Wednesday, May 2, 2012

Sir Mervyn King's view of the financial crisis and subsequent reform

In his 2012 BBC Today Programme Lecture, the Bank of England's Mervyn King lays out his view of the financial crisis and the subsequent regulatory reforms.

Please forgive the length of the post, but it summarizes many important issues.
So tonight I want to try to answer three questions. First, what went wrong? Second, what are the lessons? Third, what needs to change?...

So what was the problem? In a nutshell, our banking and financial system overextended itself. That left it fragile and vulnerable to a sudden loss of confidence. 
The most obvious symptom was that banks were lending too much. Strikingly, most of that increase in lending wasn't to families or businesses, but to other parts of the financial system. 
To finance this, banks were borrowing large amounts themselves. And this was their Achilles' heel. By the end of 2006, some banks had borrowed as much as £50 for every pound provided by their own shareholders. So even a small piece of bad news about the value of its assets would wipe out much of a bank's capital, and leave depositors scurrying for the door. 
What made the situation worse was that the fortunes of banks had become closely tied together through transactions in complex and obscure financial instruments. So it was difficult to know which banks were safe and which weren't....
This is exactly the same conclusion that the US Financial Crisis Inquiry Commission reached.

Regular readers know that there is only one reform that addresses this problem:  requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

It is only with this data that market participants know which banks are safe and which banks are not.

It is only with this data that market participants know how the banks are linked together.

It is only with this data that market participants can assess the risk of each bank and end the threat of financial contagion by adjusting the amount of their exposure to what they can afford to lose given the risk of each bank.
So how did banks find themselves in such a precarious position? 
Banks are a vital part of our economy. They run the payment system, allowing us to pay our bills and receive our wages. They finance businesses investing in new ventures and families buying a new home. Without a banking system our economy would grind to a halt. 
Because of that, markets correctly believed that no government could let a bank fail since that would cause immense disruption to the economy....
In a modern banking system, bank failure only occurs when the regulators step in and shutdown the bank and not at the moment in time that a bank becomes insolvent (a bank is insolvent if the market value of its assets is less than the book value of its liabilities).

Between deposit guarantees and access to central bank funding, an insolvent bank can continue to operate for years.  This was demonstrated in the US following the Loans to Less Developed Countries crisis and the Savings and Loan crisis.
But there are only so many good loans and investments to be made. 
In order to expand, banks made increasingly risky investments.
Risky investments that were hidden by the opacity of current disclosure practices.  Compounding the opacity problem, the financial regulators, who had access to the data to see just how risky these investments were, told the market that risk had been moved out of the banking system.

The result of opacity and the failure of the regulators to properly convey the amount of risk in the banking system was that rather than exerting market discipline investors provided funding to the banks at prices that did not reflect the true risk of the banks.
To make matters worse, they started making huge bets with each other on whether loans that had already been made would be repaid. The seeds of the eventual downfall of the financial system had been sown. As loans and investments went bad, those seeds started to sprout. 
In August 2007 came the moment when financial markets began to realise that the emperor had no clothes. The announcement by the French bank BNP Paribas that it would suspend repayments from two of its investment funds triggered a loss of confidence and a freezing of some capital markets. 
Unlike Gary Gorton and Andrew Mettrick, Sir Mervyn King knows exactly when and what event triggered a loss of confidence and a run on the repo.

BNP Paribas announced that it could not value the opaque, toxic structured finance securities in its two funds.  At that moment, market participants began to look around for who else might be holding these securities.
A month later, the crisis claimed its first victim when Northern Rock failed. In the months that followed, there was a steady procession of banking failures culminating in the collapse of the American bank Lehman Brothers in September 2008. 
Financial waters, already extremely chilly, then froze solid. Banks found it almost impossible to finance themselves because no-one knew which banks were safe and which weren't.
Please re-read the highlighted point as it cannot be made frequently enough.  Without ultra transparency, there was and still is no way for market participants to know which banks are safe and which are not.
From the start of the crisis, central banks provided emergency loans but these amounted to little more than holding a sheet in front of the emperor to conceal the nakedness of the banks. 
They didn't solve the underlying problem - banks needed not loans but injections of shareholders' capital in order to be able to absorb losses from the risky investments they had made. 
From the beginning of 2008, we at the Bank of England began to argue that UK banks needed extra capital - a lot of extra capital, possibly £100 billion or more.
There are two models for handling a bank solvency led financial crisis.  Both of them involve central banks providing emergency loans.

There is the Japanese model that places the burden of the excess debt in the financial system on the real economy by protecting bank capital levels.  Losses that exist on and off the bank balance sheet are only recognized in the income statement as quickly as the bank can generate earnings above what is needed to pay banker bonuses and shareholder dividends.

Under this model, policies are pursued to hide the 'nakedness of the banks'.  These include suspension of mark-to-market accounting and regulatory forbearance.

There is also the Swedish model that protects the real economy by requiring banks to recognize their losses today.

The Bank of England championed adopting the Japanese model for handling a bank solvency led financial crisis.  First, it attempted to conceal the nakedness of the banks using emergency loans.  Second, it argued for protecting bank book capital levels and injecting public funds to do so.
It wasn't a popular message. But nine months later, market pressure forced banks to raise new capital or accept it from the state. UK tax payers ended up owning large portions of two of our four biggest banks, Royal Bank of Scotland and Lloyds TSB, but almost all banks would have failed had not taxpayer support been extended. 
Almost all banks, but in particular the largest, had failed as they were and, in the absence of ultra transparency to show otherwise, still are insolvent.
That bold action in October 2008 could have happened sooner. But the most important thing is that it was done. And the policy of recapitalising the banks was soon copied by other countries. 
Bailing out the banks was unnecessary.  With the modern financial system that exists in the EU, UK and US, these banks could have continued to operate and support the real economy as they were rebuilding their book capital levels.

The fact that other countries followed the UK lead does not make bailing out the banks and adopting the Japanese model the right decision.

In fact, Iceland choose the Swedish model and did not bailout its banks.  Its economy has rebounded.
Bailing out the banks came too late though to prevent the financial crisis from spilling over into the world economy.
Actually, bailing out the banks rather than having them absorb the losses on the excesses in the financial system forced the global economy to deal with these excesses.
The realisation of the true state of the banking system led to a collapse of confidence around the world and a deep global recession.
It was not the realization of the true state of the banking system that led to a collapse of confidence, but rather the realization that governments would do anything to protect bank book capital levels and not the real economy.
Over 25 million jobs disappeared worldwide. And unemployment in Britain rose by over a million. To many of you this will seem deeply unfair, and it is. I can understand why so many people are angry.
It's vital that we learn from the crisis. A good place to start is to ask, as the Queen famously did, "Why did no-one see this coming?"
As a reminder, it is a matter of public record that your humble blogger did see this coming.
The answer is extremely simple: no-one believed it could happen....
Actually, it was quite easy to believe it could happen considering all of the opacity that the regulators let build up in the global financial system.
But conquering inflation was not enough to ensure stability. Although inflation was under control, fragilities were building in the banking system. 
On all sides there was a failure of imagination to appreciate the scale of the fragilities and their potential consequences. No-one could quite bring themselves to believe that in our modern financial system the biggest banks in the world could fall over. But they did.
That isn't to say we were blind to what was going on.
Actually, in the absence of the requirement that banks provide ultra transparency, the Bank of England was blind to the true extent of what was going on.  As the Bank of England's Andrew Haldane observed, current disclosure practices leave banks resembling 'black boxes'.

The result of this opacity is that the Bank of England had no idea of how much risk was actually building up in the banking system.

For the record, the banking regulators should have had an idea.  However, like their counterparts in the US and elsewhere, they either did not see the risk or were incapable of communicating the risk to all market participants (the Nyberg Report on the Irish financial crisis discusses why regulators cannot be relied on to properly communicate risk to market participants extensively).
For several years, central banks, including the Bank of England, had warned that financial markets were underestimating risks....
However, without ultra transparency, the Bank of England could not quantify how badly market participants might be underestimating risk.

More importantly, without ultra transparency, market participants could not independently confirm the Bank of England's findings.
In the 1930s, the Great Depression saw a collapse of the banking system in the United States.  
So severe was it that President Franklin Roosevelt, only a week after his inauguration in March 1933, announced a bank holiday shutting the banks to provide a breathing space so that confidence could be restored. Here he is, in his first fireside chat, explaining banking to the American people: 
[AUDIO INSERT] "My friends I want to talk for a few minutes with the people of the United States about banking… We have had a bad banking situation. Some of our bankers have shown themselves either incompetent or dishonest in their handling of the people's funds. They had used some money entrusted to them in speculation and unwise loans. 
This was of course not true in the vast majority of our banks but it was true in enough of them to shock the people of the United States for a time into a sense of insecurity and to put them in a frame of mind where they did not differentiate but seemed to assume that an act of a comparative few had tainted them all. And so it became the government's job to straighten out this situation and to do it as quickly as possible and that job is being performed."...
As this blog discussed previously, FDR used this fireside chat to implicitly guarantee the deposits at all banks that the government allowed to reopen after the bank holiday.

Nobody knew if these banks were solvent or not.  What mattered is that the government guaranteed depositors they could get their money back.

Please notice what FDR's Administration did not do.  It did not bailout the banks.
Three reforms top my list. The first concerns regulation of banks. Next year, the responsibility for regulating banks will return to the Bank of England. 
Next time we find ourselves with steady growth and low inflation, but with risks building in the financial sector, we shall be able to do something about it. The Bank's new Financial Policy Committee will have the power to step in and prevent a hangover by taking away the punchbowl just as the party in the financial system is getting going. 
Prior to the financial crisis, in the US, the Fed was responsible for regulating the banks and monetary policy.  This did not result in the Fed removing the punchbowl just as the party was getting going.

In fact, the reshuffling of regulatory authority highlights the simple fact that regulators are a single point of weakness in the financial system.  Since they currently have a monopoly on all the useful, relevant information about the banks, other market participants are dependent on them to a) accurately assess this information and b) communicate this assessment.

If either does not occur, the result is financial instability at a minimum and, more likely, a financial crisis like the one we are experiencing.
We believe that successful regulation means understanding and guarding against the big risks, not compliance with ever more detailed rules. That means focussing on the wood not the trees, looking not just at individual banks but also at how their fortunes are tied together with other banks and with the rest of the economy.... 
If Sir Mervyn King is serious about guarding against the big risk, then he will champion ending the regulator's information monopoly and requiring banks to provide ultra transparency.

With this information, contagion is ended as each individual bank can look out for itself and adjust its exposure to the other banks based on is assessment of how risky these banks are.
In future, to protect the rest of the economy from failures in the banking system, we need to ensure that more of banks' shareholders' own money is on the line, and banks rely correspondingly less on debt. If banks and their shareholders have more to lose, they will be more careful in choosing to whom they lend. And, when banks make losses, there is more of a cushion before the bank fails, and less chance that the taxpayer will have to foot the bill....
Protecting the rest of the economy from failures in the banking system does not require money from taxpayers.  It requires policymakers to not override how the modern banking system is designed and allow bank book capital to absorb the losses.

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