Paul Tucker: Financial crisis and G20 financial regulatory reform -
an overview
Remarks by Mr Paul Tucker, Deputy Governor of the Bank of England, at the Financial
Stability Board (FSB) and Korean G20 Presidential Committee Conference, Seoul,
3 September 2010.
* * *
Being a Western financial official, one comes to Asia with some humility in truth. This has
been a financial crisis born and bred in the Western world, but inflicted throughout the world.
That makes it all the more important that Korea and the other countries in Asia and
elsewhere in the emerging market world are involved in the reform efforts. The reforms are
not simply going to be cooked up in the West where the problems were bred. In Korea, you
have to play a really important leadership role, especially in steering us through the next
couple of months.
Much of the work towards the Leaders summit is being handled in the Financial Stability
Board. And here is a very brief overview of what is going on in the FSB contribution to the
G20 effort, under the following headings: 1) surveillance; 2) bank capital and liquidity; 3) too
big to fail; 4) capital markets; 5) incentives; and finally the regulatory perimeter.
1. Surveillance of the system
Very obviously this was a crisis that was not spotted - in the most important sense of being
prevented - ahead of time.
People did issue warnings about developing leverage in the system and accumulating
macroeconomic imbalances. But no one acted to make the financial system more resilient to
those vulnerabilities. This was not just an intellectual failure, as is widely discussed and
recognized now. It was also partly a failure of machinery.
The FSB has been encouraging new machinery to survey and head off risks. The FSB itself
has created a vulnerabilities group. It is probably the least prominent part of the Financial
Stability Board's effort to date, but it could have enduring significance over the years and
decades. It is paralleled in various regions.
Europe is setting up a Systemic Risk Board, which will be supported by the ECB but involve
all of the EU. The USA is setting up a Systemic Oversight Council; and in the UK, the
government is establishing a macroprudential Financial Policy Committee in the Bank of
England. Maybe something is needed in Asia, too. Martin [Wolf] talked about complacency;
for the machinery I have described to make any difference, people will have to stick to it year
in and year out.
2. Supervision of individual firms
One of the things that should not be neglected is that the severity of this crisis was as great
as it was partly because a large handful of individual massive firms failed due to poor
management and weak balance sheets.
Part of the solution lies, therefore, in much better microprudential supervision and regulation
of individual firms. The Basel Committee has had Core Principles for Effective Banking
Supervision for some considerable time now. But, going beyond that, the FSB has
encouraged and is sponsoring an exercise on effective supervision of SIFIs, Significantly
Important Financial Institutions.
A remarkable fact is that although the style of banking supervision varies enormously across
the world, almost nothing seems to have been done to get to the bottom of the question of
which approaches are the more effective - having an army of on-site examiners, such as for
example in the United States; or relying on offsite analysis, which tends to be the pattern in
much of Europe.
An exercise led by Julie Dickson for the Financial Stability Board is producing an evaluation
of what is needed to supervise the largest firms in the world effectively. The idea is that that
will either get encapsulated in an FSB code or in a re-draft of the Basel Core Principles for
Effective Supervision.
3. Capital and liquidity
The third element is capital and liquidity. Virtually all crises have at their root over leverage in
the financial sector and excessive maturity mismatch. We need to overhaul the
corresponding policy instruments -capital and liquidity requirements.
On liquidity, Basel is introducing an accord for minimum liquidity requirements for the first
time; this is about a quarter of a century after it was first contemplated and so rather overdue,
but therefore very welcome. There is an awful lot of debate around this still. Many in the
industry - in the banking industry - have been resisting it. But this will happen. It will lay
down minimum standards for banks to hold some resiliently liquid assets and about the
funding of illiquid assets.
To date, much more prominent has been the work on capital. Although there has been some
dilution of the proposals from a few months ago, real substantive progress is being made in
reforming the minimum standards and in introducing various buffers, taking into account
credit cycle conditions and the circumstances of SIFIs. The key element of the overall
package is that "capital" will mean capital. The world of hybrid instruments - pretending to be
so-called capital instruments but which in fact cannot truly absorb losses in a going concern
- should become more or less a thing of the past. The Bank of England would like it to be
completely consigned to the past. Only equity can absorb losses.
For that reason, in calculating regulatory capital, deductions from capital should really be
from equity. As part of the emerging compromise, there will be some derogations from that,
but the derogations should be transparent. Markets should learn to evaluate bank's capital
adequacy on the basis of what is made transparent about the makeup of that capital.
The other really key change will come in stages - partly in the package this autumn and
partly during next year and beyond - which is reducing the pernicious regulatory arbitrage
that has existed between "banking book" capital requirements and "trading book" capital
requirements. Far too many instruments that were held in the trading book were subject to
low capital requirements but actually could not be traded, leaving values exposed to big
swings in liquidity premia. This was a fatal design flaw in the existing regime, and it is one
which I hope should be fixed over the next year or so though the Basel Committee's
"fundamental review of the trading book".
4. Too big to fail
At the centre of the reform effort in the FSB work is "Too Big To Fail." If one of the largest
firms in the world got into trouble right now, in almost every country in the world we would not
be able to cope with its demise other than through fiscal support.
This is completely unacceptable.
If there is one thing that I think unites the members of the G20 - at the political level and at
the official level - it is that this will be consigned to the past. We will re-introduce market
discipline back into the financial system, which really means re-introducing capitalism back
into the heart of capitalism. The acid test has to be whether, for every financial institution in
the world, it could be resolved if it faces distress in a way that does not disrupt the flow of
essential financial services to the economy and without state solvency support. That is the
single goal in this area. When achieved, it can transform the global financial system more
than anything else.
It's not for me to set out the ideas today (Svein will do so later), but there are ideas
developing that I believe will, in at least some key centres, become concrete policies for
putting losses in the largest firms in the world not just onto shareholders but onto their
unsecured, uninsured creditors rather than onto taxpayers. I would expect that over time to
lead to adjustments in the business models and organization of the most significant firms in
the world. What's more, on the whole, I think they will welcome that.
5. Capital markets
The next element of the reform programme is capital markets. Too much of the reform
debate has probably revolved around banks, both in response to this crisis and in response
to earlier crises. We live in a world where financial intermediation does not just go via banks
and insurance companies, but it goes via capital markets and the vast array of institutions,
investors and issuers that the capital markets encourage into existence.
I will highlight just two key changes on this front. One, there is a determination that a lot more
OTC (over-the-counter) derivative activity will go through central counterparties, rather than
being settled bilaterally. This can have enormous benefits in terms of laying down standards
for collateralisation, valuations, and ensuring transparency of what is going on in those
markets. There is a residual question about how much of that activity should go via
exchanges or via other trading platforms. That's something which I doubt will be completely
resolved this year. I think it will remain part of the G20 and the FSB agenda going into next
year. But it is a very important part.
Another key element of changing capital markets is much greater transparency around, and
much reduced reliance on, credit rating agency ratings. One of the problems in global capital
markets has been that too many investors and banks have given up on reaching their own
view on borrowers and on instruments, but have effectively subordinated their own judgment
to the judgment of credit rating agencies. The FSB is sponsoring and leading work in order to
reduce the extent to which credit rating agency ratings are inscribed into, or embedded in the
regulatory fabric of our capital markets.
6. Incentives
The sixth thing is incentives. The issue that gets most attention here is compensation or pay,
on which the FSB issued a code. The essence of that is that more pay should be deferred. I
would add that perhaps part of deferred compensation should be in the form of a debt
contract, so that the managers and workers in large firms eventually become creditors of the
firm and so they themselves have the same risks as other debt holders. That works only if we
can develop resolution regimes leaving debt holders taking risks in our largest firms. So that
comes back to whether or not we can resolve the largest firms in an effective way and so can
reintroduce market discipline through that route.
7. Concluding remarks
Let me conclude with something on shadow banking.
Martin [Wolf] talked about the grave problems that are present in the global financial system
through global imbalances. I completely agree. To the extent that we do not solve the global
imbalances problem, our financial system will need to be more resilient than otherwise. That
must be understood.
Global capital flows are one of the givens of the world that we will continue to live in. The
other given, in my view, is regulatory arbitrage. The biggest misjudgment that our
predecessors made in the 1980's and 1990's was to underestimate the ferocious ability of
capitalism to arbitrage regulatory rules. That will not change. Therefore, whatever rules we
put in place now, capitalism will find ways around them.
An important element of the reforms therefore has to be a much greater consciousness of
regulatory arbitrage and a willingness to do something about it. This must not mean charging
after windmills. It means identifying where something is happening that could threaten
stability from outside the regulated sector, and being prepared to move the perimeter of
regulation in those circumstances. The authorities must be more interested in shadow
banking. That is something that the FSB, I believe, should focus on next year.
I hope that brief overview of the FSB's work can help our deliberations and exchanges today.
Thank you.