Paul Tucker: Macroprudential policy - building financial stability
institutions
Remarks by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
at the 20th Annual Hyman P Minsky Conference, New York, 14 April 2011.
* * *
These remarks do not necessarily represent the views of the Bank of England or the interim Financial Policy
Committee. I am grateful for comments from Charles Bean, Alastair Clark, Roger Clews, Spencer Dale, Paul
Fisher, Andy Haldane, Don Kohn and Hector Sants.
Thank you very much for inviting me to join you this evening. Having spent much of my
career thinking about or living through the issues studied by Hyman Minsky, it is a very great
honour to be here.
I am going to begin with the birth of the Federal Reserve. And then I am going to discuss the
birth, a century later, of a new institutional framework for financial stability in the UK.
It is almost a hundred years since the Federal Reserve was established, after successive
waves of bank runs. Against the instincts and interests of the followers of President Andrew
Jackson, America finally found itself with a central bank. Its purpose, cast in 1913, was "to
furnish an elastic currency, to afford a means of rediscounting commercial paper, [and] to
establish a more effective supervision of banking in the United States". In other words, the
Federal Reserve was to be the lender of last resort and it was to ensure stability of the
banking system: a financial stability mandate. Experience showed that instability often
followed a speculative bubble and that such bubbles were often fuelled by credit. The
framers of the 1913 Act were, accordingly, anxious to avoid the new Federal Reserve making
it easier for the private sector to lend into such bubbles. The Act gave the Fed permission to
"discount notes and bills of exchange arising out of actual commercial transactions for
agricultural, industrial or commercial purposes". But it barred the Fed from rediscounting
paper "drawn for the purpose of carrying or trading in stocks, bonds or other [private]
investment securities". The Real Bills Doctrine was, therefore, a driving principle of the
Federal Reserve's original charter. And in 1935 Senator Carter Glass, who had sponsored
the 1913 Act, resisted attempts by Fed Chairman Marriner Eccles to change that part of the
Fed's mandate, because he blamed the Great Depression on the preceding speculative
excess.
The mandate did not really have anything to say about preserving nominal stability - that is,
low and stable inflation of consumer prices. So long as the Gold Standard delivered, that
lacuna was probably masked. But as the Fed became the anchor for a flat currency, the Real
Bills Doctrine proved woefully inadequate as a founding precept. Lending only against
self-liquidating commercial paper does nothing to prevent an acceleration in prices, as the
central bank's balance sheet simply accommodates any increase in credit driven by a rising
general price level. As central banks around the world came to concentrate on preserving
stability in the value of their money in terms of goods and services, they put the Real Bills
Doctrine in the dustbin of ideas.
Wind forward a hundred years. The buzzword is "macroprudential". And the talk is of how to
lean against speculative bubbles or tame the credit cycle; of how to contain contagion and
systemic crises; of the role of central bank liquidity facilities; and of how to give banking
supervision a more systemic perspective.1 It is striking that those concerns are not so distant
from those of the framers of the 1913 Federal Reserve Act. Much is said about "missing
instruments". It has been a mistake for central bankers, and the legislators to whom they are
accountable, to focus at different points of their history on only one of either the
stability-threatening excesses of (real) credit cycles or, alternatively, inflation. In the language
of the Bank of England's 1991 statement of Core Purposes, central banks need a mandate
for both monetary stability and financial stability.
In the UK that will now be enshrined by putting a Financial Policy Committee alongside the
Bank of England's existing Monetary Policy Committee. The Committee has recently been
established, on a non-statutory basis for the interim. But that poses a host of questions. How
do we define financial stability? What is the FPC and what is its objective? Why should it be
separate from the microprudential supervisor, which is also being moved to the Bank? What
will be the FPC's instruments? Are they all directed at banks? Will they conflict with monetary
policy? And, more prosaically, how will the FPC operate and be accountable?
I shall set the scene with some general reflections on financial stability, including how it might
be defined, and how its scope extends to the resilience of capital markets as well as that of
banks (and shadow banks). After those more general observations, I shall try to answer
some of the key questions about the FPC.
What is financial stability?
Why financial stability matters
Under legislation introduced in the UK in 2009, the governing body of the Bank of England,
Court, is required to set out a strategy for the Bank's financial stability work. We publish it in
our Annual Report. We have tried to clarify why society should care about financial instability.
It is for the obvious reason that we need to preserve the key services that the financial
system provides to the real economy: payments and transactions deposits; the
intermediation of savings and investment via credit and equity; and insurance and risk
transfer. In the latest crisis, the payment system was preserved but only at a massive cost to
the taxpayer, and even then official support operations could not prevent the severe credit
crunch that led to a horrible global recession. That is why we care. And it underlines the
importance of ensuring that the system of credit intermediation (and risk transfer), not only
the payment system, is robust.
Instability and resilience
But not every severe interruption in the provision of financial services is the result of
instability. Instability is characterised by a problem in one of part of the financial system - a
bank, a market, part of the infrastructure-spreading to other parts and threatening to spiral
out of control.
Financial systems are prone to bouts of instability, due to the inherent fragility of the balance
sheets of many participants, together with the complex networks through which they are
connected. First, many firms are highly leveraged, meaning that a given fall in the value of
their assets has a magnified effect on their net worth; and run significant liquidity risks, so
that they can face distress if their liabilities crystallise before their assets. Given opacity
about their financial strength, this can leave such firms exposed to runs when the weather
turns nasty. Second, as recently laid out by Governor Tarullo,2 a problem in one firm can
spread via the domino effect created by chains of counterparty credit exposures; forced
asset sales; or contagion due to the reality or perception of common problems.
And, to be clear, this is not just a vulnerability of firms. Markets too can suffer a self-fulfilling
evaporation of liquidity. A central element of the recent crisis was, indeed, the drying up of
liquidity in the ABS markets and the money markets. As liquidity premia soared, many asset
values collapsed, and the net worth of many traders and banks was eroded. This was a
vicious circle, because the liquidity of many financial markets depends on short-term traders
being ready and able to trade, since end-buyers and sellers will not always want to transact
at the same time. Those traders often depend, in turn, on maintaining access to financing
from banks. Everyone has been reminded, therefore, that the liquidity of markets and the
well-being of leveraged, maturity-mismatched firms are inextricably intertwined.
Our capital markets and much of the "plumbing" of the financial system - notably the
payments system - rely on confidence in the integrity of the assets being traded, in the
robustness of counterparties, in the reliability of infrastructure. Crises nearly always involve
that confidence sliding away. So, although financial systems look solid most of the time, they
can in fact prove brittle. Their degree of vulnerability or resilience depends, amongst other
things, on the leverage and the liquidity mismatch in the system as a whole. That entails
thinking of the system in aggregate (effectively netting out intra-system exposures), in terms
of its position vis a vis borrowers and savers in the rest of the economy. And it means
thinking of the system distributionally (ie gross), meaning the network of exposures amongst
firms and taking into account the weakest links in the chain.
Pulling those various strands together, a definition of financial stability that has informed my
own contributions to the reform debate is the following:
"financial stability prevails where the financial system is sufficiently resilient that
worries about bad states of the world do not affect confidence in the ability of the
system to deliver its core services to the rest of the economy."
The key words are "confidence" and "resilience".
"Bad states of the world" obviously include recessions; and other jolts from the real economy,
due to the accumulation of too much debt within or between countries. Macro imbalances do
not invariably lead to instability in the financial system, but they do often extend the chain of
intermediation between savers and investors, can unravel in ways that reduce asset values
and increase volatility, and are often sustained by accumulating indebtedness. In the face of
ultimately unsustainable macroeconomic imbalances, whether domestically or internationally,
the financial system therefore needs to be more resilient than otherwise. That was badly
neglected around the western world in the years running up to the current crisis. (And it
remains a risk going forward.)
Resilience sounds, and is, highly desirable. But it is not a free good. There are trade-offs.
And here lies an important contrast with monetary policy. No one seriously believes that
there is a trade off in the long run between, on the one hand, inflation and, on the other hand,
growth and employment. While a monetary authority can pump up nominal demand to
enhance output and employment in the short run, in the long term the impulse is dissipated in
a higher price level, with the economy's real equilibrium determined by real factors alone. But
in the financial stability arena, there is a long-run trade off. An economy with a repressed
financial system is unlikely to experience financial instability, but it would have plenty of other
problems.
In consequence, the authorities have to set standards of resilience suited to tail events
without impairing the wider functioning of the economy. But we also need to be equipped to
raise the required standard of resilience in the light of changing circumstances, notably if we
judge the world to have become more threatening than previously foreseen. That is the basis
for macroprudential policymakers, such as the UK's FPC, being able to deploy "cyclical"
instruments, as I shall describe later.
Firms, markets and infrastructure
The resilience of the system depends on that of its component parts and on how they are
connected. In the real world, that means firms, markets and infrastructure. It means looking
for and addressing vulnerabilities or faultlines in all three. And it entails choices, trade offs,
about how far to make individual firms robust and how far to strengthen the system by
reducing spillovers from a distressed firm to other firms and markets.
Amongst firms, plainly banks are a priority. As monetary institutions, they are special. Their
deposit-liabilities are money. And that enables them to provide committed, on-demand lines
of credit, ie liquidity, to households and firms in the real economy and to traders in financial
markets. Firms of all kinds are able to economise on the stock of liquid assets they would
otherwise need to hold.3 But banks can provide those liquidity-insurance services only if
depositors are confident that they can convert their deposits into cash (central bank money).
That does not mean that every bank must be completely safe, but it does mean that the
resolution regime must be equipped to preserve their core monetary services whether by
resurrection or the transfer of transactions-deposits to a healthy competitor.
In talking about banks, I must stress that it is the economic substance that matters, not the
legal form. We must also take care with the resilience of "shadow banking" firms and
structures characterised by liquidity transformation and leverage.4 And we must take account
of the network of exposures and behavioural influences of funds, long-term institutions,
brokers etc.
They are all connected by markets.
I find it is helpful to distinguish between those markets whose role is to provide essential
support to banking and insurance, and those markets that directly deliver the financial
system's core functions to the rest of the economy.
For example, the overnight wholesale money markets are vitally important, because banking
could not operate without them. They are effectively part of the payments system
infrastructure, and have long been of concern to central banks. The financing markets,
notably repo, fall into the same broad category, although the authorities could have been
closer to the securities lending markets over the past decade. There is a lesson in that.
Some other markets, typically in the past more distant from the attention of the financial
stability authorities, may matter in their own right to end users. That is especially relevant
where a significant proportion of the intermediation of savings/investment occurs via capital
markets rather than via bank balance sheets. In the USA at least, some securitisation
markets probably pass that test. In the UK, I would guess that the equity and corporate bond
markets do so. The integrity of those core capital markets is vital. Such markets must be
resilient to shocks. Otherwise disruptions could materially impair the supply of credit (and
equity) to the economy, with macroeconomic and other welfare costs. When the
securitisation markets closed in the USA, it was not realistic for that part of the credit system
to be reintermediated by the banking system in short order.
The essential ingredients of a resilient market include a robust post-trade infrastructure for
clearing and settlement. But trading platforms matter too, as do disclosure standards, and
even the pattern of demand. In my book, a market is unlikely to be resiliently liquid if demand
is almost entirely from leveraged investors and traders: not only do they vanish when prices
stop rising, but prices are then subject to the sudden force of gravity. Much of the
securitisation markets would have failed those tests from around the middle of the past
decade. That is a lesson we and our successors will need to recall when contemplating
future innovations.
Over time the Financial Policy Committee will need to consider whether, as a matter of fact,
core capital markets in the UK are sufficiently resilient for stability to be preserved in stressed
conditions. We will not be able to do that without working constructively with the securities
markets regulator and with infrastructure providers.
Resilience, risks, and financial firm behaviour
So far, I have spoken as if the external threats to the financial system from the business
cycle and its capacity to withstand the crystallisation of those risks are essentially separate.
That is not remotely true, of course. The behaviour of the financial system affects the
weather.
This is due to the particular features of the credit system. A credit boom leads both to
borrowers becoming overindebted and, unless they have shed the risk, to lenders finding
themselves overextended as well. As the probability of default rises, the capacity of lenders
to absorb default typically becomes impaired. A double whammy. And a credit boom can fuel
asset price rises, giving a boost to banks' net worth and back into lending conditions, in an
apparently virtuous circle, until it proves vicious.5
It matters enormously, therefore, that the system is prone to periods of exuberance in which
credit conditions become loose, borrowers overextended and asset prices inflated. That
owes a lot to myopia about tail risks.6 But incentives matter too. Whether the diluted
incentives of bondholders to price risk in banks prudently, given a belief that they would be
bailed out. Or the incentives, here in the USA, for Government Sponsored Enterprises such
as Fannie and Freddie - massive players in global capital markets and so with a significance
stretching beyond your borders - to take on more risk in lending to poorer households. Or for
banks to badge illiquid ABS tranches as trading positions in order to benefit from much lower
Trading Book capital requirements. Or for banks to move credit portfolios to off-balance
sheet vehicles supported by liquidity lines against which no regulatory capital had to be held.
I could go on and on. The microeconomics of finance matters hugely to stability. The
faultlines of the system are sometimes obscure.
And a macroprudential authority needs, therefore, to be attentive to the complex ways in
which the different parts of the financial system interact, generating leverage and liquidity
risk. Threats may often be buried in the complex details of the system - subprime CDO2,
conduits and SIVs etc in the latest crisis; investment trust cross holdings in the 1920s - but
the task is to make the connections without getting lost in the trees.
Which brings me from scene setting to the real world of the new UK framework.
The UK's new Financial Policy Committee
Who we are
The FPC exists. We will hold our first formal policy meeting in June.
We are a Committee of eleven. Five of us are drawn from the executive of the Bank,
increasing to six when microprudential supervision of banks and insurers moves across in
2012/13. The two senior officials of the UK's existing regulator, the Financial Services
Authority, are members during the interim period. And once the legislation has passed, the
chief executive of the planned new securities/consumer regulator, the Financial Conduct
Authority, will be a member, reflecting, as I have outlined, the vital role of market regulation in
preserving stability. There are four external members, including from the USA Don Kohn, the
former Vice Chairman of the Federal Reserve Board.
The Government expects the legislative process to be complete towards the end of 2012. In
the meantime, during the interim, non-statutory phase of our existence, the Financial Policy
pave
Committee has two broad functions: "paving" and "shadowing". We will the way for the
statutory incarnation of the Committee by advising the government on the instruments and
powers we could be given by Parliament. And, secondly, we will as far as possible shadow
the role of the statutory FPC, which essentially means advising the FSA on where and how it
should use its regulatory tools for system-wide ends.
So what are those ends? They are consistent with my earlier overview of financial stability.
The Objective of the FPC
The UK government has proposed that the FPC's main responsibility should be taking action
to remove or reduce systemic risks with a view to protecting and enhancing the resilience of
the UK financial system (my emphasis). "Systemic risk" is defined to embrace both faultlines
in the structure of the financial system, ie the way its components are joined up; and cyclical
threats from unsustainable levels of leverage, debt or credit growth.
Two glosses on that are warranted.
First, the government's plan does not entail the FPC being held accountable for fine tuning
the credit cycle, but rather for ensuring stability by maintaining the resilience of the financial
system. An example might help. Say that in the face of a credit boom, the FPC raised banks'
capital requirements. That might help to slow the boom, and it would be helpful if it did so.
But even if the boom continued, by virtue of having higher capital ratios the banking system
should be more resilient when the bubble burst. If those FPC actions prevented the banks
going bust, the downswing in the credit cycle, and so in the business cycle, would be less
severe because the flow of credit services could be sustained. That would be a success.
Perhaps not always a glorious success, but a whole lot better than where we are right now.
Secondly, due to the trade offs I described earlier, the government has proposed that the
FPC be subject to a constraint that it should not act to preserve stability at the cost of
significantly impairing the capacity of the financial sector to contribute to medium-to-long
term economic growth. What this means in practice is that when faced with an immediate or
incipient threat to stability, we must try to find a solution that avoids damage to long-term
growth. That discipline is welcomed by the Bank.
This is obviously all novel stuff. It is therefore helpful that the government plans to ask
Parliament for a power periodically to flesh out the statutory objective, via a Remit from the
Chancellor of the Exchequer - an arrangement that has worked well in the monetary field in
the UK. It will enable practical lessons to be incorporated into the regime over time.
Why is the UK's macroprudential body separate from microsupervision?
Most central banks have traditionally regarded their contribution to financial stability as
deriving from their markets and banking supervision functions. That is explicit in the Federal
Reserve's 1913 statute, with which I began these remarks. And given the UK's heavily
concentrated banking system, effective banking supervision is obviously an essential
precondition for preserving stability. But in terms of how organisations work in the real world,
the flaw in relying entirely on this is that it assumes that those operational areas of the central
bank will invariably make time and space to address the financial system as a system.
Incentives work in the opposite direction. Nearly all the bank supervisors I have known over
the past three decades have invariably been drawn towards the parts of their InBox about
individual firms, for the simple reason that that is where their individual accountability is
starkest. At its heart, the FPC is a device to overcome this problem. It charges a group of
policymakers to step aside from the fray, resisting myopia and synthesising the perspectives
of supervision, securities regulation, market operations and macroeconomics, with the goal
of identifying and addressing the big developments that could jeopardise stability.
Lest it be doubted, that task will, of course, be unachievable without a suitable flow of
information from the bank supervisors (and the securities regulators) to the FPC and its staff
in the Bank. The FPC's instruments will not be aimed at individual firms per se. But we are
expecting that the Committee will be briefed by Hector Sants' supervisory team on the
circumstances of the most significant firms, and to be informed routinely about shifts in the
supervisors' ratings of firms generally. Symmetrically, the FPC's concerns will surely help the
efforts of the microsupervisors. In particular, the macro perspective can make a big
contribution to the design of stress tests of firms' soundness, whether "top down" stress tests
conducted for the FPC itself or "bottom up" stress tests conducted as part of micro
supervision. And the markets perspective can help to identify issues or types of firm that
warrant closer examination. We need to make that work on the ground. Being part of the
same organisation, the Bank of England, will help. The legislation needs to wipe away legal
impediments to the free flow of information. And we need to embed a culture of mutual
respect and co-operation.
The FPC's instruments
But what will the FPC be able to do?
What, indeed, would the world's financial stability authorities have done if they could have
their time again? The answer is surely reasonably clear in the programme of the Financial
Stability Board, as endorsed by the G20 leaders.
On markets, we - where "we" throughout is the authorities internationally - would have
subjected the burgeoning CDS markets to the disciplines of central clearing in, I would say,
around 2003-05; and the CDO markets to a more rigorous transparency regime. We could
have contained the extent to which shadow banks could be built within insurance companies,
money market funds, securities lending markets, etc. We would all have been noisier about
the distortions in global capital markets caused by Fannie and Freddie. We would have
pressed harder on the adequacy of the consolidated supervision of US securities dealers.
We would have plugged the most obvious problems in the Basel Capital Accord for banks, so
that they were less levered; and we would have remembered that banks need to carry a
liquidity cushion, and that treasury functions should not be profit centres. We would have
been attentive to the opacity around the ABS market; and to the cliff effects stemming from
mechanistic reliance on rating agency ratings by banks, investors and regulatory regimes.
And, finally, I trust that we would have been more exacting in following up the early-2000s'
G10/Financial Stability Forum report on the difficulties of resolving Large Complex Financial
Institutions.
Some of those interventions would have addressed long-standing structural faultlines in the
global financial system. Others, perhaps more speculatively, would have been contingent on
cyclical conditions. For example, a respectable macroprudential authority would ideally have
tightened banks' capital requirements against exposures to property and to shadow banking.
do
Perhaps more compellingly, I think a macroprudential authority equipped with powers to
things would at least have asked whether the system was sufficiently resilient given a
pervasive sense, from the market itself, that risk was underpriced.
Lo and behold, the sphere of influence of the FPC will come via both "structural" and
"cyclical" instruments.7
Once the legislation is in place, the FPC will be able to make Recommendations, on a
"comply or explain" basis, to the Prudential Regulation Authority and to the Financial Conduct
Authority (the planned securities markets-cum-consumer regulator) on their rules and
policies. And the FPC will also be able to Direct the microregulators to take certain kinds of
action, to be set out in secondary legislation; that is so that our Parliament decides the
spheres in which the microregulators will be obliged to follow the FPC's lead. On the US side
of the Atlantic, some of you will recognise echoes here of the Paulson Plan for the creation of
a financial stability authority in the Federal Reserve.
Furthermore, FPC will have a responsibility to advise the government on when the perimeter
of the PRA's microprudential supervision should change. Very obviously, this is aimed at
countering the risk of regulatory arbitrage undermining attempts to tighten up banking
regulation. It also recognises that the shape of the financial system is bound to evolve in
unexpected ways over the years. The regulatory regime needs to be adaptable.
It is not all about banks: instruments addressed to network issues
That underlines that the UK's new macroprudential regime is not all about banks.
For example, were it to be warranted, the FPC could potentially intervene via
Recommendations or Directions to the microregulators on disclosures made around the
issuance and structuring of securities; on the trading infrastructure of markets, to increase
the likelihood that liquidity would prove resilient under stress; on limits on large exposures
amongst different kinds of firm; and on the rules of the game for the many varieties of
shadow banking.
On the last, for example, it is no secret that, speaking only for myself, I should like to see the
rules for money market mutual funds altered to address the "break the buck" problem. That
could be done either by making MMMFs hold capital, which essentially amounts to turning
them into de jure banks; or by requiring MMMFs to mark-to-market daily, so that they
become Variable Net-Asset Value investment vehicles. In other parts of the shadow banking
forest, I hope that we can consider the merits of the industry establishing a Trade Repository
for data on what goes on in the securities lending market, including on the reinvestment of
cash or securities collateral. While that will sound technical, this is one of the world's biggest
financing markets: firms and the authorities need at least to be able to gauge broadly what is
going on. And, to give a third example, I hope that we will treat ostensibly "non-bank" prime
brokers as banks if they finance their business with client balances that can be withdrawn on
demand.
My FPC colleagues will not necessarily agree with all of that, but I hope the examples
illustrate that we are not going to focus myopically only on the banking system.
"Cyclical" instruments: how does macroprudential policy relate to monetary policy?
The cyclical dimension of macroprudential policy is essentially about leaning against credit
booms with a view to maintaining financial system resilience.8
The benchmark instrument, in the sense that it will definitely exist, will be the countercyclical
buffer (CCB) in the Basel 3 Capital Accord. In the UK, it will be the FPC that decides whether
to switch off the semi-automatic application of the CCB when triggered by the ratio of credit
to GDP and other indicators exceeding certain thresholds. (It is not altogether clear, by the
way, who will have that responsibility in other countries; the function requires a system-wide
perspective and a macroeconomic capability and so is not exclusively in the domain of
microprudential regulators.)
Beyond the one instrument agreed internationally so far, the UK government is also
considering whether to give the FPC a variety of other instruments. These include varying
liquidity requirements; and varying capital requirements against specific types of exposure
("risk weights") and/or minimum haircuts for specific types of secured lending, whether
financing hedge funds etc or Loan-To-Value ratios for property-related lending. The
availability of such targeted instruments might be especially useful where the FPC wished to
mitigate risks from overexuberance and collective imprudence in lending to a particular
sector without necessarily affecting credit conditions more generally. Targeting a specific
area of business might also sometimes help to resolve a collective action problem sustaining
a bubble if enough lenders themselves thought risk was being underpriced.
That is all about maintaining the resilience of firms as and when the environment proves
more threatening than catered for in the standard, static regulatory requirements. There is
also the possibility, argued by Governor Carney of the Bank of Canada, that maintaining
appropriate minimum margining requirements across the cycle would help to prevent liquidity
spirals in key funding markets.9 The Basel Committee of the Global Financial System, when
under the chair of my new colleague Don Kohn, has published a review of this important
area.10
The interim FPC will have to advise HMG over the next year or so on which instruments in
particular we think we should be granted by Parliament.
In their different ways, as well as making the system more resilient, they would have the
effect of intervening in the (real) credit cycle. And so, in some degree, this endeavour
recovers something of the spirit of the Real-Bills Doctrine disciples of a century ago.
In consequence, this part of the macroprudential scene has, naturally, posed questions about
how it will interact with the setting of monetary policy. Not that the nominal business cycle
and the credit cycle are the same thing or always perfectly aligned. In the years during which
the latest crisis was brewed, credit conditions were plainly too loose, but the UK did not
obviously experience burgeoning nominal demand growth or upward pressures on
underlying inflation.
Nevertheless, influences will obviously flow in both directions. If the FPC requires lenders to
carry higher capital, liquidity or collateral, that will affect credit conditions and so the ou