Guy Debelle: Credo et fido - credit and trust
Text of the 2012 Richard Searby Oration by Mr Guy Debelle, Assistant Governor (Financial
Markets) of the Reserve Bank of Australia, at Deakin, Melbourne, 25 September 2012.
* * *
It is a pleasure to deliver the Richard Searby Oration here at Deakin University. I feel
honoured to follow the esteemed speakers who have preceded me. Dr Searby has had a
singularly impressive career throughout which he has made a great contribution to the
community of Australia in many different arenas. As I read his record, one area with which he
has had little direct involvement has been that of finance, perhaps unfortunately, as it could
well have benefitted from his guidance. It is the current state of the financial sector that I will
talk about today.
As you are all aware, the global financial system has been in a state of turmoil for more than
five years now. The repercussions of this have been widespread, although thankfully
Australia has been spared the worst of the impact. In other parts of the world, most obviously
Europe, the United States and the United Kingdom, the fall-out from the financial crisis has
seen millions lose their jobs, many for a number of years. This is most stark in Greece and
Spain where around one quarter of the workforce is unemployed. Young people entering the
workforce in those two countries have little prospect of finding meaningful employment any
time soon; an experience that can scar their income prospects over their whole working lives
and runs the risk of leading to a dangerous breakdown in social cohesion.
The crisis has been very much financial in its genesis but with losses that have extended to
all parts of the global economy. Unlike some recent downturns, the recovery in a number of
countries has been particularly protracted this time around. In a number of countries, even
some five years on, the level of output in 2007 has still not yet been reattained. This
represents a sizeable loss of income and wealth.
Tonight, I am going to talk about one of the elements that has contributed to this financial
crisis being so long-lasting, and which might mean that there is still some way yet for it to
run. The issue I want to focus on is the importance of trust in banking, and finance more
generally. Hence the title of my talk today. Credo is the Latin for "I believe", from which we
get the word credit, while fido is the Latin for "I trust", from which we get fiduciary and
fidelity.1 So credit is fundamentally an issue of trust. Without trust, we don't have credit. That
lack of credit is a phenomenon which is playing out in a number of countries around the
world at the moment, again, thankfully, not here in Australia.
The lack of trust is contributing to the unwillingness of financial institutions to extend credit
and the difficulty some governments are having in obtaining funding. In turn, the lack of credit
growth is exerting a major restraint on the economic recoveries in a number of countries
around the world. In the post-war period, easier monetary policy has invariably helped foster
a rebound in economic growth following a recession. An important transmission channel for
monetary policy to take effect has almost always been a pick-up in lending to businesses and
households. That is clearly not happening in many countries at the moment. Central banks in
those countries are reaching deep into their toolkits to revive lending and foster economic
recovery. But the lack of trust is significantly curtailing the ability of the normal
implementation of macropolicy tools, both monetary and fiscal, to engender a sustainable
economic recovery.
The outline of my talk is to firstly discuss the role that the financial sector plays in the
economy. Then I will examine the crucial role that trust plays in financial intermediation and
in ensuring the financial system runs smoothly. Following that, I will document the breakdown
of trust that has occurred over the past five years. To finish on a more positive note, I will
outline some of the avenues that might be taken to restore trust in the financial system.
Some of these themes were addressed in a speech entitled "Credit is Trust" delivered by my
colleague at the Bank of England, Andy Haldane, in September 2009.2 Andy highlighted the
reduction in trust that had taken place in the previous two years - what was then the first two
years of the financial crisis. But three years on from 2009, the situation is even worse. The
lack of trust in the financial system has intensified. Distrust has spread beyond the finance
system to other institutions. This is particularly evident in Europe, where there is a lack of
trust in some quarters in the longevity of the euro, and a lack of trust by bondholders of some
European governments that they will be repaid in full. In the case of Greece, this lack of trust
proved to be well-founded. This diminished trust in political and economic institutions is a
particularly worrying development.
I fear that the path back will be a long one. In all walks of life, including finance, trust takes a
long time to build, but can be quickly and easily shattered.
The financial sector and the economy
To set the scene, I will start with a brief description of what the financial sector does. I hope I
can avoid being too jargonistic, but please forgive me if I lapse into economists' speak every
once in a while.
The financial sector plays an important role in the functioning of the economy, primarily
through intermediation. Simply put, the financial sector sits between savers and borrowers. It
takes the funds it raises from the savers through, for example, deposits, and then lends it to
those who wish to borrow, be they businesses, governments, or households. If the system is
working well, it allocates the funds to their most productive use. This benefits the savers
whose money is being invested profitably, and the economy and society at large.
It is important to note that the financial sector is an intermediate sector. It is not at the end of
a production chain producing something which directly generates utility for society. It is a
critical link along the way, the oil that keeps the economy ticking over. When the oil dries up,
the economic engine starts to malfunction and can ultimately grind to a halt.
In that regard the financial sector is different from other parts of the economy. It is one of the
reasons it is subject to considerably more regulation and oversight, although clearly the
experience of the past few years indicates that in many parts of the world the oversight and
regulation were deficient. When the finance sector stops functioning properly it has knock on
effects to all parts of the economy in a way that other sectors generally don't. The experience
at the end of 2008 following the collapse of Lehman Brothers demonstrated this point starkly.
The contraction in the global economy was breathtaking in its rapidity, but also in its
simultaneity, in a way that hadn't been seen before.
I will now step a bit deeper into the process of financial intermediation to provide a better
sense of where trust comes into the process. Again, apologies if this gets a bit too arcane,
but hopefully you can bear with me.
Why do financial intermediaries exist? Why don't I as a saver lend directly to you the
company?
One of the main reasons is because of the presence of what economists refer to as
asymmetric information. Asymmetric information arises when I know more about my own
situation than you do. It would be difficult for individual savers to know whether they were
lending to a business that was going to put the funds borrowed to a productive purpose and
be in a position to repay the loan when it became due.
A financial institution such as a bank that is practised in credit assessment can reduce these
information asymmetries. When a bank makes a loan, it does the due diligence on the lender
and assesses the capacity of the lender to repay. While the due diligence cannot completely
eliminate the information asymmetry, it can allow the bank to make a reasonable assessment
of the risk incurred in making the loan. On the basis of that risk assessment, the lender
charges the borrower an interest rate to compensate for the risk incurred. With an
appropriately diversified portfolio of loans then, the bank should not be overly exposed to any
particular development. The risk is mutualised. If there is a problem with one loan, the lender
should be earning sufficient interest on the rest of its loan portfolio to cover the loss.
The lender, and thereby the savers who provide the funds to the lender, are compensated for
the risk incurred. Relative to lending their own funds directly, the savers are benefiting both
from the (hopefully) professional risk assessment that reduces the information asymmetry
and the risk mutualisation.
One difficulty in this process that is apparent from what I have just said is the possibility that
the risks in a portfolio of loans are correlated. In plain English, when one loan goes bad, how
likely is it that other loans will go bad at the same time? For example, in an economic
downturn where there is a rise in unemployment, a lender might find that more loans are
becoming problematic than expected, because they are all being affected by the realisation
of the same risk. The interest rate charged may have been sufficient to compensate the
lender for one realisation of the risk but may not have been adequate for a large number of
simultaneous realisations of risk.
In addition to intermediating funds, one can also think of the financial sector intermediating
risk. As I've just said, a financial institution has a wide range of loans on its books. By holding
a diverse portfolio of risk, the institution is, in theory, less vulnerable to the realisation of any
of those risks.
But a financial institution doesn't always hold all the risks on its own books. Through
channels such as securitisation, a financial institution can also distribute the risk around the
financial system to other institutions that are, again at least in theory, better placed to hold
that risk. Who might be better placed to take on these risks? Some possible candidates are
pension or superannuation funds and insurance companies that should have long horizons
and a diversified portfolio of assets.
It is an interesting question as to whether it is better for a bank to pool the risks on its own
books or whether it is better for the risk to be off the books of the banks and instead be
distributed round the system. If the risks are distributed around the system, the bank making
the loan may be less inclined to do the appropriate amount of due diligence, as they are no
longer so directly exposed to the consequences. In principle, the entity which buys the risk
from the bank should also do an appropriate amount of due diligence. But the experience of
the past few years shows that the more chains there are in this process, the more removed
the end-holder of the risk is from the originator of the risk and the worse the process of due
diligence becomes.
On the other hand, if the bank holds too much risk on its balance sheet, and if too many of
those risks crystallise, the bank is likely to find that its ability to continue to intermediate funds
is severely curtailed. It will cut back on its lending - what's commonly referred to as a credit
crunch - worsening the economic environment. There are plenty of examples of this through
history, including in the current crisis. So conceivably, risk should be intermediated as much
as funds.
These considerations are currently at play in the debate over the Volcker rule in the United
States and the "ring-fencing" proposed in the Vickers report on the UK banking system. The
conclusion reached in both those cases is that it is better to separate the investment banking
(or risk generation) arm of financial institutions from the commercial banking or regular
lending arm of the institution. Then, if some risk blows up in the investment arm, there is not
a detrimental spillover to the commercial bank that crimps its ability to continue lending,
thereby limiting the impact on the economy.
Alternatively, one can consider a world of fractional risk banking, analogous to fractional
reserve banking. With fractional reserve banking, I refrain from lending some portion of the
funds you, and others, deposit with me so that I can repay you, should you decide to
withdraw the funds at short notice. As long as all the depositors don't want their funds back
at the same time, that is, as long as there isn't a bank run, then I am fine. In the case of
fractional risk, I would retain some part of the exposure on my own balance sheet rather than
pass it all on to you, to give me some incentive to monitor the risk and continue to do due
diligence. This is often described as "skin in the game".
Trust and finance
Having spent a bit of time setting the scene by describing how the process of financial
intermediation works, I will now focus on the main argument: the role that trust plays in
finance.
Trust is pervasive at many levels of the financial system, in large part because of asymmetric
information. There is the trust between the depositor and the bank. The depositor is trusting
that her funds are safe with the bank. This is embodied in Frank Capra's famous movie, It's a
Wonderful
Life, where Jimmy Stewart saves the day with a paean to trust, to stop the run on
the bank.
Trust of this sort is particularly important because banks undertake maturity transformation,
that is, borrow short and lend long. For example, banks are willing to let you deposit your
money "at call", but lend the money for periods considerably longer than that. If depositors all
lost trust in a bank at the same time, as in a bank run, the bank would be unlikely to be able
to repay the funds immediately. It could not call in all its loans. It would be forced to engage
in a fire sale of its assets, which are mostly illiquid loans. To prevent this situation occurring,
central banks provide a liquidity backstop, where they stand ready to lend money to banks if
needed, against the bank's assets (collateral). The trust in these arrangements is almost
always enough for them not to be needed.
There is trust between the borrower and the bank. The bank is trusting that the borrower will
repay the loan. The bank can do a lot of due diligence on the borrower to be reasonably
confident that the lender will repay. But ultimately there will be some trust involved. The bank
needs to trust that the borrower has provided accurate information and will act in good faith.
There will, however, always be a gap between what the bank can learn through its due
diligence and what it needs to be completely confident the loan will be repaid in full.
Because the process of financial intermediation often has a number of links in the chain,
there also needs to be trust between financial institutions. Many financial transactions don't
just involve one bank lending out its deposits to the end-borrower. Often the funds are
on-lent to one financial institution after another, before ultimately finding its way to the
end-borrower. So trust needs to be present at every stage in the chain. One breakdown in
this chain of trust between counterparties can throw a spanner in the works of the whole
process.
Ultimately there is only so much due diligence that can be done. Risk is always present in the
financial system. Information asymmetries will always be present between the two parties in
a financial transaction. Transparency can reduce but not eliminate the risk from these
asymmetries.
Finally, there has historically been trust between regulators and financial institutions. (I am
not sure there is all that much of this trust at the moment, as I will discuss later.) "Trust me, I
know what I'm doing", was the banker's exhortation for the light touch approach to regulation
that was pervasive prior to the crisis in many countries, most obviously the UK. The
argument was that banks should be broadly left to their own devices, with the discipline
provided by the market deemed sufficient to keep them on track.
The breakdown of trust
Having described the critical role that trust plays in the process of financial intermediation, I
will now describe how trust has broken down over the course of the financial crisis.
The period leading up to the financial crisis saw what might be labelled, in the context of my
talk today, the development of lazy trust. Things were generally going along fine, so my due
diligence was that I will take you, the lender, at your word. I won't really bother to verify that
what you are telling me is true. I won't bother to consider the possible circumstances that
might hinder your ability to repay me.
Moreover, with long chains of intermediation involved, there was often too much distance
between the ultimate holder of the risk and the source of the risk. Too many links means that
details get lost or misheard. If the due diligence is necessarily incomplete by the very nature
of financial transactions, then that incompleteness is likely to get magnified, the more chains
there are in the transaction. The due diligence gets dissipated along the chain. There is a
presumption that someone further up the chain did the due diligence. And when times were
good, no-one thought to challenge that presumption.
So complacency set in, encouraged by the seemingly benign growth in the world economy.
That benign environment led to an incorrect pricing of risk. Now this need not be the case,
but it does seem to be a trait of human behaviour that has been evidenced many times in
financial history. Good times begets complacency.
Let me take a quick detour here. Taken to the extreme, this line of argument leads to a view
of the world most famously associated with some Austrian economists. Good times are
always setting us up for the next disaster. It is not clear to me what the appropriate policy
response should be to this. Certainly one should always remain alert to the possible dangers.
And certainly it may be difficult to take away the punchbowl when the party is in full swing.
(Maybe that is why central bankers are never invited to good parties...) But surely it doesn't
mean we should never have good times, and instead endure a constantly mediocre
performance so that no-one ever gets carried away.
Obviously there needs to be a balance. To some extent, one can do the calculus. The large
costs of the current financial crisis does make one think hard whether one should have let
the previous boom persist for so long, as great as the benefits of it were while they lasted.
But another aspect of human nature is the belief that one can avoid the mistakes of the past
by learning from them. Inevitably therefore, there is the ubiquitous assertion that this time it is
different. And in many aspects, each time it is different. It is easier to assess the differences
than the similarities in real time. The similarities only generally become apparent after the
fact.
Thus, as mentioned earlier, we actually do need some level of distrust, at least initially, for
the financial system to function effectively. I shouldn't take you completely at your word. I
should do some background checking to make sure that what you are telling me is true. I
should check whether your circumstances have changed so I can be confident that you will
still be able to repay me.
So back to the breakdown of trust. Some time around 2007, it became clear to many in
financial markets that there had been a major mis-assessment of risk in many parts of the
financial system. While some had been warning about this mis-assessment of risk prior to
this, and some had even positioned themselves to benefit from this mis-assessment, as
Michael Lewis described in the Big Short, it wasn't until the middle of 2007 that this became
a more widely held opinion. Interestingly, through the second half of 2007, there was a
marked disconnect between equity markets and credit markets. Credit markets came to the
realisation significantly earlier that something was going badly wrong in the financial markets,
but for quite a considerable period of time, equity markets assumed nothing worse than a
garden variety economic slowdown was in prospect.
Lazy trust evaporated. The financial system switched rapidly from complacency to deep
mistrust in a short period of time. In particular, trust broke down between financial
institutions, best illustrated by the final days of Bear Stearns in March 2008, and then
Lehman Brothers in September of that year (see House of Cards by William Cohan and Too
Big to Fail by Andrew Ross Sorkin, that are amongst the many books written about those two
events). Both institutions experienced a run on them by their financial counterparties, who
were unwilling to roll over their funding because of the concerns that the poor quality of the
assets on their balance sheets might render the two institutions insolvent.
The crucial distinction between uncertainty and risk came to the fore. I can assess the
riskiness of an asset or an institution by assigning a probability to its likely value. I can then
manage that risk appropriately. But if I am uncertain and unable to make a firm assessment
about the value, the situation is a lot worse. I am likely to pull back and be unwilling to
provide any finance to you, except on steep terms and probably only for a short term.
Uncertainty is much more pernicious than risk. As I have spoken about earlier,3 the famous
Rumsfeld quote very much applies to the financial crisis. Risk is very much about the "known
unknowns" but uncertainty is about the "unknown unknowns". But maybe Mark Twain puts it
a lot better: "It ain't what you don't know that gets you into trouble. It's what you know for
sure that just ain't so."
Financial institutions and investors knew that many assets in the financial system were badly
mispriced. In the case of some financial institutions, they knew about the mispricing on their
own books and rightly assumed that the same was probably going on with their competitors.
But they didn't know how much.
They did not know what exposure various financial institutions had to these mispriced assets.
So what is termed "counterparty risk aversion" became all pervasive. The lack of trust meant
that financial institutions were only willing to lend to one another for increasingly shorter
periods, ultimately only overnight. A financial markets version of the bank run portrayed in It's
a Wonderful Life took place. In the UK, in the case of Northern Rock, a traditional bank run
occurred as depositors became concerned about the safety of their savings. They no longer
trusted the institution because they were uncertain about its ability to fund itself, given its
reliance on mortgage-backed securities for funding - a market that was no longer functioning
at all because of a lack of trust in the value of these securities.
This breakdown in trust led to a breakdown in intermediation. Central banks stepped into this
hole to play their historical role of intermediary of last resort. Central banks can replace, to a
reasonable extent, the decline in the intermediation of funds by the banking sector. But it is
considerably more difficult for central banks to replace the lost trust.
The extent to which central banks have needed to be intermediary of last resort is evident in
the vast size of central bank balance sheets in major advanced economies: the euro area,
the United States, Japan and also the UK. The central banks are standing between financial
institutions that are unwilling to lend directly to each other.
The euro area provides a particularly clear example of this. In the second half of 2011, banks
in the euro area became increasingly unwilling to lend to each other. First of all, banks would
only lend against collateral (secured lending) rather than lending directly to another bank
without any security (unsecured lending). In plain English, this means that banks would only
lend to another bank if the borrowing bank would provide something like a government
security or a portfolio of mortgages as collateral to the loan. Then even if collateral was
provided, the length of time they were willing to provide the loan for shortened, because of a
concern that the borrower would not survive long enough to repay.
This placed some financial institutions in significant financial difficulty. Concerns mounted as
to whether some institutions would be able to fund themselves at all. As a result of this, the
European Central Bank (ECB) announced that it would provide as much funds as banks in
Europe required through three year loans. So the European central bank has become the
intermediary of last resort for the European banking system because the banks do not trust
each other.
More recently, as the lack of trust of some of the governments of Europe has intensified, the
ECB has had, in effect, indicated its willingness to act as intermediary of last resort to these
governments too. One of the main reasons the ECB has decided to do this is because of the
lack of trust in the longevity of the euro. Investors are concerned about the possibility of
redenomination risk: the possibility they are left holding an asset whose value is markedly
decreased, when a country leaves the euro area and re-introduces its own currency.
As a result of this mistrust, we are witnessing a balkanisation of the financial system in
Europe. Investors in one European country don't trust banks or governments in other
countries. They pull back from financing across borders, preferring instead to invest their
money close to home. This almost certainly is not an optimal allocation of funds to their most
productive use.
On top of this dangerous state of affairs in Europe, and amplifying the diminution of trust in
the financial sector, recent controversies in the banking sector have hardly provided any
justification for the public regaining trust in the banking system.
To the extent that trust was slowly being restored in some parts of the banking system over
the past few years, it was shattered by the recent revelations surrounding the LIBOR
scandal, allegations of money laundering and the like.
The restoration of trust
So all in all, the state of the financial system in many parts of the world is not in good shape.
So what is to be done about it? As in the old Irish saying, the first response is to say I
wouldn't start from here. But unfortunately, here is where we are.
Using the recent experience in Europe as an example, we can consider a number of possible
avenues as to what might be needed to rebuild trust.
When it comes to the distrust of the state of banks' balance sheets, transparency about the
true nature of the assets on the balance sheet will clearly help. But the transparency and the
disclosures clearly need to be credible to reduce the information asymmetries. Stress testing
of the balance sheet by a credible independent party such as the prudential regulator (APRA
in the case of Australia) can give depositors, and other investors, confidence that their
money will be safe. These sorts of actions work to take the solvency risk off the table. For
depositors, this is reinforced by the presence of deposit guarantees. But often it is the
sovereign who is providing the deposit insurance. So if there is a lack of trust in the solvency
of sovereign, this interlinkage between the financial sector and the government can amplify
the problem, as has been evident in the case of Ireland and Spain, for example.
The willingness of the central bank to provide a liquidity backstop, very evident in Europe at
the moment, reduces liquidity risk concerns. Investors are not so concerned that they will be
the ones left in the burning building when everyone else has already run to the exit.
The quid pro quo for this support is that banks will be subject to more comprehensive
regulation and, at least as important, more intensive supervision and scrutiny by their
prudential supervisors than was the case before the crisis. The light touch is no longer
acceptable. One can make a reasonable case that in Australia's case, this doesn't require
much change. APRA has long exercised intensive scrutiny over the banks it supervises. But
even here in Australia, there are a number of lessons learned through the crisis that are in
the process of being applied.
The regulatory regime for financial institutions has tightened considerably. While this might
impose some costs on the financial sector and increase the cost of financial intermediation,
the benefits are sure to outweigh those costs. This is particularly the case when we see the
terrible costs of the high unemployment being experienced in a number of countries around
the world at the moment in the aftermath of their financial crises.
A change in management practice at financial institutions is surely also necessary in a
number of cases, and this must start at the top. The culture around risk management and
risk tolerance clearly is an important element of this. The practices that became pervasive
throughout the first part of this century that contributed to the excesses need to change.
What was considered an acceptable way of doing business will no longer suffice.
Given the role that the financial sector plays in the economy, there is a form of social contract
between it and the general public. As I have mentioned earlier, the financial sector enjoys a
level of support that is not present for other sectors of the economy, because of the crucial
role it plays.
But leverage implies financial institutions are more vulnerable. We need to consider what the
safe degree of leverage is. That is a debate that is being had currently. The rate of
profitability in the financial sector is also a debate society needs to be having. If financial
institutions are perceived to be earning too high a rate of profitability, particularly if the
institution is enjoying a degree of support from the public sector, that too will impede the
restoration of trust.
It will be a long road back to restore trust. Without trust, the process of intermediation and
credit provision will be greatly curtailed. In turn, this will impede the path to global economic
recovery with costs to all.
We have to lay out the road ahead, put down the road rules in the form of regulations and
other curbs on the financial sector. But then the journey still needs to be taken. There are no
short cuts.