Sir Andrew Large: Financial stability oversight - past and present
Speech by Sir Andrew Large, Deputy Governor of the Bank of England, at the London School of
Economics, London, 22 January 2004.
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1. Introduction: Globalisation and the Financial World
The financial system has been in the vanguard of globalisation of economic activities. The past 30
years or so have seen a transformation of the financial scene. Just as the financial world has become
significantly more complex with an ever more inter-connected global network across firms and
countries, so too has the challenge been transformed for those involved in financial stability oversight.
That is my theme tonight.
Much of what I am about to say may be familiar. But what I have tried to do tonight is to tie these
subjects together - to provide a picture of the whole area we grapple with. So I may have exchanged
some depth for breadth in the interest of getting home tonight.
I would like first to consider what financial stability oversight is and why it is important. Then, what has
changed in the financial market place and the challenges that this has brought. And finally the
response of the public authorities to these challenges.
2. What is financial stability oversight?
Unquestionably financial stability is a critical ingredient in a high performing market economy, although
its definition has been an elusive subject of endless fascination to generations of commentators. I
agree with Raymond Goldschmidt,1 who said: "It is hard to define, but recognisable when
encountered". But any definition would surely refer to the crucial roles of confidence, resilience and
reliable liquidity. These are the indicators if you like of what is a state of financial stability.
In times of instability or crisis, that confidence - and with it liquidity - can evaporate. Bank runs are
phenomena that result from loss of confidence: resulting from or causing withdrawal of liquidity. The
fear of collapse of other non-bank financial institutions could also give rise to a drain on liquidity. The
huge cost of preparing for Y2K was about preventing the dangers of loss of liquidity. And the horrific
events of 9/11 required a temporary massive injection of liquidity.
The starting point for this confidence is the players in the market place. It relies on integrity in
individual firms and markets, effective standards and high quality prudential controls and risk
management practices.
But to underpin integrity and confidence in the financial system as a whole also requires financial
stability oversight. In the first instance this relies on effective supervision. This is a key aspect of the
prevention of financial instability. Financial stability oversight must also look at the system as a whole.
So it is involved with the oversight of concentrations and of risk correlations, interrelationships and
interdependencies. There is a premium on understanding channels of risk transfer and likely behaviour
in response to shocks. This is what enables an appropriate policy response.
Real effort is needed to try to understand the dynamics of collective, and sometimes irrational
behaviour of firms, their clients and counterparties - particularly behaviour that could lead to one-way
markets. In a downward market they can be the scourge of stability and destroyer of liquidity.
3. Financial stability and public policy
The business of oversight of, and possible intervention in, the financial system falls to public
authorities. The justification for this involvement is accepted by all but the freest of free marketers.
Financial stability can be looked on as a public good. And the costs to society of crises and instability
can go well beyond the cost borne by players within the financial services arena itself. Not only is it
important in providing an effective monetary transmission mechanism, but collapse and instability can
lead to decline in aggregate demand and a rise in unemployment. Research suggests that the
average cumulative output loss of a banking crisis in an emerging market economy is nearly 14% of
GDP, and up to 25% in developed countries.2
The roles and aims of the public authorities - a combination of supervisors, central banks and
government - embrace two interdependent fields. First there is the process of oversight itself - spotting
risk concentrations and threats that could cause instability: and taking actions to mitigate these threats
in a variety of ways.
Second, however, there is as a last resort the mechanism for intervention: if things go wrong and crisis
is threatened or actually occurs. And things will go wrong. A zero-risk environment would not only be
impossible, but would be undesirable. The moral hazard which would ensue, together with unwelcome
restriction of market processes could ultimately add to, rather than detract from, social cost. We need
to be in a position to decide about, and where necessary to act, in occasional injections of liquidity and
support for particular firms or markets. Breaking the chain of adverse behaviour may sometimes be
necessary to restore confidence in the integrity of the system as a whole.
Using financial stability oversight to reduce the costs to society requires sophisticated and up-to-date
techniques. Despite today's complexity the basic concepts in relation to oversight have not changed.
Concentrations of risk have been with us since financial markets began and so have mechanisms for
the transfer of risks. The concepts of guarantees, of options and of securities transfer date back into
history - references to the use of derivatives can be traced back to the Sumerians in Mesopotamia
4000 years ago. And so too does the concept of speculative, or misconceived excess being deflated
by a variety of possible macro or micro shocks.
4. The new environment
But the financial world today has globalised both across borders and different kinds of firms. Risk
transfer processes have mushroomed. And there has developed a corresponding will and ability to
exploit them. The new world is characterised by new concentrations of risk. They can be built - and
dissipated - with bewildering speed.
Before looking at the consequences of the changes for financial stability oversight it is worth reflecting
on the main causes of this new world. There are of course many drivers, but to my mind development
of the new products and risk transfer techniques is based on the precondition of liberalisation and
technological advance.
5. Liberalisation
As to liberalisation, it was little wonder that the rise in popularity of derivatives in the global economy
was stimulated by the emergence in the 1960's of that most liberal of markets: the international capital
market. This burgeoning and open market place provided the preconditions to develop the new
techniques. Regulation was minimal and market imposed. Disintermediation and securitisation
gathered pace from the early 1980's. And as derivative instruments were developed, newly emerging
players including hedge funds and others entered the scene. So today we see a global market place
of truly astonishing size and breadth where contracts straddle both national boundaries and the old
functional areas of banking, insurance, and securities: and where the old silos are no more.
The international capital market was itself in my view a major stimulus in encouraging individual
governments to liberalise their markets. The new techniques employed could lead to a lower cost of
capital. In addition the market and its capabilities began to highlight the ineffectiveness of national
barriers, and restrictive practices. It gave governments the courage to dismantle restrictions and
barriers despite protest from those who, in a series of big bangs, lost their franchises. The examples of
the international Swiss Franc - and Sterling - debt markets highlight this. In each case the authorities
in the 1970's imposed flow controls on new bond issues through queues. But this could be bypassed.
As derivatives and swaps developed, so Swiss Franc liabilities could be created by borrowing US$ on
an unrestricted basis and swapping them outside the jurisdiction of the Swiss authorities into Swiss
Francs. So this caused a gradual rethink, as the national grip of the authorities had ceased to be
effective.
6. Consequences of technological advance
While liberalisation was an important trigger, technological advance also played a vital role. We may
not understand its full impact yet: just as it took us time to exploit fully the benefits of the printing press,
electricity, and the motor car. But the advance and speed of communication with its erosion of
geographical and national barriers spawned the development of often derivatised financial instruments
and risk transfer techniques.
The concepts involved in this risk transfer may not be new. But the instruments to handle them, to
quantify their value, to measure them, and to judge the risks inherent in them, are. The consequences
of these developments, whose impact took off in the 1980's, have been quite dramatic.
Firstly they have enabled greater dispersion of risks. Banks, at the heart of the financial system, used
to act as warehouses, with the loan assets they generated staying on the books until maturity and -
normally - repayment. The balance sheet was the net result of these events. But today banks
approach matters in a fundamentally different way: they review their balance sheets intraday. They
ask themselves, "What is the opportunity cost of not altering the balance sheet?". And they are then in
a position to act. Assets can be disposed of, packaged, securitised, and sold. In size. And fast. This is
what is so new. So risk can be, and is, dispersed across the system globally. Not only from bank to
bank, but also between different types of financial institutions, as well as to private individuals, or to
corporate entities.
This can create the build up of concentrations of risk in new areas, and often with new players, who
may or may not be well informed about what they are doing.
But this set of processes adds to the opacity of the financial system. It is more difficult to see where
risks reside. Despite steps forward through enhanced disclosure and improved accounting standards,
there have been other steps back towards opacity: the result of the sheer complexity, speed of
movement of risks, and in some cases obfuscation through special purpose vehicles, or other
offbalance sheet devices.
Another implication of the derivatised world is the premium it places on risk management. The
deployment of intellectual capital in finding new opportunities to create and disperse risk has been
prodigious. This in turn places a real burden on the managers of the great array of risks and
interdependencies and on those supervising the entities that take them.
A particular feature of these risk management processes is the reliance on modelling techniques.
Although when used judiciously models are a valuable tool, they also have limitations and contain
hazards when in the wrong hands. First, they are only as good as the assumptions on which they are
based. And second, hazards exist where models can provide a false reassurance that liquidity to
deliver assumed value will be available.
This leads to the question of measurement and accounting for values and risks. Inherited systems of
accounting - with historic cost conventions for banking and insurance - bring real tensions in today's
world. There is understandable concern regarding the added volatility which the developing Fair Value
techniques can give rise to, in relation to reported earnings and disclosed values. But equally, the
need for management of risks, and for comparison of values across all sectors with a mark to market
capability, is how business is actually managed and conducted. That is why I have for some time
argued that a resolution of the conflict is important. The lack of consensus makes this a difficult
process, needing consideration of the governance and control process of accounting, quite apart from
the standards themselves. In this respect I recommend a recent report by the G303 as outlining a
possible way forward.
Paradoxically the existence of standards of risk management, or prudential control, themselves can
lead to unintended consequences. For example, if banks all have similar approaches to risk
management or all use similar models, or if rules require them all to provide more capital at times of
economic downturn, then they may all react similarly to a given shock. This could itself amplify market
movements and trigger liquidity difficulties, despite the best intentions.
There is also the question of legal certainty. If counterparties doubt an institution's strength or
solvency, their behaviour may be influenced if they feel that complex and untested types of contract
may not "close out", particularly in adversity. Such concerns lay behind the LTCM crisis in 1998.
Counterparties feared LTCM might be insolvent. They could sense a drain of liquidity from LTCM
which might precipitate collapse. If collapse occurred, the vast array of complex contracts within LTCM
might not close out. The dimensions of the exposures were considerable, and a disorderly run on
LTCM, triggered in part by a lack of legal certainty, could well have provoked a serious liquidity
situation. No surprise that there was a co-ordinated purchase by the main creditors to enforce an
orderly wind down. A key lesson for financial stability oversight is the need to encourage ways of
improving legal certainty.
7. Implications of the new environment: risk and culture
So much for the drivers of change - liberalisation; technological advance and new products. But what
about the implications for the financial markets and their oversight?
The first implication is to highlight the need for examination and possible change in supervisory and
regulatory frameworks. What made sense before, in terms of separate regulation for each silo of
banking, insurance and securities might look different today. We have also certainly seen a move
towards consolidated supervision. I will return to this area later.
But second, oversight needs an understanding of a number of different soft issues: of culture and
attitudes to risk which can affect behaviour. These can and do vary across the different areas of
activity.
The existence of new concentrations of risk might not matter if their new holders are fully aware of the
risk implications, or if their likely behaviour could be anticipated by other financial participants or the
public authorities. But new holders of such risk may not have the same understandings of what the
risks consist of, as those who generate them. And accordingly they may behave in unexpected ways
when shocks arise.
For example in banking, confidence in the liquidity of the system and expected behaviour is
underpinned by the presumption that, in the absence of a credit event, obligations will be honoured at
a known time and date. This would typically beon the expiry of a loan contract - the crystallising event
if you like. In general insurance on the other hand, the industry is used to handling crystallising events
differently. Rather than acting as the trigger for immediate payment of due amounts, it may instead
lead to discussion - even dispute - the results of which will determine how much is eventually paid and
when. So risk transfer contracts straddling the two areas may engender expectations that in practice
may harbour surprises; with unexpected outcomes and adverse behaviour.
8. Implications of the new environment: new types of financial player
A key ingredient of life in today's financial world of course is the new players, or the increased
significance of previously smaller players - encouraged as they have been by liberalisation and new
risk transfer techniques.
Firstly there is the advent of globally active Large Complex Financial Institutions - LCFIs. These create
a particular challenge for public policy. They are built on highly sophisticated understandings of the
global market place. Their deployment of intellectual capital has been dramatic. And they have
overcome both technical and juridical barriers so as to operate on a global basis. You cannot label
them in the historical categories: - are they banks? Are they securities firms? Are they insurers?
Of course you can categorise them by their historical roots. The large so-called broker-dealers such as
Morgan Stanley and Goldman Sachs come from the securities side. The big banks - Citigroup and
HSBC - come from the banking side. But today they are all involved in convergent thought processes
and operations, even if their precise legal structures, and in many cases regulatory arrangements,
may differ. They are all involved in considering in real time whether they are comfortable with the
balance sheet of assets and liabilities that they have. And they all are involved in risk transfer
techniques to adjust to a desired proprietary outcome.
Their scope is multifunctional and multinational. This enables them to maximise opportunities for
return. But it can also create challenges for the markets, and for the authorities. With global firms if
there should be a failure, then who will oversee its resolution, and will there be any safety net to
counter what could be significant economic and social costs globally? Which set of taxpayers in which
countries will be prepared to share the burden to support such LCFIs?
This highlights a real tension in the globalised world. The markets have globalised, and so have the
firms. But, to a large measure, the oversight apparatus remains nationally based. This is an important
area which will provide all those of us involved in financial sector oversight with major challenges for
years to come.
Increasingly active players are the hedge funds, employing alternative investment techniques and
attracting a multitude of investors searching for higher yields. They often operate globally on the
strength of the derivatised and securitised world. There has been a dramatic growth in hedge funds:
data suggest that the past eight years alone have seen the value of assets rise by nearly 450%. Many
of them are unregulated in a prudential sense, and are typically characterised by large proprietary
positions, sometimes with an emphasis on unconventional assets and arbitrage positions.
The complex and diverse operations of hedge funds can help to arbitrage away pricing mistakes, and
to integrate financial markets. But they also raise new questions for financial stability oversight.
The areas we need to look at are quite wide. There is of course the opacity aspect - what are the
underlying concentrations hedge funds hold? But there are also other questions. How leveraged are
they? Do lenders to them understand the risks that they are taking? And what is the potential impact of
confidence and liquidity if they don't? And what would happen if the new investors in hedge funds
became disillusioned by their performance. Would it trigger an exodus and cause markets to go "one
way"?
And I would stress that many of the issues raised by the attributes of, and thought processes within,
hedge funds themselves are shared increasingly by securities companies and other types of financial
institution including banks. Overseers of financial stability take note!
A third group of new players is the non-financial groups who straddle finance and the real economy. I
could mention industrial giants like GE. We need to understand their implications, and any new
vulnerabilities they may cause.
Next I want to highlight the rating agencies. The new holders of financial assets find that
understanding the credit risks inherent in the assets they hold has become more difficult. So they
outsource credit evaluations to the rating agencies, as third party specialists who benefit from
economies of scale. Indeed in the case of collateralised debt obligations whole categories of assets
are dependent on their rating.
But this can give rise to particular vulnerabilities. What happens if there is a rating downgrade? Did the
investors in Parmalat bonds rely on the fact that they were rated investment grade? Changes to
ratings will be known to all at the same time. And this could trigger mass exodus either by holders of
rated assets or, in cases where banks themselves are rated, by depositors or other counterparties.
Of course the rating agencies provide valuable services and information. And their increasingly public
significance raises calls for them to be regulated. In my view, attempts to do so could actually create
additional moral hazard, particularly in today's compensation orientated society. If rating agencies
were regulated who would you blame if mistakes are made: the rating agency, the regulator, or both?
9. Implications of networks
Finally we need to consider the financial stability oversight implications of the networks which
increasingly hold the financial system together. These are the plumbing or the nervous system of the
financial world. This is the world of payments, clearing and settlement systems. Such networks can
and do both generate significant economic benefits, but they also create vulnerabilities.
The economic benefits of scope and scale from such networks come as a result of the development of
standardised messaging, IT protocols and other areas of interoperability. However, the universal
reliance on these networks makes the financial system increasingly vulnerable to any failure, whether
financial or physical.
If the market all settles in one system and is faced by single points of failure how could we work
around these?
Secondly, if there is a failure, what about data retrieval? If an entity containing a series of uncompleted
transactions fails, how can that data be retrieved or recreated so that you can get markets up and
running again? Fortunately significant effort is being put into developing innovative solutions:
something which may give confidence to the many who are unfamiliar with this area.
10. Implications of the new environment for financial stability oversight
It will be clear from the litany of issues I have just mentioned - new players, new products, new risk
transfer techniques and interconnections - that the changes in today's financial world are indeed quite
profound in relation to financial stability oversight. But are they net benign or net negative? The world
here is sometimes portrayed as being in two designated camps. This may be a bit of a parody, but I
am sure the two protagonists would forgive my little sketch.
The bullish view is led by Governor Greenspan. This holds that, in the new financial world, banks now
possess the enhanced ability to disperse risk - to offload risk to others, be they investors, insurance
companies or whatever. The banks have thereby been able to weather a variety of shocks, which in an
earlier age might well have engendered financial instability. The Asian crisis, Russia, 9/11, Enron: I
could go on. In each case the banks came through and the financial system has demonstrated greater
resilience as derivatives and sophisticated risk transfer processes have dispersed risk to a wider
audience.
The bearish camp is led by Warren Buffett. This points out the opacity of today's world: the difficulty of
spotting risk concentrations; or judging the behavioural expectations in the face of given types of
shock.
My view would be that both schools of thought are right! I think in reality it depends on your vantage
point. There has been improved capital formation. And well managed banks have indeed been able to
weather the shocks - a real positive from the point of view of financial stability oversight. But on the
other hand the added vulnerabilities too are real. So I do not find it surprising that there are calls for
public policy response.
The consequences of liberalisation and the derivatised world of enhanced risk transfer are indeed
formidable. There is the breakdown of the old barriers; with unfamiliar and new players operating in
often unfamiliar territory; uncertainty over concentrations of risk and with a more difficult or
unpredictable set of behaviours; and newly created networks whose failure could be catastrophic.
Spotting threats is tougher: and there is a premium on intelligence from a broader network to cover a
multitude of new transmission channels. The tension between globalised players in a world of national
supervisors needs to be managed.
But let me not leave you with the impression that we are deterred by the task. On the contrary
challenging certainly, but hopeless certainly not. After all, the market place itself has to act prudently;
to judge potential behaviour of counterparties; to improve risk management techniques; to understand
where concentrations of risks reside and what their dangers are. If firms fail to do so they go out of
business. And as for the public authorities, we all know the maxim or guiding prayer "Lord let there be
failures: but let them be small ones". No better way of encouraging market discipline! We cannot, and
should not aspire to a zero-risk solution, but we do need to be prepared to take measures to restore
confidence if things do go wrong.
11. Public policy response - process
The first area of public policy response concerns how we handle our day to day activities. These have
to be sharpened and broadened to oversee this more complex environment: a real life challenge for all
of us here in London. Given our position as a major international financial centre the stability of the
system could be impacted by any significant storms from elsewhere.
Perhaps I can say a few words about what this means to us at the Bank of England. Responsibility for
the overall stability of the financial system as a whole means we undertake activities ranging from
behavioural research to oversight of payment and settlement systems; from involvement in standard
setting to implementing infrastructural change. To do this efficiently means, as our Governor Mervyn
King recently reminded us, that we have to see the wood for the trees. The challenge is where you
draw the line. This entails a prioritisation process to decide on the extent and degree of potential
threats - and also a "sunset" approach where we subject each area of work to regular review to assess
progress and continued relevance.
There are a number of, interconnected, areas of work. These focus both on "hard infrastructure",
including payment and settlement systems, and on "soft infrastructure"; standard-setting in areas like
accounting, audit, prudential and legal standards. We also analyse key developments in the
international arena, for example in relation to threats of failure of emerging market economies and
response to this.
12. Public policy response - institutional
As to the second area - the institutional response - there are both national as well as international
dimensions.
On a national basis, countries increasingly recognise the distinction between supervision (looking at
the individual institutions and markets) and the systemic factors involving concentrations,
interrelationships and behaviour in relation to the system as a whole. Each is an essential element in the
provision of financial stability oversight. In relation to supervision, in some jurisdictions - including the
UK, Japan and Germany - all the supervisory functions are carried out within one institution. In others
they are handled by different agencies.
Certain countries have combined questions of the systemic issues with those of prudential oversight,
and then put the investor and consumer protection aspects of regulation into separate agencies [the
"twin peaks" approach adopted in Australia and France]. Yet others still survive with a multiplicity of
agencies. The US is a case in point - and it is worth noting that, despite all its complexities and
conflicts, the health of the US financial sector as well as its economy do not appear to have suffered
unduly, despite episodes like the savings and loan crisis. However, the broad trend is to combine
investor protection and consumer protection for banking securities and insurance, and split these away
from the systemic aspect. The precise architecture in different countries depends on historical, political
and institutional factors.
Personally I feel we have been quite enlightened in the UK. As a former Chairman of the old Securities
and Investment Board - a forerunner of the FSA - I could certainly see the limitations of the earlier
situation. And despite the inevitable challenge - being well addressed in my view - of managing a
supervisory authority with the size, scope, and powers of FSA, it reflects the realities of today's
environment.
And as for financial sector oversight in the UK, this is carried on under the auspices of a Standing
Committee of the three authorities involved: HMT, FSA and the Bank of England. The roles of each
party have been carefully thought out in relation to which party is best placed to do what, and laid out
in a published MoU.
The FSA is responsible for the supervision of firms, markets and clearing systems, and for the conduct
of regulatory operations in response to problem cases affecting these players. The valuable
intelligence it gains can help in understanding concentrations and threats. The Bank has responsibility
for the overall stability of the financial system as a whole. Without the need to focus on the regulatory
responsibilities for the individual firms, we focus on what might disrupt the functioning of the financial
system, and especially what might pose a threat to liquidity, and what can be done to mitigate it. We
also need to be in a position to advise on the extent of possible financial support if major problems
arise, and to provide that support if and as agreed. And the Treasury of course has to play a vital role
in reflecting Government policy as a whole, with a particular scrutiny of developments which ultimately
could bring into consideration the need for taxpayers' money.
On the global level things are very different. You could argue intellectually that, since national
boundaries mean so little in relation to financial stability oversight, there is a case for creating a single
global body. In reality of course we are nowhere near that, any more than we are to creating global
Government itself. The difference in political and legal systems and culture, clearly make it
impracticable. So for the time being, whether at a global or even an EU level, we have to rely on
proxies and co-ordination.
This proxy must be as effective as possible. This explains the activity to create and maintain robust
international standards and practice in the institutions, and infrastructure of the global market. It
explains endeavours to encourage or enforce compliance with them, through a variety of measures
including international bodies, such as the Basle Committee, IOSCO, the Committee on Payment and
Settlement Systems, the IMF, and the World Bank - and others too numerous to mention. The
Financial Stability Forum is noteworthy too, as it brings together the three sets of key bodies involved
in financial stability oversight - central banks, regulators and finance ministries - to supplement the
actions of other international organisations in promoting standards globally.
13. Public policy response - if things go wrong
I spoke about identifying threats and the steps to mitigate them, but we also need to be able to
intervene if things do go wrong. In a non-zero risk environment, failure is a possibility. So we need to
look at both mitigants in relation to the impacts of financial crisis, and how to restore confidence.
This is true both for financial crises which could occur as a result of business failure, as well as
possible major operational disruption - whether from terrorism, cyber failure, or natural calamity. They
are situations where predictability is so vital, when normal mechanisms for decision making may be in
abeyance.
I have left until last the tricky question of emergency liquidity injection and lender of the last resort.
This is an area full of mystique and ambiguity. "Intervention," as the late - Charles Kindleberger4 said,
"is an art form not a science." My contention is that, whilst an aspect of such ambiguity may be
inevitable, or even necessary, the demands of today's complex world for enhanced predictability of
behaviour and transparency should not be ignored.
Ultimately public policy may require emergency liquidity injection through lender of last resort facilities.
This may be justified to defend the public good of financial stability which the