Paul Tucker: The debate on financial system resilience -
macroprudential instruments
Speech by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
at Barclays Annual Lecture, London, 22 October 2009.
* * *
What stage have we reached in the current financial and economic crisis?
The stage where the most hideous macroeconomic nightmare - a second Great Depression
revisited - is now probably remote but where the outlook remains highly uncertain by any
normal standard.
Where the banking system is recovering, but where some big UK (and overseas) banks have
a lot left to fix. And where there has been real progress with many policy initiatives to make
the international financial system more resilient in future, but where perhaps some of the
biggest issues remain unresolved, even incompletely articulated.
After some scene setting, I will address one of those issues this evening: whether there
might be macroprudential instruments that could lean against and preserve banking system
resilience in the face of credit boom and bust. I will also provide an update on international
plans for banks to produce recovery and resolution plans, known here as Living Wills.
The macrobackdrop and the credit system
At the beginning of this year,1 I thought it would take until the autumn at least to tell whether
the economy was going to lurch downwards into a spiral of falling prices, rising real debt
burdens, generally enfeebled banks and falling output. While absolutely nothing can be
definitively ruled out, that nightmare now seems unlikely. I shall weigh that in my own policy
considerations, as for me the size of the massive monetary stimulus has partly been
designed to insure against that catastrophe risk. So a key question over the coming period
will be whether or not conditions are developing where some of that insurance could be
withdrawn, consistent with leaving policy highly stimulative.2 But the economy has in actual
fact been very weak, with output falling and unemployment rising. The policy debate in the
months ahead therefore will turn, as more usually, on the broad outlook for the risks around
inflation over the medium term. That will depend on the data and, in particular, whether the
data and surveys about real activity and demand come more closely into line, here and
overseas. One of the biggest questions is whether, given the policy stimulus, recovery will be
anaemic or whether we can attain the above-trend growth needed to absorb the slack in the
economy necessary to ameliorate downward pressures on inflation. This will be at the heart
of the quarterly forecast round on which the MPC is just embarking. And it could hardly
matter more. Anaemic demand growth would lead to inflation undershooting the target for a
period. And it would be likely to see firms continuing to shed labour, scrapping capital and
delaying new investment, adding to the hardships the crisis has already brought. But I fear,
however, that we may not be much clearer about the general trends in demand until at least
late spring/early summer next year. There are major uncertainties about global demand and
about domestic saving given the need for many households to strengthen their balance
sheets over time. And, in particular, I doubt it will be clear before then whether or not the
financial system is sufficiently recovered to support what may well prove to be a more
creditintensive phase of cyclical recovery.
The continuing uncertainties about credit supply underline just how much an effectively
functioning financial system matters to the real economy. That much has been demonstrated
beyond doubt by the massive measures taken here and elsewhere to prop the system up
when the vortex beckoned.
Those measures have rightly drawn attention to what for too long was a neglected issue: Too
Big To Fail - or, as we have also discovered, Too Interconnected, Too Complex to be
allowed to fail in the way of an ordinary business. Like all truly big policy questions, this is a
partly social question. It just cannot be acceptable that the downside from excessive risk
across the financial system as a whole falls to the general taxpayer, to households and firms
throughout the economy, if the upside is enjoyed by a narrower group of shareholders and
managers. This is not just an issue of economic efficiency - of the allocation of resources -
and of leaning against the risk of even bigger crises down the road, but also of social justice.
That is why the debate has attracted so much interest. But I hope I can persuade you that
the Too Big To Fail problem matters to bankers too. Because the Lehman case
demonstrates that in a democracy, political constraints are uncertain and so even Too Big To
Fail firms can sometimes be allowed to fail. Banks need a system in which they are better
protected against mismanagement by their peers.
The debate calls for technocratic solutions to be laid out, but choice amongst those solutions
should be understood and accepted by society at large. And the solution needs to be an
international one. It is therefore good news that the G20 has commissioned work from the
Financial Stability Board on the Too Big To Fail issue.
So the stakes are high. By the lights of our successors, we are bound to get it wrong, but can
we get to the right ballpark?
Reforms to the "how" approach to the banking system oversight
The Governor of the Bank said earlier this week that we face a choice between an overhaul
of the regulatory regime and directly altering the structure of the banking system. As earlier
policymakers would have put it, this is a choice between, on the one hand, regulating what
banks and other financial firms can do and, on the other hand, leaving open the scope of
what they may do but regulating and supervising how they do it.
Since the thoughts on macroprudential instruments I shall go on to outline this evening are
based on something like the existing structure of the banking system persisting, I shall briefly
recap what I have said in a series of speeches earlier this year about the current reform
agenda.3
The three necessary planks are re-regulation and a return to supervision; for the first time,
agreeing effective resolution plans with banks and any other key firms; and, I would hope, a
clear Capital of Last Resort regime designed to avoid perverse incentives.
On regulation, as Adair Turner has said, it is clear that firms need to hold more capital; and,
as the Governor emphasised earlier this week, that that capital needs to be proper,
lossabsorbing capital. It is equally clear that banks need to hold a portfolio of high-quality
liquidity; that there should be no compromise about what counts as such liquidity; and that
any banks thinking a decent treasury policy involves holding the bonds of other banks are
way off-beam. That much has pretty well been agreed by international policymakers. The
numbers remain to be set.
Just as important is the necessity of reviving supervision. By that, I do not mean checking
compliance with rules after the fact, punishing breaches; punishing offenders does not bring
back to life a bank or the customer businesses that have collapsed with it. I mean
forwardlooking judgments about the prudence of a firm's management and the resilience of its
business. The FSA under Hector Sants have been saying much the same thing, and it was
what an earlier generation focused on most. It involves supervisors making judgments; and,
no doubt, occasionally judgments that individual banks find unwelcome. They need to cover
competence. But also the adequacy of liquidity portfolios and the reasonableness of asset
valuations; over the decades too many banks around the world have failed after they
reporting apparently healthy ratios. Not a new lesson. But a vital issue is whether we are
ready, today, collectively to back an approach based on judgments rather than on enforcing
a book of detailed rules? If we are to tolerate supervisors where necessary substituting their
judgment for that of managers and boards, then commentators, appeal tribunals and even
parliamentarians will need to give supervisors the benefit of the doubt occasionally. Of
course, such judgments need to be grounded and reasoned.
But we need to go further than this. Today, there is a realisation that it is not enough to look
solely at individual firms atomistically. The resilience of the system in the face of seriously
adverse disturbances - whether from the real economy or from within the financial system -
depends heavily on common exposures and interconnectedness. In a way, this is another
reremembering. I am fond of quoting the following from a speech by George Blunden, a former
Deputy Governor and the first chairman of the Basel Committee in the mid-1970s, gave over
twenty years ago:
"Supervisory standards are set with an eye to protecting [banks] from
problems which could be created by wider, systemic developments. A bank
may consider a course of action it wishes to take to be acceptable - as it
may well be in a limited context. But the same course might, if widely
copied by other banks, have unfortunate effects on the banking system as
a whole. It is part of the supervisors' job to take that wider, systemic view
and sometimes to curb practices which even prudent banks might, if left to
themselves, regard as safe."4
A number of things flow from this core insight.
First, the central objective of prudential supervision is systemic stability. That is underlined
now that the UK has moved to a system of deposit insurance where 100% of retail deposits
up to £50,000 are protected. It is that which delivers consumer protection. Supervision
affects the incidence of calls on the insurance fund. And since such calls are met from levies
on the industry, that means supervision is in the business of containing such calls to
systemically manageable amounts.
Second, a systemic - or macroprudential - orientation is what lies behind the thought of
"systemic" add ons to capital and liquidity requirements for so-called "systemically significant"
banks. Personally, I do not much like the notion of a list of "systemically important firms"
because, as a previous generation of policymakers taught us, what proves to be systemic
depends so very heavily on the circumstances. For example, it judged it safe to let Barings
fail because the causes were clearly idiosyncratic and, just as important, the financial waters
were calm. But essentially the same group of senior officials judged that it would not have
been safe, in the circumstances of the time, to leave unaddressed the distress amongst
fringe banks in the Secondary Banking Crisis of the mid-1970s, or amongst small banks in
the crisis of the early 1990s. In both cases, actions were taken to stop the problems
spreading to larger banks. But I do agree, of course, that banks are woven into the fabric of
the financial system in potentially dangerous ways should carry more capital and liquidity
than otherwise. That amounts to overturning a consensus that, assessed on an atomistic
basis, greater diversification in a bank's risks is a sufficient reason for lower regulatory
requirements. The FSA published some thoughts on this area earlier today.
Third - and this is a major departure from the past - we need a regime that recognises that
inevitably regulation and supervision is flawed and, occasionally, will prove seriously wanting.
However good a country's supervision, banks and other firms will fail. And they will fail in
circumstances that, at least with - and possibly without - hindsight, could have been
prevented. So it has been a mistake, over recent decades and in a number of countries, to
claim to have a regulatory framework that is not premised on zero failures when we lacked a
resolution regime that could cope with failures of even quite simple banks. In the UK, this
was cruelly exposed in August 2007 when Northern Rock failed, denting confidence in UK
mortgage banks generally.
That is the backdrop to the suggestion, stressed by the Governor earlier this week, that the
market should explore whether banks can raise contingent capital from private sector
investors. Beyond that, we need an effective resolution regime.
The UK does now have a decent resolution regime for small and medium-sized banks, which
we used directly for the Dunfermline Building Society and indirectly in getting a few cases
satisfactorily worked through. More important for today, it is the origin of the Bank pushing
the "Living Wills" idea, which dovetailed with international conclusions about the horrendous
problems of managing cross-border crises. The G20 heads of government have made it
clear that something must be done about this. It is being pursued by the Financial Stability
Board, a grouping of regulators, central bankers and finance ministry officials drawn from the
G20 countries and a few other key centres.
Speaking as chair of the Financial Stability Board's working group on the resolution of
crossborder firms, I can update you on the work already in train. Basically for the top roughly 25
banks and dealers, the authorities will work with them over the next 6-9 months to produce
recovery and resolution plans. The effort will build on the existing supervisory colleges, but
typically at a more senior level, and involving resolution authorities and central banks as well
as line supervisors. After official level exchanges, there will be engagement with those firms,
also at a senior level (say group CFO). The desired outputs will cover two things. First,
recovery plans for "de-risking" a group where it can and should be maintained as a going
concern. Second, a resolution plan when a firm needs to be wound down and put to rest, but
with essential economic functions maintained somehow. The FSA has explained their
contribution to the exercise.
No one should think that this will be easy; or that anyone in the official sector is naïve about
that. It will, in fact, be formidably difficult. The process is, for that very reason, designed to
flush out the issues, so that they can be properly debated and reviewed. There will quite
probably be hard questions about the organisation of some banks; about which services
needed to be maintained; about conflicts between the insolvency laws and special resolution
regimes of different countries; about how losses can in the future credibly be made to fall on
wholesale creditors; and, maybe, about the issues confronting burden sharing amongst
national authorities if, notwithstanding these efforts, fiscal support nevertheless proves
unavoidable when an internationally active bank fails in the future. Over time, this could lead
to something of a revolution in the supervision of banks - because of the inducement to
design regulatory arrangements to cater for circumstances in which supervision had failed to
avert distress.
Imagine that despite all the obstacles, we make terrific progress with recovery and resolution
plans over the next few years. To be clear, it is not that we can promise that yet: the work of
the regulators: internationally has just begun. Rather, the point is that even that would not be
enough. The community having finally recognised that we cannot rely wholly on regulation
and supervision, we must not now make the analogous mistake of thinking that we can rely
on resolution plans.
However good, those de-risking and wind-down plans will sometimes prove flawed. That is
why for some months I have been arguing for the need to articulate a framework for Capital
of Last Resort provision. We must not again find ourselves in a position where the authorities
in different countries are developing as they go along how capital support should be
provided: what triggers it, its terms, and who pays. I have aired the possibility of eventual
losses falling on the surviving banking system, as a way of avoiding burdening the general
taxpayer and as an incentive for firms to recognise and act upon their interest in the health of
the system as a whole. But the more important point is the need to have a plan. And of
course the fiscal support comes after drawings in any private sector provision of contingent
capital.
Banking and the credit system: might there be macroprudential instruments?
At this point, I should issue another caution: that however all those issues are resolved, the
banking-structure debate is resolved, I doubt they could prove sufficient to rule out bouts of
instability, even crises, in the future. That is because I am doubtful that the tendency to
excess can be curbed solely by addressing the circumstances of individual firms. Booms are
spurred by plausible illusions and collective-action problems.
The current crisis has, in my view, been at root a crisis of liquidity - of an over abundance of
liquidity in the upswing, succeeded by a drying up of liquidity during the crash.
Usually, material rises in asset prices are initially triggered by reasonable perceptions of a
favourable shift in fundamentals. In the latest episode, that plausibly included improvements
in monetary policy regimes, in the flexibility of the real economy, in the outlook for global
costs, and in enriched instruments for hedging and dispersing risks. But it is very hard for
anyone to gauge the extent of the warranted revaluation of asset prices. If investors and
shareholders extrapolate forward ex post windfall gains into forward-looking ex ante required
returns, funds and banks may be incentivised to increase risk in order to deliver.
In an environment of rising asset prices, continuing strong investor demand and high
volumes in primary and secondary markets, liquidity is typically abundant. Liquidity premia
fall, adding to the upward pressure on asset values. That liquidity may not in fact be resilient,
but it can easily look like it to market participants. And with the ability to fund and to manage
risk in the markets looking straightforward, financial firms feel they can relax the supply of
credit - to real economy borrowers and to each other.
When the music stops, almost whatever the trigger, four problems arise - at least. First,
some borrowers - households, firms and financial intermediaries - prove to be over
indebted. Second, it can be hard to tell who has fundamental problems and who does not:
the so-called Lemons Problem.5 Third, some of the assumptions on which financial activity
has been predicated turn out to be (or are seen as being) invalidated; eg, in the current
crisis, the reliability of ratings of ABS. Fourth, the demand for liquidity rises, and its supply
falls back. Markets become less liquid. Rising liquidity premia and forced sales depress asset
values. Credit supply is reined in. A vicious circle is threatened by the excess leverage and
liquidity mismatch that have developed in the financial system during the upswing.
During that upswing, important contributory factors will typically have included illusions about
risk-adjusted returns; underestimating the extent to which buoyant conditions are being
driven by falling liquidity premia; and a sense that, if the bubble bursts, the central bank will
somehow be able to contain the spillovers. This amounts to "risk illusion", which should
probably be as much debated as "money illusion" is in monetary economics. Separately,
there is a potent collective action problem in getting off the dance floor. Not a few senior
market participants felt from at least 2006 that financial risk was underpriced, and that
conditions in, for example, the leveraged loan market were silly. But they also had no
conviction about when, or indeed whether for sure, the music had to stop, and so feared
individually that stepping away from the dance "too early" would crystallise business risk, as
the dance would simply go on without them and their franchise would be undermined as
customers migrated to their competitors.
These seem pretty close to the circumstances that Federal Reserve Chairman William
McChesney Martin had in mind, over 50 years ago, when he talked about Taking Away the
Punchbowl just as the party gets going. An intervention of some kind is needed from
someone outside the dance.
Some commentators argue that the intervention should come via monetary policy. That as
well as steering the path of nominal demand in order to maintain low medium-term inflation
expectations, monetary policy should seek to tame the credit cycle. As MPC colleagues have
already argued publicly,6 we are very doubtful about that. It is likely that much higher rates
would have been needed in the UK to choke off the credit boom, with the likely effect of
pushing the economy into quite a prolonged recession, with a persistent and substantial
undershoot of our inflation target. The business cycle and the credit cycle were simply not
closely aligned. That is not to say that monetary policy should not take into account risks to
the inflation outlook that accumulate slowly and with great uncertainty about when and how
they will crystallise. But it makes a compelling case that monetary policy is not sufficient on
its own. There are essentially two objectives here.
So there is a missing set of instruments. And the big question is whether a set can be
devised that stack up not only in theory but in practice; instruments that can be used in the
real world.
Having first flagged 18 months or so ago that the Bank would work on this general area,
earlier this year I set out four questions which the debate would need to address;7 objectives,
6
See, Bean C. R "The Great Moderation, the Great Panic and the Great Contraction", Schumpeter Lecture at
the Annual Congress of the European Economic Association, Barcelona, August 2009 and "Some Lessons for
Monetary Policy from the Recent Financial Turmoil", remarks at Conference on Globalisation, Inflation and
Monetary Policy, Istanbul, November 2008. Also Dale S, "Inflation Targeting: Learning the Lessons from the
Financial Crisis", remarks at the Society of Business Economists' Annual Conference, London, June 2009.
7
My remarks at the Institutional Money Market Funds Association Annual Dinner in London on 2 April 2008
included the following on macroprudential policy: "Looking ahead further, the big question will be whether the
authorities can tame the credit cycle without sacrificing the incentives to enterprise that are so important in a
dynamic economy. The debate about the micro regulation of banks will need to take account of whether or not
we can deliver that macroprudential objective. For too long, the debate has got sidetracked. Into whether we
can rely on monetary policy "mopping up" after bubbles burst. Or into whether monetary policy could be used
to control asset prices as well as doing its orthodox job of steering nominal trends in the economy, which I
should say can include taking account of prospective risks of inflation volatility over the medium term. Ideas
circulating already include minimum margin requirements or capital ratios that vary not only across
instruments or firms but also through time as credit conditions change. We need calmly to explore whether
there are also other possibilities. But let me make this absolutely clear: there are formidable obstacles to
finding a solution. In the monetary sphere, a regime of floating exchange rates allows individual countries to
BIS Review 134/2009
instruments, whether the instruments would be operated under a rule or discretionary
judgments, and whether it was feasible for one country to attempt to employ such
instruments in a world of freely flowing capital. I will sketch our preliminary views on those
questions. The Bank will publish a Discussion Paper, going deeper than I can today, over the
next few weeks. We do not have all the answers and I must stress that we are not in
advocacy mode, but we have reached the point where we should like to try to inject some
further thoughts into the debate.
(a) Objectives
A few generations ago, Federal Reserve Board Chairman Martin (of the Punchbowl)
described how the Fed approached the task it had been given by Congress in 1934, in the
wake of the Great Crash, to set minimum margin requirements for loans to purchase
security:
"The task of the Board, as I see it, is to formulate regulations with two
principal objectives. One is to permit adequate access to credit facilities for
securities markets to perform the basic economic functions. The other is to
prevent the use of stock market credit from becoming excessive. The latter
helps to minimise the danger of pyramiding credit in a rising market and
also reduces the danger of forced sales of securities from undermargined
accounts in a falling market."8
Today's task is somewhat broader, focused not just on securities markets, but on the stability
of the banking system as a whole and on maintaining, through otherwise severe economic
disturbances, the essential services banks provide to the real economy. But it is instructive
that Chairman Martin focused on the risks of "pyramiding credit".
In big picture terms, candidate objectives include quelling asset price bubbles; credit growth;
and strengthening the resilience of the banking system during credit booms. We are minded
dynamic resilience of the banking
to favour the third - system.
Why not asset price bubbles? Essentially because we are doubtful that financial stability is
liable to be threatened by exuberance in asset markets unaccompanied by excess credit
growth and indebtedness. It is the impact of falling asset prices on an over-levered and
liquidity-stretched financial system that imperils the provision of essential financial services.
A necessary condition for a pervasive financial system problem is weakness amongst
financial firms. The late-90s tech bubble is arguably instructive in this respect. The collapse
of dot.com shares obviously caused a lot of volatility, but it was the wave of defaults on
telecom debt that threatened banking stability.9
Why not then cast the objective solely in terms of credit growth? Essentially for three
reasons. First, a macroprudential instrument will alter the terms on which credit is supplied by
the banking sector, but the resulting growth of credit will depend on demand conditions,
which lie beyond the direct reach of the macroprudential instruments I shall go on to discuss.
Second, and again anticipating part of my later remarks, the residents of industrialised
countries are free to borrow from abroad, so total credit growth may lie beyond the control of
national authorities. There is no good reason to turn our backs on free flowing capital. Third,
a "dynamic resilience" objective would not leave credit conditions untouched.
"Dynamic resilience of the domestic banking sector" should, by contrast, be something
national authorities can influence. A required increase in banks' capital resources or liquidity
during a period of exuberance would be likely to act, in degree, as a circuit-breaker on
domestic credit supply. So there would be an effect on credit conditions, and so plausibly
some indirect taming of the credit cycle during the upswing. And, crucially, during the
subsequent downswing, the macro-prudential dial could be relaxed where necessary to lean
against the risks of a perverse downward spiral. A broadly symmetric approach would be
important. Its feasibility would depend on there being appropriate minimum capital
requirements in the first place for normal conditions. That is part of the Basel agenda.
So, on this view, the mandate or mission could be expressed in terms of ameliorating the
impairment of banking system resilience that typically occurs during credit booms. It would
probably be hard to achieve that without influencing domestic credit-supply conditions, in
booth the boom and contraction phases.
(b) Possible instruments: capital requirements, risk weights and haircuts
There are two dimensions to pursuing this objective. One is making the system more resilient
in the face of severe shocks by acting on its inter-connectedness. The other is seeking to
adjust the capital and liquidity resources of the system during the up and downswings of the
credit cycle; that is to say, over time. Internally, we refer to these as the "cross-sectional" and
"time-series" dimensions. I am going to focus mainly on the latter this evening.
Work is already underway in Basel to reduce the pro-cyclical properties of the Second
Capital Accord and to encourage dynamic provisioning against expected credit losses. On
the face of it, that seems unlikely to be enough to deliver a "dynamic resilience" objective in
the terms I have described, as it would not directly address stress scenarios. That is a point
of departure for the wider debate on extra instruments.
Much of the existing public commentary starts from an assumption that any such instrument
should be variation in required minimum capital ratios over the course of the credit cycle.
We are currently doubtful about that. But we agree that macroprudential instruments directed
broadly at taming the credit cycle will be functions of - dare I say, derivatives of - micro
prudential requirements on capital and liquidity. That is because, as I have discussed, the
central vulnerabilities in the financial system, and the mechanisms through which it can
amplify the credit and business cycles, are leverage (inadequate capital) and maturity
mismatch (inadequate liquidity). Today, I shall focus almost entirely on the macroprudential
deployment of capital requirements. That is largely because the microprudential toolkit for
liquidity regulation is still in its infancy and subject to international discussion.
So why are we doubtful about simply varying headline capital requirements through the credit
cycle? Imagine that the authorities judge that a boom in lending to (or related to) a particular
sector of the economy had become overly exuberant. To make it topical, assume that this
was lending to the shadow banking system (say conduits, SIVs etc). The authority raises the
minimum capital ratio by Xpp. The affected banks could respond in a number of very different
ways. This could include the perverse reaction of cutting lending to unexuberant parts of the
real economy, while continuing to lend on overly relaxed terms to, in this example, the
exuberant shadow banking system. That kind of thing really could happen if such lending
seemed to offer terrific returns.
What lies behind this problem is, of course, that quite often a credit boom is at least initially
concentrated in one or a few sectors of the economy. That being so, the appropriate
instrument needs to be able to work with a degree of granularity. Two options are changing
capital-ratio risk weights on exposures to particular classes of borrower; and, second, varying
minimum collateral haircuts on secured lending. Since, by definition, the latter can apply only
to secured lending, the Bank has so far been giving more thought to operating on risk
weights.
Using risk weights as the instrument might also enable the authorities to address incipient
problems emerging from credit exposures held in banks' Trading Books and off-balance
sheet exposures as well as in standard loan books. For example, in the upswing of the latest
credit cycle, it would have been helpful to withdraw the 0% weight on 364-day lines of credit,
which fuelled the shadow-banking system of conduits etc; and to have raised the weights on
super-senior credit exposures held in marked-to-market trading portfolios. (By the way, the
appropriate micro supervisory response would have been to ensure that the individual LCFIs
were in fact managing those holdings as trading positions. It seems that some were not.)
Of course, none of this would be straightforward. There would be a lot to be learned about
the transmission mechanism. And using risk weights as the instrument would require
judgments on the relative as well as absolute risks of different types of exposure. I must
stress, therefore, that we are outlining these thoughts precisely so that they can be explored
and challenged. In particular, we should think about whether a macroprudential toolkit might
sensibly include variations in minimum haircuts as well as in risk weights. An eclectic
approach should not be ruled out.
(c) Rules or discretion?
As I have said on a previous occasion, we are doubtful that macroprudential instruments
could be operated by a rule. To steer the banking system towards increasing its resilience to
incipient problems in a stretched sector, a whole series of judgments would have to be made.
Whether the rate of credit growth seemed excessive; whether terms were overly lax; or
whether the "bubble bursting" would materially damage