Philip Lowe: Some tensions in financial regulation
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the
Institute of Global Finance Second Conference on Global Financial Stability and Prosperity,
Sydney, 4 July 2013.
* * *
I would like to thank the Institute of Global Finance for the invitation to speak today. It is a
pleasure to be here.
As I am sure you are all aware, over recent years regulators have looked into almost every
corner of the global financial system. Too often they found practices and behaviours that they
judged generated unacceptable risks. In response, they have developed a very large and a
very complex regulatory reform agenda. Much of this agenda is now being implemented, and
other pieces are still being negotiated.
It is understandable why this reform is taking place. While financial intermediation can be a
force of great good, it can also do much damage if not done well. Indeed, the decisions that
were made in the 2000s by some financial institutions ended up causing very real damage to
the global economy. These decisions caused many people to lose their jobs and suffer a loss
of their hard-earned wealth. There were also serious ethical failings by some of the highly
paid staff in a number of these institutions. And a significant amount of taxpayer dollars had
to be put at risk to help solve the problems.
The societies in which this has occurred have been, and continue to be, rightly angry. I am
sure that you have all heard variations of statements that run something like this: "regulators
need to make sure that these problems never occur again" or "not one cent of taxpayers'
money should ever again be put at risk to support a financial institution".
Many of you in this room would, I suspect, agree with such sentiments.
This afternoon I would like to reflect on the ideas behind both of these statements, which are
clearly relevant to the theme of this conference, Global Financial Stability and Prosperity. In
the world of finance, implementing what seems like simple and attractive ideas often turns
out to be quite difficult. Tensions emerge and trade-offs are inevitable. You touch one piece
of the financial system and another piece moves, sometimes quite unexpectedly. This partly
reflects the fact that the way in which savers and borrowers connect with one another is
constantly evolving. Moreover, views about the role of the public sector in the financial
system are not static over time. All this means that it can be problematic to put into practice
what seem like simple ideas.
"Regulators should make sure it does not happen again"
I would like to start with the first of these two ideas: that regulators should make sure that this
type of financial instability never happens again.
This idea has motivated much of the reform effort. And it is entirely understandable.
Good, well-designed regulation can make an important difference. This reflects a number of
features of financial intermediation, including the existence of pervasive information
asymmetries and the potential for runs if confidence is shaken for any reason. In addition,
financial institutions and investors seem too often to underestimate risk in the good times,
with sometimes severe consequences for the broader community. This all means that our
societies can benefit from a well-designed set of rules and standards to govern how financial
intermediation takes place.
At the same time, though, we need to be realistic about what can be achieved through the
application of rules alone. History provides some salutatory lessons here. As soon as the ink
is dry on a set of rules, people start trying to find ways around them, and they generally have
some success in doing so. One possible response to this is to write more rules, and this is
sometimes the appropriate response. But, as we are discovering (perhaps rediscovering), as
we write more rules, new tensions emerge and new difficult trade-offs become apparent.
I would like to highlight a couple of the difficult trade-offs that are evident at the moment.
The first arises from efforts to shift to a system in which a greater share of banks' exposures
is collateralised. This shift is being encouraged through regulation as well as by financial
institutions themselves. It can be seen in the move to secured funding markets, for example,
covered bonds. It can also be seen in initiatives to increase the collateralisation of
counterparty exposures in OTC derivatives markets, including by having more derivatives
novated to central counterparties and by introducing margining where novation is not
possible.
A common high-level objective of these changes is to reduce counterparty risk. Few would
disagree that this is a sensible objective. After all, if more exposures are collateralised,
shouldn't the system be safer?
The reality, though, is that there is some uncertainty as to what the end effects of this shift
will be. The reasons for this uncertainty are spelt out in a recent report by the Committee on
the Global Financial System (CGFS) at the Bank for International Settlements (BIS).1 The
report noted that financial institutions are likely to respond to the increased calls for collateral
by changing the way they do business. Some change is clearly desirable, given that a
number of risks were previously underpriced. But if past experience is any guide, as prices
change and the demand for collateral increases, financial institutions will seek to manage
their collateral more efficiently and this is likely to increase interconnections in the financial
system. The report also noted that the greater collateralisation is likely to increase the
procyclicality of the financial system and to increase uncertainty about the strength of the
claim that unsecured creditors have over the assets of a financial institution.
So there are clearly tensions. Reducing counterparty risk is an appropriate objective. But the
BIS report suggests that the side effects of doing so could run counter to achieving other
high-level objectives, including reducing interconnectedness, reducing procyclicality and
reducing uncertainty. The challenge is getting the balance right so that fixing one problem
does not create another one.
A second example of where tension between objectives is evident is in the effort to increase
the stability of banks' funding. In this context, it has become common to think of deposits as
"good and stable" and wholesale funding as "bad and unstable". Signs of this thinking are
evident in Australia, as they are in many other countries. Many financial institutions have had
an explicit objective of increasing the share of their liabilities that are accounted for by
deposits. Consequently, they have been prepared to pay large premiums for liabilities that
are called deposits relative to wholesale funding liabilities of similar maturity. This has
pushed up banks' overall funding costs and led to increased spreads between lending rates
and wholesale rates.
It is difficult to argue with the idea that this shift towards deposits is helpful for overall
financial stability. While there can be a deposit run on an individual bank, a deposit run on
the system as a whole is very unlikely, as deposits tend to get recycled from one bank to
another. In comparison, it is easier to think of scenarios in which disruptions to foreign
wholesale funding cause system-wide stress.
But, once again there is a balance to be struck. The recent problems in Cyprus give us a hint
of this. The Cypriot banks were very heavily deposit funded. This turned out to have two
distinct disadvantages.
The first was that when the value of the banks' assets fell, depositors had to bear the brunt of
losses after the equity holders. This significantly complicated the resolution of the banks'
problems. A similar tension is currently evident in some of the international policy
discussions. In particular, some regulators want banks to have more deposit funding
because it is seen as more stable. At the same time, others want heavily deposit-funded
less
banks to rely on deposits and issue certain types of wholesale debt to make it easier to
resolve a problem should it occur.
The second disadvantage is that with only limited wholesale liabilities, the Cypriot banks
were arguably subject to less market scrutiny than were banks with a different funding
structure. One benefit of wholesale funding is that the issuing bank needs to keep turning up
to the market and selling its story to sophisticated investors. There is no guarantee that this
extra scrutiny will prevent problems, but it is likely to help.
The general point from both these examples is that there are tensions in financial regulation.
Regulations are introduced to address one issue, and another issue emerges. Many
countries have had the experience of regulating one aspect of the financial system only for
other parts to grow very quickly, and problems to emerge in those other parts.
I do not want this to be interpreted as a counsel of despair. But we need to be cognisant of
the limits of rules alone. It may well be possible that a set of rules could be introduced to
ensure that the specific problems of recent times are never allowed to occur again. But what
different
is much less certain is whether these rules could ensure that a set of problems, but
with broadly similar consequences, do not emerge at some point in the future.
I suspect that it is simply not possible, or in fact desirable, to regulate a modern financial
system to the point that we can say with absolute confidence that problems will not occur.
What we can do, however, is to reduce the likelihood and severity of future problems.
If we are to do this on a sustainable basis, we need to look beyond rule-making, as important
as that is. In particular, any set of rules needs to be accompanied by strong risk management
frameworks, both within financial institutions and within the regulatory community. A critical
element of these frameworks, and thus ultimately of a stable and well-functioning financial
system, is the undertaking of holistic risk assessments by those who manage financial
institutions and by those who regulate them.
These holistic risk assessments are not easy to undertake, involving as they do both
systemwide and more detailed, disaggregated views. But neither are they impossible. While each
situation is different from the one before, there are a number of system-wide variables that
need to be monitored carefully. These include, but are certainly not limited to: the rate of
increase in the overall level of borrowing in the community; developments in key asset
prices, particularly property; the amount of construction activity in the economy; the pace of
innovation in financial products; the degree of competition in the financial products; and
changes in market-wide lending standards.
Obviously, this is only a starting point and managers of financial institutions and supervisors
need to keep their eyes and ears open for new developments in the financial system. Both
need to ensure that the institutions they manage or supervise comply with the rules but,
equally importantly, they need to examine what is going on in the system as a whole. In
some cases, supervisors' perspectives will differ from those of bank management, and
supervisors clearly face different incentives from bank management. Where they reach
different judgements they need to be prepared to use their discretionary supervisory tools to
buttress the rules that are in place. In the end, ensuring financial stability requires as much
attention to supervision as it does to regulation.
It is important to point out that in this regard the Australian Prudential Regulation Authority
(APRA) has done a better job than many prudential authorities elsewhere. It has been able to
combine a sensible approach to rule-making with a focus on the big picture. It has been
assisted in this by the Reserve Bank with its broad responsibility for financial stability, and
the coordination arrangements between APRA and the Reserve Bank have worked well.
These arrangements are one of the factors that have supported Australia's stable financial
environment over recent times.
"Not one cent of public money should ever again be put at risk"
I would now like to turn to the second sentiment: that not one cent of public money should
ever again be put at risk.
Over recent times, there has been a noticeable swing in international forums against the idea
that the public sector's balance sheet has a role to play in dealing with financial stress. Many
people find it difficult to accept the idea that the very same banks that caused the problems
have been supported, either directly or indirectly, by the public sector's balance sheet. A
number of the regulatory proposals under consideration aim to ensure that this does not
happen again.
This response is entirely understandable, particularly where such support is seen to have
benefited the management of a troubled bank and/or its shareholders. Societies rightly rail
against the idea that those who were responsible for problems receive some benefit at the
expense of the taxpayer. A better set of arrangements needs to be found, so that taxpayers
are not always drawn into troubles in financial institutions.
It would be a mistake, however, to reject completely the idea of the public sector using its
balance sheet during a period of financial stress or crisis. Indeed, in some situations the
public sector can play an important stabilising role.
One example of this is where the central bank liquefies assets in a stressed environment.
In a "first best" world, all assets are liquid; they can be bought and sold at any time at a fair
price. The real world is clearly not like this. Markets are incomplete, information asymmetries
exist and the technology supporting trading is sometimes expensive to put in place. So we
are in world of second best, which is sub-optimal from a welfare perspective.
Most of the time, this deviation from first best is probably not that costly. But in a stressed
environment - when even high-quality assets cannot be bought and sold - it can become
very costly.
One way of ameliorating this departure from first best is for the central bank to use its
balance sheet to liquefy assets in times of stress. It can do this by purchasing assets under a
repurchase agreement with a conservative haircut. In doing so, it can provide liquidity when it
is most highly valued, and do so with relatively little risk.
This type of activity should not be viewed, a priori, as a bailout of the banks. Arguably, it is an
efficient solution from society's perspective to a potentially costly deviation from the first best
world of complete markets. Central banks, by virtue of their ability to create money, are
uniquely placed to deal with such situations. The alternative solution is for the private
financial sector to self-insure fully against liquidity problems. If the objective is to maximise
the welfare of the community - as it should be - it is far from clear that full self-insurance is
the right policy.
A second example of the public sector playing a stabilising role was provided during the
2008-09 financial crisis, when governments issued bank funding guarantees. During that
period, risk aversion soared, capital markets shut down, and even the well-rated financial
institutions found that they could not raise funding and provide critical financial intermediation
services to the broader economy.
These types of temporary surges in risk aversion can be very costly for society. At least in
principle they can be ameliorated if there is an entity that has a stable risk appetite and that
is prepared, and financially able, to play a stabilising role. This was what happened in
Australia during the crisis, where the Australian Government was prepared to insure bank
debt for a fee. The fee was considerably higher than what the market would have normally
less
demanded for providing such insurance, but was substantially than the near infinite fee
that the market was then implicitly charging. There is a strong argument that the Australian
taxpayer was well compensated for the risk that it undertook, with insurance premiums paid
to date by financial institutions exceeding $4 billion, and no money has had to be paid out
under the guarantee.
A third example in which the public sector can play a stabilising role is through the
government underwriting a capital injection for a troubled bank when a very risk-averse
private sector is not prepared to do so. This example is of a distinctly different character than
the other two and the threshold of action is higher. There may, however, be some very
limited circumstances where it does make sense for the government to take an institution
under public ownership before selling it again when the risk appetite of the private sector has
returned to more normal levels. As the Scandinavian experience from a couple of decades
ago illustrates, this type of policy can work. I want to emphasise, though, that I am not saying
the Australian authorities would or should behave in a similar way, but rather that such a
response should not be excluded from the potential toolkit. Importantly, if such a policy were
to be used, then private shareholders of the troubled institution as well as its managers
would need to be held to full account.
The common element in each of these three examples is that the private sector has swung
from relatively normal risk preferences to being temporarily very risk averse. In modern
financial systems, these swings in risk aversion can be very costly. High levels of risk
aversion mean that good assets cannot be bought and sold, that otherwise sound institutions
cannot access funding markets and that investors are not prepared to purchase capital in
banks. In these situations, the public sector, with its more stable risk preferences and its
financial capacity, can play a stabilising role. There are obviously financial risks in doing this,
but there are also potential benefits to the broader community.
There are two main arguments against such involvement. The first is that financial institutions
will change the way they operate if they think that the public sector will provide support, that
these changes will make the system less stable. The second is that if the public sector is
prepared to play the role of a countercyclical provider of liquidity, insurer or - in limited
circumstances - capital, then there is the potential for this role to be misused. One way that
this could happen is for support to be provided to avoid confronting problems in a financial
institution, with the result that taxpayers take on additional risk.
Both of these concerns are real and they need to be taken seriously. But these concerns
should not rule out public sector support in some situations. Concerns about adversely
changing behaviour can be addressed through ensuring that shareholders are not bailed out
and that the managers of financial institutions are exposed to the downside as well as the
upside. And governance arrangements can be put in place to address concerns about public
decision-making.
The critical question needs to be what set of policies best maximise social welfare, not what
set of policies best minimise the risk of public sector involvement. It may be the case that the
answers to these two questions are the same, but I suspect that there are circumstances
where they are not. Once again, the challenge is to find the right balance.
Where does this leave us?
So where does this leave us?
I am afraid that those who want a cast-iron guarantee that financial instability will never be
allowed to return, or that the public sector will never have any risk exposure to the financial
sector, are likely to be disappointed.
Modern financial systems can be a force of great good. But they can be prone to bouts of
instability. Attitudes to risk can change abruptly and willingness to extend credit and to trade
assets can evaporate almost instantly. Over recent years we have seen too many examples
of where investors seamlessly moved from seeing risk nowhere to seeing it everywhere.
If we are to live up to the challenge of this conference - Global Financial Stability and
Prosperity - we need to find a better way of dealing with these swings. First and foremost,
this is a responsibility of the managers of financial institutions. But public policy also has an
important role to play in designing a system that is strong enough to cope with these swings.
A core set of prudential rules is obviously an important element here. But rules can never be
enough. An understanding of how borrowers and investors are viewing risk and how their
decisions are affecting the financial system as a whole is critically important. Also, we should
not lose sight of the fact that the public sector - with its more stable risk appetite - has a
balance sheet that can be used to play a stabilising role. Importantly, if this balance sheet is
to be used, we need to be sure that it is done in a way that promotes the welfare of the
community at large, rather than just the welfare of the owners and managers of financial
institutions.
Thank you.