John Gieve: Learning from the financial crisis
Speech by Sir John Gieve, Deputy Governor of the Bank of England, 2008 Europe in the
World Lecture Panel Discussion, at the European Business School, London,
19 November 2008.
* * *
The years after sterling left the ERM were the most successful and stable in my lifetime. In
early 2007, for example, inflation had not moved by more than a single percentage point
away from target in the previous 10 years, the output of the economy had grown in every
quarter since 1992 Q3 (Chart 1), unemployment had fallen by 5 percentage points from its
peak in the early 1990s and living standards had steadily increased. Interest rates had been
low and stable.
However as we know now, that was the end of "the Great Stability". The summer ushered in
a period of extraordinary turmoil in Western financial markets which we are still trying to
calm. And this year has seen the onset of recession not just in Europe but throughout the
advanced economies. Despite the dramatic policy measures of the last months, the outlook
for 2009 is bleak and the prospects beyond are uncertain.
That move - in the space of only 12 months - from the policy maker's dream of steady
noninflationary growth to the biggest banking crisis since the outbreak of World War I and the
onset of recession sets the questions for this evening.
First, how did we get into this position?
Second, what are the immediate challenges for policy?
And finally, what lessons should we draw for the future?
How did we get here?
The path that led from losses in the US sub prime housing market to a collapse of confidence
in the Western banking system and a savage credit squeeze has been described many
times, most recently in the Bank's Financial Stability and Inflation Reports. I don't need to
repeat that here but I would highlight two features: first this is a global story; second, the
nature of the crisis has changed over the past 15 months and has called for a changing
policy response.
A global crisis
You cannot explain recent developments on a national basis, even in the US. The roots of
the crisis lay in global imbalances in trade and capital flows between advanced and emerging
economies. The rapid growth of exports from Asia, and latterly the Gulf, was reflected in a
substantial build up of savings. In China the national saving rate peaked in exceeded 50% of
GDP. Those funds flowed back to the developed world and to the US in particular. That kept
interest rates low and allowed a rapid growth of credit. Following the dotcom bubble, there
was a particular appetite for fixed income investments which led to an increasingly risky
search for yield. That was the platform for the excesses of lending to the sub-prime housing
market in the US and a sharp rise in house prices more generally.
The impact was not confined to the US. The flow of funds into the US was re-exported to the
advanced economies, especially through the growing securitisation markets, and helped
finance the rapid increases in house prices in the UK (Chart 2) and many other countries.
And that internationalisation of markets was reflected also in the build up in our banks of
portfolios of AAA-rated securities which offered a slightly better yield than traditional bonds
and many of which were based on sub-prime assets.
So when losses emerged in sub-prime market, they not only hit US banks but ricocheted
through the international financial system. Much of the commentary has focused on the
structured credit losses in banks' trading books and treasuries and they have certainly been
large.
But equally as important was the impact on the liability side of balance sheets. Banks had not
only expanded their balance sheets too far, they had in the process become reliant on
wholesale funding markets which had not been tested in a downturn. In the UK, the gap
between customer lending and deposits moved from zero at the turn of the century to over
£700 billion in 2008 H1 (Chart 3). That proved a structural weakness when investors realised
that the AAA label concealed substantial and uncertain risks and withdrew from the
securitisation markets.
Just as the origins of the crisis lay in global imbalances its effects are also global. Initially, the
impact of the crisis seemed to be concentrated in the US and a handful of European banks in
Germany, the UK and Switzerland which had pursued particularly risky strategies. The euro
area as a whole did not see a marked reduction in credit growth. Meanwhile the emerging
economies of Asia continued to boom. With wages and prices rising, many of the people I
met in India and China at the start of the year rather welcomed the prospect of a fall in
Western demand as a means of taking a little of the heat out of their own economies.
But despite different starting points and policies, we have now seen bank failures in many
countries in Europe and acute pressures develop everywhere. And the US, Japan, the euro
area and the UK have all entered recession. This summer has also brought a slowdown in
growth in the Far East and other emerging economies which is likely to test political as well
as economic regimes.
The challenge for policy
It was clear last autumn that the financial crisis was leading to a squeeze on credit and
lowering the prospects for growth and inflation in the UK. That was why the MPC, which had
been raising rates as late as July, cut Bank Rate in December last year and followed with two
more reductions in February and April. While the euro area started with lower rates and
initially seemed less affected than the UK by a credit crunch, expected increases in rates
were delayed.
However, these downside pressures were not the only challenge to policy. Oil prices which
had been pushed up by the rapid growth in emerging markets took another dramatic jump
and food prices began rising more quickly too. Between 2007 and mid-2008 oil more than
doubled in price, while food prices rose by around 80%. At the same time sterling which had
climbed to $2.10 in November 2007, fell back. The result was that consumer price inflation in
the UK rose well above target to 3% in April and over 5% in September, its highest rate since
1992 (while RPI inflation has been over 4% for all but 4 months out of the past two years).
Not surprisingly expectations of inflation also rose sharply (Chart 4), raising the risk that
higher inflation would become embedded in decisions on the prices for other goods and
services and on pay. Of course commodity prices and inflation more generally have now
begun to come down but I believe the risk of dislodging expectations was a real one, not a
mirage. Certainly I felt that to reduce rates during months when inflation was not only rising
rapidly, but was rising faster than we had forecast, would be confusing and might weaken
confidence in our resolution and the credibility of the inflation target . On similar grounds,
despite the appreciation of the euro, the ECB raised rates in July this year.
In the spring and early summer, the financial crisis also was showing some signs of
stabilising in the US and in Europe, particularly after the takeover of Bear Stearns in March
signalled that the "state safety net" in the US had been extended to cover investment as well
as commercial banks. The introduction of the Special Liquidity Scheme in April here and
extensive liquidity measures in the US led to a period in which funding pressures eased and
Libor spreads and CDS premia softened. Our August forecast was for a pronounced but
limited deterioration in growth. The threat of a strengthening feedback loop from a
contracting banking sector to a severe downturn in the real economy had not disappeared
but did not seem the central case.
But the risks and the challenges changed dramatically in the autumn.
First, the losses incurred by investors in the rescues of Fannie and Freddie combined with
the decision to allow Lehman Brothers to go into administration, led to a dramatic loss of
confidence in financial markets (Chart 5) threatening a savage further twist in the squeeze
on credit for households and companies.
Second, we saw a sharp weakening in oil prices (Chart 6), with the odds implied by options
of such a fall less than 1%. Other commodity prices also fell. And, even before that was
reflected in consumer prices, the public's inflation expectations turned down decisively.
In short, the balance of risks between inflation being above or below target in the medium
term shifted decisively to the downside.
That was the background to the internationally coordinated reductions in interest rates in
early October and the aggressive cut of 150 basis points in Bank Rate in November, the
largest reduction in official interest rates since 1992 (indeed I believe it was only the third
time Bank rate had been cut by 150bp since the Bank was founded over 300 years ago).
Even so, our latest medium term projections for inflation show inflation remaining below
target in the medium term and suggest further reductions may be necessary (Chart 7). Of
course, there are large uncertainties around that projection; more so than usual. In particular,
they take no account of any fiscal measures that the Government may announce next week.
Just as we had to change gears on monetary policy, so we needed to change our approach
to the banking sector. The tripartite authorities - the Bank, FSA and Treasury - were
criticised for the handling of Northern Rock and for being slow off the mark when the crisis
started in 2007. But we learned from that experience. We have established new ways of
providing the market with the liquidity that it needs. And, as the crisis has widened, we have
dealt with vulnerable and failing banks, such as Bradford and Bingley, more speedily and
cleanly.
But as the crisis deepened in late September, it became clear that we needed more than a
case by case approach here to tackle the continuing loss of confidence in the banking
system in the UK, in euro area and in the US. On 8 October therefore we announced a
comprehensive package of measures including support for recapitalisation, guaranteed
funding and enhanced liquidity. That very quickly became the template for action in other
advanced and some emerging countries.
The central plank of the package was the offer to underwrite capital issuance of at least £50
billion and it is important to be clear what that was intended to do. It was not to establish new
regulatory minimum ratios. It was intended to underpin confidence in the banks and to
ensure that each institution would have a sufficient capital buffer both to absorb losses that
are likely to arise during a recession and to continue lending on normal commercial criteria.
Under the new Basel II rules the ratio of capital to risk weighted assets is almost bound to fall
as arrears and losses mount. The aim of the package was to create the headroom for that to
happen and to remove the capital pressure on banks to deleverage quickly by refusing even
good credit requests.
The capital raising is not complete of course but the process is underway. Banks and
building societies have already secured around £50 billion of guaranteed funding in the
market and has facilitated new bank debt issuance without the need of a guarantee. Overall
there has been some easing in the money markets and some repair in confidence. The
complete seizure that was looming has been averted.
However, we are clearly not out of the woods yet. Financial markets across the world are still
badly impaired; spreads have not yet returned to their summer levels; and, while banks look
more secure, many hedge funds for example are under increased pressure. In the wider
economy, we are only in the early stages of a recession in the advanced economies and of
the slowdown in emerging markets. So we must be ready to take further action if required
whether monetary, fiscal, or directly in the financial sector.
Lessons for the medium-term
That is the immediate prospect. I want to finish by drawing out some lessons for the medium
term.
1. Closer international co-ordination of macroeconomic policy
The first lesson is the vital importance of international cooperation in a global economy.
For several years we worried about the growing imbalances between the US in particular and
emerging Asia. We can now see how painful the rebalancing is proving. No doubt we could
do better in national policy making but we also need to recognise that the sum of policies
which make sense at the national level may well not be optimal at the global level. To give
one example, for most economies individually a change in the oil price is an external event -
something beyond the reach of policy. But clearly that is not true of the global economy as
whole.
Of course we have a great deal of experience in the EU of establishing common rules and
policies. We know it is a painstaking process among 27 countries. But on finance and the
economy we need to go wider than the EU and wider than the G7 to engage the new
economies which account for so much of world growth. That is why it was so important and
welcome that the recent meeting in Washington was of the G20 rather than the G7.
Alongside the IMF it is going to play a key role in global macroeconomic coordination.
2. Better ground rules for cross-border financial crises
The failure of Lehman Brothers has confirmed that cross-border failures of large and
complex firms are just as damaging and difficult to manage as we had feared. We need to
ensure that proper contingency plans are prepared between the authorities most concerned
for failures not just within the EU, where a lot of work is in hand, but on a global basis.
As a start I hope we can establish a robust and predictable framework of rules and
conventions that ensure that home authorities will co-ordinate a cross-border response
better. The Financial Stability Forum is working on these urgently.
This is not easy. In particular emergencies there are often different national interests at stake
and the sheer pressure of events can limit cross-border consultation. However, if we do not
tackle this we will see the growth of national restrictions on the terms on which cross-border
operations are permitted - in terms of capital, liquidity and legal structure - and that could
have great economic costs.
3. Strengthening banks' resilience
The financial crisis has revealed a number of gaps and flaws in the regulatory and
accounting conventions especially for banks. We need to put those right quickly and on an
international basis. The G20 Summit has asked the Financial Stability Forum to take that
forward.
For example the events have shown up the lack of any agreement on liquidity requirements
on banks. The FSA is developing proposals for UK which will deliver tougher standards. But
we are pressing also for international agreement in the Basel Committee. Events also
brought home the need for a fundamental review of both the amount and the definition of
capital requirements.
4. And developing macro-prudential tools
The last lesson I have drawn is that we need to bridge the gap between macroeconomic
policy and the regulation of individual firms. We need a third club in our bag which can
directly dampen the financial cycle. This is needed both for financial stability and for wider
economic management.
As we have been reminded over the past 15 months, it is primarily in the "bad times" that
banks need to demonstrate that they have adequate financial resources. We need to ensure
that banks build up resources in good times to a greater extent, which can then cushion the
shock in bad times. I think of this as "protecting banks from the economic cycle".
But we have seen also how the financial sector can drive the wider business cycle, by
becoming over-confident in the upswing and over-constrained (by lack of financial resources
- capital and liquidity) in the downswing. It seems to me that mechanisms which oblige
banks to build up resources in good times can serve a second useful purpose of dampening
the economic cycle. I think of this as "protecting the cycle from banks".
We need two-way protection and I would like to describe three ways you might go about
providing it.
The first is the Spanish system of dynamic provisions, which requires banks to build a
general reserve that can be drawn on in downturns. Each period, banks are required to make
general provisions equal to the difference between the "inherent" losses (based on the
growth of loans and a long-term average of incurred losses) and the specific provisions on
impaired assets for the period. The difference, if positive, is treated as an expense in the
profit and loss account. If negative, it is treated as income - provided that the general
reserve has been previously built up to the required level.
The specific provisions made by Spanish banks fluctuate substantially through the business
cycle, as one would expect, falling during upswings and increasing in downturns. But the flow
of general provisions moves in the opposite direction, acting as a countercyclical mechanism.
In the last boom, the accumulated stock of total provisions grew steadily between 2005 and
2008, to a level which at the start of this year was twice as large as their non-performing
loans. That figure has fallen sharply in recent quarters, in the face of fast-growing credit
losses, but it did ensure that Spanish banks were better placed than their counterparts in
other countries to absorb such losses without immediately eating into their core capital. The
Bank of Spain estimates the current level of general provisions could absorb losses
associated with a doubtful assets ratio of 9% (the current level is 1.5%). The general reserve
is also substantial in comparison with the tier 1 capital ratios, representing 1.3% of the
riskweighted assets.
I know that general provisions fall foul of modern accounting practice and can be unpopular
with tax authorities. But the Spanish example demonstrates that - despite all the technical
arguments there might be about the details - a mechanism with broadly the right features is
practicable and can generate worthwhile additional reserves against the losses which
crystallise in cyclical downturns. It does not require precise estimates of the length of the
cycle, or predictions of when the cycle will turn; and it can be capped, so that the reserve
does not continue to grow inexorably in an extended upswing. I think it merits serious
consideration for more widespread adoption, irrespective of the accounting and tax treatment
such reserves might attract.
One key feature of such reserves is that they should be useable. That is, the markets and
analysts need to accept that using such reserves to absorb write-offs when losses are high is
the natural counterpart of building them up when losses are cyclically low. It is not a sign of
weakness or of inadequate capitalisation, but of prudent management of the cyclical pattern
of losses. From the point of view of market acceptability, separating cyclical reserves from
more structural capital requirements seems a valuable idea.
The second scheme I want to promote is growth-related capital requirements.
Losses tend to be lower in the early stages of a loan's life than when it is fully seasoned
because borrowers are more certain of their own and the economy's near-term prospects. A
loan book which is growing more rapidly than average will be weighted towards such
unseasoned loans, and so will appear to be performing better than a balanced portfolio of
loans of different vintages. In addition, rapid growth of lending tends itself to be associated
with taking on poor business - even if that is not obvious at the time it is written. Typically,
rapid growth can only be achieved by drawing in marginal borrowers to the market. That is
true of the banking sector as a whole. And when such growth is achieved by an individual
bank, over and above that achieved by its peers, adverse selection - attracting weaker
borrowers, who are unable to raise funds from other lenders - is an additional factor
depressing the quality of the loan book. The simple fact is that rapid absolute and relative
growth is strongly associated with poorer average loan quality and, sooner or later, sharply
higher non-performing loans.
The proposal is that, the risk weighting (and so, the capital requirement) of bank loans should
include a growth-based component. This could be linked either to the economy-wide growth
rate of a particular type of business, or to the growth rate of an individual bank's lending
relative to the market as a whole; or some combination of the two. This would make it more
expensive for banks to expand their balance sheets faster that normal when confidence is
high and could be a useful means of dampening banks' contribution to the business cycle.
The third, less direct, mechanism to discourage over-rapid expansion would be on the
liabilities side. Rapid balance sheet expansion tends to be fuelled by access to less stable
sources of funding, attracted perhaps by higher interest rates as the bank seeks to meet its
balance sheet aspirations (and feels able to pay, because - as already explained - loan loss
experience is good). Such funding could be treated as an added risk factor in assessing a
bank's liquidity needs and those needs should be reflected in a requirement to hold high
quality liquid assets. So banks which are funding their expansion in this way will need to
match that expansion with an increasing stock of safer and lower-yielding assets. This will
tend to reduce their profit margins and so discourage rapid growth which is funded from less
stable sources.
Of course these outline proposals need a lot more work. Striking an appropriate balance
between the prudential objective of protecting the banks against the cycle and the
macroeconomic objective of dampening lending in the upswing will not be easy. And they are
never going to be the whole answer. The more we raise the cost of cost of increasing lending
by banks, the greater the incentive we will create for the growth of intermediation outside the
regulated banking sector or to foreign banks not subject to such counter-cyclical
requirements. Even if such unregulated competition had no consequences for banks
themselves, it could certainly undermine the desired counter-cyclical effects. And the
secondary banking crisis of the early 1970s is a reminder that we cannot anyway be relaxed
about changes in the scale of lending taking place outside the regulated sector.
Conclusion
To sum up, the last 15 months have brought home the costs of unbalanced growth in the
world economy. Although the correction started with a bursting property bubble in the US, it
has expanded into a global financial crisis and brought on recession throughout the
advanced economies and a sharp deceleration of growth elsewhere. The immediate priority
is to deal with this downswing. The extraordinary measures we have taken in this country
and others are having a positive impact but we may need to do more. We must also learn
some lessons for policy in the medium term including the need for far better coordination of
policy internationally and the need for some new policy instruments alongside interest rates
to dampen the financial cycle.
Chart 1: GDP and employment Chart 2: House prices and earnings
Source: Halifax, Nationwide, ONS and Bank calculations
Source: ONS (including Labour Force Survey)
Chart 3: Major UK banks' customer funding Chart 4: CPI and households' inflation
gap, household saving ratio and foreign expectations for the year ahead (scaled to match
interbank deposits CPI on average)
Source: Bank of England, Dealogic, ONS, published accounts
Sources: The AlphaMonitor: consumer, YouGovAlpha, Bank of
and Bank calculations.
England, Barclays Capital, Citigroup, GfK NOP, research carried
out by GfK NOP on behalf of the European Commission and
YouGov.
Chart 5: Sterling three-month interbank rates relative Chart 6: Oil prices
to future expected policy rates
Sources: Bloomberg and Thomson Datastream
Sources: Bloomberg and Bank Calculations
Chart 7: CPI inflation projection based on market interest rate expectations