Paul Tucker: Discussion of Lord Turner's lecture, "Reforming finance -
are we being radical enough?"
Remarks by Mr Paul Tucker, Deputy Governor of the Bank of England, at the Clare
Distinguished Lecture in Economics, Cambridge, 18 February 2011.
* * *
Master, it is a real pleasure to be here this evening. And it is a real pleasure to kick off the
discussion of Adair's paper. We spend a great deal of time together - constructive and
productive time - at international fora, and this evening Adair has typically provided a
splendidly thorough survey of responses to the financial crisis.
Adair casts it as about "Radicalism". I don't think it's necessary to frame the issues in that
way. In his monumental survey of the long-eighteenth century revolution of ideas and
practice, Radical Enlightenment,1 Jonathan Israel argues that the "true" force of the
Enlightenment was the democratic urge of a loosely allied group of thinkers
underemphasised by mainstream historiography. But even if he is right, the so-called
"mainstream Enlightenment" still, surely, turned the world upside down. One does not need
to sign up to Whig views of history to believe that, by largely separating the world of enquiry
from the world of faith, it set in train profound forces.
But if I do not see a need for one of the organising rhetorical constructs of Adair's lecture, I
do most certainly think that we need to deliver fundamental change in the "rules of the game"
for the financial system. Adair's talk therefore provides an excellent opportunity to pause and
review some of the ways in which policy and theory have been interacting so far.
The literature on myopia and the crisis
I want to begin with theory not policy, and the paper by Shleifer et al cited by Adair helps to
provide an organising framework.
This paper reflects the growing response of the economic profession to the crisis, and should
hearten us all that theory is alive and well and productive. Unlike most papers written over
the past three to four decades, Shleifer abandons rational expectations (RE) in favour of a
world in which agents are seriously myopic about certain low probability, high impact risks.
It is worth reminding ourselves of the RE paradigm, which has dominated macroeconomics
and finance since the '70s. It posits a state of affairs in which agents know the world - know
the structure of the model, and so have expectations. Bad things
model-consistent can
happen - but only in virtue of exogenous shocks. And depending on the structure of the
world, those bad states can be relatively small beer, as famously argued by Lucas on the
relative unimportance of business cycles. Disagreeing with that, the so-called salt-water
economists wanted to show that, upon the crystallisation of those exogenous shocks, really
bad things, recessions and persistent unemployment, can happen due to flaws - or, as
economists like to say, frictions - in the make up of the world. But the frictions perform an
amplifying role only; the initial impetus comes from an exogenous shock over which the
behaviour of agents exerts no influence, directly or indirectly. That is because agents - firms
and households, as normal people call them - do not make any ex ante mistakes.
Shleifer describes a different kind of world altogether. It is a set up in which the myopia of the
agents - investors, bankers, intermediaries -leads them, and the economy more widely,
towards trouble, sometimes disaster. Because they are effectively blind to certain lowish
probability risks, they generate and invest too heavily in securities that carry precisely those
risks. The effects of innovation get out of hand. This is a nice complement to papers by
academics and policymakers attributing the ballooning of ABS issuance in the West to a
combination of (i) an ex ante excess of savings from the East in the hands of investors with a
preference for low risk fixed-income assets, and (ii) a shortage of precisely those highly rated
fixed-income instruments. The effect, on that view, was initially to drive down credit risk
premia relative to equity risk premia, and to spur the issue of synthetic securitisations to fill
the gap in supply.2 If that story drives expansion of ABS/CDO issuance, Shleifer's model
helps motivate a lot of those securities being fundamentally mispriced.
During the good times, everyone feels that they are achieving a nice balance of risk and
return. They are getting, they think, safety, liquidity and return! But something eventually
happens to cause them to wake up, and to see the risks they have neglected. Investors can
then react in a dramatic way. They stop buying, sell; prices collapse etc. But an exogenous
shock is needed to generate that unravelling. If the overpriced securities have led to
not
credit conditions being too loose, then somebody - households, firms, sovereigns, or
everyone - will have accumulated too much debt, and so eventually fundamentals assert
themselves: defaults rise, and realisation sets in. As a younger colleague said to me, "the
model's key features are all way outside what I was taught in the '90s". But doesn't it sound
ever so slightly like the real world?
For me, one of the strengths of Shleifer's paper is that he cites good examples, not only from
the recent crisis but earlier ones too. A key past case is the boom in issuance of
Collateralised Mortgage Obligations (CMOs) in the run up to the 1994 mini-crisis, an episode
that I tried - too timidly - to highlight in 2006.3 Of many examples from the run up to the
recent bust , a great one is the late-cycle CPDOs - constant proportion debt obligations -
which were rated AAA, paid around 200bp over money market rates, and had a big
exposure to tail risk.4 And on the great awakening, Shleifer himself gives the example of a
realisation about ABCP, ABS and so on in mid-2007 after subprime delinquencies had risen
and faith - note, faith - in rating agency ratings of structured finance securities had
evaporated. This exactly chimes with the market intelligence that the Bank was picking up in
August 2007. I well remember Stuart Gulliver, now CEO of HSBC, saying to me very early on
something to the effect of "anything with "ABS" or "securitisation" in the label is now toxic".
Indeed, Shleifer's story, and the broader one told by Adair this evening, fits with the thrust of
the Bank of England's strategy towards Market Intelligence, framed in around 2002/03. This
amounted to saying that we needed to think about markets somewhat differently when we
are doing monetary policy and financial stability. For monetary policy, in most circumstances
a reasonable default assumption is that core markets are more or less efficient most of the
time. So, while we absolutely have to be alert to distortions, we are not crazy to infer, from
yield curves, expectations about the path of policy rates or of inflation. But for financial
stability, which of course affects macroeconomic conditions, I have always encouraged the
team to do a Gestalt flip to thinking of markets as inefficient, riddled with preferred habitats,
imperfect arbitrage, regulatory arbitrage, herding, and inhabited by agents with less than
idealised rationality. That's how during the early 2000s the team came to write about CDOs,
ABCP, monolines and, eventually, vehicular finance etc.
Shleifer's paper strikes me, therefore, as one example of exactly what the academic end of
the economics profession needs to do in order to speak to policymakers framing and
implementing reform. It engages with what I have previously described as "risk illusion", in
motivating a macroprudential prudential approach to policy.5
In other words, it carries policy implications.
Policy
Moreover, the policy implications of Shleifer's paper are arguably rather different from those
stemming from theories that attribute the crisis solely to bankers acting rationally in
response to the private incentives created by remuneration packages and the problem of Too
Big To Fail. In that sense, Shleifer's model formalises the argument of Charles Goodhart and
others that bankers badly misjudged the risks rather than consciously ran the system
towards the edge of the cliff.
One policy implication of myopia is that, as Shleifer himself says, we need to attend to risks
beyond banking - in shadow banking etc. I spoke about that around this time last year.6 We
need policies on firms and funds that perform similar economic functions to banking, such as
money funds; as Shleifer says, the constant-net-asset-value basis of most money funds
encourages a belief that they are riskless, and yet in fact they are not insured and carry no
capital. We also need policies on that deliver maturity transformation and leverage.
markets
This crisis happened partly because the authorities did not keep up with developments in
capital markets. I shall not revisit that in detail this evening, other than to say that the Bank is
glad that its new Financial Policy Committee will have a responsibility for advising HMG
when to move the perimeter of microprudential supervision and a power to make
Recommendations to the securities regulator on rules governing funds and markets where
they are material to stability. Thankfully, all this is now also being worked on internationally in
the Financial Stability Board.
A second and obvious policy inference that one could draw from Shleifer's paper, and one I
want to spend a little more time on this evening, is that it is absolutely vital that (regulatory)
capital requirements for banks more or less truly capture their risks. Two thoughts on that, of
rather different kinds. First, it was very obviously a false step when, in Basel 2, the
international-standard setters tried to follow the techniques and calibrations of private sector
risk managers rather than engaging with the externalities that warrant State intervention in
this area in the first place. Second, more particularly and more concretely, this underlines the
vital importance of the current Basel work to review fundamentally the capital requirements
for banks' trading books. In short, Basel has recognised that the amount of capital a bank
should hold against a liquid trading position often has good reason to be smaller than needed
for a hold-to-maturity portfolio, ie where the bank can shed its exposure. But it failed utterly to
recognise that since such books are marked-to-market (or model) and since the boundary
conditions for solvency derive partly from accounting measures of asset values, it is vital that
banks hold capital against the risk of violent swings in liquidity premia. Yet that is exactly
what torpedoed a fair fraction of the largest banks and dealers in the world through their
(levered) holdings of leveraged loans and super senior tranches of CDOs. It was a risk about
which bank management, investors, regulators and supervisors were all myopic. The
socalled Fundamental Review of Trading Book Capital Requirements is, as Adair said, a very
important opportunity to correct this.
What that amounts to in practice is recognising that the degree of of market
resilience
liquidity matters a lot. I have been arguing that a market's liquidity is unlikely to be resilient if
demand is dominantly from leveraged investors and traders. They buy when prices are
rising, but stop buying or even sell when the price stops going up, leaving prices without a
firm underpinning - and often with prices perched on a precipice. That element of recent
events is missing from Shleifer's set up, but in the real world it is precisely what we might
expect if one joins up his story about innovation induced by myopia with Hyun Shin's earlier
paper7 about the association of leverage and asset-prices fluctuations.
If securities are fundamentally mispriced because of blindness to a type of risk and, further,
are held dominantly by leveraged players, the adjustment when it comes will be all the
greater. In commentary on other papers, Shleifer himself has argued against one of the
fundamental drivers of the crisis being the liquidity exposures stemming from ABS and other
securities being financed by short-term repos; what Gary Gorton and others have called the
run on repo.8 But the spirit - if not the analytics - of his paper could extend to myopia about
liquidity risk; it was neglected because agents forgot about it. Only recently the leader of a
financial institution that emerged relatively unscathed from the crisis told me that they had
been blind to the possibility of a really severe liquidity crunch; and that they had reacted by
massively cutting their short-term funding in the worst days of the crisis. As a policymaker,
for whom explanations can be complementary rather than seminar papers in competition, the
myopia and run-on-repo se stories seem to me to join up rather well.
What to do? As the Basel Supervisors Committee proceeds with the FRTB, I can imagine
reluctance to opine on the liquidity of markets, but it was not beyond the wit of the official
sector to observe that crucial parts of the ABS market were utterly dependent on levered
money and so very unlikely to be liquid when the music stopped. This partly makes the case
for reconnecting supervisors and markets specialists in central banks.
This is all part of getting the level of capital in the banking industry closer to what is
warranted. Adair has said a great deal about that this evening. But before coming to the
associated international policy debates about the biggest and most complex firms, I want to
go back to incentives. Because whatever the merits of the riskmyopia argument I have been
reviewing, we absolutely must not build a system that relies on dismissing the incentives
argument. While I doubt that many bankers deliberately - that is to say, consciously - took
outsized risks that crashed the system because they believed they would be bailed out, I do
believe that their behaviour will have been profoundly affected by their cost of debt being too
low because asset managers believed they would not lose money. Asset managers held
beliefs about the policy world that fatally diluted their incentive, as creditors, to monitor and
discipline banks (this is the Too Big To Fail problem).
That brings me to the policy debate on resolution. Those of us promoting enhanced
resolution regimes, who include Adair by the way, do so for two reasons. First, no one can
guarantee that losses will not exceed equity cushions in the future and when that happens if
the losses do not fall on bondholders - via resolution or the much more disruptive liquidation
- they will end up falling on taxpayers. And second, exposing bondholders to risk has the
potential to harness market discipline - or, as I have put it, to bring capitalism back into the
heart of capitalism. That weighs with me both as a matter of principle, and because minds
have been concentrated by the planned transfer to the Bank of responsibility for micro
prudential supervision of banks. A system in which our bank supervisors were the next line of
defence after management would be badly designed. We need to set rules of the game that
harness boards, shareholders, auditors and, in today's context, crucially bondholders to the
cause of preserving the safety and soundness of the firms they run, monitor and finance.
Adair airs some questions about reliance on resolution. Namely, (i) the incidence of failure
amongst the largest and most complex firms is so rare that, over time, participants in
financial markets will forget it can happen; and (ii) that when such a firm does fail, the
spillovers will be so great that the market will expect it to be bailed out, validating the myopia.
Those arguments seriously underestimate the determination of policymakers in this area.
Perhaps the first point to make is that Lehman was allowed to fail, even though no one can
seriously have been in much doubt about the severity of the consequences. In a democracy,
interventions are sometimes severely constrained. It would be myopic for market participants
to set aside the probability of that happening again. In fact, I doubt markets will forget for a
long time. And arguably one can see awareness of this risk in bank debt spreads today and
in the movements following policy consultations in Europe and the US on "bailin" and
resolution reforms. But, secondly, the idea of not equipping ourselves with better tools for the
"last chance saloon", when all else had failed, would be a counsel of despair. Adair must be
right, though, that we will need to build credibility for our commitment to resolve rather than
bailout. That means building institutions to underpin that commitment. Idiosyncratic failures
do occur. We can - and where appropriate should - prospectively apply the same resolution
tools to the failure of medium-sized firms as we are developing for the largest global firms,
demonstrating our willingness to use them. Living wills - or, as they are now called,
Recovery and Resolution Plans - will help, provided they have teeth. Which means ensuring
that firms are organised and structured to permit effective resolution of different kinds of
business line. And a prompt-intervention supervisory action regime can be designed to limit
the scope for regulatory forbearance. That will be an important part of the reforms of
microsupervision in the UK, as we prepare for the Prudential Regulatory Authority.
Enhanced resolution regimes are aimed at putting asset managers at risk through their
holdings of credit instruments, just as they accept risk as equity investors. That will affect the
oxygen that bankers breathe. But we could underpin the positive incentive effects by paying
part of the deferred element of the remuneration of bankers in risky debt securities as well as
in equity; equity gives them upside as well as downside, whereas a fair chunk of their wealth
being a debt claim on their bank would give them a powerful interest in its medium-term
soundness. My guess is that senior bank management team would not object to that.
But none of what I have said makes a case for placing all of our eggs in the resolution
basket. Switching metaphors, we need belt braces. Which is why the G20 agreed that
and
the so-called Global Systemically Important Financial Institutions (G-SIFIs) should carry
greater loss absorbing capacity (or GLAC) than implied by Basel III.
First best would be equity. Indeed, Adair has argued this evening that ideally Basel 3 would
have set a higher equity requirement. But that did not happen. In practice, we are going to
have to be open-minded, but also principled, about quasi-equity instruments contributing to
GLAC for SIFIs (sorry about the acronyms!). Currently, the leading candidate is so-called
Contingent Capital bonds (CoCos), which convert from debt into equity in certain states of
the world. It seems to me that to serve the purpose of GLAC for large and complex firms,
such instruments would need to convert when a firm was still fundamentally sound, which is
to say that they should have high capital triggers. For a large and complex firm, a low capital
trigger would be dangerous, as funders and counterparties would be likely to flee before
reaching the point at which the firm would be recapitalised through the CoCos' conversion.
Moreover, high-trigger CoCos would presumably get converted not infrequently which, in
terms of reducing myopia in capital markets, would have the merit of reminding holders and
issuers about risks in banking.
"Macroprudential" and the Financial Policy Committee
Bringing this together, policies on trading-book capital requirements, loss-absorbing capacity,
resolution and shadow banking can all contribute towards addressing the stability-threatening
problems of myopia identified in the literature. And the higher effective capital requirements
that this package can deliver might potentially affect incentives by exposing debtholders to
risk; and, via reducing return on equity, by harnessing the energies of shareholders in
monitoring the terms of distributions to managers. In that sense, quite technical things might
have significant effects over time on behaviour and the structure of the financial system.
That assumes that lessons from this crisis endure. But, of course, the most pernicious forms
of myopia surely come out of prolonged periods of apparent tranquillity in markets and the
economy. That is when everyone gets suckered into believing the world is a safer place than
it is, with elegant theories and eloquent practical stories for why the world has really
changed. Which ultimately tips us from tranquillity to disaster. One of this university's
greatest twentieth century thinkers taught us that what counts as an argument - not just as a
good argument, but as an argument - is not always firmly grounded. The deepest
at all
problem during the years in which a grave crisis is brewed is that those who see the signs
are marginalised or literally not heard. What on earth are we to do about that?
Part of the solution must lie in the design of policy institutions. One reform would ask a
dedicated and expert group to identify risks to stability and give them powers to address
those risks that threaten the system or are leaving it vulnerable; and, vitally, to require them
to stick at that task year in-year out, even when everyone else would otherwise be losing
interest, taking stability for granted. As Adair said this evening, that is precisely what is
going on in the UK through the creation of the Bank of England's Financial Policy Committee.
The first members were announced yesterday. This is a big reform. Rather undermining my
strictures to Adair on his use of "radicalism", I've described it a number of times as
revolutionary.
The FPC's success (or otherwise) will not depend solely on its own ability to identify risks.
Rather we must ensure that the debate about stability - the flame if you like - never dies. For
that reason, our accountability to the Treasury Select Committee can help greatly through the
public debate and commentatory that our appearances will stimulate.