Paul Tucker: Building resilient financial systems - macroprudential
regimes and securities market regulation
Speech by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
at the International Council of Securities Associations, London, 23 May 2011.
* * *
My thanks to, amongst others, to Svein Andresen (Financial Stability Board), Alastair Clark, Michael Cohrs,
Dilwyn Griffiths (FSA), Andy Haldane, Edwin Latter, Pippa Lowe, Graham Nicholson, Sarah Casey Otte (FSB),
Hector Sants, Victoria Saporta, Philip Thorpe, Martin Wheatley (Hong Kong SFC) and Andrew Whittaker (FSA).
These remarks do not necessarily represent the positions of the Bank of England or of its Financial Policy
Committee.
Thank you very much indeed for inviting me to join you today. I am especially grateful as it
gives me an opportunity to air some thoughts about how the regulation of our securities
markets fits into the development of macroprudential regimes for preserving stability in the
future. In a debate often dominated by concerns about banks, the vital importance of resilient
and effective capital markets is easily neglected. This is not at all to diminish the vital lessons
from the crisis for banking supervisors around the world, many of whom had lost their
traditional system-oriented perspective.1 But the rules of the game set by securities
regulators provide a framework for the functioning of markets that is as important to the
operation of the financial system as the regime for banks.
This is especially important for the UK authorities because London hosts the most
international capital markets and yet the City is not a hermetically sealed entrepôt. It is bolted
into our real economy. And it is especially important for the Bank of England as we establish
the new Financial Policy Committee, the UK's new macroprudential committee. But my
remarks today are a contribution to the international reform agenda rather than for the UK
specifically.
The importance of capital markets
I am guided by my working definition of financial stability. That is that financial stability
prevails where the financial system is sufficiently resilient that worries about bad states of the
world do not undermine confidence in the ability of the system to deliver its core services to
the rest of the economy2.
As the Bank has set out in its strategy for financial stability3, the core services are the
transfer of payments; the provision of credit and equity; and risk transfer or insurance.
It is obvious that the resilience of firms matters hugely. But that cannot be all. Firms are
linked by markets and infrastructure though a network of contracts covering derivatives;
repos and securities lending; correspondent banking, clearing and prime brokerage services
etc. Moreover, some markets bring end users together. A financial-stability policy regime that
focused solely on the financial soundness of a few firms would, therefore, be myopic. But
while nearly all markets are subject to regulation, relatively little thought has been given over
the past decade to how different markets matter to stability and, hence, about the role of the
authorities in this area.
Markets matter to stability in different ways
As a provisional attempt at this, I think it might be helpful to distinguish between three types
of market: infrastructural markets, intra-financial-system markets, and end-user markets.
The first type is those markets that provide essential, quasi-infrastructural support to
banking. The obvious example is the overnight wholesale money markets. They are
effectively part of the payments system infrastructure. Banking, which is integral to the
provision of all three core financial services, simply could not operate without these markets.
They have long been, and will remain, of concern to central banks. I will not return to them
today.
The second category is intra-financial system markets (a slightly broader concept than
inter-dealer markets). These markets determine the interlinkages amongst financial firms.
They matter because banks, dealers and funds rely on them in order to provide services to
the rest of the economy, and also because they can increase fragilities in the system. They
are perhaps represented best by what have become known as the "financing markets": repo,
securities lending, certificates of deposit etc - the markets that financial firms use to access
short-term wholesale funding. The authorities' engagement with them is, frankly, patchy. At
one end of the spectrum, central bankers in particular have a good track record of ensuring
the professionalism of core government-bond repo markets. That was not without good
cause. When the US Treasury repo markets started in the mid-to-late 1970s, there was a
string of scandals4. When the UK authorities opened up the way to a gilt repo market in the
early-90s, therefore, we worked with the industry on the supporting hard and soft
infrastructure, including a Code drawn up by the Stock Lending and Repo Committee, to
avoid a repetition in London of Wall Street's experience. It would be hard for the authorities
to claim the same foresight concerning the wider securities lending or repo markets in recent
years. The employment by securities lenders of cash collateral became a core but hugely
opaque financing market in the run up to the latest crisis5. The run on repo, documented by
Gary Gorton6, was how the US securities dealers unravelled. The authorities need to develop
policies for monitoring and, where necessary, controlling these markets for providing
leverage and maturity transformation. I believe that central banks can play a special role in
this area.
Important "intra-financial system markets" are not restricted to banking. The reinsurance
markets, and the mechanisms for sharing risks in Lloyd's of London, are other examples. As
are the inter-dealer markets in derivatives, which have traditionally employed different
protocols (notably collateralisation, under Credit-Support Annexes) than get used in
transactions with end users. Away from banks, these Over the Counter derivative markets
have been the principal focus of policy. They are being rethought, under a mandate from the
G20 Leaders7.
The third category of markets is those that matter directly in their own right to
end users.
Notably the primary markets in equity and debt. These markets and the associated
secondary markets often rely on "market makers" for liquidity, but they are not the marginal
source of financing or risk management for banks and dealers. In the past, they have often
been distant from the attention of the financial stability authorities, but their integrity has long
been a focus for securities regulators. They are especially important in economies where a
significant proportion of the intermediation of savings/investment occurs via capital markets
rather than via bank balance sheets. If those core capital markets are not resilient to shocks
and, crucially, if substitutes are not readily available, disruptions could materially impair the
supply of credit and risk-capital to the economy, with macroeconomic and other welfare
costs. Equity and high-grade corporate bond markets probably pass that test in a number of
developed economies. In the USA at least, some securitisation markets were probably
significant too. When the securitisation markets closed, they had become so big in the USA
that it was not realistic for that part of the credit system to be reintermediated by the US
banking system in short order. Even if the banks had been strong, they would have needed
to raise a lot more capital to expand their balance sheets.
It is, of course, natural that policy has focused on those markets - securitisation and some
OTC derivatives - that featured prominently in the crisis. But we do need to develop a
framework for identifying more generally which markets really matter to stability. That means
being attentive to exchange-traded derivatives and to cash markets, whether on or
off-exchange, and perhaps especially to the short-term financing markets.
Where firms are concerned, we have learned to focus on maturity transformation and
leverage. For markets, it is, perhaps, not quite so straightforward. In the case of
intrafinancial system markets, we are interested in whether they produce chains of cumulative
maturity transformation and leverage, and how transparent that is. With end-user markets,
we are also interested in whether they are driven by strongly procyclical forces; whether they
are especially liable to generate assets whose risks are mispriced or obscure; whether
demand is dominated by leveraged investors and traders. We are interested in whether they
can crater - becoming illiquid or even closing - under stress. And in whether there are ready
substitutes. If not, intermediation can become impeded and end-users deprived of valuable
services. Across all of these concerns, the underlying factors may be either structural or
cyclical. And they go wider than the traditional focus of securities regulators on the integrity
of transactions in "end user" markets.
public
In practice, the components of individual markets give us a list of things to focus on. A list
that goes well beyond firms: products and their distribution in primary markets; the rules of
the game and infrastructure for including the role of market makers; the
trading,
infrastructure for post-trade clearing and settlement; and asset management practices.
Especially for "end-user markets", these are subjects typically associated with securities
market regulation not with mainstream supervision. I want to bring out that
microprudential
they are, nevertheless, integral to financial stability authorities. Under each of those
headings, I shall raise a few points that have not featured prominently in recent debates. To
be clear, I shall not attempt to cover all important markets. And I shall not address important
questions about the role of securities regulators in crisis management, circuit-breakers, or
counter-cyclical policies such as varying minimum margin requirements as conditions
change. Moreover, I must stress that I speak only for myself.
The issuance and distribution of securities
Toxic ABS and CDOs - cash as well as "synthetic" or derivative versions - were at the
centre of the crisis. They were not toxic for the financial system because they were risky or,
indeed, because many underlying household and business borrowers became overindebted.
Markets can price (and ration) risk they comprehend (if appropriate requiring yields that
inhibit issuance). They were toxic because they were mispriced; and they were mispriced in
part because they were misunderstood. Through the consequent enticements to leverage,
that misunderstanding engulfed banks, asset managers, credit insurers and, eventually, the
authorities. Both dealer-financing markets and end-user markets closed.
Listing authorities and securities regulation
And yet all of those securities were issued and/or distributed under the securities laws and
policies of developed countries or financial centres with elaborate securities market
regulation. Prospectuses or other documentation had to meet regulatory or listing
requirements. Those requirements were meant to be exacting if the securities were issued
onto the public markets. In Europe, it seems most issuers of ABS and CDOs chose to list
them in Ireland or Luxembourg. In many jurisdictions, including the USA, the requirements
were deliberately less exacting if the securities were distributed solely via the "private
markets" to wholesale or sophisticated investors.
This prompts two thoughts.
First, with hindsight, could Listing Authorities and securities regulators8 do more in the future
to ensure that the disclosure around complex securities are comprehensible, coherent and,
crucially, simple and short enough to be capable of being absorbed? And should Listing
Authorities be more willing to step in and require changes to the structure of complex
securities where they conclude that the disclosure is inadequate and just realistically
cannot
be made adequate? Have "risk factors" become so numerous, wordy and wide-ranging that
they lose their impact? In their understandable desire to avoid validating products and
securities, have securities regulators retreated too far towards simply checking that the
required boxes have been ticked? Perhaps I am imagining it, but I recollect a period in which
Listing Authorities were guardians of the integrity of primary markets. That over time came to
rely upon disclosure. And that ended up meaning accepting documents that were
comprehensive rather than comprehensible. Where something is incomprehensible, and has
reached a scale where it could even jeopardise stability, the relevant authority should say so.
Where it can be made comprehensible via a succinct piece of analysis in the introduction of a
Prospectus, the Authority could require that.
What I am suggesting would entail Listing Authorities and securities regulators more
generally thinking about themselves somewhat differently and, if I may say so, being
somewhat less bound by the traditions of public equity markets. This seems unavoidable
given the growth in private offerings of complex securities and the involvement of banks in
securities-market intermediation. It might require legislation in some jurisdictions to entitle
securities regulators to take into account financial stability9. Prior to the crisis, that had hardly
been debated anywhere, but IOSCO's principles of securities regulation have recently been
revised to identify reducing systemic risk as one of the three objectives of securities
regulation.10 That innovation is big, but it needs to be incorporated into national regimes and
practices.
Second, is it always right to make a clear distinction between laws and rules governing
"public" issues and private placements? Viewed against the historical objectives of securities
regulation - fairness, transparency, and investor protection - the public market v.
privatetransaction distinction does indeed seem valid. But we need to debate whether the
separation is so neat when the public policy objective of financial stability is taken into
account. That is because the creation and private placement of very large amounts of
particular types of security can affect the amount of risk being borne by the system as a
whole in ways that are opaque to everyone. For example, in the USA, as the SEC has
commented, a lot of structured-finance products, including pretty well all CDOs and
AssetBacked CP, were issued privately and so were exempt from a panoply of disclosure
requirements that apply to "registered" offerings.11 Reducing that opacity, and ensuring the
integrity of these market mechanisms, could well be in the interests of investors in private
placements themselves.
This issue is not easy. On the one hand, it is reasonable for the regulatory regime to make
allowance for private transactions amongst "consenting adults". And the issuance of small
amounts of any type of security cannot possibly jeopardise stability. On the other hand, it is
reasonable for public policy regimes to address the externalities - in this case, the potential
systemic effects - of thousands of large private transactions that take place away from public
markets. My concern is not that sophisticated investors cannot fend for themselves. And I do
not want to deny that private transactions can aid stability, as indeed has been the case with
much recent private-market debt issuance by banks. But nobody can assess the risks they
are incurring in some transactions without much more information about the of risks
totality
out there and the network of exposures within the financial system. At the least, good
aggregate information is needed about patterns of issuance in private markets.12
Product gatekeepers: securities regulators
These questions of how securities regulators should respond to the possible effects of
innovations on the stability of the system are not limited to their listing-authority function. The
rules for collective-investment schemes matter too.
A good example, highlighted recently by the G20 Financial Stability Board, is the
development of the Exchange-Traded Fund markets to include synthetic structures,
leveraged funds, less liquid underlyings, and all three combined.13 Remind you of how
securitisations ended up in CDO2 and CPDOs? In the EU, ETFs are subject to the UCITs
rules for what are in effect mutual funds available to retail investors.
Securities regulators need to think about how to avoid mechanically applying a regime for
vanilla investment schemes to the structuring and distribution of much more complex and
sophisticated products.
In the same spirit, recent ETFs innovations underline the need for securities regulators to
work closely with bank supervisors and macroprudential authorities on shadow banking and
what I earlier called "financing markets". For both physical and synthetic funds, the
underlying collateral pools are being swapped to provide financing for dealers and banks. It
is not clear whether bank supervisors have caught up with this, or whether the risk of the
collateral swaps being called is treated appropriately in regulatory maturity-mismatch
ladders. Who would have guessed that vanilla collective investment schemes, could be
turned to this purpose? The truth is that any pool of assets can be.
While the FSB has already called for authorities to act to keep the evolution of ETFs on a
sustainable path, the broader lesson is that securities regulators need to be alive to the need
to keep up with innovations and, like bank supervisors, they need to be ready to accept an
occasional steer from macroprudential authorities.
Product "gatekeepers": Credit Rating Agencies
It would be hard to talk about the issue and distribution of securities without mentioning
Credit Rating Agencies. It is important to reduce the significance of CRA ratings in our capital
markets. Pervasive mechanistic reliance on ratings is by no means mainly the fault of the
Rating Agencies themselves or of financial firms, although many of the latter have acted -
and probably continue to act - foolishly. The extent to which ratings have been bolted into
regulatory regimes - by securities regulators and prudential supervisors - has plainly been a
great mistake. And it is one of those mistakes whose effects have become so woven into the
fabric of "modern" finance that it is going to take an extraordinary act of will (and patience) to
undo it. Yes, we do have asset managers (and banks) who might not be able to evaluate
some securities on their own if they were not permitted, by official regimes, to rely on CRA
ratings. But what on earth are we doing not only tolerating but effectively encouraging a
financial system in which asset managers and banks can't always understand their
portfolios?
It is therefore vital that, together with the Basel Supervisors Committee, securities regulators
around the world actively implement the FSB's Principles for reducing reliance
mechanistic
on CRA ratings.14 In the US, the SEC is embarked on that. But I worry that others, including
prudential supervisors, might not grapple with this admittedly difficult exercise in a
determined way. The enhanced (meaning better not longer) disclosure by issuers I discussed
earlier could make the standard-setters' task somewhat less difficult.
Infrastructure
One of the wonderful things about capitalism is innovation. It helps to drive technical
progress and higher-living standards. Open economies allow those innovations to spread
across the world. Freely flowing capital is essential for this to work in my view. But
innovations can take a nasty turn in financial markets when they outgrow their supporting
infrastructure.
This is an area where the authorities can do good, because there is often a collective action
problem. For example, the recent crisis would have been much worse if the authorities, led
by the New York Fed, had not "asked" the dealer and fund community to clean up the
problem of assignments in credit-default-swap markets in the early years of the last decade.
But we need to remember to be ready to step in. The OTC derivative markets are an
example where the authorities have had to chase after events. The cash ABS markets are
another, with central banks now taking a lead by introducing standards for transparency and
the structure of the securities we are prepared to take as collateral.
Trading platforms and exchanges
Currently, a key area of reform is the infrastructure for the main over-the-counter derivative
markets.
In the trading area, there is a debate about how far to unravel the predominantly bilateral
mechanics of OTC derivatives markets and how far to move towards exchanges. Perhaps to
different degrees in the US and the EU, there is an unresolved issue about whether all
standardized derivative products should be traded via Multi-Dealer Platforms, which are a bit
like exchanges, or whether to allow Single-Dealer Platforms through which a broker-dealer
sets up its own quasi-exchange. A preliminary study by IOSCO did not reach a clear
conclusion given the dispersion of views.15
I want to inject one thought from a financial stability perspective into this debate. So far as we
can see, the debate has been cast pretty much entirely in terms of market integrity (honesty
and fairness), transparency and the efficiency of price discovery - the core concerns of a
securities regulator. The missing word is "liquidity". And the question is whether or not
liquidity would be more resilient under stress depending on whether an asset class was
traded on MDPs or SDPs.
The question of resilient liquidity matters enormously. As the crisis in 2007 reminded
everyone, the liquidity of markets can evaporate, causing liquidity premia to soar,
undermining the net worth of those intermediaries and investors who mark to market, feeding
back into market dynamics in a vicious circle. As well as controlling leverage, prudential
standard setters can help here by ensuring that bank and dealer intermediaries carry capital
to cover the risk of swings in liquidity premia and against the pervasive basis risk
warehoused by "market makers" in illiquid or non-standard products. The Basel Supervisors
Committee is working on that in its Fundamental Review of Trading Book Capital
Requirements.
But, surely, the design of the market microstructure also matters. In that sphere, might the
choice between MDPs and SDPs also make a difference? It is hard to know. There is some
evidence from the fx markets that, during the crisis, volumes shifted to single-dealer
platforms. One possible explanation for that would be the incentive of individual firms to
make clear to their customers that they provided a liquidity service during thick and thin,
expecting to be rewarded with more business as normality returns. But I must stress that I do
not have a position on this. Rather, my point is that this very important issue has been
debated without the liquidity dimension being explicitly considered. Following discussion at
FSB, that gap in the analysis is now being addressed by the IOSCO leadership.
Post-trade infrastructure: CCPs as risk managers
The other big area of reform is, of course, around central counterparties. Clearing more OTC
products; being more resilient; revisiting criteria for access to CCPs, and so on. You don't
need me to rehearse all of that for you.
But I would note that this is not just about derivatives markets. LCH's move to clear repos in
Spanish government bonds helped that market stay open during some dark days.
And I do want to make one very important general point about the role of CCPs and their
management.
CCPs simplify the complex web of counterparty exposures through multilateral netting -
precisely what the US authorities contemplated trying to achieve ad hoc towards the end of a
weekend when Lehman was unravelling. They act as a central market authority for valuing
positions and setting minimum margin levels. Having centralised risk upon themselves, they
redistribute it to their clearing members through a clear waterfall. They are, in effect,
systemic risk managers. They absolutely must think of themselves as that. Their job is not
just to deliver ever greater operational and capital efficiency for their clearing members. Too
many senior executives at CCPs I have met over the past decade or so have seemed to fall
into that trap - a trap encouraged by some being for-profit organisations. I fear that what I am
saying will seem novel. In fact, this emphasis on their role as systemic risk managers was a
clear lesson from the very few instances of clearing houses failing over past decades.16 If I
may quote from the post-87 crash Report of the Hong Kong Securities Review Committee:
"When everything else is stripped away, the most pressing issue is the
management of risk. The focus of this is ......increasingly, the central clearing
houses - indeed [their] prudent operation is perhaps the single most important
objective for the market authorities and regulators.17"
What does this mean in practice? My personal view is that, amongst other things, it means
that CCPs should not outsource their core risk management functions; they should monitor
the robustness of their clearing members; and they should monitor risks from the business
that their clearing members are bringing to them as an indication of incipient fragility.
Amongst other things, that means collecting and analysing information from clearing
members on large positions taken by their customers. In 1987, it was the long positions of a
trader that bankrupted the Hong Kong clearing house.
Some elements of the clearing house regime are clearly for the authorities to determine. One
important one, which is implicitly being debated in some jurisdictions but not in a way noticed
by anyone other than specialists, is whether clearing houses should adopt what is called
Gross Margining rather than Net Margining. What this means is that a clearing member - ie a
dealer - could not net off positions of their various customers and their own house position
when the amount of margin they have to hold with the clearing house is determined. That
would affect the incentives of clearing members to collect minimum margin amounts from
their customers. And, more generally, it would probably reduce the amount of leverage in the
system and simplify the chain of credit. Again, my point is not at all to advocate a position on
this one way or another. It is to note that this is about more than investor protection through
the segregation of client moneys, and so needs to be debated against the goal of preserving
stability without impairing efficiency.
Post-trade infrastructures: trade repositories
Moving on from CCPs, a quick appeal - in fact, two if I may - to the securities regulator
community on Trade Repositories.
They are one of the most interesting innovations brought forth by the crisis. They are
expected to house information, on a trade-by-trade basis, on the type of contract, notional
value, currency, maturity, counterparties of derivative transactions. This needs somehow to
extend to valuation(s) and collateral terms.
My appeal to the US, EU and Asian authorities is twofold. First, should we not have a Trade
Repository covering securities lending - a cash market - including the way collateral is
employed? We surely need to do something to lift the veil on this vital financing market and,
probably, on the collateral swap market more generally.
Second, we need to think carefully about the purposes for which the information in TRs is
collected, and thus how it is stored. As well as helping to identify market abuse, which of
course is a core mission of securities regulators, we need to use the information to track
more generally what is going on in markets to help us spot incipient, often slow-moving
threats to stability. And even though individual Trade Repositories are being set up to
handle specific markets (credit-default swaps, interest-rate swaps etc), it needs to be
possible to see the pattern of risk and flows across markets and products. Recognising that,
the FSB has called for the relevant authorities, liaising with the BIS Committee of the Global
Financial System, to set requirements for reporting of transactions to trade repositories that
meet the needs of financial stability analysis.18 This work needs a higher profile.
Firms
Markets are places where end-users and intermediaries meet. Securities regulation affects
financial firms - traders and asset managers - as both intermediaries and as users. It is
important this gives proper weight to financial stability. Three broad thoughts on that.
Regulated banks: provisions and disclosure
Everybody in this room and outside knows, or should know, that for much of the past quarter
of a century there was a stand off between bank supervisors and securities regulators over
provisioning policy. On the one hand, until they gave up in exhaustion, many bank
supervisors wanted banks to set aside (general) provisions against losses that were implicit
in portfolios but not yet manifest in arrears or other concrete measures of impairment. Today
we would call this forward-looking or expected-loss or dynamic provisioning. On the other
hand, securities regulators typically opposed this because they feared, no doubt with some
reason, that it could be used to smooth profits in a misleading way. There were some famous
stand offs. I do not doubt the sincerity of the securities regulators' concerns. And no-one
could ignore the constraints that, as the years passed, were codified into accounting policy.
But the stand off across the supervisor/market regulator divide was a problem. Progress is
now being made by the IASB and FASB on developing more forward-looking impairment
standards. The key to progress was the joint recognition by market regulators and
supervisors that earlier identification of credit losses is consistent both with financial
statement users' needs for transparency regarding changes in credit trends and with the
prudential objective of safety and soundness.19
In the other direction, bank supervisors have typically insisted on the vital confidentiality of
the information they receive, while securities regulators emphasise transparency. One could
argue that, in many countries, the bank supervisors have done too well in this debate. That
was brought home to me some years ago when, in a previous existence at the Bank of
England, my then team realised that we could analyse large and complex firms most easily
using disclosures made under SEC rules. As announced last week in the joint Bank of
England/FSA document on how the future Prudential Regulation Authority will approach
banking supervision, we plan in the future to publish prudential returns to the extent possible.
Shadow banking and the prudential perimeter
My second point about firms concerns shadow banking, defined to mean non-bank firms or
structures that replicate the monetary and/or credit services of banks in some way, involving
maturity transformation and/or leverage20.
In a world in which regulatory arbitrage is endemic, it is a fact of life that the re-regulation of
banks will set up incentives to build banking-like functions in other forms.
The import of this for my remarks today is that securities market regulators (and insurance
regulators) need either to be relaxed about the supervision of shadow banks being
transferred to banking supervisors or, alternatively, vigilant about maintaining regimes that do
not permit systemic risk to accumulate beyond the perimeter of the banking system. In the
UK's planned new regulatory framework, the Financial Policy Committee will be responsible
for recommending to the Treasury when prudential supervision of a type of firm should shift
from the securities regulator to the prudential regulator (and vice versa); and it will be able to
advise the FCA on when it needs to revise its rulebook in the interests of stability. Different
jurisdictions will come up with different arrangements to address this issue, but I would say
that every jurisdiction is going to need its own solution. And, perhaps for the first time, that
has highlighted the need for some international co-ordination of policies on shadow banks.
The FSB is just starting to explore this virgin territory.21
Asset managers and incentives
The vast majority of the asset management world is not engaged in shadow banking and,
more important, does not of itself jeopardise the stability of the system directly if it gets into