journal of regulation & risk - north asia, volume iii, issue i

8/6/2019 Journal of Regulation & Risk - North Asia, Volume III, Issue I

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Articles & PapersAter eects o 2008 fnancial crisis will last decades Prof. Carmen M. Reinhart & Vincent R. Reinhart

Awkward things, even ugly acts can be useul William R. White

Central bankers need to be more, not less, proactive Adam S. Posen

Macroprudential policy perspectives: Emerging markets Ramon Moreno

European crosshairs ocus on short selling, OTC derivatives Carlos Tavares

Economists hubris: The case o equity asset management Shahin Shojai, George Feiger & Prof. Rajesh Kumar

Can the yuan ever become an international reserve currency? John H. Makin

How Spain can avoid a repetition o the Irish error Prof. Charles W. Calomiris & Desmond Lachman

The European Union debt crisis: Worrisome delusions Prof. Charles Wyplosz

Fiscal policy in the US and European Union misguided Nobel Laureate Prof. Paul Krugman

Reliance on fnancial models risks repeat o 2008 fasco Dr. Jon Danielsson

The economic consequences o naked credit deault swaps Dr. Rajiv Sethi & Dr. Yeon-Koo Chi

Collateralised debt obligation detox or the European Union Satyajit Das

Capital in large fnancial institutions cant be measured Steve Waldman

Lambs to the slaughter: Real causes o the fnancial crisis Peter J. Wallison

Sarbanes Oxley regulation in current fnancial markets Gavin Sudhakar

Integrating Chinas economy into global capital markets Terry Tse & Gene Guill

Volume III, Issue I Spring 2011

Journal of regulation & risknorth asia

In association with


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Standard & Poors Fixed Income Risk Management Services group is analytically and editorially independent

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Journal of Regulation & Risk North Asia 1

Publisher & Editor-in-Chief

Christopher Rogers

Editor Emeritus

Dr. John C. Pattison

EditorIan Watson

Chief Sub Editor

Fiona Plani

Editorial Contributors

Pro. Lawrence Baxter, Xavier Bellouard, Pro. William Black, Pro. Charles L.

Calomiris, Dr. Yeon-Koo Chi, Pro. Jon Danielsson, Satyajit Das, George Feiger,

Ian Fraser, Dr. Gene Guill, Andrew G. Haldane, Pro. Laurence J. Kotliko, Dr.

Brett King, Pro. Paul Krugman, Pro. Rajesh Kumar, Desmond Lachman, JohnH. Makin, Ramon Moreno, Adam S. Posen, Robert Pringle, Pro. Carmen M.

Reinhart, Vincent Reinhart, Dr. Rajiv Sethi, Benjamin Shobert, Shahin Shojai,

Gavin Sudhakar, Pro. Jennier S. Taub, Carlos Tavares, Terry Tse, Adair Turner,

Steve Randy Waldman, Peter J. Wallison, William R. White, Pro. Charles Wyplosz.

Design & Layout

Lamma Studio Design

Printing

DG3Distribution

Deltec International Express Ltd

ISSN No: 2071-5455

Journal of Regulation and Risk North Asia

5/F, Suite 502, Wing On Building, 71 Des Voeux Road, Central, Hong Kong

Tel (852) 2982 0297

Email: [email protected]

Website: www.jrrna.org

JRRNA is published quarterly and registered as a Hong Kong journal. It isdistributed to governance, risk and compliance proessionals in China,

Hong Kong, Japan, Korea and Taiwan.

Copyright 2011Journal of Regulation & Risk North AsiaMaterial in this publication may not be reproduced in any orm or in any way

without the express permission o the Editor or Publisher.

Disclaimer: While every eort is taken to ensure the accuracy o the inormation herein, the editorcannot accept responsibility or any errors, omissions or those opinions expressed by contributors.


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Journal of Regulation & Risk North Asia2

Volume III, Issue I Spring 2011

Contents

Q&A Andrew G. Haldane 9

Debate Adair Turner 19

Debate Pro. Laurence J. Kotliko 35

Opinion Pro. Lawrence Baxter 41

Opinion Pro. Jennier S. Taub 45

Book review Benjamin Shobert 49

Book review Satyajit Das 53

Comment Ian Fraser 57

Comment William Black 61

Comment Xavier Bellouard 65

Comment Dr. Brett King 67

ArticlesAter eects o 2008 fnancial crisis will last decades 73

Prof. Carmen M. Reinhart & Vincent R. Reinhart

Awkward things, even ugly acts can be useul 105William R. White

Central bankers need to be more, not less, proactive 115Adam S. Posen

Macroprudential policy perspectives: Emerging markets 141Ramon Moreno

European crosshairs ocus on short selling, OTC derivatives 159Carlos Tavares

Economists hubris: The case o equity asset management 163Shahin Shojai, George Feiger & Prof. Rajesh Kumar

Can the yuan ever become an international reserve currency? 177John H. Makin

How Spain can avoid a repetition o the Irish error 185Prof. Charles W. Calomiris & Desmond Lachman

The European Union debt crisis: Worrisome delusions 189Prof. Charles Wyplosz

JOURNAL OF REGULATION & RISK

NORTH ASIA


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Fiscal policy in the US and European Union misguided 193Prof. Paul Krugman

Reliance on fnancial models risks repeat o 2008 fasco 197Dr. Jon Danielsson

The economic consequences o naked credit deault swaps 201Dr. Rajiv Sethi & Dr. Yeon-Koo Chi

Collateralised debt obligation detox or the European Union 207Satyajit Das

Capital in large fnancial institutions cant be measured 215Steve Waldman

Lambs to the slaughter: Real causes o the fnancial crisis 221Peter J. Wallison

Sarbanes Oxley regulation in current fnancial markets 233Gavin Sudhakar

Integrating Chinas economy into global capital markets 243Terry Tse & Gene Guill

Articles (continued)


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Foreword

THE Journal, its sta and contributors associated with this publication wish to

extend their deepest sympathy to all individuals, their amilies and colleaguesbereaved or greatly aected by the March 11 earthquake and tsunami in Japan.Further, we commend all those who have shown great stoicism and made valianteorts in dealing with the traumatic atermath and nuclear crisis in Fukushima.We, like people everywhere, trust that the Japanese nation will switly recover romthis catastrophe and apply the valuable lessons learnt to lessen the impact o anyuture natural disaster in one o the worlds oremost economies.

In this, our rst publication o 2011, we hope as ever to provide our readership with

valuable insights, opinion and comment on issues o importance to those dealing withgovernance, risk management and compliance within northeast Asias nancial servicessector. As usual, the Journal presents an eclectic mix o papers and articles rom some othe worlds oremost authorities on monetary policy, oreign exchange, regulation, com-pliance, accounting and risk modelling much o this inormed by both the nancialcrisis o 2007-8 and regulatory eorts, or lack thereo, to prevent another crisis in uture.

This author, in league with many other authorities among them the Bank o England,Bank o Switzerland, UK Financial Services Authority, Swiss Financial Market Supervi-sory Authority and numerous other voices remains sceptical that Dodd-Franks andBasel III have addressed adequately the causes that contributed to the nancial melt-down. As such, our attention now ocuses on regulatory reorms expected to be imple-mented by the European Union and United Kingdom during the remainder o this yearas politicians, central bankers and regulators balance the requirements o the nancialservices sector with those o the electorate and a sound banking inrastructure able towithstand another black swan event without recourse to massive state bailouts.

The Journal remains committed to advancing a protable nancial services sectorthat benets the economic wellbeing o nations worldwide as well as the global economy.We are in no doubt that banking and nance are o central importance to all developedeconomies and that a well ordered and regulated nancial services sector benets all seg-ments o society. As ever, we are opposed to onerous knee-jerk regulations that benet noone and will continue to present both sides o this ongoing debate throughout the year.

Christopher Rogers

Publisher & Editor-in-Chief


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Acknowledgments

THE editorial management o theJournal of Regulation and Risk North Asia would

like to extend its gratitude to SWIFT Asia Pacic and Dow Jones or enabling theJournal to publish and distribute this edition o the JRRNA. Further, the Journalextends its thanks to those organisations and individuals that co-operated with,contributed to, or authorised publication o content in this issue.

A ull list o those who kindly assisted with this, the Spring 2011 issue o theJournal is not possible, but the Publisher and Editor would like to thank the ol-lowing organisations or their generous assistance and support: The FederalReserve Bank o Kansas City; the Bank o England; the Bank or InternationalSettlements; CAPCO; Quartet FS; Financial Services Authority; Deutsche Bank;Peterson Institute or International Economics; American Enterprise Institute;Pareto Commons; VoxEU; economics21.org; Interfuidity, and Wiley Publicationsor their kind permission to reproduce material rom their respective publica-tions and websites.

Detailed comments and advice on the text and scope o contents rom Pro.William Black, Dr John C. Pattison, Pro. Lawrence Baxter, Pro. Laurence Kot-

liko, Satyajit Das, Steve Randy Waldman, Terry Tse and Pro. Jennier Taub wereinvaluable; we are also grateul to Ian Watson and Fiona Plani o Edit24.com ortheir due diligence in setting out, editing and correcting the text.

Further thanks must also go to the China Banking Regulatory Commission,Beijing & Shanghai Chapters o the Proessional Risk Managers International As-sociation, and the Hong Kong Chapter o the Global Association o Risk Pro-essionals or their kind assistance in helping to distribute the Journal to theirrespective memberships in Greater China, Japan and Korea.


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Robert Pringle: Turning to macroprudentialpolicy, what tools does the Bank have to makethe market pay due attention to its views e.g. tocool a uture asset price boom?

Andrew Haldane: The past is inormativehere. Pre-crisis, many central banks, includ-ing the Bank o England, did have an instru-ment in their back pocket. That instrument

was voice. It ound expression in FinancialStability Reports, which prolierated over thepast decade. Looking back over those pre-

crisis reports, the Bank (and other centralbanks) did a reasonable job o identiying thekey nancial ault lines.

At the Bank we even tried to quan-tiy the impact o those ault lines using,at the time, a relatively untested approach aggregate, system-wide stress tests. Theestimated losses were large enough to chewup a chunk o the banking systems capital.

But, individually, those ault lines did notappear to be lie-threatening or the globalnancial system.

Robert Pringle: So what went wrong?

Andrew Haldane: Two things. First, theauthorities perhaps discounted too eas-

ily the possibility o these ault lines beingexposed i not simultaneously then at leastsequentially. In the nancial system, eve-rything and everyone is connected. Thoseholding subprime securities also had expo-sures to various nancial vehicles: struc-tured investment vehicles, collateraliseddebt obligations, monolines and variousother nasties.

This interconnection across assets,institutions and countries is one reason

Lehmans ailure brought the entire globedown to earth with a bump at precisely thesame time. Given this interconnectivity, theprobability o simultaneous nancial earth-

quakes is many times greater than i yousimply multiplied their individual probabili-ties together.

Cumulative pre-crisis losses o manyo these nancial earthquakes would havebeen lie-threatening or the worlds bankingsystem. For UK banks at the end o 2006, theBanks Financial Stability Report stress tests

estimated total losses in the region 100 bil-lion [approx. $162 billion]. We had the analy-sis, and even the numbers, roughly right.But pre-crisis, they were viewed through toorose-tinted a lens.

Barking dogsSecond, even i we had had the right lens,this would probably not have altered the

course o the crisis. The Bank, and others,spoke with increasing orceulness aboutpotential stresses in the system rom 2003onwards. We were dogs barking at the pass-ing trac. As the cars drove past at increas-ing speed, these barks grew louder. Thedrivers o some o the cars took notice, butthey did not slow down.

Why? Because they knew the dogs barkwas worse than its bite. What was neededin this situation was someone to slow thetrac, all o the trac, or the game beingplayed was a collective mania. These maniasare ounded on a desire to keep one stepahead o the opposition. This results in arace to bottom which, although individuallyrational, is collectively calamitous. It is a clas-sic co-ordination ailure and so requires a co-ordination solution.


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The solution? A watchdog with teeth.That is one vital element o macropruden-tial policy, being able to reinorce the words

with action. The typical macroprudential

tools to lean against such cycles are likelyto be regulatory ones or example, capitaland liquidity ratios. By varying them coun-ter-cyclically, banks cost o capital can helpmoderate the credit cycle. Moderate but noteliminate. Elimination o the credit cyclethrough macroprudential policy is ineasible,and possibly undesirable.

Radical departureSo microprudential tools will serve macro-prudential ends. This sounds airly simple.It will be anything but. It is a radical depar-ture. And this policy experiment will be tak-ing place pretty much simultaneously allaround the world or example, in Britainthrough the Banks new Financial Policy

Committee (FPC), across the euro-areathrough the new European Systemic RiskBoard (ESRB), in the United States throughthe new Financial Stability OversightCouncil (FSoc).

Robert Pringle:How does this compare withthe early days o monetary policymaking?

Andrew Haldane: Technically, this policyexperiment will be no less daunting than-

when monetary policy rst began to operateactively. As then, knowledge o the trans-mission mechanism is scant. The authorities

will be sailing in largely uncharted waters ina new boat with a new crew. Against thatbackdrop, it is perhaps understandable thatsome pessimists have predicted an immi-nent shipwreck.

But there are good grounds or opti-mism. First, we are hopeully some yearsaway rom the next nancial storm, cer-tainly o the severity just witnessed. This will

give the new crew some time to practicemanoeuvring the vessel in calmish waters.Second, the impact o policy on lendersexpectations may be the key transmissionchannel. To see why, recall that the origins omany past credit cycles are unco-ordinatedlending expectations. So the key is to nd ameans o co-ordinating expectations.

Changes in regulatory requirementshave the potential to do so. The brakes areapplied to everyone in the race. Lendersknow that i the initial policy signal is notheeded, tightening will continue until it is.Knowing that, there will be strong incentivesto slow or stop provided policy is credible.Knowledge o the precise impact o changesin regulatory ratios on lending behaviour,

thereore, may be less important than thecredibility o policy announcements whenmade. This underscores the importance oclear communications. It also suggests theneed to keep the macroprudential regimerelatively simple, especially at the outset.

Robert Pringle:How does the macropruden-

tial objective and toolkit t into the monetary policymaking process? In particular do youexpect monetary policy interest rate setting tobe more infuenced by macroprudential concernsthan in the past?

Andrew Haldane: Recent announcementsin Britain signal a signicant change in theBanks policy armoury. This will in uturecomprise three elements: microprudential,macroprudential and monetary policy. And


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these three responsibilities will be executedby three, three-letter acronyms: the PRA(Prudential Regulatory Authority), the FPCand the MPC.

These three arms are complementary.Micro and macroprudential policy will drawon some similar inormation (or example, onbanks resilience) and will deploy some simi-lar instruments (or example, capital ratios).

And macroprudential and monetarypolicy will likewise draw on some similarinormation (or example, on credit condi-

tions) and both will have the eect o moder-ating aggregate cycles in the macroeconomy(credit and business cycles respectively).

Housing these three policy levers underone roo helps ensure the necessary inor-mation is made available to all who mightneed it as smoothly as possible. It also helpsinternalise any potential spillovers betweenthe three, lowering the risk o institutional

arm-wrestling.More than that, i well executed the

three levers ought to be mutually support-ive. Consider the evolution o the nancialsystem between 2000 and 2007. In Britain,nominal spending was growing roughly attrend, at around ve to six per cent a year. Butbank balance sheets were growing at three

times that rate.

Missing linkHad monetary policy aimed to check thatgrowth, the pain would have been elt by thenon-nancial sector. Prudential policy couldhave more eectively tackled those nancialexcesses at source. It was the missing link inthe monetary/nancial stability chain. Withthe introduction o the FPC, that link willnow be orged.

Robert Pringle:More generally has the rela-tionship between nancial stability and mon-etary policy changed?

Andrew Haldane: This relationship is, ocourse, long-established. Both are aboutpreserving aith in money whether centralbank or commercial bank money. Historytells us it is impossible to deliver monetarystability without nancial stability, and

vice-versa.

One spanner short riskIt is not dicult to see why monetary andnancial stability have an umbilical link.The crisis has underlined the importanceo recognising the join between the two.Macroprudential policy is intended to com-plete that join. It lls the policy gap down

which the authorities have sometimes allenin the past. It reduces the risk o the authori-

ties being one spanner short o a ull toolkit.

Robert Pringle:Are you satised that you willhave access in timely ashion to the data yourequire, and how are you going to analyse it to

pinpoint emerging risks?

Andrew Haldane: Out o crisis springs

opportunity as well as threat. The experienceo the Great Depression is salutary in thisrespect, as out o it sprang a three-prongedrevolution in macroeconomics. A revolu-tion in macroeconomic theory through theIS/LM model which, with a ew knobs and

whistles, remains the mainstay o macrotheory today.

A revolution in macroeconomicpolicy the dawn o activist monetaryand scal policy. And a revolution in


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macroeconomic data, with the introduc-tion o the National Accounts.

Although the least heralded, the third othese was every bit as signicant as the rst

two. In responding to the current crisis, it ispossible we need a data initiative every bitas radical as ollowed the Great Depression.Data gaps have emerged and have ampli-ed stress at every stage in the crisis. Perhapsmost dramatically, a lack o knowledge onetwork connections and counterpartyexposures helped contribute to the seizure in

nancial markets that ollowed the collapseo Lehman Brothers.Things are changing or the better.

Initiatives are underway internationally,including through the Financial StabilityBoard, to identiy and plug data gaps. Andsome o the policy initiatives in train willdeliver much better data on nancial risksand transactions. In uture, a much larger

number o nancial instruments will betraded on exchanges and cleared on centralcounterparties or transactions recorded intrade repositories.

Potential goldmineThese changes will generate a potential datagoldmine or policymakers panning or nug-

gets o systemic risk. Its not oolproo. Thekey will be to ensure the authorities andmarket participants put these data to worksystematically to help spot problems. TheBank or International Settlements interna-tional banking data were introduced as adirect response to crisis the less-developedcountries debt problems o the 1980s.

And they quickly demonstrated theiruseulness, signalling clearly debt problemsin the run-up to the Asian crisis. Yet the data

themselves went largely unanalysed until itwas too late. We need to avoid alling intothat same trap.

Robert Pringle: Federal Reserve historianAllan Meltzer and others have argued that allthe regulation and restructuring in the world willnot produce nancial stability unless and untilindividual responsibility or avoiding excessiverisk is brought back. Do you agree and i so howcan this be brought about?

Andrew Haldane: I am doubtul it wouldbe sucient, but greater market disciplineis a necessary ingredient in taming utureexcesses. Perverse incentives contributedsignicantly to the crisis. The pay-o sched-ules acing sta and shareholders in nancialrms were option-like, with liability limitedon the downside but returns unlimited onthe upside.

Incentives to gambleThis generated inevitable incentives to gam-ble. With taxpayers having urther cush-ioned the downside during the crisis, theseincentives have been urther distorted. Itis not dicult to conceive o contractualmeans o altering the pay-o schedules ac-

ing shareholders and sta. Paying them inequity, perhaps with a minimum vestingperiod, would help.

But Lehman Brothers and Bear Stearnsdemonstrated that it is no panacea. Indeed, itcould actually increase incentives to gambleor resurrection when rms are on the brink.It may also reduce incentives to issue newequity or ear o diluting existing sharehold-ers and sta.

Such was the Lehman story.


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Robert Pringle: So whats the solution?

Andrew Haldane: An alternative, recentlyproposed by Jerey Gordon, a law proes-

sor at Columbia University, is to distributeto shareholders and sta in convertible debtrather than equity. That would preserve,indeed heighten, incentives to keep out othe tail, or at that point conversion o debtinto equity would crystallise losses.

Capital cushion

These same instruments would, throughconvertibility, provide an additional capitalcushion or a bank should it all rom heaven.Measures such as these could help re-bootthe nancial system with market discipline.They probably need to be accompanied bygreater transparency about the risks banksare taking.

Transparency has been one o the true

casualties o the crisis. Condence in banksaccounts had been badly damaged by thecrisis even beore the Repo 105 revelationsat Lehman Brothers. A rethink o disclo-sure practices is needed. It is easy to be criti-cal o the accountancy proession. In somerespects, the judgments they are required tomake when auditing bank balance sheets

are next to impossible.At times o acute uncertainty, it is unre-

alistic to expect accountants to reach a trueand air view o asset valuations when mar-ket participants themselves have no clue.In situations like these, bank balance sheetuncertainty is intrinsic. This intrinsic uncer-tainty might useully be better recognised inaccountancy practices.

For example, Michael Mainelli and BobGiords in their book, The Road to Long

Finance: A Systems View o the Credit Scrunch,have suggested a move to condenceaccounting placing condence intervalsaround banks asset valuations. This has par-

allels with publishing an charts or macro-economic variables in the Banks InfationReport. Fan charts signal the extent ounderlying economic uncertainty, as a betterbasis or planning and pricing. The sel-samerationale applies to condence accounting.

Robert Pringle: From a systemic risk per-

spective over what period should Basel III bephased in?

Andrew Haldane: Few people are anticipat-ing the imminent return o a rampant hunt orrisk. Balance sheets still need to be repaired.Memories o the recent crisis remain strong.Financial bruises are still visible. And marketnervousness is still pervasive.

Overcooked claimsThis ebrile environment gives us somebreathing space. There have been a num-ber o recent private sector studies o theimpact o hasty regulatory reorm. Theysuggest the damage to growth rom enact-ing regulatory reorm could be very signi-

cant.Having looked closely at these studies,these claims seem to me to be overcooked,oten dramatically so. But there is some tailrisk o a drag on the real economy rom theregulatory agenda a possibility rather thana probability.

In the ace o these uncertainties, itmakes sense or the authorities to tread care-ully. Put more ormally, uncertainty calls ora minimax strategy, where you minimise thechance o an awul outcome. This speaks to


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smoothing the transition to a new regula-tory regime.

The G20 endorsed that position at theirmeeting in Toronto in June 2010. This was

recognition that countries cycles and bank-ing systems were in dierent phases andstates o health. It was also recognition that,i the regulatory regime is to be fexed, thisis better done through the transition paththan end-point. Against that backdrop, amulti-year transition timetable or reorm

would be tolerable, provided the end-point

remains credible.

Robert Pringle:Turning to longer-term issues,the crisis orced central banks and governmentsin many countries to take unprecedented actions.Some people including some central bankersthink these have damaged central banks cred-ibility. What is your perception?

Andrew Haldane: No ones credibility hasescaped unscathed. The ocus o the pub-lics ire has predictably been the banks and,to lesser extent, the authorities. But the eco-nomics and nance proession has not hada good war. And nor should borrowers beexcused rom blame. Both sides need to bemore disciplined i uture credit cycles are to

be tamed.

Keynes dictumFor the authorities, elements o pre-crisispolicy ramework, in the teeth o the worstcrisis in a hal-century, were fexed. That isnot something to apologise or. When theacts changed, policymakers changed theirminds. Keynes dictum was ollowed. The

world would have been a worse place hadit not. But there are costs rom having acted

outside o established policy rameworks,as agents internalise the possibility o theauthorities blinking again next time.

The key is, then, to design policy rame-

works which are time consistent in the aceo tail events. This means striking a balancebetween the credibility o the rameworkon the one hand and its fexibility on theother. The evolution in policy rameworksduring the crisis has taken us somewhat inthat direction. Say on liquidity provision, theBanks new ramework provides a Discount

Window Facility and longer-term reposagainst a wider set o collateral to achieve acredible ramework with built-in fexibility.

Rainbow coalitionOn the regulatory ront, the architecture ocapital rules is also moving in this direction.Historically, regulatory capital was usable indeath but not lie. The new capital regime

aims to add a buer that is intended to beusable in lie as well as death, rising whenthe good times roll and alling when the badtimes rumble. This will introduce a muchgreater degree o fexibility into the regula-tory regime a rainbow coalition o conserv-ative minimum and liberal buers.

Robert Pringle: When you and I took part ina seminar in Hong Kong last March organisedby the Journal o Regulation & Risk - North Asia

where you gave the speech entitled the $100billion question and I listened as you estimatedthe scale o the massive annual subsidies tobanks rom taxpayers, I could not help wonder-ing whether the game is worth the candle.

The price in terms (or example) o costs totaxpayers and o growing inequality as bankshold society to ransom, seems unacceptable;


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anything would be better, even the nationalisa-tion o the nancial system. What conclusions do

you draw rom your analysis?

Andrew Haldane: Now is as good a timeas any to rethink the industrial organisa-tion o banking. Given a clean slate, theexisting structure o nance is not where

you would start.The nancial system is large (perhaps too

large), concentrated (possibly too concen-trated), risky (probably too risky) and com-

plex (almost certainly too complex). Eventssince the crisis have, i anything, ampliedsome o these trends. That is why the worko the new Banking Commission set up bythe new government is so important.

Regulatory reorm is seeking to leanagainst these trends. But it has obvious lim-its. Ater each crisis the lament has been thesame more o the same, but better. To

date, the same path o reorm has been ol-lowed: more capital and liquidity only thistime it will be better quality; more regulators only this time they will be smarter.

The same but better ideology has notserved us especially well to date. That is whypolicy may need to reocus its sights on a di-erent objective regulating structure as well

as behaviour.

Structural bogeymanThere are good theoretical reasons or doingso. Structural (or mechanism) design is aneective way o shaping incentives in a way

which is robust to uncertainty and arbitrage.There are also some good practical reasonsor seeking structural reorm; it reduces theneed or an encyclopaedic regulatory rulebook and an omniscient regulator.

There seems to me to be a lot o resist-ance among members o the banking com-munity to structural reorm. Structure is abogeyman or much o the nancial industry.

Part o the problem is semantic. The struc-ture debate too easily attracts labels Glass-Steagall this, McFadden that. But the debateneed be neither narrow nor name-specic. Itshould embrace reorm o nancial structurein a general sense the structure o nan-cial contracts and inrastructures, as well asnancial institutions.

Altered topologyOn the last o these, a airly radical set oreorms are underway to improve marketinrastructure, including through centraltrading and clearing o nancial instruments.That will alter undamentally the topology othe nancial network. The nancial system

will go rom resembling a ball o wool to a

bicycle wheel. This rewiring ought to makethe system less prone to short-circuit whennext a use blows.

Hidden complexitiesOn nancial contracts, many contracts writ-ten ahead o the crisis amplied stress ratherthan moderating it. Many had hidden com-

plexities which conused investors or hiddenoptions which crippled them. As Yale econo-mist Robert Shiller has discussed, it is notdicult to design contracts which automati-cally hedge risk state-contingent contracts.

Contingent capital is one topical exam-ple. GDP bonds issued by sovereigns areanother. Asset-price-indexed secured debt

would be a third.On nancial institutions, there is an

ongoing debate about separating retail and


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investment banking, the casino rom theutility. In reality, banking does not neatlydivide in quite this way. Some retail bankingis race-track betting and some investment

banking is utilitarian.

Hedging the risksIn engineering structural reorm, the keyinstead is to better align the risk character-istics o the assets banks hold and the liabili-ties unding them. Consider retail deposits. Iretail deposits are to be riskless, as customers

demand, the assets backing these sae liabili-ties need to be similarly sae.Equally, i risky assets are to be held,

then to align risk characteristics theseassets need to be unded with loss-absorbing liabilities, either equity orconvertible debt. By restructuring in this

way, risks to banks balance sheets arehedged without resort to the taxpayer or

the chainsaw.There is risk ring-encing. That ring-

encing can be done within a group structureor outside o one.

Robert Pringle:The major centres are settingup systemic risk regulators, with central bankshaving important roles. Can these avoid being

procyclical? Shouldnt we be encouraging diver-sity o regulatory system?

Andrew Haldane: The diversity issue is animportant one. Homogeneity hallmarkedthe run-up to crisis: homogeneity o busi-ness strategies by banks, as they collectivelygrew towards the newest source o sun-light; and homogeneity o the risk man-agement systems intended to keep thisbehaviour in check.

The regulatory authorities played theirpart in encouraging both. This lack o diver-sity increased the systems brittleness whenthe sunlight was eclipsed.

This is a nding other disciplines havelong recognised. There are literally thou-sands o years o empirical evidence romnatural ecosystems on the link betweenspecies diversity and system-wide robust-ness. In environmental ecosystems, diversityprevents disease spread and strengthens theimmune system.

Systemic diversityAnd in decision-making ecosystems, diver-sity o opinion makes, on average, or betterdecisions. All o this is reassuring at a time

when new committees on systemic risk arespringing up all over the world. In makinguture macroprudential decisions, diversityo the system should be given prominence

as a public policy objective not because itis politically correct, but because it is analyti-cally compelling.

Editors Note: The Journal o Regulation & Risk North Asia would like to extend itsgratitute to the Chairman o Central BankingPublications, Robert Pringle, and the Bank o

Englands Executive Director or FinancialStability, Andrew Haldane, or taking timeout rom busy schedules prior to the New

Year to participate in the Journals regularQ&A section.

We would also like to instruct readers othe Journal that this interview arranged bythe JRRNA rst appeared in the autumnedition o Central Banking and has beenmodied slightly or the purposes o thispublication.


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Debate

Remove excess credit if youwish to mitigate against crisis

Adair Turner, Chairman o the UKsFinancial Services Authority, weighs up a

myriad o problems associated with banking.

In this sectio o the Joural, we cover

ogoig debate ad dialogues co-

cerig major issues o the day. I this,

the frst part o our debate sectio, the

Joural publishes a abridged versio

o a speech delivered by the head o the

UKs FSA i the autum o 2010 which

drew cosiderable criticism rom Pro.

Laurece Kotliko, author o the criti-cally acclaimed book: Jimmy Stewartis Dead Ending the Worlds FinancialPlague with Limited Purpose Banking.

What do banks do: Why do credit booms andbusts occur and what can public policy doabout it? In this paper, we attempt to answer

this vexed question as the global economybegins returning to some semblance o nor-mality ollowing the 2007/8 fnancial crisis atumultuous series o events that precipitatedthe largest downturn in global GDP sincethe Great Depression o the early 1930s.

Finance plays a crucial role within a mar-ket economy, but that role has continuallyevolved during the 200-year history o mod-ern economics. And one striking thing aboutthe past 40 years, which clearly distinguishes

the period 1970 to 2010 rom the mid-20thcentury, is that the complexity o fnance andits scale relative to the real economy has dra-matically increased. Debt to GDP ratios haveincreased dramatically in the household andcorporate sectors, but even more so withinthe fnancial sector.

Increased complexityThe value o trading activities whetherin oreign exchange or debt, or equities, orcommodities, has increased hugely relativeto related real economy variables. And thecomplexity o the wholesale fnancial mar-kets has greatly increased, with the emer-gence o interest rate and credit derivatives,

and structured credit products, which didnot even exist 30 years ago.

Ater a mid-20th century o relativefnancial repression a reduction in the rel-ative role in fnance we have seen fnan-cial deepening and increased complexity.

And the predominant pre-crisis conven-tional wisdom was that this deepening andincreased complexity had been benefcial,increasing both allocative efciency andsystem stability.


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Financial deepening and liberalisationwere seen as an integral part o the packageo structural reorm which would deliverimproved economic perormance. But these

confdent assertions are not clearly sup-ported by the acts.

It is not clear that fnancial deepeningbeyond that already achieved in the devel-oped world 30 years ago has signifcantlyincreased allocative efciency and growth.Looking at the highest level, at overall cor-relations o fnancial intensity and GDP

growth, there is no clear relationship.The period o relative fnancial repres-sion rom 1935 through to 1970 deliveredgrowth almost as substantial as the subse-quent 40 years o fnancial deepening andliberalisation. It may be true that specifcelements o increased fnancial intensityand sophistication in certain circumstancesdeliver increased allocative efciency.

However, that must o necessity be illus-trated at the specifc level; it is not proved byhigh-level correlations.

Financial dustbowl As or the claims o increased stability clearly they have turned to dust in the fnan-cial crisis o 2007/8. And in the wake o that

crisis, it is easy to identiy numerous specifceatures o the new fnancial system whichcreated greater risk, such as: Overly complex structured credit

products, with deeply embeddedoptions which many investors did notproperly understand;

Bonus structures which created incen-tives or excessive risk-taking;

Conictsofinterestandpoorpracticesincredit rating agencies;

Over-reliance on apparently sophisti-cated mathematical models to measureand manage risk;

Poor corporate governance and risk

management processes; And theexplosion of uncleared coun-

terparty exposures, which created a catscradle o non-transparent relationshipsbetween multiple fnancial institutions.

Fundamental questionsFixing these and other obvious defciencies

in our fnancial system must orm an impor-tant part o the new regulatory agenda. Butfxing these problems will not be a sufcientresponse. And we will not design a sufcientresponse unless we ask relatively undamen-tal questions about what a fnancial systemdoes and what it should do, and about whyfnancial markets and institutions, in particu-lar banks, are so vulnerable to instability.

And what that undamental analysisshows is that the roots o instability lie not,or not just, in specifc aulty eatures o thecurrent system in bad incentives, poor riskmanagement, over-complex products orover-reliance on ratings but in too muchcredit, too easily available at too low a price,

with the undamental problem being that

bank lending, fnancial markets and prop-erty markets interact in ways which drivedestabilising credit and asset-price cycles.

Careul managementOur regulatory response will not there-ore be eective unless: in the long run itreduces leverage in the fnancial system andconstrains it in the real economy; and, putsin place new policy tools to take away thepunchbowl o excessive credit and property


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price inationbefore thepartygets outofhand. The transition to that sounder systemneeds to be managed with care too rapida progress to higher capital and liquid-

ity standards could slow recovery but weneed to be clear that long-term reorm o thefnancial system will have at its core changesthat mean that credit is not as easily availableas in the pre-crisis years.

Financial systems and markets in aggre-gate perorm our unctions. They providepayment services; they provide insurance

services; they create markets in immediateand short-term utures contracts, such as inoreign exchange or commodities; and theyintermediate between providers o undsand users o unds, savers and borrowers,and as a result play a crucial role in the allo-cation o capital within an economy.

Greatest risks

There are risks involved in all o these unc-tions. But it is primarily in the ourth unc-tion, and sometimes in the third unction,that the greatest risks to fnancial stabilityarise and thereore deserve greater attention.The fnancial intermediation unction linksproviders o unds to users o unds.

Sometimes the link is a matched one

with, or instance, a householder directlybuying the equity or bond o a business ora government so that the asset the undprovider owns looks exactly the same asthe liability the und user owes. And thefnancial system helps lubricate that pro-cess through market-making, and throughresearch and distribution.

But the really crucial intermedia-tion activities, and those which introducethe greatest risk, are those which create

unmatched assets and liabilities, so that theprovider o unds can hold an asset whichlooks dierent in risk, return and maturityrom the liability the und users owes.

Four unctionsThis is achieved by our transorma-tion unctions: Pooling which enables ahouseholder, or instance, to hold an indi-rect claim on many dierent SME loans,rather than be exposed to a specifc riskySME; Maturity transormation, which

can be delivered in two dierent ways: contractually on bank balance sheet, withhouseholders holding on-demand depos-its but borrowing 20-year mortgages; or

via liquid traded markets, with individualsable to hold equities or a day, even thoughthe und user enjoys perpetual equityfnance. And fnally risk/return tranching,

with moderately risky bank loans unded

with a mix o very low-risk deposits andhigh-risk bank equity.

Inherent vulnerabilityThe remainder o this article explores the

value added which these transormationsdeliver and the risks they create. It identifesfve interacting actors which help explain

why banking crises occur and cause harm,and why the latest was so severe:

First, the act that all fnancial marketsare inherently vulnerable to divergencerom equilibrium values and that as aresult increased fnancial trading activitycreates increased risks, even i it deliverssome benefts.

Second, that credit contracts introduce very specifc vulnerabilities in our econo-mies, and that the greater the role o credit


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contracts, i.e. the greater the level o leveragein the real economy and in the fnancial sys-tem itsel, the more vulnerable the system isto shocks and sel-reinorcing cycles.

Third, that ractional reserve banksintroduce specifc vulnerabilities into theeconomy because o their specifc ability tocreate credit and money and because o theirmaturity transormation unction.

Fourth, that dierent types o creditsperorm quite dierent unctions withinthe economy, with credit extended to

fnance existing assets, in particular tofnance property, quite dierent in naturerom credit extended to fnance new invest-ments, and peculiarly susceptible to volatilesupply and pricing.

Fith, that the growth o securitised credit, while theoretically having the potential todisperse and reduce risks, in act interacted

with the specifc risk characteristics o banks

to make the whole system less stable.

Crucial interactionsThe essence o why the fnancial systemproved so unstable, and why the latestfnancial crisis was so great, lies thereore, Iargue, in the interaction between the specifccharacteristics o credit contracts, o banks,

o real estate fnance, and o liquid tradedmarkets. The regulatory reorm agenda mustthereore address these interactions. At itscore should be two elements: much highercapital and liquidity requirements across thebanking system and, in particular, or largesystemically important banks, addressingthe Too Big to Fail (TBTF) conundrum butnot believing that fxing TBTF is sufcient initsel to make the system more stable; andthe development o macro-prudential policy

tools, which lean against the wind o exces-sive credit creation and o asset-price cycles.

It is now necessary to look at what arethe key arguments o each o the fve points

raised thus ar and then explore policy impli-cations associated with these points.

Key driverWe begin with the premise that liquid fnan-cial markets are inherently vulnerable toinstability.Onekeydriverofpotentialinsta-bility is that fnancial markets are inherently

susceptible to momentum and herd eects;to over-shoots; to sel-reinorcing irrationalexuberance, and then irrational despair.Charles Mackays classic work on the

Madness o Crowds,CharlesKindlebergersonManias, Panics and Crashes have docu-mented that inherent susceptibility, rom theDutch tulip mania o 1635-37 to the WallStreet boom o the 1920s. And we have an

increasingly rich theoretical understandingo why these overshoots occur.

The behavioural economics o DanielKahnemanandothersprovideexplanationsrom psychology and evolutionary biology,

with people acting in instinctive or emo-tional ways which, even at the individuallevel, might reasonably be described as irra-

tional, with animal spirits sometimes a keydriver o market dynamics.

Irrational boomBut theories o imperect principal/agentrelationships and decision-making underconditions o imperect inormation andinherent irreducible uncertainty, also explainhow even the most rational o people mightparticipate in a collectively irrational boom,calculating that they will be among those


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clever enough to get out just in time amatter Paul Woolley touched upon recently

when detailing principal/agent relationshipsand their implications.

But while all liquid fnancial marketsare susceptible to unstable divergence romequilibrium values, it is clear that somebooms and busts matter more than others,and that, in particular, booms and busts incredit pricing and credit supply are ar moreimportant than those in specifc commodi-ties or in equities. The internet boom and

bust o 1998-2001 was large enough to moveequity indexes in a dramatic ashion and tocreate wealth gains and losses which weresignifcant relative to US GDP, but the busthad only a slight impact on US or globalgrowth. The all o corporate bond spreads toa low point in spring 2007 ollowed by hugerisesin2007-09,bycontrast,reectedacreditboom and bust which tipped the whole

developed world into severe recession.

Volatility the culpritAnd throughout modern economic history,in the 19th century banking crises and in themany banking collapses o the 1930s, andin the numerous crises o the past 30 years,it was volatility in credit supply within the

economy, surges and sudden stops o credit whether to governments, to other banks, orto the non-bank private sector, which havehad a peculiar ability to cause real economicharm. A banking crisis, as the IMF notes, isar more likely than other fnancial crises tocause severe recessions.

Turning our attention to the second oour raised points, that is, credit contractsintroduce specifc vulnerabilities. The expla-nation or the greater impact o credit-related

crises lies in the specifc character o creditcontracts. Four eatures are important: speci-fcity o tenor, specifcity o nominal value,the irreversibility and rigidities o deault and

bankruptcy, and the credit/asset price cycle.

Continuous credit supplyWe shall come back to the credit/asset pricecycle later in this paper; or now, a brie com-ment on the frst three eatures:

Specicity o tenor: The act that a debtcontract has to be repaid at a particular

date, and that at any time there are largedebt repayments due next month or next year, means that a continual supply onew credit is essential to the working othe economy in a way which is not true oequity fnance. Equity prices can collapse,and frms may be unable to raise newequity, but they are not also required torepay existing equity; and economies could

operate or sustained periods o time withno new primary equity issues: they cannotoperate without new lending to refnanceold.Creditisdifferentbecauseifthenan-cial machine suddenly stops lending, theeconomy can go into reverse.

Deation hazard

Specicity o nominal value: Debt contractsin nominal value money terms is an equallyimportant eature, harmless as long as gen-eralisedinationismaintainedatarelativelystable and predictable level, but potentiallydestructiveinthefaceofunanticipatedina-tionordeation.

Unanticipatedinationandhyper-ina-tion can destroy fnancial wealth and socialcohesion, but it isunanticipated deation,such as that o 1930-33 in the US, which has


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arguably even greater capacity to wreak realeconomic harm through its impact on thereal value o debt, via the mechanisms whichIrving Fisher set out in his classic article on

Debt Defation.

Direct contradictions Irreversibility and rigidities o deault andbankruptcy: which generate economiccostsevenintheabsenceofdebt-deationor fnancial crisis, but which i combinedwitheitherdebt-deationorbankingcrisis

(banks as well as corporates going bankrupt)can have an enormously destructive eect.As Ben Bernanke points out in one o

his Essays on the Great Depression, theexistence o debt deault and bankruptcyare direct contradictions o any theory osmoothly adjusting economic relationships.In a complete markets world, bankruptcy

would never be observed, Bernanke notes

because complete state contingent loanagreements would uniquely defne eachpartys obligations in all possible circum-stances. As frms approach deault, eco-nomic rationality and perect inormation

would dictate a smoothly operating write-down o debt claims or translation o debtclaims to equity claims.

Destructive credit crunchesThe act that instead we have large legaland administrative costs, and fre sales oassets, illustrates how ar rom the Arrow-Debreu nirvana o complete markets ourreal world economy actually is, and it makescredit crunches hugely disruptive. Fractionalreserve banks introduce urther specifcrisks, but it is not just credit which is dier-ent: bank credit is even more specifc. The

characteristics o credit mentioned earlier specifcity o tenor and nominal value,the rigidities and irreversibilities o deaultand bankruptcy, and the potential or credit

driven asset price cycles apply to non-bankcredit securities as well as to bank intermedi-ated credit and indeed one crucial issue to

which we return later is whether a non-banksystem o credit extension introduces somespecifc drivers o instability which are notpresent to the same extent in a bank-basedcredit system. But it is certainly the converse

case that bank credit intermediation intro-duces specifc risks not present in the non-bank case.

Dierent combinationsEssentially, what leveraged ractional reservebanks do is to increase the range o poten-tial contracts available to both users andsuppliers o unds, by making it possible

or suppliers to hold assets with dierentcombinations o risk, return and maturityrom those which users o unds ace in theirliabilities: they maturity transorm enablingproviders o unds to hold deposits o muchshorter tenor than the maturity o the loansadvanced to users o unds; and they trancheby risk and return so that moderately risky

loan assets are unded with a mix o close tozero risk deposits, moderately risky seniordebt, and high risk equity.

Those transormation unctions appearto deliver signifcant economic benefts, atleast at some stages o economic develop-ment. Economic historians o 19th centuryBritain have oten argued that Britainsmore developed banking system was oneo the actors driving superior economicperormance, acilitating the mobilisation o


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savings which would have been more di-fcult i savers had been linked to users ounds through untransormed contracts, in

which the risk, return and maturity o the

issuers liabilities had to match precisely theaggregate risk, return and maturity o thesavers assets.

Borrowable moneyWalter Bagehot certainly believed so, argu-ing in Lombard Street that Britain enjoyedan economic advantage over France

becausetheUKsmoreadvancedbankingsystem ostered the productive investmento savings rather than leaving them dor-mant. Much more cash he wrote, existsout o banks in France and Germany andin the non-banking countries than can beound in England or Scotland, where bank-ing is developed. But this money is not . .. attainable . . . the English money is bor-

rowable money.But these benefts o leveraged and rac-

tional reserve banks also bring with themvery signifcant risks. Banks acilitate greaterleverage in the real economy and they areleveraged themselves, increasing the dan-gers that arise rom the specifc characteris-tics o credit rather than equity contracts.

Risky institutionsAnd they introduce maturity transormationrisks, and related confdence and contagionrisks, rooted in the simple act that bankscreate a set o contractual liabilities whichlegally have a right to simultaneous execu-tion, but which banks could never simulta-neously honour, given the contractual tenoro their assets. Banks are thereore inherentlyrisky institutions, which can only be made

sae through the combined eect o capitaland liquidity regulation and central bankliquidity insurance. Finally, banks have a par-ticular ability to drive credit and asset price

cycles the ourth specifc eature o creditinstruments to which I will now turn withina consideration o the dierent economicunctions o dierent credit categories.

Turning our attention to the ourthpoint I raised previously, this being di-erent categories o credit deliver dierentvalueandcreate different risks.Over the

past 40 years, household and corporatesectorsterlingdenominateddebtintheUKhas grown rom about 22 per cent to 125per cent o GDP.

Sel-reinorcingThe vast majority o this debt has been lent bybanks, and has been largely matched, thoughnot entirely, by the growth o bank deposits,

with bank credit and bank money created ina sel-reinorcing ashion. Banks have thusdelivered more leverage to the real economy.But with two thirds o the loan assets long-term mortgages, and with deposits primarilyshort term, they have also delivered muchmore maturity transormation.

Both increased leverage and increased

maturity transormation create risks orthe economy, but can also deliver benefts.The challenge or prudential regulation isto preserve the benefts while constrainingrisks to an acceptable level. In many debatesabout credit extension, and about the impacto new prudential regulations which mayrestrict it, it is assumed that credit contractsprimarily perorm the unction o linkingsavers with businesses investing in produc-tive assets.


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More credit supply and cheaper creditsupply is assumed to be good or businessinvestment, enabling more investment pro-jectstoexceedthecostofcapital.Capitaland

liquidity regulations, which restrict creditsupply or increase its price, are thereoreoten assumed to produce harmul eects ongrowth through their impact on investment.

Household depositsIt is certainly essential in our assessment ocapital and liquidity rules that we consider

such possible eects and balance any suchadverse impacts, whether in the long term orover the transition period, against the bene-fts o reduced instability, which higher capi-tal and liquidity requirements would deliver.

But it is also important to understandthat only a minority o credit extension intheUK and other rich developed econo-mies now perorms this economic unction.

Whereas in 1964 a mental model in whichtheUKbankstookhouseholddepositsandlent them on to business captured much othe reality, over the past 40 years, loans to thehousehold sector, and in particular residen-tial mortgages, have become dominant.

Socially useul

This intermediation rom household depos-its to household mortgages is socially useul,but its social value is only to a limited extentrelated to new physical investment in thehousing stock, instead primarily delivering

value to the extent that it enables more eec-tive lie-cycle consumption smoothing andinter-generational resource transer.

Loans to the corporate sector, mean-while, are increasingly dominated by loansto fnance commercial real estate. These

loans, only to a limited extent, fnance newproductive investment: rather they are pri-marily used to fnance the tax advantagedpurchase o already existing assets in the

expectation o uture capital gain.Policies to ensure fnancial stability there-

ore need to recognise the central impor-tance o real-estate fnance in the bankingand wider credit markets of the UK andmany other developed countries, and the

way in which credit supply and asset pricescan become linked in sel-reinorcing cycles

o the sort described by Hyman Minsky.These credit and asset price cycles are inher-ent potential risks in any system o ractionalreserve banks, and are the key drivers ofnancial and economic instability whichprudential regulation needs to address.

Interest rate elasticityIt is thereore essential that our assessment

o the impact o prudential regulation recog-nises the very dierent economic unctionso dierent categories o credit. It also needsto recognise that the interest rate elastic-ity o dierent categories o credit is likelyto be highly variable, particularly in boomtimes. The interest rate increase required toslow down a commercial real estate boom,

uelled by expectations o uture capitalgain, may be so high that it causes severeharmtotheowofcredittonancenewproductive investment.

The appropriate policy response maythereore need to include quantitative levers

which directly address credit supply, andtheir variation by sector o the economy.

Andrew Smithers and Andrew Large con-sider the options or such macro-prudentialtools in their contribution to this book.


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Turning to my fth and fnal point,namely, that securitisation was supposedto reduce the risks, but instead created newones. In the confdent pre-crisis conven-

tional wisdom, securitised and structuredcredit and related credit derivatives werelauded as a new fnancial technology, which

was both increasing allocative efciency andreducing risks.

Inherent dangerBut while in theory securitised credit could

have achieved risk reduction, its particularimplementation undermined that potentialand it simultaneously created a new anddangerous source o instability.

Simple credit securities governmentor single name corporate bonds haveexisted or almost as long as bank loans,and continue to play a major role in thecredit extension system, linking investors

to users o unds in matched, non-trans-ormed, credit relationships. But rom the1970s pooling was used to create creditsecurities out o multiple small credits, andtranching was used to create securities tai-lored to the risk return preerences o di-erent investor groups.

Array o beneftsEssentially, securitisation achieves the samerisk tranching unction perormed by abank balance sheet, but without overt bal-ance sheet based maturity transormation.By the early 21st century securitised credithad grown to account or over 50 per cento all US home mortgages, 25 per cent oUS commercial mortgages and consumercredit, and in theUKover 20 percent ofhome mortgages.

It seemed to deliver an array o benefts.It enabled investors to select assets moreprecisely tailored to their own specifc riskreturn preerences. Thereore, it was argued,

it acilitated increased credit extension per-haps a true but also an ambivalent beneftto which I will return later. And it enabledbanks to better diversiy risk: originatingloans but then distributing some o themto end investors, so that banks no longerneeded to hold portolios determined bytheir own specifc regional or client base. As

a result, it was believed, securitisation madepossible a more stable fnancial system.

Undelivered beneftsAnd in theory it should have been more sta-ble, because it appeared to remove rom thecredit extension system the particular riskyeatures which come with bank balancesheets. It should result in assets being held by

end investors rather than by leveraged bankintermediaries. And it should remove thecontractual maturity transormation o bankbalance sheets, substituting instead liquid-ity through marketability. Part o what went

wrong, however, was that neither o thesesupposed benefts was actually delivered.

When the music stopped in 2008, a large

share o credit securities turned out to beheld on the trading books o banks banks

which had originated and distributed credit with one hand, then bought back otherbanks credit securities with the other hand,encouraged to so by utterly inadequatecapital requirements against trading assets.

And shadow bank maturity transorma-tion SIVs and conduits and mutual undsholding long-term assets against short-termliabilities and relying on market liquidity to


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allow sales to meet redemptions turnedout to be quite as risky as the contractual onbalance sheet variety.

These specifc aults in the system

can be addressed by better regulation though as a result, much o the demandor securitised credit instruments maynever return, the aults being essential totheir apparent attractions.

Exuberance, despairBut the wider development o securitised

credit and credit derivatives also created anew category o risk a risk which takes usback to the frst o my fve points, that all liq-uid fnancial markets are vulnerable to herdand momentum eects, to surges o collec-tive irrational exuberance and then despair.

At the core o these eects are sel-reer-ential rather than undamental assessmentsofriskandpriceequitypricinginKeynes

words being like a pick the prettiest acecompetition in which we devote our intel-ligence to anticipating what average opinionxpects the average opinion to be.

As trading o securitised credit and creditderivatives grew in importance, it becameeasier or such sel-reerential approaches tobe applied to credit markets with not only

non-bank credit investors, but also banksthemselves using the price o credit to inerrisk, rather than using undamental riskassessment to determine the appropriateprice o credit.

Enhanced transparency A trend which the conventional wisdomo efcient market theory not only noted,but positively welcomed, the IMF GlobalFinancial Stability Review o April 2006

noting with approval that credit derivativesenhance the transparency o the marketscollective view o credit . . . [and thus] . . . pro-

vide valuable inormation about broad credit

conditions and increasingly set the marginalprice o credit.

But setting the marginal price o creditby reerence to the markets collective viewo credit risk is allocatively efcient and riskreducing only i the markets collective viewofriskissound.Ifinstead,CDSspreadsforthe major banks ell dramatically, as they did

rom 2002 to reach a historical low in spring2007, just beore the fnancial crisis broke,and providing no early warning whatsoevero the increased risks, then the greater useo market credit prices to inorm risk assess-ment can accentuate still urther the risksinherent in credit contracts and ractionalreserve banks.

Accentuated risksThe development o securitised credit withtransparent and potentially sel-reerentialprices, and combined with mark-to-marketaccounting, as a result played a role in accen-tuating the risks o credit and asset pricecycles always present in systems o bankcredit extension.

Overall, therefore, the explanationo why the latest fnancial crisis was sosevere seems likely to lie in the interactionbetween dierent sources o instability.Excessive bank lending to fnance assets

which increase in value as a result o thecredit extended, had caused multiple pastcrises long beore securitised credit andcredit derivatives had been created.

And liquid fnancial markets are inher-ently vulnerable to momentum and herd


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eects which drive divergence rom equilib-rium values, but booms and busts in equityprices are not always hugely harmul at themacro level.

Classic cycleWhat was especially toxic about the fnancialsystem in the run-up to the crisis, however,

was the intensity o interaction betweenmaturity transorming banks, real estatemarkets, new and complex orms o creditextension and non-bank maturity trans-

ormation, and liquid fnancial markets in which credit risk assessment and pricingbecame sel-reerential. This interactiondrove an extreme version o the classic creditand asset price cycle, more complex andmore global in reach.

I began this article by reerring to someobvious things that went wrong withfnance beore the crisis and some obvious

and very important things we need to putright. Large bank bonuses or selling over-complex and risky products o little real useto humanity were a major problem, and weneed remuneration practices and regulations

which make excessive risk taking less likelyin uture.

Fundamental issuesWhilst it is right to ocus regulatory reormon the key issues Ive thus ar raised, thereorm process also needs to address moreundamental issues. I we only addressbanker bonuses and not the undamentaldrivers o credit supply instability, we willnot adequately reduce the probability o arepeat perormance.

The central issue is the availability ocredit, and in particular the pro-cyclical

orces which drive credit and asset pricebooms and busts. The importance o credit

was indeed recognised as a central issueby the cheerleaders o fnancial liberalisa-

tion and deepening, but with the simplis-tic assumption that more credit was, bydefnition, good.

Thus as mentioned earlier, one o thearguments or securitisation and creditderivatives was that they acilitated creditextension. And in the debates about theBasel II capital regime, one o the overt aims

o the reormers was to introduce advancedrisk assessment techniques which wouldallow banks to operate with less capital thanbeore, thus making possible higher bankand real economy leverage.

Rising inequalityThe rapid growth o credit in the pre-crisis

years, particularly in the United States,

was not thereore an accidental by-prod-uct o fnancial liberalisation, but a delib-erate aim. And as Raghuram Rajan pointsout in his recently published book, FaultLines, rapid credit growth served a useulpolitical purpose, enabling low-income

Americans to maintain consumption evenwhen real incomes stagnated in the ace

o rising inequality.But much o this credit turned out to be

unsustainable: the resulting high levels oleverage produced increased the vulnerabil-ity o the economy to shocks; and its rapidgrowth linked to property prices, ollowedby inevitable bust, was the major driver oinstability. Regulatory reorm cannot there-ore avoid questions relating to the optimallevel o credit within an economy and tothe management o credit growth linked to


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asset prices. In assessing proposals or radi-cal structural reorm o the fnancial system,

we thereore need to ocus on whether suchproposals address the undamental drivers

o volatile credit supply and pricing.

Ex-ante expectationsFour specifc structural options merit con-sideration. The frst o these is fxing TooBig to Fail:

TheToo Big to Fail agenda is undoubtedlyimportant and a key ocus or the Financial

Stability Boards Standing Committee onSupervisory and Regulatory Cooperation.It is not acceptable that taxpayers have tobail out large ailing banks, and the ex-anteexpectation that they will undermines mar-ket discipline.

A range o policy responses are possible;these include capital surcharges, impairedresolution processes, and changes in legal

structure increased use o separate subsidi-aries. It is important to understand, however,that in the latest crisis, as in previous ones,direct taxpayer costs o bank rescue are likelyto account or only a very small proportion othe total economic costs.

Too liberal, too low

IMF estimates suggest they are unlikelyto exceed two to three per cent o GDP inthe developed economies most aected bythe crisis, and they may turn out signif-cantly less once bank equity stakes are sold.But public debt burdens in the developedeconomies are likely, as a result o this crisis,to increase by something like 50 per cento GDP. These much larger costs deriverom our essential problem, rom volatilityin credit supply, frst extended too liberally

and at too low prices especially to realestate and construction sectors and thenrestricted. This has two implications:

The frst is that when we say that in uture

all banks, however big, must be allowed toail, the objective should not be to put theminto insolvency and wind-up, since that willproduce a sudden contraction o lending, butinstead to ensure that we can impose losseson subordinated debt holders and seniorcreditors sufcient to ensure that the bankcan maintain operations, under new man-

agement, without taxpayer support.The second is that the multiple ailureo small banks could be as harmul to thereal economy as the ailure o one largebank, even i all such banks ailed at no taxpayer cost, and even i the market knewex-ante that no tax payer support wouldbe orthcoming.

Insufcient responseThe American banking crisis o 1930-33 wasprimarily a crisis o multiple relatively smallbanks. Fixing Too Big to Fail is thereore anecessary but not a sufcient response.

Separating commercial rom invest-ment banking: Limiting the involvement ocommercial lending banks in risky propri-

etary trading is also undoubtedly desirable.Losses incurred in trading activities can gen-erate confdence collapses, which constraincredit supply and in extremis necessitatepublic rescue.

The interaction between trading activ-ity and classic investment banking played acrucial role in the origins o the latest crisis:indeed, the thesis o this chapter is that it wasprecisely the interaction o maturity trans-orming banks and o sel-reerential credit


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securities markets, which drove the peculiarseverity o this latest crisis. But legislatedseparation o commercial and investmentbanking will not prove a straightorward or

sufcient solution or three reasons:First, because in a world where securi-

tised credit is likely to continue to play a sig-nifcant role, drawing a legislative distinctionbetween proprietary trading and customeracilitation is close to impossible.

Key lever

For that reason indeed the Volcker ruleclauses o the US legislation make the dis-tinction in principle, but leave it to regulatorstoapplyitinpractice.Oneofourkeyleversin doing that will be appropriate capitalrequirements or trading activity, to preventbanks holding credit securities in tradingbooks with the inadequate capital supportallowed beore the crisis.

Second, because while large integratedcommercial and investment banks (such asCiti,RBSandUBS)playedamajorroleinthecrisis, so too did large or mid-sized commer-cialbanks(suchasHBOS,NorthernRock,and IndyMac) which were not extensivelyinvolved in the proprietary trading activities

which a Volcker Rule would constrain.

Sel-reerential cycle And third, that even i proprietary tradingo credit securities was largely conductedby institutions separate rom commercialbanks, important and potentially destabi-lising interactions could still exist betweenmaturity transorming banks and creditsecurities trading.

A credit supply and real estate priceboom,aswitnessedbothintheUSandUK

in the beginning o this century, could bedriven by the combination o commercialbanks originating and distributing credit andnon-banks buying and trading it, the two

together generating a sel-reerential cycle ooptimistic credit assessment and loan pric-ing, even i the unctions were perormed byseparate institutions.

Volcker Rules are in principle desirable,and there may well be merit in writing theprinciple into legislation, but are not a su-fcient response. What about separating

deposit taking rom commercial banking, anideafavouredbyProf.JohnKayinnumer-ous economic papers and theFinancial Times .

Gilts backingThis is quite dierent rom Paul Volckers.Rather than splitting commercial rominvestment banking, it would separateinsured deposit-taking rom lending. All

insured retail deposits would be backed 100per cent by government gilts, while lendingbanks would be unded by uninsured retailor commercial deposits or by wholesaleunds, and would compete in a ree, unregu-latedandunsupervisedmarket.AsProf.Kay

well knows, I disagree with his argumentthat this would create a more stable system.

The underlying assumption is that theexisting system is unstable only becauseexplicit deposit insurance and implicit prom-ises o uture rescue undermine the marketdiscipline which would otherwise produceefcient and stable results. I instead webelieve that fnancial markets, maturitytransorming banks, and credit extensionagainst assets which can increase in value, areinherently susceptible to instabilities whichcannot be overcome by identiying and


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removing some specifc market imperec-tion,thenProf.Kaysproposalfailstoaddressthe undamental issues. It would create saeretail deposit banks which would never need

to be rescued, but it could leave credit supplyand pricing as volatile, pro-cyclical and sel-reerential as it was pre-crisis.

Abolishing banks 100 per cent equitysupport or loans: Professor Kotlikoffsproposal, in contrast, suggests a truly radi-cal reorm o the institutional structure orcredit extension. Lending banks would

become mutual loan unds, with investorssharing month-by-month (or even day-by-day) in the economic perormance o theunderlying loans.

Pooling, not tranchingThis is equivalent to making banks 100 percent equity unded, perorming a poolingbut not a tranching unction. And it would

clearly exclude the possibility o publiclyunded rescue: i the price o loan undassets ell, the investors would immediatelysuer the loss. But it is not clear that such amodel would generate a more stable creditsupply. As stated previously, a system osecuritised credit combined with mark-to-market accounting can generate sel-reer-

ential cycles o over- and under-confdence.

Pro-cyclicalityAndwhileKotlikoffsloanfundsmightseemto abolish the maturity transorming bank,

with investors enjoying short-term accessbut not capital certainty, investors would belikely in the upswing to consider their invest-ments as sae as bank deposits. Investmentsin loan unds would thereore be likelyto grow in a pro-cyclical ashion when

valuations were on an upswing and then torun when valuations and confdence ell,creating credit booms and busts potentiallyas severe as in past bank-based crises.

Essential challengeThe essential challenge indeed is that thetranching and maturity transormationunctions which banks perorm do delivereconomic beneft, and that i they are notdelivered by banks, customer demand orthese unctions will seek ulflment in other

orms. We need to fnd saer ways o meet-ing these demands, and to constrain the sat-isaction o this demand to sae levels, but wecannot abolish these demands entirely.

There is thereore a danger that i radi-calism is defned exclusively in structuralterms small banks, narrow banks, or thereplacement o banks with mutual loanunds that we will ail to be truly radical in

our analysis o the fnancial system and tounderstand how deep-rooted are the driv-ers o fnancial instability.

Thrusts o reormThe core drivers o instability lie in thecredit asset price cycle and in the interactionbetween banks, credit securities markets and

real estate markets. There are two thrusts oregulatory reorm which could address this.

The frst, much higher bank capital andliquidity requirements, will create a moreresilient banking system less likely to suercrisis and bank ailure. But these changes

will also, by constraining but not eliminatingthe extent to which the banking system canperorm its tranching and maturity transor-mation unctions, constrain total leverage inthe real economy and thereby reduce the


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vulnerability which derives rom the rigidi-ties o credit contracts.

And by reducing the likelihood o bankailure, they will reduce the danger that con-

fdence collapse leads to sudden constraintson credit supply. Even i not varied throughthe cycle, higher bank capital and liquidityrequirements will thereore tend to reducethe procyclicality inherent in banking sys-tems and credit markets.

The crucial question is, thereore, are howmuch higher these requirements should

be and how we transition rom todays lessdemanding level.

Lower leveragingTo think straight, we need to consider thesetwo questions separately; it is quite possiblethat an economy signifcantly less leveragedthan today would be optimal, but also thattransition rom high leverage to low lever-

age will have a depressive eect on short tomedium term growth.

Onthelong-termissue,onestrikingfactisthat in the past we have had banking systems

which operated with ar higher levels o capi-tal and liquidity than today, but were still ableto serve the fnancial needs o growing econ-omies. And macroeconomic analysis con-

ducted to inorm global regulatory decisions,suggests that lower levels o bank and realeconomy leverage have no necessary impacton long-term steady state growth rates.

Factually out o lineThis should not surprise us, given that themental model in which all credit is essen-tial to drive investment and growth is, as Isuggested earlier, out o line with the acts.But the act that much credit does not drive

investment and economic growth does notmean that it has no value; the unctionso lie-cycle consumption smoothing andintergenerational resources transer, which I

identifed earlier as the primary unctions othe credit system, are socially valuable.

Striking a balanceSociety thereore aces a trade-o. We canmake the fnance system more stable viasignifcantly higher capital and liquidityrequirements without hitting long-term

growth but at the expense o less easy accessto credit. We need to strike a balance, hon-estly recognising that the benefts o fnan-cial stability have a cost in terms o customerchoice. In light o the severe economic harmcaused by the fnancial crisis, a signifcantshit in the balance towards stability andresilience makes sense.

But we also need to manage the tran-

sition with care, and the FSA and globalauthorities are thereore also using eco-nomic modelling to consider careully howincreases in capital and liquidity standards

will impact short and medium-term growth.

Transitional costThe analysis suggests that, with appropriate

o-setting, monetary policy and long imple-mentation periods, the cost o transition canbe small. But it cannot be nil: de-leveragingis difcult to achieve without some growthpenalty, even i the increase in leverage deliv-ered no permanent growth improvement astrong argument or designing a uture sys-tem less likely to create excessive leverage inthe frst place.

Higher capital and liquidity stand-ards, applicable throughout the cycle, will


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themselves create a fnancial system lessvulnerable to shocks.

But we cannot remove the dangers obank ailure entirely without moving to

a Larry Kotlikoff style abolition of banks, which as argued earlier, would still leaveimportant other risks in the fnancial sys-tem. Moreover, the risk tranching andmaturity transormation unctions whichbanks perorm do deliver value, even i thescale on which they perorm them needs tobe constrained.

VulnerabilityLevels o capital and liquidity requirement

which leave banks able to perorm theiruseul unctions will still thereore leave theeconomy vulnerable to destabilising up-swings in credit supply and asset prices,deriving rom the interaction betweenmaturity transorming banks, credit securi-

ties markets, and sel-reinorcing credit andasset price cycles.

In addition to higher capital andliquidity requirements, thereore, theregulatory response needs to involve thedeployment o counter cyclical macro-prudential tools, which directly addressaggregate credit supply.

Broad categoryThese could include automatic or discretion-ary variation o capital or liquidity require-ments across the cycle, or constraints, such asLTV limits, which directly address borrowersrather than lenders. Such policy levers maymoreover need to be varied by broad cat-egory o credit (e.g. distinguishing betweencommercial real estate and other corporatelending) given the very dierent elasticity o

response o dierent categories o credit toboth interest rate and regulatory levers.

Leaning against the wind

The details o what policy levers shouldbe available and how they should bedeployed have been written about exten-sively by Andrew Large and AndrewSmithers.And theUK is now commit-ted to creating a new Financial PolicyCommittee, chairedby theGovernor ofthe Bank o England, and drawing on

the analyses and insights o both centralbankers and prudential regulators, andresponsible or considering the overallevolution o credit supply, and or tak-ing appropriate action to lean against the

wind o excessive credit creation.This is a vital response to the previous

gap in our regulatory system, to the underlapwhich previously existed between a central

bank ocused on monetary policy alone, anda regulator ocused on micro rather thanmacro issues.

Credit supply constraintBut to be eective, the new body will needto be willing to take away the punchbowlo excessive credit when everybody else

property developers, householders, andthe government as recipient o the tax rev-enue generated is thoroughly enjoyingthe party.

Creating a safer nancial systemrequires not just action to prevent over-paid bankers rom selling overly complexfnancial products and, in doing so, tak-ing undue risks; it also requires constrain-ing a credit supply which, in the upswing,it seemed that we all rather enjoyed.

8/6/2019 Jour

journal of regulation & risk - north asia, volume iii, issue i

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