Paul Tucker: The state of the markets - four issues
Remarks by Mr Paul Tucker, Deputy Governor, Financial Stability, of the Bank of England, at
the Association of British Insurers 2009 Biennial Conference, London, 9 June 2009.
* * *
Many thanks for the invitation to be here today. The Bank greatly values its relationship with
the insurance industry. We are just immensely grateful for the intelligence you provide, as
asset managers and insurers; and for our constructive dialogue on policy issues.
I have a few brief remarks on four broadly linked issues.
The macroeconomic outlook and bank lending
Since the beginning of the year I have felt that it will take until late autumn at least to have
any kind of a handle on broadly what type of outlook we face. My view on that hasn't really
changed. Of course, over recent weeks near-term indicators, notably the business surveys,
have improved a bit. Confidence seems to have stabilised. And that has been most obvious
in the financial markets, where the really good news is that firms on both sides of the Atlantic
have been raising funds in the equity and bond markets.
But a sense of perspective is needed if those apparently small steps forward are not to be
frittered away. Inevitably the medium-term outlook remains highly uncertain, and the path
back to anything like normality can only be gradual I'm afraid.
In particular, for the moment it is unclear - as, I must say, it is bound to be at this stage -
whether the financial system can generate the expansion of credit that will most likely be
necessary to support recovery. The reopening of high-grade bond markets has definitely
been encouraging. But in most countries, including the UK, bank lending remains subdued. It
is hard to disentangle how much of that is down to weak demand, and how much to tighter
supply conditions from the banks. I would just say this. I truly believe that it is in the interests
of the banks themselves to ensure that businesses get the working-capital finance they need.
While one can imagine, I suppose, individual banks being tempted to sit it out in order to
deleverage their balance sheets in an environment that is obviously tougher for them, there
cannot sensibly be free riders. If all banks were to adopt such a strategy, recovery might end
up being anaemic at best, which would feed back into the banking system itself - increasing
defaults and depleting banks' capital. Not lending would be a counterproductive business
and financial strategy. I'm reasonably confident that senior bankers can be persuaded to see
that themselves, if indeed they don't already.
But it will, in my view, take until the autumn at least to gauge whether tolerable progress is
being made on this front. Without it, confidence could ebb away. But with it, recovery will
have a fair chance of becoming rooted.
Risks will, I should be clear, persist from the international environment and, in particular, the
pattern of international saving. If the Asian economies were to continue to save at an
extraordinary rate but the Western economies increase their saving, as over time we must in
order to repair national and sectoral balance sheets, longer-term risk-free rates could again
fall in order to bring about the counterpart expansion in investment. And, although it may
seem far-fetched right now, that could give an upward impetus to asset prices over the
medium-term. We would need to be careful not to mistake any such future developments for
a miracle improvement in underlying economic and financial conditions. Indeed,
internationally, we need to learn lessons about brewing risks from medium-term imbalances.
The Bank's policy response, and credit markets
Alongside the Government's actions to underpin the capital resources and funding of the
banking system, the Bank's policy actions have been designed to assist recovery in credit
flows and nominal demand.
The big downside risks to the outlook have warranted a substantial monetary stimulus, which
the MPC has provided by bringing Bank Rate down to nearly zero, and by injecting a
substantial amount of money directly into the economy. Speaking of course only for myself, I
have so far preferred that approach to one where we would instead commit to keep Bank
Rate low for a specified extended period. It would be hard to avoid the country
misunderstanding that any such commitment was conditional on the outlook; in other words
that our plans could and would change as the outlook changed. And the current strategy has
been consistent with a mildly upward-sloping money-market curve, which signals that the
market is confident - as it should be - that the MPC will retighten monetary conditions when
in due course that is warranted by the medium-term outlook for inflation. Our 2% target is a
valuable anchor in shaping and implementing our strategy.
In this, insurance companies are by no means on the sidelines. By focusing our purchases
on medium and long-maturity gilts, we are aiming in part to shift the composition of the
portfolios of long-term investment institutions. And it was encouraging, therefore, that the
money holdings of non-bank financial institutions expanded recently. Some economists
argue that gilts and central bank money are near perfect substitutes, so that the effect of our
Quantitative Easing will be negligible. They may well be close substitutes for traders. But I
doubt they are perfect substitutes for insurance companies and pension funds, many of
which probably don't participate in the secured deposit "repo" markets for switching gilts into
cash; and which in any case desire assets with a longer "interest-rate duration" than money.
If so, holding zero-yielding money balances will not suit them, and we could reasonably hope
for increased demand for, perhaps, corporate bonds and other financial assets. Risk premia
might decline slightly. And the flow of credit outside the banking system may improve,
helping to support a recovery in nominal demand. Over the next quarter or so, amongst other
indicators I will therefore be looking at what happens to firm and household money holdings,
as well as credit flows and risk premia.
The Bank's Asset Purchase Facility schemes for corporate paper are designed to help
catalyse that process. The fact that the Bank is buying relatively small amounts of paper may
have been misunderstood by some. As the central bank, we are not operating the schemes
in order to lend in scale to the real economy, but rather to help revive the markets. Some
have described this variant of liquidity insurance as acting as "Market Maker of Last Resort",
and I recently aired some thoughts on the kind of principles that might guide central banks in
this area.1 They include consistency with monetary policy; avoiding undue risk to the central
bank; acting as a catalyst; and avoiding attempts to prop up markets that would not be
fundamentally viable once peacetime resumes.
Yesterday, the Bank issued for consultation some ideas on how we might be able to extend
our liquidity insurance, through the APF, to facilities for working capital finance. They cover a
possible facility for secured commercial paper, where the underlying assets would be
portfolios of SME trade-finance credit, and a facility for supply chain finance. I would hope
that the insurance industry, and the liquidity and investment funds you run, might be
investors in such paper, whose liquidity would receive some underpinning. Certainly you will
be an important part of the Bank's consultative process led by my colleagues Paul Fisher
and Sarah Breeden.
Addressing trade and working capital finance has become all the more important given the
reduction in the availability of trade-credit insurance, which our regional Agents hear quite a
lot about. We therefore welcomed the initiative of that relatively concentrated industry to
release a code of conduct, supported by the ABI, for handling difficult cases where
unnecessary firm distress could be avoided. The Bank has followed this carefully given our
role as midwife for the London Approach designed to help facilitate the orderly resolution of
creditor/debtor problems. In a few cases over recent months, as well as over the
trade-creditinsurance code, my colleague Andrew Bailey has played a behind-the-scenes role - the
traditional role of providing the Bank's good offices where (and only where) we can help, and
where help is desired by those involved. Effective resolution mechanisms are an important
back-stop when the system's resilience proves wanting, as recently.
Developing more resilient capital markets
Over the medium term, we of course need a much more resilient financial system. This is not
just a matter of a better structured, better capitalised, more liquid, more prudently
riskmanaged, more transparent, and better regulated banking system (and I emphasise system).
We also need more resilient capital markets. In the 1980s and into the 1990s the authorities
here and elsewhere helped to bring about a number of important structural changes in the
market infrastructure: LIFFE; reforms at LCH; book-entry transfer, and later
delivery-versuspayment, settlement systems; a wholesale payment system designed to withstand bank
failures; the introduction of the gilt repo market. A lot of plumbing! And proof from the past
that, working together, the industry and the authorities can do good. Those initiatives were
designed to underpin stability in the rapidly evolving capital markets of the day. The current
crisis has reminded everyone of the need for the authorities, occasionally and in a
welltargeted way, to help remove blockages or quietly steer private sector initiatives on to a
course serving the wider public interest. Entrepreneurial innovation is the life blood of
economic growth. But sometimes it outstrips the supporting infrastructure. That happened
with some parts of our capital markets over the past decade or more. The recent initiatives
coming out of the US Treasury to strengthen markets are therefore to be welcomed in their
broad thrust and goals.
In particular, the Bank of England agrees that more of the vanilla OTC markets should be
cleared via central counterparty clearing houses. LCH led the way globally in opening up
central counterparty services to interest-rate swaps, breaking a mis-think that somehow
CCPs could clear only exchanged-traded instruments. And recently it has made the welcome
announcement that non-dealers will be able to access such central clearing, at least
indirectly via "clearing members", as for exchange-traded contracts. Central clearing can help
to provide transparency and consistency in valuations and haircuts. It can help to promote
greater standardisation in terms. It makes haircuts more visible to the market as a whole, and
to the authorities, who as overseers of the system should be prepared to form a view when
haircuts are too low - and the associated market leverage is too high - for system stability to
be assured. The role of the authorities is important. It is absolutely vital that management
maintain the integrity and soundness of the key clearing houses as they expand their range.2
As overseers of the payments systems embedded in clearing houses, the Bank will work with
the FSA and our international counterparts on this.
It is often said that dealers resist such initiatives, as it can squeeze their margins. That may
well be the perspective at desk level, but I suspect it is unfair to many CEOs, who have a
clear interest in the health, safety and soundness of the system. And if some didn't recognise
it before, they will now - as their predecessors did in the relatively recent past.
The key industry associations can also play a constructive role in this whole area - as,
indeed, they have in the past. This crisis would have been even worse if ISDA and others
had not overseen the introduction of the collateralisation of derivatives-related counterparty
credit exposures amongst the dealer community. But there are lessons about extending
collateralisation, and standardising terms in vanilla instruments, beyond the dealer
community in some circumstances.
The debate is not just about clearing houses and post-trade infrastructure. The financial
community must also be open to more trading in core, vanilla markets going via exchanges
or other well-designed and open trading platforms. If well constructed, that could help to
preserve liquidity when times are tough. We would, for example, like to see serious
consideration of whether the corporate bond markets could benefit through something along
those lines.
Bank capital instruments
The insurance industry is involved, one way or another, in everything I have touched on this
morning. But there is one other area - as investors in bank capital instruments. I am
therefore sure you understand that the authorities, internationally, cannot avoid reviewing
what should count in the medium term as regulatory capital for banks. It won't do for banks to
be able to leverage up on subordinated debt (or other forms of hybrid capital) if, just when it
matters, the holders do not suffer because the authorities cannot let the banks concerned be
liquidated without bringing system collapse down on us all. We either need a system where
banks of any type can quietly fail and hybrid capital is actually useful in protecting the deposit
insurer; or, more realistically, we shall need a much narrower definition of capital. Only equity
can absorb losses and sustain a going concern. Finding a way through that in the current
crisis remains a challenge. One helpful step might be for the investment industry to seek out
opportunities to convert subordinated debt into equity; or, at a discount, into senior
unsecured debt, as has occurred in a few instances already. It would probably entail a
haircut, but I wouldn't air it unless I thought it could be in your collective and medium-term
interests as investors in our economy and the system of credit that supports and lubricates it.
The new Special Resolution Regime for banks may create healthy incentives in that broad
direction.
In concluding, can I thank you again for inviting me to join you today. Authorities everywhere
are having to innovate to help get us through this crisis. And we will need to innovate to build
a better system for tomorrow. Our dialogue with you can only help that. We are very grateful
for it.