Stanley Fischer: Preparing for future crises
Revised version of the paper by Professor Stanley Fischer, Governor of the Bank of Israel,
presented as the lunchtime speech at the 33rd Annual Symposium of the Federal Reserve
Bank of Kansas City, on "Financial Stability and Macroeconomic Stability", at Jackson Hole,
Wyoming, 21 August 2009.
The main changes, which relate to the role of the Financial Stability Board, are based on comments made by
Mario Draghi. I am grateful to Mervyn King for extremely helpful comments and suggestions, and to Joshua
Shnek and Philip Yhelzon of the Bank of Israel for their assistance.
* * *
At last year's Symposium, "Maintaining Stability in a Changing Financial System", I had the
privilege of delivering the concluding remarks of the conference, and ended with the forecast:
"But if the authorities in the U.S. and abroad move rapidly and well to stabilize the financial
situation, growth could be beginning to resume by the time we meet here again next year."
Well, here we are, one year later, and growth does appear to be beginning to resume.1
Following the Lehman Brothers bankruptcy, the authorities, especially the central banks, in
the U.S. and abroad did by and large move rapidly and well to stabilize the financial situation.
But the route the world economy traveled between 2008 and August 2009 was extremely
bumpy, uncertain, and at times frightening. Further, despite the encouraging signs of
recovery, it is too early to declare the economic crisis over. Much remains to be done, not
least in bringing banking systems back to health, and there are good - though not conclusive
- reasons to fear a sub-standard recovery. Nonetheless, it is reasonable to declare that the
worst of the crisis is behind us, and that the first signs of global growth have appeared earlier
than was generally expected nine months ago.
This, the worst recession in the advanced countries since the Great Depression, is bound to
leave major marks on economies - on financial systems, on the public finances, on
economic policy, on economics, and more broadly. At its height, in the fourth quarter of 2008
and the first quarter of 2009, the crisis sparked apocalyptic articles about the length and
depth of the recession and the possibility that we were facing a rerun of the Great
Depression, about the future of capitalism, about the decline of the west and the transfer of
the center of gravity of the global economy and its leadership to the emerging countries,
particularly China, about the decline of the role of the dollar, about reforming the international
financial system, about reforming economics, and more.
Fascinating and important as these issues are, I will focus on narrower economic structure
and policy topics relating to the question of how to reduce the frequency and mitigate the
extent of future crises. Prior to the crisis, two main, interrelated, reasons had been given for
global
fearing a major recession: imbalances, which had been at the core of dire forecasts for
several years, and which had become part of the explanation for low real interest rates
during the first half of this decade; and financial fragility, based in part on the bubble in house
prices, and in part on the complexities and vulnerabilities of the financial superstructure that
had been built up around mortgage financing and associated sophisticated derivative
instruments. Concerns about financial fragility had been mounting in the years leading up to
the crisis, but not to the point of leading to major changes in the behavior of either the
authorities or most of the private financial sector.
Both financial fragility and global imbalances contributed to the crisis, and in discussing the
measures that need to be taken to reduce the frequency and mitigate the extent of crises, I
will deal with both - with financial issues and their implications for financial supervision, for
corporate governance, and for central banking, and with global imbalances and the
international system.
I. Financial sector reforms - regulatory and corporate governance
In contrast to most of the financial crises of the previous decade, which started in emerging
market countries, this crisis started in the center of the global financial system - in the United
States - and spread outwards. In the words of Guillermo Ortiz, Governor of the Banco de
Mexico, in August 2007: "This time it wasn't us". So the reforms that need to be implemented
to reduce the frequency and depth of financial crises have to start at the center.
The crisis has generated an explosion of reports recommending wide-ranging reforms of the
financial system.2 For a non-random example, the G30 report, Financial Reform: A
Framework for Financial Stability,
(January 2009) presents 18 recommendations, grouped
under four headings: (i) "Gaps and weaknesses in the coverage of prudential regulation and
supervision must be eliminated"; (ii) "The quality and effectiveness of prudential regulation
and supervision must be improved";3 (iii) "Institutional policies and standards must be
strengthened, with particular emphasis on standards for governance, risk management,
capital, and liquidity"; and (iv) "Financial markets and products must be made more
transparent, with better-aligned risk and prudential incentives. The infrastructure supporting
such markets must be made much more robust and resistant to potential failures of even
large financial institutions".
Regulation and supervision of the financial system
Systemic or macroprudential regulation. Almost all the reports on the reform of the financial
system see a need for macroprudential or systemic regulation, and many place this
responsibility with the central bank.
The U.S. Treasury report of June 2009 (p.11) defines macroprudential supervision as
supervision that considers risks to the financial system as a whole, and recommends placing
the responsibility for such regulation with the Fed. To give the Fed the capacity to meet this
responsibility, the report (p.10) specifies that it should have the authority to regulate "[a]ny
financial firm whose combination of size, leverage, and interconnectedness could pose a
threat to financial stability if it failed (Tier 1 FHC) .... regardless of whether the firm owns an
insured depository institution". Further, the prudential standards for these firms should be
2
The UK and US governments, and the EU Presidency, have all issued reports on financial sector reforms. See
Reforming financial Financial Regulatory
HM Treasury, markets, July 2009; US Department of the Treasury,
Reform, June, 2009; and the Presidency Conclusions of the Council of the European Union, June 19, 2009,
which essentially adopt the recommendations of the Report of the High-Level Group on Financial Supervision
in the
EU, chaired by Jacques de Larosiere, Brussels, February 25, 2009, with regard to the establishment of
a European Systemic Risk Board, whose chair is to be elected by the members of the General Council of the
ECB. See also: the G-30 report, Financial Reform: A Framework for Financial Stability, January 2009;
Financial Services Authority, UK, The Turner Review: A regulatory response to the global banking crisis,
March 2009; Committee on Capital Markets Regulation, The Global Financial Crisis: A Plan for Regulatory
Reform, May 2009, which includes a table comparing its 57 recommendations with those of other reports, pp
221-225; a series of reports on regulatory issues by the Financial Stability Forum, starting with its early and
important paper on Enhancing Market and Institutional Resilience, April 2008; G-20, Declaration on
Strengthening the Financial System, April 2009, based in part on the recommendations by the Issing
Committee, New Financial Order, February, 2009; IMF, Lessons of the Financial Crisis for Future Regulation
of Financial Institutions and Markets and for Liquidity Management, February 2009.
3
One of the recommendations under this heading relates to improved international regulatory and supervisory
coordination, an important topic on which I touch only lightly in this speech.
BIS Review 107/2009
stricter and more conservative than those applied to other financial firms; and the supervision
of these firms should extend to the parent company and all its subsidiaries.4
By contrast, the report of the UK Treasury of July this year (Chapter 6) is more hesitant about
assigning this responsibility, though it gives the impression that in the end it would give it to
the Financial Services Authority (FSA), the unified financial system regulator.5 In developing
its argument, the UK Treasury report takes note (p.91) of the "broad international consensus
that central banks should be independent and should pursue stable inflation, and that
regulators should pursue risk-based micro-prudential regulation. But because of the links
between financial and macroeconomic stability, they need to work closely together to ensure
macroeconomic stability." It further emphasizes that macroprudential tools "would need to be
developed and agreed at an international level and implemented in a standardised way in
order to avoid jurisdictional and regulatory arbitrage." (p.92)
What are these tools likely to be? Among the candidates are the central bank interest rate,
and tools that aim directly at the rate of credit creation and the overall riskiness of the
financial system, including capital and leverage ratios. In addition, it is possible to use and/or
revive more specific regulatory tools that affect the financial system, for instance maximum
loan to value ratios and other mortgage terms, margin requirements, and other regulations
that were in place during the post-Great Depression and post-World War II period, which
have fallen out of use or been repealed.
The argument about macroprudential regulation is closely related to a topic that has been
discussed repeatedly at these conferences - how the central bank should respond to asset
prices, and particularly to perceived asset price bubbles. This discussion has suffered from
three distortions. First, if the issue is posed as that of how to burst a bubble when the only
tool at the central bank's disposal is its interest rate, it is all too easy to argue that nothing
should be done until the bubble bursts. The more general issue is whether the interest rate
should respond to asset prices and the financial situation more generally, and there is a
strong argument that the answer is yes. Second, there is no reason to confine the central
bank's policy tools to the interest rate. Macroprudential tools can be added to its quiver. And
third, the right question is not what the central bank should do, but rather what actions need
to be taken by the authorities to maintain economic stability and support growth. There is a
need for macroprudential regulation, and the question that should be discussed is that of the
optimal institutional arrangements to this end.
Historically supervision has been structured along sectoral lines - a supervisor of the banks,
a supervisor of the insurance companies, and so forth.6 More recently the approach has
been functional, in particular distinguishing between prudential (control of risk) and
conductof-business (with respect to both investor and consumer protection) supervision. In the
twinpeaks Dutch model, prudential supervision of the entire financial system is located in the
central bank, and conduct of business supervision in a separate organization, outside the
central bank. In the Irish model, both functions are located in the central bank.7 In Australia,
prudential and conduct-of-business supervision are located in separate organizations, both
separate from the central bank. As already noted, in the UK the FSA - the Financial Services
Authority - is responsible for supervision of the entire financial system, and is located outside
the central bank. In the United States, supervisory responsibilities are widely dispersed, there
are gaps in the system, and coordination has been difficult; the US Treasury plan seeks to
deal with all these problems.
I doubt that there is one best model. In Israel bank supervision is under the aegis of the Bank
of Israel, and I found the presence of the bank supervisor and the information flows from his
department essential in enabling us to deal with the current crisis. Information flows are
critical, and the plain fact is that information flows more readily within an organization than
between organizations - which is one of the reasons to have prudential supervision within
surely
the central bank. Those who have not lived in bureaucracies might suggest that it is
possible to ensure rapid and accurate information flows between institutions. It may be
possible, but it is not the rule - and the importance of timely and accurate information flows
to the making of policy decisions in a crisis cannot be exaggerated.
In addition there is the crucial question of how to coordinate decisions on monetary policy
and macroprudential policy. There may be occasions - as in recent years - when
considerations of inflation stabilization and those of systemic stability need to be balanced. If
the responsibility for systemic stability is in the central bank, then it decides how to strike the
balance. If not, someone else has to do so. Who? It could be the organization responsible for
macroprudential policy, but in the words of the UK Treasury, financial regulators usually
"pursue risk-based micro-prudential regulation"; that is to say, their concern is with the safety
of individual institutions. If the decision is not made the responsibility of the central bank, it
will likely end up with an inter-agency committee or with the Treasury. Inter-agency
committees have difficulties reaching rapid decisions, and there would be great difficulty in
coordinating decisions on monetary and macroprudential policy if one were under the control
of the central bank and the other under the control of the Treasury.
I conclude that the central bank should be given the responsibility, and the tools to do the
macroprudential job. In the case of the United States, the US Treasury proposal gives the
Fed the authority to regulate systemically important institutions, which is part of what it would
need to fulfill its macroprudential responsibilities, but it is not clear what additional policy tools
- such as regulation of financial institution capital ratios - it would be given.
The size and complexity of the financial system is bound to be a consideration in determining
the structure of the regulatory system, for there are diseconomies of scale in running any
large organization. That is to say, the case for a single financial-system wide regulator is
typically stronger in a smaller economy. In addition, the political system is likely to be
cautious about making any individual independent institution too powerful. Hence financial
supervision in a large economy, such as that of the United States is likely to remain
dispersed among several institutions, even though it needs to be coordinated, and even
though that coordination is difficult.
In a small economy, such as that of Israel, it would be possible to place the responsibility for
the prudential supervision of the entire financial system in the central bank, and to make
another institution or institutions responsible for conduct of business supervision.8 The new
law of the Bank of Israel, which we hope will be passed soon, specifies supporting financial
stability as one of the Bank's three main missions, and we believe that our ability to do so
would be strengthened by implementing the Dutch model of financial sector supervision, with
all prudential supervision in the central bank.
As to whether macroprudential tools "need to be developed and agreed at an international
level and implemented in a standardised way in order to avoid jurisdictional and regulatory
arbitrage", as argued by the UK Treasury report, that would be desirable, but only if it can be
done quickly. If not, there is no time to wait and countries need to begin putting in place their
national approaches to macroprudential supervision, while seeking simultaneously to
coordinate internationally.9
Capital and liquidity ratios. It is both likely and desirable that required capital ratios around
the world will rise in the wake of the crisis, and that there will be a greater emphasis on Tier I
capital. The Spanish model of countercyclical capital ratios has gained widespread support
and is likely to be implemented in more countries, and this should contribute to stabilizing the
business cycle.10 In effect the Spanish model treats the countercyclical element in a bank's
capital as a reserve for use during a downturn, to enable banks to continue lending as the
economic situation deteriorates.
Given the constant pressures from financial institutions to find ways to reduce capital
requirements, including through off-balance sheet activities, regulators will have to be on
their toes in the cat-and-mouse game between regulator and regulatee, to ensure that
effective capital ratios do not get whittled away as a result of financial innovation and political
pressures.
In addition to increasing capital ratios, regulators are likely to introduce required liquidity
ratios. Experience, including that of the last year, suggests that there should be a liquidity
ratio, and that the range of assets defined as being liquid should be small. Here too is an
area where international agreement and coordination would be desirable, but where national
regulators should not wait for international agreement before introducing liquidity ratios.
Financial institutions are likely to complain that higher capital ratios and the introduction of
formal liquidity ratios increase their costs of doing business and are in effect tax increases.
Given the vivid demonstration during the last year of the fragility of financial systems faced
with a loss of confidence, and the fact that their survival depends on government backing
and action - in the last year on a massive scale - it is fully appropriate that financial firms be
required to self-insure against future crises by holding more capital and more liquidity. The
tax treatment of the counter-cyclical elements in the additional capital may need to be
considered.
Too big to fail, resolution mechanisms, and moral hazard.
The experience of the last year
has brought much-needed clarity to the "too big to fail" issue. Some of the great names of
financial history have disappeared (e.g. Lehman Brothers), some companies are in the
process of working their way out of existence (e.g. AIG), many would not have survived but
for government assistance (e.g. Citigroup), and many holders of their shares have suffered
very large losses.
It is likely that the need to show that the authorities would not save every big financial
institution - in other words to counter the effect on financial behavior of the "too big to fail"
doctrine - was a factor in the decision not to save Lehman. The worldwide panic brought on
by the Lehman failure led directly to the decision two days later to provide massive aid to
AIG, making it seem that "too big to fail" was alive and well. But the truth is that if some part
of AIG survives, it will not recognizably be the same institution, and that the shareholders of
the original AIG will not recoup their investments - in other words, it has failed. Similarly,
much of Citigroup is now state-owned, and its private sector shareholders have suffered very
large losses.
So in what sense were these institutions too big to fail? In at least three senses. First, deposit
holders in the relevant institutions were not significantly penalized: as the financial crisis
deepened, governments either gave very broad guarantees of bank deposits or at a
minimum, greatly augmented formal deposit insurance schemes. This was unavoidable and
appropriate, given the need to prevent runs on banks. Second, bondholders in most financial
institutions that received state aid and survived in some form were not penalized. The issue
here was to prevent "runs" on bank debt, which would have taken the form of even larger
system-wide declines in the value of bank debt, and enhanced difficulties for the banks in
mobilizing resources through debt issuance. The issue of the standing of bank debt in future
crises is not yet resolved, but needs to be; indeed in some countries where bank debts have
received government guarantees, a way out of those guarantees needs to be devised. And
third, many firms that did survive needed the state's aid to do so: they have been given an
opportunity to restore their fortunes and some of them are already apparently well into the
process of doing that. This does not sit well with the general public, which seems to feel that
a greater price should have been paid by both the owners of companies and their
highestpaid employees - even though many of the managers and high-paid employees lost large
parts of their wealth as a result of the decline in the value of the stock and options they held
in their institutions.
Lehman was not an especially big firm. Nonetheless, because its operations involved
counterparties all over the U.S. and global financial systems, its failure created widespread
damage. In its wake, the category of "too interconnected to fail" was added to "too big to fail".
That is a nice category, but the real lesson is not about "big" versus "interconnected"; rather
it is about trying to form a realistic estimate of the costs and benefits of alternative courses of
action when faced with an institution in trouble.
As a result of the crisis, it is now more widely understood that the key to dealing with financial
resolution mechanisms
institutions in trouble is that of - that is, mechanisms for winding
down a firm in trouble in an orderly way, as the FDIC typically does with a failing bank. In the
words of Sheila Bair,11 "... resolution would concentrate on maintaining the liquidity and key
activities of the organization so that the entity can be resolved in an orderly fashion without
disrupting the functioning of the financial system. Losses would be borne by the stockholders
and bondholders of the holding company, and senior management would be replaced.
Without a new comprehensive resolution regime, we will be forced to repeat the costly, ad
hoc responses of the last year."
If there had been a usable resolution mechanism for Lehman, the company could have been
taken over by the resolution agency - which would have had to have access to the funds
needed to do this - and its liabilities run off over the course of time. Such an approach would
have been much less costly than was the Lehman failure. Mervyn King has described the
need for efficient resolution mechanisms by saying that every financial firm should be asked
to write a will - a document that specifies how its assets are to be allocated in the event of its
death.
There has also been considerable discussion about how to deal with very large financial
firms, including those that are very large relative to the size of their economies, as in the
case of the Icelandic banks, or two of the Swiss banks. It seems clear that countries should
seek to limit the size of individual financial institutions relative to the size of the economy,
both to reduce the costs to the economy of the firm's failing, and to reduce the overall
vulnerability of the financial system to individual failures. One way to do this is to require
larger banks, or those of systemic importance, to have higher capital and prudential ratios.
The Swiss authorities are strongly encouraging their largest banks to add to their capital.
Whether the authorities should use other regulatory mechanisms to this end is another issue
that is on the table.
Even for the largest economies, there is a case for discouraging financial institutions from
growing excessively. While it is clear that there are economies of scale in commercial
banking up to a certain point, it is less clear that those economies of scale continue at the
very largest banks - and the costs of dealing with the failure of an individual bank rise as the
size of the bank rises. It is even less clear that there are serious economies of scope in the
financial sector - that is, there is little evidence that the financial supermarket view by which
the end of Glass-Steagall was justified in the United States leads to more efficient and
cheaper provision of financial services. And although investment banks became commercial
banks during the last year, to obtain access to the Fed's facilities, there do not appear to be
major economic benefits - and there are certainly potential economic disadvantages - from
combining trading activities on a serious scale with normal commercial banking.12
This issue - that of the most efficient structure of financial institutions and of the financial
system - is central to the question of how best to regulate the financial system in the years
ahead, taking into account the fact that financial institutions are liable to failure as a result of
a loss of confidence in them, and that the costs of those failures may be macroeconomic in
scale. At this stage we seem to taking it for granted that we should go back to the structure of
the financial system as it was on the eve of the crisis. But we need to be thinking more
broadly, including the possibility that some radical restructuring is needed, for instance by
sharply restricting proprietary trading by banking institutions, or by some other forms of
narrower banking.
There has been very little progress so far on how to deal with the failure of a major
international bank. The main issue is which country or countries take responsibility for
dealing with the aftermath of a failure. One possibility is to require internationally active
financial institutions to have legally separate subsidiaries in each country, so that each
subsidiary is wound up in its country of operation.13
Finally, on moral hazard: this must be a prime issue in the design and supervision of financial
systems. No policymaker wants to be in a position in which concern over moral hazard
creates the dilemma of either taking an action that is extremely costly to the economy to
teach some people a lesson, or else doing something that may well encourage undesirable
behavior in the future. Both in the design of the system, and in its operation, we need to do
whatever we can to avoid placing decision-makers in such a situation. If we do find ourselves
in such a situation, it is too late - for it is a mistake to inflict serious and unwarranted damage
on many people in order to teach a lesson to a few.
Corporate governance
Although it is natural for policymakers to focus on improving supervision and regulation, the
larger failures responsible for the crisis were those of the management of financial
institutions. Management, particularly corporate risk management, failed in a big way in this
crisis, and that failure is more worrisome than the failure of the regulators, for we should not
expect regulators, with their limited resources and inherent limits on how much information
they receive and can master, to do better than corporate risk management in understanding
and controlling the risks facing a financial institution.
John Kay has recently expressed the view that modern banks are too complicated to be
managed by mere mortals.14 Accepting that view as a challenge rather than a counsel of
despair, I will briefly discuss potential reforms in the areas of risk management and
compensation, drawing mainly on the recent report prepared for the British government by
Sir David Walker, and a June 2009 OECD report on corporate governance.15
Corporate risk management.
The Walker Report focuses on the board as the key vehicle for
improved corporate governance. It recommends (p.81) the establishment of a board risk
committee, separate from the audit committee, "with responsibility for oversight and advice to
the board on the current risk exposures of the entity and future risk strategy". The executive
risk committee would be required to operate within the parameters and limits set by the
board risk committee.
The report recommends the appointment of a Chief Risk Officer, who should be totally
independent from individual business units, reporting directly to the CEO16 and to the board
risk committee, and who "should be accorded both status and remuneration reflective of the
key importance of the role" (p.84).
Beyond strengthening the board's capacity to supervise risk, it is necessary also to
strengthen risk management within the corporation. Internal risk managers need
independence from other business units and the full backing of management and the board
to carry out their function, for the pressures that the competitive environment of a large
financial firm place on a risk manager are intense. "Just say no" is easy enough to say, but
harder to do when it means cutting colleagues off from a potentially highly profitable fee, or
trade, or investment.
The internal risk managers I met during my short life in the private sector were technically
proficient. They may have been under pressure to agree to risky trades. But what was most
lacking, in the case I'm aware of, was somebody taking a system-wide view of the risks that
were being faced, someone with the capacity to ask tough questions about the possibility of
radical changes in the market environment - and then getting management to do something
about it.
There is a delicate point here. If risk managers are required to assign high probabilities to
extreme scenarios, such as those of the last year, the volume of lending and risk-taking more
generally will be seriously and dangerously reduced. It is neither wise nor efficient for the
management of financial firms or their regulators to require financial institutions to become
excessively risk averse in their lending and market activities. But if these institutions pay too
little attention to adverse events that have a reasonable probability of occurring, they
contribute to excesses of volatility and crises.17
18
Compensation and risk taking. In its "Principles for Sound Compensation Policies", the
FSF specifies (pp. 2-3) that: compensation must be adjusted for all types of risk;
14
"Our banks are beyond the control of mere mortals", Financial Times, July 8, 2009.
15
A review of corporate governance in UK banks and other financial industry entities, prepared for the UK Prime
Minister and the Treasury, July 2009. See also OECD, Corporate Governance and the Financial Crisis: Key
Findings and Main Messages, June 2009 ; and FSF, FSF Principles for Sound Compensation Practices, April
2009.
16
The report specifies "CEO or FD", where FD is the finance director.
17
This paragraph is based on the assumption that there is a rational expectations equilibrium in which
companies take reasonable risks and make profits commensurate with those risks.
18
See the report by the FSF, FSF Principles for Sound Compensation Practices, April 2009. The OECD report
on corporate governance, op cit, contains an excellent summary of the issues relating to remuneration
practices, actual and desired from the viewpoint of financial stability and efficiency. For the modern theory see
for example Lucian Bebchuk and Jesse Fried, Pay without Performance: The Unfulfilled Promise of Executive
BIS Review 107/2009
compensation outcomes must be symmetric with risk outcomes; compensation payout
schedules must be sensitive to the time horizon of risks; and the mix of cash, equity and
other forms of compensation must be consistent with risk alignment.
Just three comments: First, it is extremely difficult to line up pay with incentives and
performance, but it is critical that companies try to do better. Second, the fact that individuals
in effect have limited liability creates an asymmetry that encourages excessive risk-taking
whatever the form in which conditional compensation might be paid. Third, after the disasters
of the last year, and the large costs of government intervention, the financial sector needs to
regain the confidence of the public, and returning to previous modes and levels of
compensation as if nothing has happened is not the way to achieve that goal.19
The current discussion of corporate governance places much of the responsibility for
achieving better performance on corporate boards. But we should not exaggerate what they
and the regulators can do, for both lack the full-time immersion in the problems of the
company that company management has. With regard to risk management and to
compensation, and to corporate governance