential in our assessment of capital and liquidity rules that we consider such possible effects and balance any such adverse impacts, whether in the long term or over the transition period, against the benefits of reduced instability, which higher capital and liquidity requirements would deliver.
But it is also important to understand that only a minority of credit extension in the UK and other rich developed economies now performs this economic function. Whereas in 1964 (Slide 15) a mental model in which the UK banks took household deposits and lent them on to business captured much of the reality, over the last 40 years, loans to the household sector and in particular residential mortgages have become dominant (Slide 16).
This intermediation from household deposits to household mortgages is socially useful, but its social value is only to a limited extent related to new physical investment in the housing stock, instead primarily delivering value to the extent that it enables more effective life-cycle consumption smoothing and inter-generational resource transfer (Slide 17).
Loans to the corporate sector, meanwhile, are increasingly dominated by loans to finance commercial real estate (Slide 18). These loans, only to a limited extent, finance new productive investment: (Slide 19) rather they are primarily used to finance the tax advantaged purchase of already existing assets in the expectation of future capital gain.
Policies to ensure financial stability therefore need to recognise the central importance of real-estate finance in the banking and wider credit markets of the UK and many other developed countries, and the way in which credit supply and asset prices can become linked in self-reinforcing cycles of the sort described by Hyman Minsky.10 (Slide 20) These credit and asset price cycles are inherent potential risks in any system of fractional reserve banks, and are the key drivers of financial and economic instability which prudential regulation needs to address.
It is therefore essential that our assessment of the impact of prudential regulation recognises the very different economic functions of different categories of credit. (Slide 21) It also needs to recognise that the interest rate elasticity of different categories of credit is likely to be highly variable, particularly in boom times. The interest rate increase required to slow down a commercial real estate boom, fuelled by expectations of future capital gain, may be so high that it causes severe harm to the flow of credit to finance new productive investment. The appropriate policy response may therefore need to include quantitative levers which directly address credit supply, and their variation by sector of the economy. Andrew Smithers and Andrew Large consider the options for such macro-prudential tools in their contribution to this book.
5. Securitisation was supposed to reduce the risks: but created new ones
Let me turn to my fifth and final key conclusion – on the impact of credit securitisation. In the confident pre-crisis conventional wisdom, securitised and structured credit and related credit derivatives were lauded as a new financial technology, which was both increasing allocative efficiency and reducing risks. But while in theory securitised credit could have achieved risk reduction, its particular implementation undermined that potential and it simultaneously created a new and dangerous source of instability.
Simple credit securities – government or single name corporate bonds – have existed for almost as long as bank loans, and continue to play a major role in the credit extension system, linking investors to users of funds in ‘matched’, non-transformed, credit relationships. But from the 1970s pooling was used to create credit securities out of multiple small credits, and tranching was used to create securities tailored to the risk return preferences of different investor groups. (Slide 22) Essentially, securitisation achieves the same risk tranching function performed by a bank balance sheet, but without overt balance sheet based maturity transformation. By the early 21st century (Slide 23) securitised credit had grown to account for over 50% of all US home mortgages, 25% of US commercial mortgages and consumer credit, and in the UK over 20% of home mortgages. It seemed to deliver an array of benefits. (Slide 24)
•It enabled investors to select assets more precisely tailored to their own specific risk return preferences. Therefore, it was argued, it facilitated increased credit extension – perhaps a true but also an ambivalent benefit to which I will return later.
•And it enabled banks to better diversify risk: originating loans but then distributing some of them to end investors, so that banks no longer needed to hold portfolios determined by their own specific regional or client base. As a result, it was believed, securitisation made possible a more stable financial system.
And in theory (Slide 25) it should have been more stable, because it appeared to remove from the credit extension system the particular risky features which come with bank balance sheets.
•It should result in assets being held by end investors rather than by leveraged bank intermediaries.
•And it should remove the contractual maturity transformation of bank balance sheets, substituting instead liquidity through marketability.
Part of what went wrong, however, was that neither of these supposed benefits was actually delivered. When the music stopped in 2008, a large share of credit securities turned out to be held on the trading books of banks –banks which had originated and distributed credit with one hand, then bought back other banks’ credit securities with the other hand, encouraged to so by utterly inadequate capital requirements against trading assets. And shadow bank maturity transformation – SIVs and conduits and mutual funds holding long-term assets against short-term liabilities and relying on market liquidity to allow sales to meet redemptions – turned out to be quite as risky as the contractual on balance sheet variety.
These specific faults in the system can be addressed by better regulation – though as a result, much of the demand for securitised credit instruments may never return, the faults being essential to their apparent attractions.
But the wider development of securitised credit and credit derivatives also created a new category of risk – a risk which takes us back to the first of my five points, that all liquid financial markets are vulnerable to herd and momentum effects, to surges of collective irrational exuberance and then despair. At the core of these effects are self-referential rather than fundamental assessments of risk and price – equity pricing in Keynes’s words being like a ‘pick the prettiest face’ competition in which ‘we devote our intelligence to anticipating what average opinion expects the average opinion to be’.11
As trading of securitised credit and credit derivatives grew in importance, it became easier for such self-referential approaches to be applied to credit markets – with not only non-bank credit investors, but also banks themselves using the price of credit to infer risk, rather than using fundamental risk assessment to determine the appropriate price of credit.
A trend which the conventional wisdom of efficient market theory not only noted, but positively welcomed, the IMF Global Financial Stability Review of April 2006 noting with approval that credit derivatives (Slide 26) ‘enhance the transparency of the markets collective view of credit… [and thus]… provide valuable information about broad credit conditions and increasingly set the marginal price of credit’.
But setting the marginal price of credit by reference to the market’s collective view of credit risk is allocatively efficient and risk reducing only if the markets collective view of risk is sound. If instead, CDS spreads for the major banks follow the trend shown on Slide 27, falling relentlessly from 2002 to reach a historical low in spring 2007, just before the financial crisis broke, and providing no early warning whatsoever of the increased risks, then the greater use of market credit prices to inform risk assessment can accentuate still further the risks inherent in credit contracts and fractional reserve banks.
The development of securitised credit (Slide 28) with transparent and potentially self-referential prices, and combined with mark-to-market accounting, as a result played a role in accentuating the risks of credit and asset price cycles always present in systems of bank credit extension.
The toxic combination – interacting drivers of instability
Overall, therefore, the explanation of why the latest financial crisis was so severe seems likely to lie in the interaction between different sources of instability. (Slide 29) Excessive bank lending to finance assets which increase in value as a result of the credit extended, had caused multiple past crises long before securitised credit and credit derivatives had been created. And liquid financial markets are inherently vulnerable to momentum and herd effects which drive divergence from equilibrium values, but booms and busts in equity prices are not always hugely harmful at the macro level. What was especially toxic about the financial system in the run up to the crisis, however, was the intensity of interaction between maturity transforming banks, real estate markets, new and complex forms of credit extension and non-bank maturity transformation, and liquid financial markets in which credit risk assessment and pricing became self-referential. This interaction drove an extreme version of the classic credit and asset price cycle, more complex and more global in reach.
Reforming global finance: radical structural reform and inherent instability
I began the speech by referring to some obvious things that went wrong with finance before the crisis and some obvious and very important things we need to put right. Large bank bonuses for selling over-complex and risky products of little real use to humanity were a major problem, and we need remuneration practices and regulations which make excessive risk taking less likely in future.
But the key theme of my chapter is that regulatory reform also needs to address more fundamental issues. If we only address banker bonuses and not the fundamental drivers of credit supply instability, we will not adequately reduce the probability of a repeat performance.
The central issue is the availability of credit, and in particular the pro-cyclical forces which drive credit and asset price booms and busts. The importance of credit was indeed recognised as a central issue by the cheerleaders of financial liberalisation and deepening, but with the simplistic assumption that more credit was definitionally good.
•Thus as I mentioned earlier, one of the arguments for securitisation and credit derivatives was that they ‘facilitated credit extension’.
•And in the debates about the Basel II capital regime, one of the overt aims of the reformers was to introduce advanced risk assessment techniques which would allow banks to operate with less capital than before, thus making possible higher bank and real economy leverage.
The rapid growth of credit in the pre-crisis years, particularly in the US, was not therefore an accidental by-product of financial liberalisation, but a deliberate aim. And as Raghuram Rajan points out in his new book Fault Lines, rapid credit growth served a useful political purpose, enabling low-income Americans to maintain consumption even when real incomes stagnated in the face of rising inequality.12
But much of this credit turned out to be unsustainable: the resulting high levels of leverage produced increased the vulnerability of the economy to shocks; and its rapid growth linked to property prices, followed by inevitable bust, was the major driver of instability. Regulatory reform cannot therefore avoid questions relating to the optimal level of credit within an economy and to the management of credit growth linked to asset prices.
In assessing proposals for radical structural reform of the financial system, we therefore need to focus on whether such proposals address the fundamental drivers of volatile credit supply and pricing.
Four specific structural options merit consideration. (Slide 30)
•Fixing ‘Too Big to Fail’: The ‘Too Big to Fail’ agenda is undoubtedly important and a key focus for the Financial Stability Board’s Standing Committee on Supervisory and Regulatory Cooperation, which I chair. It is not acceptable that tax payers have to bail out large failing banks, and the ‘ex-ante’ expectation that they will undermines market discipline. A range of policy responses are possible; these include capital surcharges, impaired resolution processes, and changes in legal structure – increased use of separate subsidiaries. It is important to understand, however, that in the latest crisis, as in previous ones, direct tax payer costs of bank rescue are likely to account for only a very small proportion of the total economic costs. IMF estimates suggest they are unlikely to exceed 2-3% of GDP in the developed economies most affected by the crisis, and they may turn out significantly less once bank equity stakes are sold. But public debt burdens in the developed economies are likely, as a result of this crisis, to increase by something like 50% of GDP. These much larger costs derive from our essential problem, from volatility in credit supply, first extended too liberally and at too low prices – especially to real estate and construction sectors – and then restricted. This has two implications:
•The first is that when we say that in future all banks, however big, must be allowed to ‘fail’, the objective should not be to put them into insolvency and wind-up, since that will produce a sudden contraction of lending, but instead to ensure that we can impose losses on subordinated debt holders and senior creditors sufficient to ensure that the bank can maintain operations, under new management, without tax payer support.
•The second is that the multiple failure of small banks could be as harmful to the real economy as the failure of one large bank, even if all such banks failed at no tax payer cost, and even if the market knew ‘ex-ante’ that no tax payer support would be forthcoming. The American banking crisis of 1930-33 was primarily a crisis of multiple relatively small banks.
Fixing ‘Too Big to Fail’ is therefore a necessary but not a sufficient response.
•Separating commercial from investment banking: Limiting the involvement of commercial lending banks in risky proprietary trading is also undoubtedly desirable. Losses incurred in trading activities can generate confidence collapses, which constrain credit supply and in extremis necessitate public rescue. The interaction between trading activity and classic investment banking played a crucial role in the origins of the latest crisis: indeed, the thesis of this chapter is that it was precisely the interaction of maturity transforming banks and of self-referential credit securities markets, which drove the peculiar severity of this latest crisis. But legislated separation of commercial and investment banking will not prove a straightforward or sufficient solution for three reasons:
•First, because in a world where securitised credit is likely to continue to play a significant role, drawing a legislative distinction between ‘proprietary trading’ and ‘customer facilitation’ is close to impossible. For that reason indeed the ‘Volcker rule’ clauses of the US legislation make the distinction in principle, but leave it to regulators to apply it in practice. One of our key levers in doing that will be appropriate capital requirements for trading activity, to prevent banks holding credit securities in trading books with the inadequate capital support allowed before the crisis.
•Second, because while large integrated commercial and investment banks (such as Citi, RBS and UBS) played a major role in the crisis, so too did large or mid-sized commercial banks (such as HBOS, Northern Rock, and IndyMac) which were not extensively involved in the proprietary trading activities which a Volcker rule would constrain.
•Third, that even if proprietary trading of credit securities was largely conducted by institutions separate from commercial banks, important and potentially destabilising interactions could still exist between maturity transforming banks and credit securities trading. A credit supply and real estate price boom (of the sort illustrated on Slide 28) could be driven by the combination of commercial banks originating and distributing credit and non-banks buying and trading it, the two together generating a self-referential cycle of optimistic credit assessment and loan pricing, even if the functions were performed by separate institutions.
Volcker rules are in principle desirable, and there may well be merit in writing the principle into legislation, but are not a sufficient response.
•Separating deposit taking from commercial banking: Professor John Kay’s proposed structural solution, which he describes in his chapter for ‘The Future of Finance’, is quite different from Paul Volcker’s. Rather than splitting commercial from investment banking, it would separate insured deposit taking from lending. (Slide 31) All insured retail deposits would be backed 100% by government gilts, while lending banks would be funded by uninsured retail or commercial deposits or by wholesale funds, and would compete in a free, unregulated and unsupervised market. As John well knows, I disagree with his argument that this would create a more stable system. The underlying assumption is that the existing system is unstable only because explicit deposit insurance and implicit promises of future rescue undermine the market discipline which would otherwise produce efficient and stable results. If instead we believe that financial markets, maturity transforming banks, and credit extension against assets which can increase in value, are inherently susceptible to instabilities which cannot be overcome by identifying and removing some specific market imperfection, then Professor Kay’s proposal fails to address the fundamental issues. It would create safe retail deposit banks which would never need to be rescued, but it could leave credit supply and pricing as volatile, pro-cyclical and self-referential as it was pre-crisis.
•Abolishing banks – 100% equity support for loans: Professor Kotlikoff’s proposal, in contrast, suggests a truly radical reform of the institutional structure for credit extension.13 (Slide 32) Lending banks would become mutual loan funds, with investors sharing month-by-month (or even day-by-day) in the economic performance of the underlying loans. (Slide 33) This is equivalent to making banks 100% equity funded, performing a pooling but not a tranching function. And it would clearly exclude the possibility of publicly funded rescue: if the price of loan fund assets fell, the investors would immediately suffer the loss. But it is not clear that such a model would generate a more stable credit supply. As I argued earlier, a system of securitised credit combined with mark-to-market accounting can generate self-referential cycles of over and under confidence. And while Kotlikoff’s loan funds might seem to abolish the maturity transforming bank, with investors enjoying short-term access but not capital certainty, investors would be likely in the upswing to consider their investments as safe as bank deposits. Investments in loan funds would therefore be likely to grow in a procyclical fashion when valuations were on an upswing and then to ‘run’ when valuations and confidence fell, creating credit booms and busts potentially as severe as in past bank-based crises. The essential challenge indeed is that the tranching and maturity transformation functions which banks perform do deliver economic benefit, and that if they are not delivered by banks, customer demand for these functions will seek fulfilment in other forms. We need to find safer ways of meeting these demands, and to constrain the satisfaction of this demand to safe levels, but we cannot abolish these demands entirely.
There is therefore a danger that if radicalism is defined exclusively in structural terms – small banks, narrow banks, or the replacement of banks with mutual loan funds – that we will fail to be truly radical in our analysis of the financial system and to understand how deep-rooted are the drivers of financial instability.
The core drivers of instability lie in the credit asset price cycle and in the interaction between banks, credit securities markets and real estate markets. There are two thrusts of regulatory reform which could address this.
The first, much higher bank capital and liquidity requirements will create a more resilient banking system, less likely to suffer crisis and bank failure. But these changes will also, by constraining but not eliminating the extent to which the banking system can perform its tranching and maturity transformation functions, constrain total leverage in the real economy and thereby reduce the vulnerability which derives from the rigidities of credit contracts. And by reducing the likelihood of bank failure, they will reduce the danger that confidence collapse leads to sudden constraints on credit supply. Even if not varied through the cycle, higher bank capital and liquidity requirements will therefore tend to reduce the procyclicality inherent in banking systems and credit markets.
The crucial question is, therefore, are how much higher these requirements should be and how we transition from today’s less demanding level. To think straight, we need to consider these two questions separately; it is quite possible that an economy significantly less leveraged than today would be optimal, but also that transition from high leverage to low leverage will have a depressive effect on short to medium term growth. (Slide 33)
•On the long-term issue, one striking fact is that in the past we have had banking systems which operated with far higher levels of capital and liquidity than today, but were still able to serve the financial needs of growing economies. (Slide 34) And macroeconomic analysis conducted to inform global regulatory decisions, suggests that lower levels of bank and real economy leverage have no necessary impact on long-term steady state growth rates. This should not surprise us, given that the mental model in which all credit is essential to drive investment and growth is, as I suggested earlier, out of line with the facts. But the fact that much credit does not drive investment and economic growth does not mean that it has no value; the functions of life-cycle consumption smoothing and intergenerational resources transfer, which I indentified earlier as the primary functions of the credit system, are socially valuable.
•Society therefore faces a trade-off: we can make the finance system more stable via significantly higher capital and liquidity requirements, without hitting long-term growth, but at the expense of less easy access to credit. We need to strike a balance, honestly recognising that the benefits of financial stability have a cost in terms of customer choice. In light of the severe economic harm caused by the financial crisis, a significant shift in the balance towards stability and resilience makes sense.
•But we also need to manage the transition with care, and the FSA and global authorities are therefore also using economic modelling to consider carefully how increases in capital and liquidity standards will impact short and medium-term growth. The analysis suggests that, with appropriate off-setting, monetary policy and long implementation periods, the cost of transition can be small. But it cannot be nil: deleveraging is difficult to achieve without some growth penalty, even if the increase in leverage delivered no permanent growth improvement – a strong argument for designing a future system less likely to create excessive leverage in the first place.
Higher capital and liquidity standards, applicable throughout the cycle, will themselves create a financial system less vulnerable to shocks. But we cannot remove the dangers of bank failure entirely without moving to a Larry Kotlikoff style abolition of banks, which as argued earlier, would still leave important other risks in the financial system. Moreover, the risk tranching and maturity transformation functions which banks perform do deliver value, even if the scale on which they perform them needs to be constrained. Levels of capital and liquidity requirement which leave banks able to perform their useful functions will still therefore leave the economy vulnerable to destabilising up-swings in credit supply and asset prices, deriving from the interaction between maturity transforming banks, credit securities markets, and self-reinforcing credit and asset price cycles.
In addition to higher capital and liquidity requirements, therefore, the regulatory response needs to involve the deployment of counter cyclical macro-prudential tools, which directly address aggregate credit supply. These could include automatic or discretionary variation of capital or liquidity requirements across the cycle, or constraints, such as LTV limits, which directly address borrowers rather than lenders. Such policy levers may moreover need to be varied by broad category of credit (e.g. distinguishing between commercial real estate and other corporate lending) given the very different elasticity of response of different categories of credit to both interest rate and regulatory levers.
The details of what policy levers should be available and how they should be deployed are considered in the contribution by Andrew Large and Andrew Smithers. And the UK is now committed to creating a new Financial Policy Committee, chaired by the Governor of the Bank of England, and drawing on the analyses and insights of both central bankers and prudential regulators, and responsible for considering the overall evolution of credit supply, and for taking appropriate action to lean against the wind of excessive credit creation. This is a vital response to the previous gap in our regulatory system, to the underlap which previously existed between a central bank focused on monetary policy alone, and a regulator focused on micro rather than macro issues.
But to be effective, the new body will need to be willing to take away the punchbowl of excessive credit when everybody else – property developers, householders, and the government as recipient of the tax revenue generated – is thoroughly enjoying the party. Creating a safer financial system requires not just action to prevent overpaid bankers selling overly complex products and taking undue risks; it also requires constraining a credit supply which in the upswing we all rather enjoyed.
•The Future of Finance slides [PDF]
1 Something Old and Something New: Novel and Familiar Drivers of the Latest Crisis, European Association of Banking and Financial History, 21 May 2010.
2 Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds (first published 1841,Wilder Publications 2008.
3 Charles Kindleberger, Manias, Panics and Crashes (First published 1978. Wiley, 2000)
4 G. Akerlof and R. Shiller, How human psychology drives the economy and why it matters to global capitalism, Princeton University Press, 2009
5 See Kuhneman, Slovic and Tversky Judgement Under Uncertainty heuristics and biases (1982) for discussion of how economic agents made decisions on the bases of rough heuristics, i.e. rules of thumb. The widespread application of these rules by multiple agents can then generate self-reinforcing herd effects
6 See Vayano and Woolley, An Institutional Theory of Momentum and Reversal” (LSE November 2008), and George Soros The New Paradigm for Financial Markets (2008).
7 Irving Fisher, The Debt-Deflation Theory of Great Depression, (Econometrica, 1933).
8 Ben S. Bernanke, Non-monetary effects of the financial crisis, Essays on the Great Depression, Princeton, 2000
9 Walter Bagehot, Lombard Street, A Description of the Money Market, 1873
10 Hyman Minsky, Stabilising an Unstable Economy, Yale University Press, 1986
11 J.M. Keynes, The General Theory, Chapter 12, 1936
12 Raghuram Rajan Fault Lines: How Hidden Fractures Still Threaten the World Economy, Princeton 2010.
13 L. Kotlikoff, Jimmy Stewart is Dead. Ending the World’s Ongoing Financial Plague with Limited Purpose Banking, Wiley, 2010