Paul Tucker: The crisis management menu
Speech by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
at the SUERF, CEPS and Belgian Financial Forum Conference: "Crisis Management at the
Cross-Roads", Brussels, 16 November 2009.
* * *
It is a great pleasure to be here today. The current crisis has thrown up so many lessons in
so many dimensions of the "rules of the game" for the financial system, that I congratulate
the organisers on devoting a whole conference to crisis management. That in itself is a
meaty enterprise. But a vital one.
By way of setting the scene for today's conference, I will offer the Bank of England's
perspective on the various components of a crisis management package: central bank
liquidity insurance for viable firms and markets; firm recovery plans, and contingent capital;
resolution plans for winding down failed businesses, including payouts from
depositinsurance regimes; and official-sector support operations, including emergency liquidity
assistance and Capital of Last Resort. Every country's authorities need a policy on each of
these components, because some day in the future our successors will find that, however
good, the improvements our generation makes in the structure, regulation and supervision of
the financial system will let them down.
A thread that runs through the discussion is how to preserve the core financial services
provided to the economy through periods of extreme stress without bailing out banks' equity
holders or uninsured wholesale creditors. That is the essence of the "Too Big/Important To
Fail" debate. It is not so much that the top management of banks consciously swing for the
fences, but rather that wholesale credit may be systematically too cheap for banks, and
perhaps other intermediaries too, unless the usual market disciplines of failure can apply.
The international community is, rightly, increasingly focused on this. And, in particular, it is
good news that the G20 Finance Ministers and Governors have asked the Financial Stability
Board to pursue it. To quote the theme of this conference, "TBTF" is probably the definitive
Cross-Roads issue.
Central bank liquidity insurance: discount window lending against wide collateral
I shall begin with the central banker's role as lender of last resort, the one area where there
was quite a lot of thinking ahead of this current crisis.
Even so, one of the things many central banks, including the Bank of England, confronted
over the past two years or so was that, when conditions are bad enough, the central bank will
inevitably lend to solvent and viable firms against a very wide range of collateral. Since we
will end up doing so, it is wise to acknowledge that in advance. But, crucially, it is also wise to
set the terms so as to avoid subsidising or encouraging imprudent liquidity management by
firms in normal circumstances. That is one of the principles which underpin the Bank of
England's own new, permanent liquidity facilities introduced just over a year ago. The other
principles are that:
•
Our liquidity insurance should absolutely not cut across monetary policy.
•
In lending against a wide class of collateral, the central bank must apply appropriate
haircuts, and must be capable of valuing the assets and of managing them in the
event of a counterparty default. Our haircuts are published and include various
addons for particular risks. And the underlying assets accepted as collateral should
have a viable underlying market.
•
As a means of effecting the delivery of insurance, secured loans (repo or collateral
swaps) are preferable in most circumstances to outright purchases, as during the life
of a loan central banks can update the value of the security, the collateral margins
and other terms that control the risk to them.
• Such lending against wider collateral should routinely be for sufficiently long
maturities to help forestall panic by avoiding rollover risk for the firms without
exposing central banks to risk by tying them in for unduly long periods.
•
Permanent facilities providing bilateral liquidity insurance should routinely be made
available only to commercial banks (and other authorised deposit takers). They
unavoidably need such insurance because their deposit liabilities are money, giving
them a vital role, as monetary institutions, in the economy and financial system.
•
But such public facilities should not be available to banks where in the judgment of
the central bank there are serious question-marks over their viability or solvency.
(As I shall discuss later, that need not exhaust our menu for providing liquidity to
individual firms in support operations.1)
But the most vital principle is to avoid creating perverse incentives for banks to take
excessive liquidity risk. There are two elements to this. One is the importance of the
regulatory regime: making banks hold a minimum stock of truly high-quality liquidity.
Internationally, the Basel Committee on Banking Supervision and, in the EU, the Committee
of European Banking Supervisors are working on that. In the UK, the FSA is committed to
defining core liquidity as just that: inalienably liquid. Defining core liquidity in terms of assets
that are eligible for rediscount at the central bank, as some have argued, is in our view a
dangerous course to take. It could have the unhelpful effect of making central banks lenders
of first rather than of last resort.
The second element in avoiding perverse incentives is the terms on which liquidity insurance
is available from the central bank. Setting the right pricing is not easy. Two approaches
could, in principle, be adopted. One would be to charge an ex ante fee, say annually, for
access to the liquidity facilities, perhaps based on how much liquidity risk individual banks
had been taking. So far as I know, no central bank has done that yet, but it should not be
ruled out as an idea. The other approach is, of course, to charge a premium interest rate
upon the facilities being drawn on. The Bank of England has adopted a schedule for our
Discount Window Facility under which the rate charged increases with the size of a drawing
relative to the bank's size, and also with the illiquidity and riskiness of the collateral provided.
We want to underline that banks will end up paying more to draw on the insurance line if they
are overly reliant on illiquid, risky collateral - implying that their balance sheet was overly
exposed to liquidity risk. These considerations have to be taken into account if central banks
are to lend against very broad asset classes; for example, as we flagged earlier in the year,
the Bank of England will be deciding over the coming months whether to extend the collateral
eligible in our Discount Window to portfolios of loans to companies and households and of
equities. The Bank of England also charges a premium rate if a bank borrows from us
against assets comprising securitisations of loans they originated themselves. This is
because there needs to be an incentive to make such securities marketable; and, more
important, it can help to protect us against one of the most basic risks in banking - the
correlation between the quality of a bank's underwriting standards and its solvency.
Although central banks need to be ready to lend against a wide range of collateral, we do still
need to be careful about precisely what we take. To that end, my colleagues Paul Fisher and
Sarah Breeden will be developing criteria for the structure and disclosures around the
securitisations that will be acceptable to us in steady state. The ECB is conducting a similar
exercise. Since that may have some read across to the development of the market itself, I
hope we can count on active industry collaboration as we undertake that work.
Before moving on, I should pause for a moment on the Bank's principle that our routinely
available liquidity insurance facilities should be available only to commercial banks. Now, we
do of course realise that, especially in the US, a number of other kinds of financial firm or
vehicle have been given access to special liquidity assistance during this crisis: finance
companies, money funds, securities dealers. But in terms of the reform agenda, to our mind
this underlines the importance of ensuring that a shadow banking system, running big
maturity mismatches but offering capital certainty and instant liquidity to savers, does not
grow just beyond the perimeter of bank regulation. This is not an issue just in the US. It was,
after all, the suspension of redemptions by European enhanced-return money funds that
triggered the money market crisis in August 2007. This part of the reform agenda - the
restructuring of the continuing shadow banking system - must not be neglected.
Market maker of last resort?
The purpose of providing liquidity insurance to banks is well known - having been developed
since Bagehot's day and before. It serves us well to put a finger in the dyke, with a view to
preventing a liquidity panic developing unnecessarily into a solvency problem through the
forced-sale of assets.
But this crisis has reminded everyone that it is not only firms that can suffer liquidity runs.
Markets can too.
Liquidity insurance facilities that underpin banks' funding are obviously helpful to preserving
market liquidity, as they increase the probability of bank-dealers being able to finance
unwanted inventory.
But arguments have been advanced during the crisis that the authorities should be able to
act more directly to preserve market liquidity, especially if bank-dealers withdraw from
market-making because they become capital constrained. That is, essentially, the origin of
suggestion that central banks should stand ready to act as Market Makers of Last Resort.2
As the amount of credit that gets intermediated via markets rather than via institutions grows,
the need for a MMLR grows too.
This is by no means straightforward, and not only because it is not central to our inheritance.
Whereas lending to a bank does with certainty give that bank more liquidity, entering a
market as a buyer does not automatically enhance the liquidity of that market in a
sustainable way. Also, whereas central banks protect themselves against risk in secured
loans by requiring more collateral if conditions deteriorate, an outright purchase is a one-off
transaction; there's no going back to renegotiate the price afterwards.
By analogy with the more familiar "LOLR" function, the following thoughts suggest
themselves for debate in our community.
•
As with LOLR, central banks should only engage in MMLR operations that do not
interfere with monetary policy.
•
A MMLR should aim to buy at a discount to the fundamental value of a risky asset,
with the implicit bid-ask spreads unattractive relative to peacetime conditions in
private markets but impliedly better than those available during the crisis itself. The
purchase mechanism should be designed to reveal information about the state of
the market and the fairness of prices paid.
• While the risk inherent in outright purchases cannot be avoided, the MMLR
absolutely must stay within the capacity determined by its capital resources.
• And crucially, the MMLR should aim to be catalytic, helping ideally to kick-start a
market rather than replace it. And it should avoid propping up markets that would
not be fundamentally viable once the liquidity crisis subsided. The underlying
objective is, as elsewhere, to help to maintain continuity of the crucial services that
the financial system provides to the economy.
In big picture terms, the Bank of England's programme of auctions to purchase small
amounts of a fairly wide range of sterling corporate bonds can be viewed as one
manifestation of that broad approach to MMLR. The aim has been to aid improvements in the
liquidity of the market, including by reducing the inventory risk to "market makers".
But our community is some distance from thinking through the extent to which this kind of
thing should feature as a permanent part of our armoury. While not an urgent issue, it is an
important one given the increasing role of capital markets in our financial system.
Recovery plans, and contingent capital
Whether provided to individual firms or to markets, routine liquidity insurance will not always
suffice. Sometimes a liquidity problem is triggered by fundamental problems. Sometimes a
liquidity crisis creates credit problems through the effects of a fire sale of assets. Firms must
plan for distress. Not only is that in the interests of the financial system and, indeed, of the
economy more widely, it is in the interests of firms themselves. At not a few distressed firms
around the world, at times over the past three years the leadership "lost it" under the
pressure of events. Contingency planning is essential. Regulators must make firms do it -
properly. And that means for really disagreeable scenarios.
As the UK's FSA has recently explained,3 the clear recommendation of the G20-sponsored
Financial Stability Board is that these contingency plans need two, distinct components. A
recovery plan for maintaining a going concern. And a resolution plan for firms that, however
regrettably, need to be laid to rest. The objective in each case is to maintain the financial
system's provision of essential services to the economy.
Firms themselves need to play a leading role in drawing up "recovery plans". At least two
components are needed, roughly corresponding to liquidity and capital. First, a contingency
funding plan (CFP). Too few banks of any size seem to have had one in any serious way.
There was, for example, too little focus on the effects of ratings downgrades on collateral
calls and on the availability of lines of credit. And too little attention was paid to core liquidity
holdings: a treasury portfolio comprising the FRNs issued by other banks does not leave a
distressed bank with many options in the face of system-wide stress. Banks need to know
exactly what assets they hold in which securities-depository systems; how long it would take
to deploy them; and which are eligible in which central banks' routine facilities. Too few
banks had that information readily to hand. Maybe they do now. They should.
The FSA has very kindly agreed to share with the Bank of England the CFPs of banks (and
building societies) where relevant to our functions. As well as helping us to discharge our
financial stability responsibilities more broadly, this will be useful in making sense of requests
to draw from our Discount Window Facility.
Second and beyond liquidity planning, recovery can involve derisking. This might mean
laying off risk, shedding positions or even selling businesses. Once in distress, banks
absolutely must be prepared to shrink their franchise in order to sustain themselves. That
may entail having businesses set up within groups in a way that would facilitate sale, if
necessary. Sometimes what a group regards as its core franchise will not map exactly into
what the authorities think of as the essential economic services it provides. That is obviously
for discussion between firms and their regulators, who need to be ready to exercise powers
to force risk-reduction and recapitalisation where necessary to preserve the soundness of the
enterprise and the stability of the system.
"Derisking" is all about the capital resources of banks in the face of idiosyncratic or
widespread stress. There is, therefore, a read across from the "Living Wills" exercise to the
question of how much capital banks should hold. Almost no amount of capital is enough if
things are bad enough. Which is why contingent capital might potentially be an important
element in banks' recovery plans, as the Governor set out recently in Edinburgh.4
This would not be the kind of hybrid capital that mushroomed in the decade or so leading up
to the crisis. The familiar types of subordinated debt can absorb losses only if a bank is put
into liquidation, and so really has no place in regulatory capital requirements as we cannot
rely on liquidation as the only resolution tool. It has been a faultline in the design of the
financial system as a whole that banks issued securities that counted as capital for regulatory
purposes, and on which they could therefore leverage up, but with institutional investors
treating them as very low risk investments backing household pension and annuity savings.
By contrast, contingent capital would be debt that converted into common, loss-absorbing
equity if a bank hit turbulence. It is, in effect, a form of catastrophe insurance provided by the
private sector.
Why should long-term savings institutions and asset managers be prepared to provide such
insurance? One possible reason is that if enough of them were to do so for enough banks, it
might well help to protect the value of their investment portfolios more generally. If ever it
needed to be demonstrated, the current crisis has surely put it beyond doubt - not only for
our generation but for the next one too - that serious distress in the banking system deepens
an economic downturn and so impairs pretty well all asset values. By taking a hit in one part
of their portfolio by providing equity protection to banks, institutions might well be able to
support the value of their investments more widely. And the trigger for conversion from debt
into equity could be at a margin of comfort away from true catastrophe; say, a percentage
point or so above the minimum regulatory capital ratio.
Of course, this would entail a structural shift over time in investment portfolios. But the
system might be able to manage that adjustment. After all, it managed the all together less
desirable adjustment to the development of the existing hybrid capital markets. But demand
for contingent capital is, inevitably, uncertain at this stage. As are the terms on which it will
be provided. We welcome the growing private sector focus on this.
Resolution of bank failures
If recovery plans prove wanting, then distressed banks need to be "resolved" - laid to rest,
but without undermining crucial economic services. Sometimes the best course will be a
straightforward, whole-bank liquidation, with retail depositors receiving a payout from the
insurance fund. But, alternatively, resolution can involve selling the deposit book - and so the
vital payments services - to another bank. Good assets might go with the deposits, or be
transferred elsewhere. Bad (or at least unsaleable) assets go into run off. Choosing the best
course is central to effective resolution planning.
To split up and transfer the different parts of a bank, the authorities obviously need specific
and extensive powers. The broad model is provided by the Deposit Insurance Corporations
of the USA and Canada. The UK has recently introduced such powers, having learnt the
hard way that we needed them. A number of other countries in the EU adapt their normal
corporate insolvency regime for the special structure of banks, but do not all have the option
to break up and transfer different parts of the business. This is the subject of the recent
consultation paper published by the European Commission.5
In the UK, the Bank of England has become the Special Resolution Authority. We have been
helped by the hands-on operational expertise necessary for our market operations and for
running the wholesale payments system. This new responsibility has given us an interesting
vantage point on the preconditions for effective resolution. In the first place, let me tell you
that it is very information-intensive. It requires a lot of detail on how a bank's business is
structured and run. And that information needs to be available at an early stage. Amongst
many things, it includes details of netting and derivative contracts, and I am struck that, in the
US, the FDIC now requires troubled banks to demonstrate that they could report each day
the relevant details of derivative portfolios. The Bank of England plans to consider whether or
not something like that might be warranted in the UK. More generally, the UK FSA has said
that the authorities will need to be assured that firms are able to provide the necessary data
to assess resolution options and to execute the authorities' chosen strategy.
But it is not just the resolution authority which needs lots of information. Potential bidders for
all or parts of an ailing bank do too - of the kind typically offered to bidders in a "friendly"
M&A transaction. Banks probably need routinely to maintain such "Data Rooms" as part of
their contingency plans - something which the FSA is examining.
As will be abundantly clear from this brief review, the "recovery and resolution plan"
enterprise requires the regulators to work closely with the resolution authorities, and with
central banks as liquidity providers. In the UK, wearing our "resolution authority" hat, the
Bank hopes to be able to work closely with individual banks and the FSA in helping to specify
and guide what is needed in practice. My colleague Andrew Bailey will be discussing in more
detail tomorrow one of the issues raised by past cases.
The enterprise also entails thinking beyond the resolution of modest-sized domestic banks.
Both the US and UK authorities are exploring how to extend resolution regimes to bank
holding companies and to other types of firm that could prove systemically significant in
some circumstances. As present, no one thinks that Large and Complex Financial
Institutions could be resolved at all smoothly, as the rescues of the past twelve months show.
Cross-border resolutions and the international "living wills" exercise
There is, therefore, a substantial international dimension to this work, which is being
facilitated by the Financial Stability Board. Over the next few months, the top 25 or so banks
and dealers in the world will be working with the authorities to produce recovery and
resolution plans. The effort will involve not only line supervisors but also resolution authorities
and central banks. Firms are expected to produce recovery plans. For obvious reasons,
resolution plans need to be produced by the authorities, while still drawing on inputs from the
firms. In the UK, the FSA has recently published how they will approach this international
effort.6
It is a formidable task. Working with the FSB secretariat, my role, as chairman to the
CrossBorder Crisis Management Working Group, will be to help colleagues to flush out the issues,
so that they can be properly debated and reviewed by G20 Ministers and Governors later
next year. With the European Commission on the FSB and also the resolution working group,
I hope that will also help to inform work at the European level.
There will quite probably be hard questions. They could include whether something needs to
be done about the complex structures and organisation of some banks. Another big issue
might be which services truly need to be maintained. Whether there are conflicts between the
insolvency laws and special resolution regimes of different countries that would materially
impede effective resolution for some groups. And another would be whether losses can in
the future credibly be made to fall on wholesale creditors. Maybe even about burden sharing
amongst national authorities if fiscal support proves unavoidable when an internationally
active bank fails. In all this the objective, of course, is to get to a place where taxpayers'
resources are not needed, implicitly or explicitly, to underpin the national and international
credit systems. And some of those operational questions, therefore, shade into the broader
debates about the structure and regulation of the financial system.7
Of that list of issues, I should highlight two today.
The first is the entanglements and conflicts that can exist between home and host insolvency
and resolution laws. There is, for example, a first-order difference between, on the one hand,
countries whose regime effectively permits a de facto ring-fencing of locally domiciled assets
for local depositors and, on the other hand, those that treat liquidation as a joined-up, global
exercise, with all unencumbered assets shared pro rata across senior unsecured creditors.
These issues are not new. They were highlighted nearly twenty years ago by the closure of
BCCI's operations around the world.8 Subsequently, in Europe, insolvency law for banks was
improved through the Credit Institutions Reorganisation and Winding-Up Directive. There is a
single-entity insolvency regime for any bank incorporated in the EEA, applying to the parent
bank and also to all its branches throughout the EEA. We also have, in the Settlement
Finality Directive, a sound legal basis for the integrity of wholesale payments transfers in the
event of a default, without which the effects of failure could be truly devastating. And in the
Financial Collateral Directive, we have an assurance that national insolvency or
reorganisation measures cannot be applied to prevent or delay counterparties of a failed
institution from exercising their rights to close out, net and/or enforce their security interests
6
Financial Services Authority Turner Review Conference Discussion Paper, "A regulatory response to the
global banking crisis: systemically important banks and assessing the cumulative impact", FSA DP 09/4.
7
King Mervyn A. (2009), "Speech by Mervyn King, Governor" to Scottish Business Organisations, Edinburgh,
October 2009.
8
Basel Committee on Banking Supervision (1992). "The insolvency liquidation of a multinational bank", Bank for
International Settlements. Its key conclusions were: (1) when closing a multinational bank, supervisors should
pay attention to the nature and timing of communications among themselves and of their communications with
creditors, shareholders and management; (2) the nature of liquidation rules may be relevant to the manner in
which multinational banks are supervised; (3) differences in liquidation rules across jurisdictions in a
windingup can affect returns to depositors and other creditors and the operations of deposit protection schemes; and
4) coordination and cooperation between liquidators can affect the returns to creditors in a liquidation and can
be affected by the role of supervisors in a liquidation.
BIS Review 144/2009
in order to realise financial collateral. But we do not yet have compatible bank resolution
regimes, and some existing Directives were designed without resolution in mind.
We now have another chance. The Basel Committee on Banking Supervision has published
an extensive review of impediments to the resolution of cross-border banks arising from
national insolvency laws, resolution regimes, or supervisory practices. And the European
Commission has recently launched a consultation asking what changes to the European
legislative framework are needed to address these issues. We need to focus on who should
take what concrete actions. I think the FSB will be picking up that issue.
Resolution and support operations: who should pick up the tab?
The second issue concerning resolution I want to say something about is the allocation of
losses to creditors and to the official sector from support operations. The formal position
varies between support for insured deposits and for other creditors.
Deposit insurance, and risk-based premia
Insured deposits are, of course, insured. It is often assumed that governments stand behind
such schemes. But governments do not have pick up the final tab. Such schemes are
ultimately paid for by the banks themselves. Whether schemes are funded or not,
governments have a legal right to make recoveries from the residual banking industry over
the succeeding years.
There is, still, a question of the basis of the levy. This arises most clearly in a system which
guarantees 100% repayment up to some meaningful amount (now £50,000 in the UK). While
it has many merits, complete cover affects the dynamics of the market place in a potentially
unhelpful way. It makes it easier for banks to pay up for deposits. The implied signal that a
bank offering a high return would be taking greater risk than others, as it would have to, does
not matter to the depositors. They are covered, and so are induced to place their money
wherever they can achieve the best returns.
That is a recipe for imprudent risk taking. One possible way of addressing it would be to
make such risk-taking banks pay a higher levy into the insurance scheme. The Bank of
England thinks that this deserves serious consideration, and it is now the subject of debate in
the UK.
Beyond deposit insurance: how can the industry bear the cost of rescues?
During the current crisis, around the world governments have gone much further than
protecting only insured depositors - uninsured wholesale creditors have been bailed out too.
The need for such support operations was evident if complete systemic collapse was to be
averted. But it does raise big questions looking ahead - of fairness and of incentives. Once
more, we need some principles for what are in effect official Capital of Last Resort (CofLR)
operations.
One possible starting point is how central banks have learned to think about bespoke
liquidity-support operations, so called Emergency Liquidity Assistance. After explicitly
recognising that occasionally liquidity support operations can end up providing de facto risk
capital if the recipient deteriorates, the late Eddie George offered some thoughts on this in
1993;9 "central banks are not in the business of providing public subsidy to private
shareholders. If we do provide support, we will try to structure it so that any losses fall first on
the shareholders and any benefits come first to us. And any support we provide will be on
terms that are as penal as we can make them, without
precipitating the collapse we are trying to avoid ......... We look for a clean exit. The
company may be required to run down or restructure its operations, under our surveillance,
to the point where it can do without our support. We aim to protect the system, not to keep in
being unviable banking capacity ......" And, paraphrasing Mervyn King in 2007: "if the
[authorities] underwrite any [risk] that threatens to damage the economy as a whole, it
encourages the view that as long as a bank takes the same sort of risks that other banks are
taking then it is more likely that their problems will be insured ex post."
That provides a useful context for the debate about whether the cost of bailouts can
somehow be recovered from the industry. Compared with a year ago, a number of ideas are
now in circulation. One possibility is to establish a fund in advance. Another is to raise a levy
on the surviving banks.
An argument in favour of the former is that it would raise contributions from risky banks
before they fail. And it would allow the levies to be related to the size of their uninsured
creditors, as some in the US have suggested.10 But I do just wonder whether it would be
realistic to raise, and over the decades sustain, a sufficiently large fund.
The alternative, as I have discussed before,11 is to raise a levy from surviving firms after the
event. This would have to be linked to a systemic-crisis threshold being passed for the
deployment of public funds. And the basis for deciding how much was recovered from
individual firms would need to be both clear and principled. In particular, it would be
important to try to incorporate features that enabled costs of failures somehow to fall to
uninsured, wholesale creditors. Those who finance the system in the good times need to
have incentives to price for risk.
Summary
This has been a fairly high-level survey of the instruments on the crisis management menu.
They are, of course, interlinked. They also bear on the wider debates about the structure and
regulation of the financial system. Perhaps most obviously, the feasibility of producing
recovery and resolution plans will feed into international and domestic decisions on minimum
capital requirements for banks in general and on the mooted add-ons for so-called
systemically significant firms. The weaker a recovery plan and the greater the obstacles in
the way of its effective resolution, the more capital (and liquidity) a bank is going to have to
hold. This is why emerging interest in Contingent Capital instruments is so important. If
CoCos could form a material part of recovery plans, the landscape might just be transformed.
And that in turn goes to the big issue. Whether our community can find ways of distributing
the costs of official sector support operations back to the system and its uninsured creditors
rather than to the general taxpaye