David Clementi: Banks and systemic risk - theory and evidence
Speech by Mr David Clementi, Deputy Governor of the Bank of England, at a Bank of England
Conference held in London, 23 May 2001.
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Introduction
I would like to begin by extending a very warm welcome to you all to the Bank of England and to this
conference. It is a great pleasure indeed to be welcoming so many distinguished participants, both as
speakers and audience members; I am confident that we have the right mix of academics, officials,
and industry representatives to take forward our chosen subject.
'Banks and systemic risk' is our title, and I would like to introduce the conference by saying a few
words about the choice of material: why is it important to discuss these issues? And why is it topical to
discuss them now? Having dealt with the importance of financial stability and the challenges
presented by the current environment, I would then like to turn to some policy responses and to focus
in particular on disclosure, the procyclicality of capital requirements and the impact of the new Basel
Accord on overall capital. I would like to finish by saying something about the importance of
consistency in the capital requirements for banks and insurance companies. One theme which I will
return to throughout is the importance of achieving an acceptable balance between financial stability
and financial efficiency. And a second theme is the need to bear in mind the distinction between the
stability of individual institutions and the stability of the system.
Bank of England's role in financial stability
But if I may, I'd like to precede all this with a brief explanation of why we are discussing this topic here
- that is, why we at the Bank of England have a keen interest in promoting debate in this area.
As many of you may know, in 1997 the UK Government took the decision to separate banking
supervision from the central bank and unify it with the rest of financial supervision under the new
Financial Services Authority. At the same time, the maintenance of stability in the overall financial
system was clarified as one of the three core tasks of the Bank of England, along with responsibility
for monetary stability and promotion of efficiency and effectiveness in the financial system. So we
continue to take a strong interest in the issue of overall systemic stability, including how to monitor it,
how to promote it, and how best to deal with any stresses that might arise.
Obviously co-ordinating our efforts with the FSA's supervision of individual institutions and the
Treasury's legislative responsibilities is key. We work hard at fostering a close relationship, helped by
the fact that I am a member of the FSA Board and Howard Davies, who is giving the key-note address
tomorrow, is a non-executive director of the Bank. Our respective roles and responsibilities, including
in a crisis, are set out in a formal Memorandum of Understanding published in the Autumn of 1997
between the Treasury, Bank of England, and FSA. The MOU also established a Tripartite Standing
Committee that meets monthly to exchange information and discuss current threats to financial
stability.
I like to think that, with the departure of responsibility for day-to-day supervision of individual
institutions, the Bank has addressed the issue of systemic stability with a new-found clarity of purpose.
That said, we know that there is a huge amount of work still to be done on understanding systemic
risk. I see a clear contrast here with the monetary policy field. In monetary policy, we are closer to a
general consensus about the policy framework and the objectives of monetary policy, even if at any
moment of time uncertainty still surrounds our forecast for inflation and the appropriate policy
response. Certainly the UK target for monetary stability (the 2.5% symmetrical inflation target) is clear
and transparent. In the field of systemic stability and financial crisis, however, our understanding is at
a very preliminary stage. We face an array of fundamental questions: how to define systemic stability;
how to measure and predict it; what policy weapons we should employ to achieve it; what the costs
are if we fail; and how best to resolve instability if it occurs. We have only partial answers to these
questions. Defining the objective is possible only in the broadest sense, measuring how close we are
to it is even more difficult; there is certainly no agreed single indicator or set of indicators which tell us
when we have achieved financial stability or when we risk failing to achieve it.
Importance of financial stability
In part this is because we still lack evidence. This comment may strike some of you, perhaps those
from Scandinavia or Japan, as ironic; you may feel that the body of evidence we have is already
disagreeably large. However, whilst banking crises are not exactly rare, they are episodic rather than
regular and they tend to exhibit a number of idiosyncratic characteristics. This is in some sense
reassuring - at least banks and the authorities do not keep making exactly the same mistakes - but at
the same time it makes predicting crises very difficult. The causality is complex and difficult to grasp.
In some cases, fragility at individual banks can turn into system-wide fragility and in turn into
systemwide crisis. In others, a macro-prudential shock or policy error can impact on individual institutions,
revealing underlying systemic weakness and triggering a crisis. However, the papers to be presented
at this conference each address, in various ways, one or more of these issue s - about definitions,
objectives, and policy mechanisms - and I am confident that at the end we will have achieved our aim
of a real advance in our understanding.
I said just now that I wanted to address two questions, the first of which was why the subject is so
important. Well, in this murky and difficult area, there is perhaps one aspect which commands a fair
consensus, which is that financial crises, specifically banking crises, produce real economic costs.
There are the immediate direct costs to the public sector if crisis-hit banks require lender of last resort
support or have to be bailed out, and longer term costs to growth. There is a lively debate on how to
measure the latter, which I hope we can take further during this conference, as one of the papers is
addressing this very subject, but I would describe the range of estimates in some countries as starting
at large and ending at very large indeed. Interestingly, on some measures, the longer term output
costs seem to end up higher in developed countries than in emerging market countries, in the main we
think because crises in developed countries have typically dragged on for long er. On top of evidence
about the impact of financial instability, there is also evidence that the incidence of banking crises has
become more frequent over the past 20 years. In fact four out of the G-10 countries have suffered a
banking crisis of one sort or another in the last ten years. It is thus clear that financial instability
remains a hugely relevant topic to both developed and emerging market economies.
Threats to financial stability in the current environment
Having described the potential costs of financial crisis and why financial stability matters, I want to turn
to my second question, why it matters now. By this I do not mean that we have detected any unusually
marked amount of stress or weakness in the financial system. Indeed, I cannot resist at this point
expressing some thankfulness that we are managing to hold this discussion in relatively calm times
(although this is the sort of comment that might be better saved for the closing address at a
conference rather than the opening one). The last international conference the Bank sponsored on a
financial stability topic, back in September 1998, followed closely on considerable turbulence in global
bond markets and in fact managed to coincide with the incipient collapse of LTCM. As we found out
shortly afterwards, we were lucky to have any American colleagues at all at that event! Rather, I mean
that the financial system, and in particular the banking system, is undergoing substantial change, both
in its external environment and in the way it manages its risks and is regulated. Globalisation,
consolidation, conglomeration within and across sectors, technological change: these are not new
developments, but they are continuing and intensifying. These developments present new
opportunities to banks, as financial markets open up and mature. But they also present challenges.
New markets, new customers, new products, new technology: the risks of something going wrong are
high if the industry's risk assessment procedures and control mechanisms do not keep pace.
The impetus behind all these changes is intensified competition. This is good news for financial
efficiency, and given that this is also one of the Bank of England's core interests, we welcome it. But
there are undoubtedly some implications for financial stability, at least in transition. An increase in
competitiveness may for a period increase the financial system's vulnerability to shocks; academic
research suggests that the process of financial liberalisation can increase significantly the probability
of a banking crisis. So how do we make this trade-off acceptable, given that we certainly do not want
to exchange the overt costs of financial crisis for the hidden costs of financial protectionism?
Policy response to the changing environment
Well, a large part of the answer must be to strive for improvements in the financial and regulatory
infrastructure - to 'risk proof' the system as it were. There are a number of very significant initiatives
that are worth mentioning in this context. The proposed new Accord from the Basel Committee is
deservedly the focus of a number of the papers to be presented at this conference. A large slice of our
time here is also going to be devoted to evidence on the effectiveness of market discipline on banks.
Market discipline through enhanced disclosure does of course form one of the pillars of the new Basel
Accord but there are also broader international initiatives underway on this front. What I would like to
do is spend a little time here discussing how increased public disclosure, and certain other aspects of
the new Basel Accord, could affect financial efficiency and financial stability. Is it possible to achieve
advances in both?
Enhanced disclosure
Clearly the architects of these initiatives believe so. Increased disclosure should help the market
distinguish between well-managed and adequately capitalised banks and their poorly managed and
unsound counterparts. The latter will as a result come under pressure to improve their performance.
This should produce clear financial stability benefits, and also financial efficiency ones, since the
weaker banks are likely to be those who in some sense misdirect, or rather mis-price, credit to
borrowers.
Greater disclosure should also help to address the propensity in financial markets for self-fulfilling
crisis. By this I mean, the tendency as conditions deteriorate and confidence is dispelled for market
participants to act in a way that precipitates crisis for firms that would otherwise be solvent. The
greater the uncertainty the more participants will be liable to trigger a crisis in this way. Increased
disclosure has a part to play in reducing this risk. But it also explains the importance that we attach to
liquidity management and the need to ensure that, given the current focus on the new Basel Accord,
the regulation of liquidity is not overlooked.
There are of course a number of conditions that have to hold before we can be confident that
increased disclosure will deliver real benefits for financial stability and efficiency. As far as market
discipline is concerned, increased disclosure by itself is not enough to achieve this: the market has to
have an incentive to monitor the disclosed information, the ability to monitor it, and the means to
influence the banks once it is disclosed. There is no point, for example, in introducing extra
disclosures if the burden of producing and absorbing it proves too high. This will not achieve our aim
of improving stability and will probably negatively affect efficiency through the imposition of pointless
costs. I think that the proposals in the new Basel Accord do incorporate these considerations, even
though there has been some concern from the industry about the proposed volume of disclosure.
First, the disclosure requirements are intended to use information that is already produced for other
purposes, whether regulatory or internal. This helps to keep producer costs down. And secondly, there
are recommendations for standard formats and templates for disclosures, which will help keep the
user costs of absorbing the information low.
Equally there is no point in enhancing disclosures if the market has no incentive to apply the
information because creditors believe that banks will not be allowed to fail. So our goal of improving
and harnessing market discipline has to go hand in hand with continued rolling back of state
guarantees, whether formal or implicit. Finally, we have to do our best to ensure that market discipline
is exercised in a relatively benign and gradual way - graded differentiation of spreads on debt for
example, rather than sudden refusal by the market to rollover debt at any price. This means we need
to think hard about the frequency as well as detail of disclosures, and specifically the trade-off
between the two. Too frequent disclosure might not only be too onerous but also add to the volatility of
company ratings. Too long and the potential for large step changes in an institution's risk profile will
increase market uncertainty and volatility. Of course, there may be times when this cannot be avoided
- the sudden emergence of fraud for example - which is where crisis management by the bank
concerned and by the authorities comes into play. But we should not overemphasise the relevance of
these new disclosure initiatives in this particular sort of situation: publicly owned banks are after all
already required to disclose any information which could significantly affect their share price.
Impact of the New Basel Accord
Turning to the Basel proposals on minimum capital, their aim is to align regulatory capital much more
closely with risk. This should have financial efficiency benefits, as I explained just now. To the extent
that seriously undercapitalised risk taking by banks will in the future be more difficult, there are also
clear financial stability benefits. But for system wide financial stability, we also need to think about the
effects not just on individual banks, but collectively on the financial system. In this context I would like
to touch briefly on four issues: procyclicality; overall capital; financial consolidation; and consistency of
the capital framework for other financial intermediaries.
(a) Procyclicality
On the first I will be very brief indeed; the implications of risk sensitive capital requirements over the
financial cycle is a subject which I and other commentators have raised on a number of occasions. But
it is extremely relevant to a debate on systemic risk. It is a clear example of how rational and indeed
prudent behaviour by individual banks - raising capital, including cutting back on credit granted if no
other route is possible, in the light of perceived heightened risk - could collectively be damaging to the
system. Some academics are indeed criticising the risk-sensitive capital requirements that we already
have for market risk, on similar grounds. In the Asian crisis, for example, VaR measures of market
risk, and their associated capital requirements, increased extremely sharply, leading banks to enforce
loss limits which in turn exacerbated price falls. But I am not aware that anyone is suggesting that risk
insensitive capital measures are the answer - they are associated with much more obvious and
damaging pitfalls. Rather we need to ensure that, in so far as we can, we avoid sudden perceptions of
changed risk. To achieve this, risk sensitive capital requirements need to be both sufficiently backward
looking and sufficiently forward looking: backward-looking in the sense that they should be based on
long runs of data that incorporate experience of both peaks and troughs; and forward-looking in the
sense that risk measures hold good through the business cycle, taking account of possible future
downturns even as banks are extending credit in benign conditions.
(b) Overall capital
The issue of how the new Basel framework will affect the overall amount of capital in the international
banking system is also a hot potato at the moment. Again, this is a question which is crucial to the
right balance between financial stability and financial efficiency. Erring on the low side in the minimum
capital standard could result in unacceptable risk, while erring on the high side with too much capital is
likely to result once again in wasteful and costly regulatory arbitrage. The importance of the question
is, however, mirrored by its difficulty. Deciding the relative riskiness of different types of banking
business is technically challenging enough, but the issue of where absolutely our tolerance of banking
fragility lies is not only a problematic technical question but is also of course a normative one. And like
all normative questions, different people will have different answers.
Turning to the technical aspects of this issue, I would note that even if we can agree on, and then
measure, the minimum solvency standard which we should be targeting for our international banks,
perhaps the really hard step is making a robust connection between individual banks' solvency and the
solvency of the system. The latter is the primary focus of central banks though the former is obviously
a necessary condition. I am encouraged to see that a number of the papers to be presented here have
a go at making this connection. This is an issue which merits substantially more attention and
research. It is far from just a statistical exercise: whilst we might just possibly be able to calculate
statistically the joint probability of failure for a group of banks from their existing individual probabilities
of failure, this does not of course reflect realities. Those realities are that the risk of collective bank
failures depends on hard-to-measure and fluctuating factors such as correlations in risk profiles, and
the mood and behaviour of the market once fragility at one institution becomes apparent.
(c) Consolidation
The changing financial landscape complicates the task, and this brings me to the third point I wanted
to highlight, namely consolidation. Consolidation of financial institutions is a trend that is relevant to
several different facets of systemic risk. First, does consolidation make banks more or less likely to
fail? Diversification is a solid protection against failure, but not all mergers and acquisitions are
motivated by diversification - they may by contrast be designed to gain greater market share in an
existing business and thereby do nothing to increase diversification. Moreover, there is again the
distinction between individual banks and the system - the system can be diversified by having lots of
different specialised banks. This would not in all circumstances be a less robust system than one
where individual banks have reasonably diversified portfolios which are all as a result vulnerable to
common shocks, or one where a smaller number of large banks are all directly interconnected with
each other. And finally, even if we were to conclude that consolidation makes banks safer in the long
run, the short run effects could be very different as management tries to resolve inconsistencies in
systems or clashes in cultures.
Secondly, there is the issue that consolidation is perhaps likely to make bank failure more damaging in
its impact, although again this can only be judged case by case. And thirdly, since larger banks tend to
be organisationally more complex, there is the question that resolving large bank failures can turn out
to be an infinitely more complex task. I would stress that all this does not mean we think consolidation
extends 'too big to fail' status; but it does mean that central banks and other authorities have to ensure
that they are monitoring how consolidation is affecting risk and financial interlinkages. They should
also think ahead and examine matters such as their own operational expertise, information flows with
other bodies, legal processes and other procedures, in the event of a complex wind-down.
(d) Consistency
The final point I want to highlight is the question of consistency of regulation between different types of
financial intermediary. It makes no sense to introduce a Rolls Royce system of capital adequacy
regulation for banks if we have not considered the ramifications for the financial system as a whole, in
the light in particular of the very different capital frameworks which apply to insurance companies. We
may find that our new rules are simply arbitraged away, for example using credit risk transfers to
insurance subsidiaries, or asset securitisation sales to third party insurers, or credit insurance and
derivatives sold by insurers. In the long run, both our financial stability and financial efficiency
objectives could be undermined by this: financial stability if we find that these credit risk transfers are
not robust, or that they result in potentially systemic strains in the insurance sector; and financial
efficiency through the extra costs of arbitrage processes.
I emphasise that this is not a call for harmonisation of regulation or a blind assertion of the need for a
completely level playing field, but simply a call to re-examine the rationale for differences in regulation.
We may find that some differences are justified. For example, if we conclude that failures of insurance
companies impose fewer systemic costs than bank failures, we might certainly choose to set our
minimum insolvency tolerance at a different level. Much of the detail of risk measurement and
regulation must necessarily differ, for example because of the very different time horizons involved in
life insurance compared with either banking or securities business or non-life insurance. But there is a
body of common risks faced by banks and insurers on both their assets and liabilities - namely credit,
market, and operational risks - as well as a body of distinct risks (such as mortality risk for life
insurance companies and on the banking side liquidity risk); and to my mind this means that any very
fundamental divergences in the basic frameworks do need careful consideration: for example, whether
the trend toward risk based measures in banking needs to be mirrored in the non-life insurance
regulation in Europe. This is clearly not a small task but I would welcome it being scheduled for the
future on the international agenda. The establishment in recent years of regulators like the FSA with
responsibility in a single body for bank and insurance supervision will help to achieve progress in this
area; indeed the convergence of risks being taken by financial institutions of different origins is a
central plank underlying the need, certainly in the UK, for an organisation like the FSA.
Conclusion
I feel aware that throughout this address I seem to have repeatedly stressed the importance of
advancing our analysis of systemic risk and at the same time the huge complexities involved in this
task. Having highlighted the difficulties, it is now conveniently time to hand over the podium to those
who may have some of the answers! I'd like to end by referring back to my statement of our objective
for this conference, namely to achieve an advance in our understanding of systemic risk. This is of
course not our only objective: we also hope that you manage to enjoy the opportunity of meeting with
so many colleagues from around the world, enjoy the Bank's hospitality, and for those of you from
overseas to enjoy your visit to London. Thank-you.