Mervyn King: Finance - a return from risk
Speech by Mr Mervyn King, Governor of the Bank of England, to the Worshipful Company of
International Bankers, London, 17 March 2009.
* * *
Master, Sheriff, My Lords, Alderman, Ladies and Gentlemen,
Introduction
The financial turmoil that began in August 2007 led to a financial panic in September 2008
and now to a severe worldwide economic downturn. It is fair to describe the events that
followed the failure of Lehman Brothers as the Panic of 2008 because of the almost complete
collapse of confidence in financial institutions and the flight of funding that ensued. Perhaps
we had forgotten that such panics and banking crises have occurred with depressing
regularity in the financial systems of market economies. But the history of the City is in large
part the history of banking crises.
The measures that central banks took, and continue to take, to restore confidence in the
banking system were extreme and on an extraordinary scale - the Bank of England has lent
hundreds of billions of pounds to the banking system. But they were not unprecedented - it
has happened many times before in crises over the years. So I want tonight to reflect on why
we seem to find it so difficult to learn from experience.
But even when set against that historical background, the extraordinarily sudden, severe and
simultaneous downturn of activity and trade in every corner of the world economy last
autumn is remarkable. A collapse of confidence in the coffee houses of Lombard Street was
one thing; a collapse of confidence in the world economy is quite another.
An examination of these parallels will, I hope, help to throw light on three questions. First,
does the nature of financial risk explain the frequency of crises and what does it imply for the
design of banking regulation? Second, what are the lessons from the crisis for central banks
in their pursuit of both monetary and financial stability? And, third and most urgently, how do
we find our way out of the present crisis?
The nature of financial risk and its implications for the regulation of banks
There is no shortage of proposals for reform of bank regulation from official groups, such as
the Financial Stability Forum, and unofficial groups, such as the G 30, chaired by Paul
Volcker and the Geneva Forum. Since the excessive risk-taking of recent years has now
given way to an extraordinary degree of risk aversion, there is no hurry to choose among
them. Whatever exuberance - rational or irrational - existed has been destroyed by the
crisis. So we have time to reflect before we decide on the shape of a new regulatory system.
Another reason for reflection is that recent years have seen a natural experiment. Some
regulatory systems were light touch, others heavy touch, and yet others placed both
ownership and regulation of banks in the public sector. Yet they all failed to some degree to
prevent the accumulation of risks that finally produced the crisis. So it is unlikely that there is
a simple answer.
Any plan for reform should take into account the nature of financial risk. Why were so many
people misled for so long? And was there an inherent weakness in the structure of modern
banking?
Banks are dangerous institutions. They borrow short and lend long. They create liabilities
which promise to be liquid and hold few liquid assets themselves. That though is hugely
valuable for the rest of the economy. Household savings can be channelled to finance illiquid
investment projects while providing access to liquidity for those savers who may need it.
But given how risky banks are, it should not be surprising that from time to time they get into
trouble. And they have done so regularly since banking began. Confidence in a bank can
disappear quickly making it vulnerable to a destructive bank run. If a large number of
depositors want liquidity at the same time, banks are forced into early liquidation of assets -
lowering their value. And, of course, if banks make sufficient unwise loans to borrowers who
do not repay, then that can threaten solvency as well.
Banks can of course take their own actions to ensure that investor confidence is maintained.
For example, a visible source of liquidity helps. In the panic of 1906, the founder of what is
now the Bank of America displayed his gold reserves on the street and offered to convert
deposits into gold, creating confidence in his bank at a time when many others failed. Forty
years ago, the clearing banks in London held around 30% of their assets in short-term liquid
instruments. Today that liquid assets ratio is about 1%. For the major UK banks, almost 25%
of customer loans are now funded by short-term borrowing in wholesale markets. At the turn
of the new century it was close to zero. This was the distinctive feature of the contemporary
British model of banking. Distinctive it may have been; sensible it was not. HBoS and RBS
paid the price as the availability of this funding dried up, and not one of the building societies
that de-mutualised in the 1980s and 1990s in order to expand beyond the constraints of their
deposit base has survived as an independent entity.
Banks have changed. They have encouraged the expansion of proprietary trading, the
funding of long-term assets in short-term wholesale markets, a rapid expansion of balance
sheets and a marked rise in leverage. Commercial banks followed the path of investment
banks. Balance sheet size and high leverage were seen as the key to obtaining funds at
lowest cost. The total assets held by the world's largest banks roughly doubled in the five
years to the end of 2008, and leverage in UK banks rose on average by two-thirds. The bulk
of credit growth in the economy as a whole was taking place within the financial sector. And
the complexity of the products being created made it hard to evaluate the underlying risks.
Why did banks change so much and take risks which eventually led to some spectacular
downfalls? Ultimately, the main factor was an inability to perceive the true nature of the risks
involved. In this they were not alone.
John Maynard Keynes took pains to distinguish between risk, where probabilities or
frequencies could be calculated, and uncertainty, where there is no scientific basis on which
to form any probability estimates. Keynes went on, in an article published in 1937, to spell
out exactly how we tend to behave in the face of such ignorance. It explains a great deal of
recent behaviour in financial markets. Keynes argued that uncertainty affects our behaviour
in three ways:
"(1) We assume that the present is a much more serviceable guide to the future than a
candid examination of past experience would show it to have been hitherto. In other words
we largely ignore the prospect of future changes about the actual character of which we
know nothing.
(2) We assume that the existing state of opinion as expressed in prices and the character of
correct
existing output is based on a summing up of future prospects, so that we can accept
it as such unless and until something new and relevant comes into the picture.
(3) Knowing that our own individual judgement is worthless, we endeavour to fall back on the
judgement of the rest of the world which is perhaps better informed. That is, we endeavour to
conform to the behaviour of the majority or the average. The psychology of a society of
individuals each of whom is endeavouring to copy the others leads to what we may strictly
conventional
term a judgement".
This suggests that it is very hard to take a truly independent view - especially a contrarian
one that recognises the possibility that improbable but conceivable events could result in
large losses. In other words, the sheer difficulty of forecasting the future makes it hard for
contrarian investors without substantial net worth to survive in the market. As a result the
market is vulnerable to "sudden and violent changes". As Keynes put it, "the forces of
disillusion may suddenly impose a new conventional basis of valuation. ... At all times the
vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but
a little way below the surface". So a conventional wisdom that leads to a speculative mania,
can quickly collapse as sentiment turns on its head.
But a speculative mania is not the product solely of the creative imagination of financial
engineers. It requires the willing collaboration of gullible investors, who may not fully
appreciate the risks that they are taking. Take a simple example of an investment that
provides a long, regular stream of profits interspersed with occasional large losses, such that
on average you would expect it to have the same return as a safe investment - not an
unreasonable characterisation it would now appear of many of the investment strategies of
recent years. Over short time periods, where it is unlikely that disaster will strike, it is more
likely than not that investors will come out ahead, with a high return. But over long periods,
where the risk that disaster will strike at some point is higher, it is likely that the overall return
will be worse than the safe investment. And, because charges are often structured so that
investment managers receive more of the upside from risky behaviour than they share in the
downside, they have an incentive to promote the risky investment strategy. That, allied to a
massive increase in the complexity of financial products and instruments in recent years, has
meant that investors have, perhaps unwittingly, aided an enormous increase in the risks
being run in the financial system.
Given these problems, it seems to me that regulation should aim to be simple and robust.
Overly complex measures of risk and capital adequacy are rarely robust to developments
that are easy neither to anticipate nor calibrate. And robust rules for regulation will of
necessity need to be simple or supervisors will be lost in a morass of unnecessary detail.
For the same reasons we should not expect too much of regulation. Conventional judgment
is a safe haven for bankers and regulators alike. It is not easy to persuade people, especially
those who are earning vast sums as a result, that what looks successful in the short run is
actually highly risky in the long run.
As in monetary policy, it is unlikely that prudential supervision can be implemented as a set
of rules to be applied mechanically. Nevertheless, to rely solely on the discretionary
judgment of individual bankers and regulators is asking too much of human capabilities. This
suggests that the principle of constrained discretion, applied so successfully in monetary
policy, needs to be applied to banking regulation. That is not to say that a similar institutional
apparatus would be appropriate, but we need to build into the system some simple and
robust impediments to excessive risk-taking that can be monitored. And we must ensure that
an institutional memory is maintained so that the lessons from the crisis are not forgotten and
those impediments to excessive risk-taking are not swept away once memories of the crisis
recede.
The design of those impediments should be based on an explicit identification of the market
failures that regulation can hope to correct. Such market failures seem to relate to two
dimensions of banking - the "cross-section" and the "time-series" aspects of behaviour. The
former reflects the extreme interconnectedness of banks. Each individual institution can
appear relatively safe while the links between them mean that the system as a whole is
vulnerable. Any shock could lead banks to fail through a domino effect. The superstructure of
complex transactions within the financial sector (in derivatives for example) greatly increased
this interconnectedness.
The time-series aspect is the pro-cyclical behaviour of risk-taking in the financial system that
I described earlier. Optimism feeds on itself until the occasional setback changes the mood
to one of pessimism. And individuals are reluctant to accept that success may not be the
result of superior wisdom, which should naturally be reflected in compensation, but the
shortrun outcome of a risky strategy.
To deal with the "cross-section" problems we need to reduce the exposure of the system to
domino effects. For some, especially over-the-counter, markets this could be achieved by
increasing the role of central counterparty clearing houses. Much good work on this is going
on, led by the Federal Reserve Bank of New York. But a clearing house should not be an
excuse for allowing flawed financial instruments, such as many of the mortgage-backed
securities, to be treated as high quality assets.
We also need to improve the regulation of the liquidity of banks. After the crisis began, the
most striking feature of the regulatory system, as embodied in the Basel arrangements and
implemented in the UK, was the absence of any effective regulation of liquidity. The FSA is
acting to remedy the situation, and the Bank is in active discussion with FSA about how such
regulation should best be implemented.
More attention has been paid to the "time-series" dimension where there is now a clear
international consensus among the members of the Financial Stability Forum and the Basel
Committee that some form of counter-cyclical prudential supervision is required. The
principle has been established.
To correct these types of market failure will require a system of regulation that effectively
marries the "top down" assessment of the risks to the system as a whole to the "bottom up"
supervision of individual institutions. The present system has not delivered that.
A lot of detailed work needs to be done to convert these general principles into concrete
implementation. How would the interaction between the "cross-section" and "time-series"
risks be taken into account? Would the framework take the form of an addition to capital
requirements as a function of the degree of maturity mismatch, leverage or the rate at which
the balance sheet was expanding? Or would there be a limit on leverage ratios? How would
leverage and maturity mismatch embedded in the assets side of the balance sheet be taken
into account? And how would the framework be implemented for banks whose assets and
liabilities span jurisdictions? Can we define a group of institutions that are systemically
significant? In the present crisis most institutions are deemed to be potentially systemic
because of the impact of the failure of any of them on creditor confidence. If most banks
appear systemic in a crisis won't countries want to require foreign banks to be subsidiaries
not branches? And, more fundamentally, should there be a Glass-Steagall type of provision
to prevent retail deposits from being used to fund investment banking activities? There are
good arguments in favour - to separate the utility functions of a retail bank taking household
deposits and running the payments system from the casino trading of an investment bank,
and good arguments against - the difficulty of maintaining a credible boundary between
those institutions that are eligible to receive government support and those that are not. We
need a public and informed debate on the merits of the arguments.
We also should reflect on the fact that the belief that the authorities will step in when risks
materialise encourages risk taking and means that risk-adjusted returns to financial activity
are too high. The experience of unsustainably high returns in normal times interspersed by
regular crises has been repeated across countries and over time. So if banks are to bear the
true cost of the risks they take, changes need to be made to the environment in which banks
operate.
All these are important issues. While committing at international level to broad principles on
regulatory reform, such as extending the net to all highly leveraged institutions and making
capital requirements counter-cyclical, there is time to think through carefully the best way to
implement them, and it is important that we take it.
Many of these questions about the future of the regulatory structure will be discussed in the
Turner review to be launched tomorrow. The Bank awaits the Review with interest. It will
wish to take time to reflect carefully on the Report before expressing a view.
Given what has happened there is now international support for developing a counter-cyclical
toolkit for the prudential supervision of banks. But let us be clear what such tools would have
entailed had they operated in the past. They would have imposed constraints on the growth
and profitability of bank balance sheets. They would have been seen as a tax on the success
of the investment banking community and the City of London more generally. And that would
have taken place at a time when virtually the entire weight of opinion, not only in this country
but also abroad, was in favour of the expansion of financial services. Indeed, just before the
financial turmoil broke out in the summer of 2007, there was a debate in New York about the
need to follow London's example of unfettered markets if they were not to lose ground.
What are the lessons for central banks?
With the passage of the new Banking Act last month, the Bank of England now has two
objectives enshrined in statute: monetary stability and financial stability. Events of the past
six months show that there are limits to what can be achieved in respect of either objective.
No policy framework can, or should be expected to, stabilise output when demand in the rest
of the world suddenly and simultaneously "falls off a cliff", to use the expression heard so
often in recent months. Even the safety valve of a floating exchange rate cannot insulate an
economy from its trading partners. World trade fell by around 5% in the final quarter of 2008.
54 of the 56 nations for which data are available for the fourth quarter registered falls in
industrial output. 7 of those suffered double digit declines. For many years trade has been
the route to faster growth. Now trade is leading the world down as the economies most
adversely affected by the current downturn are those most dependent on exports, such as
Japan and some of the other Asian economies, not those with the worst banking problems.
Sharp changes in sentiment, confidence, animal spirits - whatever words you care to use -
are capable of wreaking havoc on the world and our own economy.
I shall turn later to our immediate response to the crisis. I want first, however, to ask whether
central banks have the right instruments and the right policy frameworks to deal with a world
in which some of the biggest risks are of the type I have discussed earlier, namely events
which occur very infrequently but when they do so have large adverse effects; events such
as those through which we are living. In other words, was our framework suitable for a world
of stability but inadequate for preventing or responding to large adverse shocks?
In particular, should central banks continue to use their single monetary policy instrument -
in our case Bank Rate, supplemented when necessary by unconventional operations - to
aim solely at price stability, or should they aim also at wider financial stability objectives, as
some have suggested? For over fifteen years Bank Rate has been set to meet an inflation
target. And it was very successful in achieving that objective until commodity prices pushed
up inflation in 2007. Since the Monetary Policy Committee was established, the average
inflation rate has been only 0.1 percentage points away from the target. The strategy of
inflation targeting ensured that the MPC maintained a balance between overall demand and
supply in the economy.
We could, of course, have pursued a different policy. We could have set interest rates
consistently at a higher level in order to lower the growth of domestic demand below the rate
at which inflation was stable and close to the target. In the words of my predecessor, we
could have rejected the approach of accepting "unbalanced growth rather than no growth".
But to argue that Bank Rate should have been set to achieve not price stability but other
objectives would have meant accepting rising unemployment and falling inflation. And that
would not have altered long-term interest rates in world capital markets and "irrational
exuberance" in financial markets in the US and elsewhere. If we want to slow the growth of
the financial sector balance sheet, and most of the expansion of credit in recent years was
within the financial sector, we can surely do better than raising Bank Rate to a level that
undermines the real economy and our commitment to the inflation target.
As Chairman Bernanke rightly emphasised last week, one of the causes of the crisis was the
impact of the growing current account imbalances on financial intermediation in the main
deficit countries, the US and the UK. The large and persistent inflows of capital lowered
market interest rates to extremely low levels and encouraged the "search for yield". In
response, the financial services industry rediscovered the time-honoured way of raising rates
of return - increasing leverage and taking more risk while finding ways of making the degree
of risk less transparent. The crisis resulted from the interaction between the "micro"
behaviour of banks and other institutions in creating new financial assets and the "macro"
economic strategies pursued by the world's major countries. If we are to make crises less
likely in future we will need to concentrate on policies covering these interactions.
The size to which the current account imbalances were allowed to grow reflected the fact that
the international monetary system, such as it is, placed no pressures on surplus countries
and that the main debtor country issued the world's reserve currency. Year after year
international meetings expressed surprise, and indeed concern, that the imbalances
continued to accumulate, but in the absence of a correction the theme became a worn
groove in discussions and interest waned. The more forcefully the warnings were expressed,
the more they were ignored, precisely because each country appeared able on its own to
achieve price stability and steady growth despite the continued build-up of the imbalances.
The consequences of this are now evident: a severe global downturn affecting virtually every
country in the world. In a world of imbalances it is just as dangerous to rely too heavily on
foreign demand for goods and services as it is to rely excessively on foreign borrowing.
Surely now no country can be indifferent to the objective of improving the consistency of our
macroeconomic strategies. So I hope that the debate about the need for symmetric
obligations on surplus and debtor countries alike will move on from previous unsuccessful
dialogues stretching back to the Bretton Woods conference in 1944.
Turning to the "micro" cause of the crisis, a root cause was a degree of over optimism in
financial markets. History, whether the run up to the 1929 stock market crash or more
recently in the dotcom mania, suggests that only very substantial rises in short-term interest
rates will bring to an end the excessive speculation, and that such rises bring about the very
recession which the policy is designed to avert.
What is needed is an additional instrument, or possibly a set of instruments, to provide the
authorities with the ability to control the growth of the financial sector and its interactions with
the wider economy. A set of counter-cyclical policy instruments is the right response to the
dilemma of trying to use Bank Rate to control both inflation and excessive expansion of the
financial sector. It provides the "top-down" judgement for prudential supervision that I
described earlier, but detailed work is needed to flesh out that general principle.
How should we deal with the present crisis?
I have spoken so far about the long-term lessons of the crisis for the structure of banking and
its regulation. But the immediate need is to deal with the extraordinarily steep and
simultaneous downturn in so many economies around the world, and to stabilise the banking
system in those countries where it has failed. That should be the main priority at the
forthcoming G20 Summit.
There are three parts to the required policy response. First, there is an urgent need for a
collective commitment by all the countries in the G20 to restore confidence. Second, in those
countries where the banking system has failed, there must be a credible promise that banks
will be restructured and recapitalised so that they can resume their normal functions and
support the flow of credit to their own and other economies. Third, we need to identify and
explain a coherent exit strategy through which all of the unprecedented official policy actions
can be unwound and which provides a bridge back to stability.
A joint commitment to a macroeconomic stimulus - the division between monetary and fiscal
measures is a matter for individual countries to determine - is required to ensure a growth of
nominal demand sufficient to reverse the extraordinarily steep and simultaneous downturn in
output around the world. Much has already been done. But the measures need to add up to
a collective determination to support an adequate level of money spending, and will need to
include actions to help poorer countries borrow either from the IMF or on world capital
markets.
Without that collective commitment, countries may neglect the beneficial effects that their
policy actions can have on other countries, resulting in an excessively cautious approach.
The G20 summit in London in two weeks time offers an opportunity and a challenge. The
occasions on which the words and actions of policy-makers really matter are probably fewer
than many of us care to admit. But this is one of them. And I was encouraged by an unusual
sense of determination at the G20 Ministerial Meeting at the weekend to show a collective
commitment to deal with our problems.
In the UK we are already taking unprecedented action to boost nominal spending. The
Government announced a temporary fiscal stimulus in the Pre-Budget Report in November.
Bank Rate has been reduced by 41⁄2 percentage points in the past six months. And this
month the Bank began a series of asset purchases aimed at boosting the supply of money in
the economy directly. In due course, this will act to expand money spending. In its entire 300
year history, the Bank of England has never acted so swiftly or extensively in response to an
economic downturn.
The second aspect of the required policy response is effective stabilisation of the banking
system. The experience of those countries that have most successfully resolved banking
problems, such as Sweden in the early 1990s, suggests that that will require uncertainty
about the values of some of the more opaque assets on bank balance sheets to be dispelled.
It will take many months to audit forensically the true state of those balance sheets and for
some of the underlying macroeconomic uncertainty to dissipate. In the meantime
governments have to stabilise the banking system by reassuring creditors in order to prevent
the risk of either retail or wholesale runs of the kind we saw in the Panic of 2008. They have
to subscribe sufficient equity capital - plain ordinary equity - in order to underpin the capital
position of banks in the event of future losses. Although there are different ways to do this
(splitting banks, insuring pools of assets), they all have in common a commitment to provide
contingent capital to banks so that core equity capital does not fall below some minimum
ratio and so creditors are protected. It follows that governments must be prepared to hold
whatever proportion of equity capital turns out to be necessary.
The final part of the policy response relates to the longer term. There needs to be a clear exit
route by which the extraordinary level of official financial support will be unwound as
conditions return to normal. And there needs to be a credible commitment to implement the
longer term reforms. For monetary policy, the inflation target provides a natural guide to
when, and by how much, the extraordinary degree of policy stimulus should be withdrawn. In
particular, the outlook for inflation will determine when and by how much asset purchases are
in due course reversed and the timing of a return of interest rates to more normal levels. For
fiscal policy, there needs to be a credible plan for consolidation of deficits and debt in the
future contingent on the state of the economy. And in terms of support to the banking sector,
governments should signal their commitment to return banks to the private sector once
balance sheets have been restructured. In the UK that will be underpinned by UKFI
formulating an explicit mechanism through which the Government's shares can in due course
be sold back to the private sector.
There will also, eventually, need to be a way to scale back the extraordinary levels of liquidity
support provided by central banks during the crisis. The Bank of England has lent, and
continues to lend, over £300 billion pounds through our repo operations and the Special
Liquidity Scheme. And a backstop of further liquidity support is still available if the system
requires it through our discount window. The Federal Reserve has lent more than $900
billion dollars, and the ECB around €700bn. Relative to GDP, the balance sheet of the three
central banks has broadly doubled during the crisis. But in providing this support, central
banks cannot offer long-term funding and should not offer support against assets that are
unlikely to have a viable future in the absence of official intervention. At some point central
bank balance sheets will need to contract.
Finally, although I have stressed the need to take time to think through carefully the long run
reforms required, we need to commit now, while the political will exists, to a process for
decisions on long-term reforms in key areas such as bank regulation, reform of the
international monetary system and the governance of international financial institutions.
Conclusions
Why did no one see this crisis coming? In fact, most of the underlying causes of the crisis
attracted attention from economists, central banks, international financial institutions and
regulators. But the difficulty of overcoming coordination or collective action problems meant
that nothing was done. Banks felt that they had to keep on dancing while the music was
playing. Regulators could never prove that the risks they identified would crystallize, and the
"top down" and "bottom up" dimensions of prudential supervision were not married. Central
banks and the IMF discussed the imbalances for so long that some came to believe that they
were crying wolf. And no one country could prevent the world wide increase in asset prices.
Christopher Fildes' law of the financial cycle says that "disasters happen when the last man
who can remember what happened last time has retired". Periods of euphoria and panics in
the financial system are inherent features of a market economy. They are the cost we pay for
the benefits of a market economy - long-run increases in our standard of living which other
systems have failed to deliver. After another twenty years or so, memories of the Panic of
2008 will have faded, and the regulations put in place in its wake will no doubt be seen as
old-fashioned, inhibiting of the potential of the City, and as ripe to be swept away as was the
Glass-Steagall separation of commercial and investment banking in the United States a few
years ago.
A lesson of history is that few generations have been able to avoid a repetition of earlier
banking crises. The essential problem is that we can no more bind our successors than our
predecessors were able to bind us. Rare events, even when dramatic at the time, lose their
power to shape policy as memory recedes. The role of institutions is to retain a collective
memory and to resist the temptations of the present. That is one of the most important roles
of a central bank. It is accepted as such in the domain of monetary policy. And there is an
equivalent role in financial stability.
The introduction of simple and robust policy tools into a regulatory regime based on the
exercise of constrained discretion would make it easier to resist overly rapid expansion of
financial institutions. In particular, the authorities should maintain a clear focus on the issues
that matter when the worst occurs - liquidity and leverage. It should be intrusive, in the sense
of knowing what is going on, but not bureaucratic. A syst