Mervyn King: Banking - from Bagehot to Basel, and back again
Speech by Mr Mervyn King, Governor of the Bank of England, at the Second Bagehot
Lecture, Buttonwood Gathering, New York, 25 October 2010.
* * *
I am indebted to Stephen Burgess, Philip Evans, Andy Haldane, Andrew Hauser, Vicky Saporta, Jenny Scott,
Paul Tucker and especially to Iain de Weymarn for their useful comments and suggestions on earlier drafts.
1. Introduction
Walter Bagehot was a brilliant observer and writer on contemporary economic and financial
matters. In his remarkable book Lombard Street, Bagehot brought together his own
observations with the analysis of earlier thinkers such as Henry Thornton to provide a critique
of central banking as practised by the Bank of England and a manifesto for how central
banks could handle financial crises in future by acting as a lender of last resort. The present
financial crisis dwarfs any of those witnessed by Bagehot. What lessons can we draw from
recent and current experience to update Bagehot's vision of finance and central banking?
Surely the most important lesson from the financial crisis is the importance of a resilient and
robust banking system. The countries most affected by the banking crisis have experienced
the worst economic crisis since the 1930s. Output is somewhere between 5% and 10%
below where it would have been had there not been a crisis. Unemployment is up,
businesses have closed, and the direct and indirect costs to the taxpayer have resulted in
fiscal deficits in several countries of over 10% of GDP - the largest peacetime deficits ever.
At the heart of this crisis was the expansion and subsequent contraction of the balance sheet
of the banking system. Other parts of the financial system in general functioned normally.
And we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not
cause the same damage as did the banking crisis. Equity markets provide a natural safety
valve, and when they suffer sharp falls, economic policy can respond. But when the banking
system failed in September 2008, not even massive injections of both liquidity and capital by
the state could prevent a devastating collapse of confidence and output around the world. So
it is imperative that we find an answer to the question of how to make our banking system
more stable.
As Bagehot knew only too well, banking crises are endemic to the market economy that has
evolved since the Industrial Revolution. The words "banking" and "crises" are natural
bedfellows. If love and marriage go together like a horse and carriage, then banking and
crisis go together like Oxford and the Isis, intertwined for as long as anyone can remember.
Unfortunately, such crises are occurring more frequently and on an ever larger scale. Why?
2. The practice of banking:
For almost a century after Bagehot wrote Lombard Street, the size of the banking sector in
the UK, relative to GDP, was broadly stable at around 50%. But, over the past fifty years,
bank balance sheets have grown so fast that today they are over five times annual GDP. The
size of the US banking industry has grown from around 20% in Bagehot's time to around
100% of GDP today. And, until recently, the true scale of balance sheets was understated by
these figures because banks were allowed to put exposures to entities such as special
purpose vehicles off balance sheet.
Surprisingly, such an extraordinary rate of expansion has been accompanied by increasing
concentration: the largest institutions have expanded the most. Table 1 shows that the asset
holdings of the top ten banks in the UK amount to over 450% of GDP, with RBS, Barclays
and HSBC each individually having assets in excess of UK GDP. Table 2 shows that in the
US, the top ten banks amount to over 60% of GDP, six times larger than the top ten fifty
years ago. Bank of America today accounts for the same proportion of the US banking
system as all of the top 10 banks put together in 1960.
While banks' balance sheets have exploded, so have the risks associated with those balance
sheets. Bagehot would have been used to banks with leverage ratios (total assets, or
liabilities, to capital) of around six to one. But capital ratios have declined and leverage has
risen. Immediately prior to the crisis, leverage in the banking system of the industrialised
world had increased to astronomical levels. Simple leverage ratios of close to 50 or more
could be found in the US, UK, and the continent of Europe, driven in part by the expansion of
trading books (Brennan, Haldane and Madouros, 2010).
And banks resorted to using more short-term, wholesale funding. The average maturity of
wholesale funding issued by banks has declined by two thirds in the UK and by around three
quarters in the US over the past thirty years - at the same time as reliance on wholesale
funding has increased. As a result, they have run a higher degree of maturity mismatch
between their long-dated assets and short-term funding. To cap it all, they held a lower
proportion of liquid assets on their balance sheets, so they were more exposed if some of the
short-term funding dried up. In less than fifty years, the share of highly liquid assets that UK
banks hold has declined from around a third of their assets to less than 2% last year (Bank of
England, 2009). Banks tested the limits of where the risk-return trade-off was located, in all
parts of their operations. As John Kay wrote about his experience on the board of HBoS, the
problems began "on the day it was decided that treasury should be a profit centre in its own
right rather than an ancillary activity" (Kay, 2008).
Moreover, the size of the balance sheet is no longer limited by the scale of opportunities to
lend to companies or individuals in the real economy. So-called "financial engineering" allows
banks to manufacture additional assets without limit. And in the run-up to the crisis, they
were aided and abetted in this endeavour by a host of vehicles and funds in the so-called
shadow banking system, which in the US grew in gross terms to be larger than the traditional
banking sector. This shadow banking system, as well as holding securitised debt and a host
of manufactured - or "synthetic" - exposures was also a significant source of funding for the
conventional banking system. Money market funds and other similar entities had call
liabilities totalling over $7 trillion. And they on lent very significant amounts to banks, both
directly and indirectly via chains of transactions.
This has had two consequences. First, the financial system has become enormously more
interconnected. This means that promoting stability of the system as a whole using a regime
of regulation of individual institutions is much less likely to be successful than hitherto.
Maturity mismatch can grow through chains of transactions - without any significant amount
being located in any one institution - a risk described many years ago by Martin Hellwig
(Hellwig, 1995). Second, although many of these positions net out when the financial system
is seen as a whole, gross balance sheets are not restricted by the scale of the real economy
and so banks were able to expand at a remarkable pace. So when the crisis began in 2007,
uncertainty about where losses would ultimately fall led confidence in banks to seep away.
This was obvious through the crisis. Almost no institution was immune from suspicion, the
result of the knock-on consequences so eloquently described by Bagehot when he wrote:
"At first, incipient panic amounts to a kind of vague conversation: Is A. B. as good as he used
to be? Has not C. D. lost money? and a thousand such questions. A hundred people are
talked about, and a thousand think, "Am I talked about, or am I not?" "Is my credit as good as
it used to be, or is it less?" And every day, as a panic grows, this floating suspicion becomes
both more intense and more diffused; it attacks more persons; and attacks them all more
virulently than at first. All men of experience, therefore, try to "strengthen themselves," as it is
called, in the early stage of a panic; they borrow money while they can; they come to their
banker and offer bills for discount, which commonly they would not have offered for days or
weeks to come. And if the merchant be a regular customer, a banker does not like to refuse,
because if he does he will be said, or may be said, to be in want of money, and so may
attract the panic to himself."
This sentiment is described more prosaically in Tables 3 and 4. They show that the risk
premia demanded by investors to lend to all large banks rose very sharply during the crisis.
For most banks the spreads on their senior unsecured debt had more than trebled in October
2008 relative to their levels at the start of 2007. Similarly, credit default swap premia - the
cost of insuring a bank's debt - shot up. All banks, irrespective of the precise nature of their
business and balance sheet, were tarred with the same brush. Moreover spreads and CDS
premia remain elevated today - almost universally, large UK and US banks face much higher
borrowing charges compared to risk-free rates, and are seen as riskier entities, than prior to
the crisis.
The size, concentration and riskiness of banks have increased in an extraordinary fashion
and would be unrecognisable to Bagehot. Higher reported rates of return on equity were
superficial hallmarks of success. These higher rates of return were required by, and a
consequence of, the change in the pattern of banks' funding with increased leverage and
more short-term funding. They did not represent a significant improvement in the overall rate
of return on assets. Not merely were banks' own reported profits exaggerating the
contribution of the financial sector to the economy, so were the national accounts.
In the US, the share of gross value added of the financial sector as a share of GDP rose from
around 2-3% in the decade after World War II to about 8% in 2008, driven in large part by a
rise in the gross operating surplus of financial intermediaries. And in the UK, in the past
decade, the measured scale of the financial sector, compared to GDP, has roughly doubled
to around 10%. But this exaggerates the contribution of financial services. Banks do not
always charge directly for the services they provide. So the value added of the financial
sector is measured by official statisticians (using the United Nations System of National
Accounts) as the difference between interest receipts and payments of a "reference rate of
interest" which attempts to measure the pure cost of borrowing funds. This convention
overstates the true value added of the financial sector because it includes the return to risky
lending represented by the difference between the hypothetical pure cost of borrowing funds
and the return that is earned. But the fact that risk is channelled through an intermediation
industry does not mean that the value added from risk-bearing in the economy is solely
attributable to the existence of an intermediation sector. If companies financed themselves
directly from households, the statisticians would regard the return on risk-bearing as value
added created in that industry. Financial intermediation does add value, but not as much as
the statistical convention would suggest.
Moreover, a financial sector that takes on risk with the implicit support of the tax-payer can
generate measured value added that reflects not genuine risk-bearing but the upside profits
from the implicit subsidy. And even without an implicit subsidy the return to risk-bearing can
be mismeasured. It is widely understood that an insurance company should not count as
profits the receipt of premia on an insurance policy that will pay out only when a
lowfrequency event occurs at some point in the future. But part of the value added of the
financial sector prior to the crisis reflected temporary profits from taking risk and it was only
after September 2008 that much of that so-called economic activity resulted in enormous
reported losses by banks.
It is possible to make a very rough estimate of the possible size of this distortion in the
reported financial sector output data. If we assume that true labour and capital productivity in
the financial services industry grew in line with that in the wider economy in the 10 years
prior to the crisis, then, given the inputs of capital and labour over that period, the official
estimate might have overstated UK financial sector value added by almost £30 billion up to
2007 - around half of the growth in the official measure. The impact of this adjustment on
overall GDP is likely to be relatively small because much of the output of the financial sector
is treated as intermediate inputs to other sectors in the economy. Such an estimate is
supported by the finding of my Bank of England colleagues that the increase in rates of
return on equity earned by banks were accounted for almost entirely by an increase in
leverage, capital gains on assets in trading books and the reported profits on contracts that
produced losses only after the crisis occurred. And it is consistent with the estimates
calculated by Colangelo and Inklaar (2010) for the euro area. They found that around 40% of
measured financial sector value added probably captured compensation for bearing risk.
3. The theory of banking
Why are banks so risky? The starting point is that banks make heavy use of short-term debt.
Short-term debt holders can always run if they start to have doubts about an institution.
Equity holders and long-term debt holders cannot cut and run so easily.
Douglas Diamond and Philip Dybvig showed nearly thirty years ago that this can create
fragile institutions even in the absence of risk associated with the assets that a bank holds.
All that is required is a cost to the liquidation of long-term assets and that banks serve
customers on a first-come, first-served basis (Diamond and Dybvig, 1983). Nevertheless,
there are benefits to this maturity transformation - funds can be pooled allowing a greater
proportion to be directed to long-term illiquid investments, and less held back to meet
individual needs for liquidity. And from Diamond's and Dybvig's insights, flows an intellectual
foundation for many of the policy structures that we have today - especially deposit
insurance and Bagehot's time-honoured key principle of central banks acting as lender of last
resort in a crisis. If the only problem is one of illiquidity leading to fragility, then central banks
can easily act to ward off problems. By demonstrating a willingness to step in to provide
temporary liquidity support, then the likelihood of problems arising in the first place is
dramatically diminished. It was wholly appropriate that this was the focus of Bagehot's
writings - at the time, the structure of the banking system meant that illiquidity was often the
key problem. And central banks did not appreciate the importance of the role that they could
play. Bagehot's whole purpose was to convince the Bank of England to fulfil this role. But the
changes in the banking system over the past fifty years mean that a much more diverse
range of problems can strike today. In September 2007, everyone thought that the crisis was
one of liquidity and as a result there was an expectation central banks could provide the
solution. But it quickly became clear that it was in fact a crisis of solvency.
Diamond and Dybvig's analysis consciously omitted the fact that, in reality, banks' assets are
risky. And not only are banks' assets risky, but banks are highly leveraged institutions. This
leaves them heavily exposed - with very high debt-equity ratios, small movements in asset
valuations are enough to wipe out their equity and leave banks insolvent. That means the
distinction between illiquidity and solvency can be difficult in practice - the difference in
timing might be just a few days. If a crisis is in fact one of insolvency, brought on by
excessive leverage and risk, then central bank liquidity provision cannot provide the answer.
Central banks can offer liquidity insurance only to solvent institutions or as a bridge to a more
permanent solution.
It is this structure, in which risky long-term assets are funded by short-term deposits, that
makes banks so hazardous. Yet many treat loans to banks as if they were riskless. In
isolation, this would be akin to a belief in alchemy - risk-free deposits can never be
supported by long-term risky investments in isolation. To work, financial alchemy requires the
implicit support of the tax payer.
When all the functions of the financial system are heavily interconnected, any problems that
arise can end up playing havoc with services vital to the functioning of the economy - the
payments system, the services of money and the provision of working capital to industry. If
such services are materially threatened, governments will never be able to sit idly by.
Institutions supplying such services are quite simply too important to fail. Everyone knows it.
So, highly risky banking institutions enjoy implicit public sector support. In turn, public support
incentivises banks to take on yet more risk, knowing that, if things go well, they will reap the
rewards while the public sector will foot the bill if things go wrong. Greater risk begets greater
size, most probably greater importance to the functioning of the economy, higher implicit
public subsidies, and hence yet larger incentives to take risk - described by Martin Wolf as
the "financial doomsday machine".
The failure in the crisis was not one of intellectual imagination or economic science to
understand these issues. Economists recognised that distorted incentives, whether arising
from implicit public subsidies, asymmetric information or a host of other imperfections, will
cause a market-based outcome to be sub-optimal from the perspective of society. This idea
has been at the centre of modern economics since the extraordinary series of papers written
by Arrow and Debreu in the 1950s (Arrow, 1951; Debreu, 1951; Arrow and Debreu, 1954).
The real failure was a lapse into hubris - we came to believe that crises created by massive
maturity transformation were problems that no longer applied to modern banking, that they
belonged to an era in which people wore whiskers and top hats. There was an inability to see
through the veil of modern finance to the fact that the balance sheets of too many banks
were an accident waiting to happen, with levels of leverage on a scale that could not resist
even the slightest tremor to confidence about the uncertain value of bank assets. For all the
clever innovation in the financial system, its Achilles heel was, and remains, simply the
extraordinary - indeed absurd - levels of leverage represented by a heavy reliance on
shortterm debt.
Modern financiers are now invoking other dubious claims to resist reforms that might limit the
public subsidies they have enjoyed in the past. No one should blame them for that - indeed,
we should not expect anything else. They are responding to incentives. Some claim that
reducing leverage and holding more equity capital would be expensive. But, as economists,
such as my colleague David Miles (2010) and Anat Admati and her colleagues (Admati
et. al., 2010), have argued, the cost of capital overall is much less sensitive to changes in the
amount of debt in a bank's balance sheet than many bankers claim - a proposition
demonstrated forcefully by Professors Modigliani and Miller over fifty years ago (Modigliani
and Miller, 1958). And the benefits to society, most obviously through greater financial
stability, but also through factors such as higher tax revenue, are likely to swamp any change
in the private costs faced by banks. What does reduce the cost of capital is the ability to
borrow short to lend long. But the scale of maturity transformation undertaken today
produces private benefits and social costs. We have seen from the experience of first
Iceland, and now Ireland, the results that can follow from allowing a banking system to
become too large relative to national output without having first solved the "too important to
fail" problem.
4. Finding a solution
Many remedies for reducing the riskiness of our financial system have been proposed,
ranging from higher capital requirements on banks to functional separation and other more
radical ideas. The guiding principle of any change should be to ensure that the costs of
maturity transformation - the costs of periodic financial crises - fall on those who enjoy the
benefits of maturity transformation - the reduced cost of financial intermediation. All
proposals should be evaluated by this simple criterion.
The first, and most obvious, response to the divergence between private benefits and social
costs is the imposition of a permanent tax on the activity of maturity transformation to
"internalise the externalities". Such a tax, or levy, has been discussed by the G7, and
introduced in the UK. The principle that the "polluter pays" for the costs they impose on
others is an old one, going back at least to Pigou in the 1920s. The main practical problem is
to calibrate the costs to maturity transformation. The loss of world output from the financial
crisis is enormous, even though such a crisis might be considered a once in a generation, or
even once in a century, event. It is not difficult to see that a crisis that reduces output by
between 5% and 10% for a number of years, and occurs once every fifty years, amounts to
an annual cost several multiples of the revenue that will be generated by the UK bank levy
(Haldane, 2010). But how can we be certain of correctly establishing what the tax should be
when we are trying to internalise costs that occur so infrequently? So although there is a
sound case for a levy directed at the size of short-term borrowing, it would be foolish to
regard that as the main tool to align costs and benefits of risky balance sheet activity.
If setting the appropriate price is hard, then some form of controls on quantities might be a
better answer (Weitzman, 1974). For example, limits on leverage have much to commend
them. And for a generation, the quantitative control of this type that regulators have
embraced was embodied in the capital standards set within the Basel framework. Last month
a new concordat on such standards was reached in Basel - the so-called Basel III
requirements. The challenge here is to set the requirements in a way that will materially
affect the probability of a crisis.
Other forms of quantitative intervention include functional separation to reduce the costs of
maturity transformation by ring-fencing those activities that we are most concerned to
safeguard from disruption. If successful, the costs of any failure of financial institutions would
be reduced. The challenge with this approach is to prevent the costs associated with the
activity of maturity transformation from gravitating to another set of institutions - the
"shadow" banking system.
Whatever solution is adopted, the aim must be to align private and social costs.
5. Why Basel III is not a complete answer
Lauded as a new standard, Basel III is seen by some as the answer to the failure of
regulation to prevent the financial crisis. It is certainly a step in the right direction, an
improvement on both Basel I and the ill-fated Basel II, and we should all welcome it. But if it
is a giant leap for the regulators of the world, it is only a small step for mankind. Basel III on
its own will not prevent another crisis for a number of reasons.
First, even the new levels of capital are insufficient to prevent another crisis. Calibrating
required capital by reference to the losses incurred during the recent crisis takes inadequate
account of the benefits to banks of massive government intervention and the implicit
guarantee. More fundamentally, it fails to recognise that when sentiment changes only very
high levels of capital would be sufficient to enable banks to obtain funding on anything like
normal spreads to policy rates, as we can see at present. When investors change their view
about the unknowable future - as they will occasionally in sudden and discontinuous ways -
banks that were perceived as well-capitalised can seem under-capitalised with concerns over
their solvency. That is what happened in 2007-08. As the IMF have pointed out differences
in capital ratios failed to predict which financial institutions would be vulnerable in the crisis
(IMF, 2009). Only very much higher levels of capital - levels that would be seen by the
industry as wildly excessive most of the time - would prevent such a crisis.
Second, the Basel approach calculates the amount of capital required by using a measure of
"risk-weighted" assets. Those risk weights are computed from past experience. Yet the
circumstances in which capital needs to be available to absorb potential losses are precisely
those when earlier judgements about the risk of different assets and their correlation are
shown to be wrong. One might well say that a financial crisis occurs when the Basel risk
weights turn out to be poor estimates of underlying risk. And that is not because investors,
banks or regulators are incompetent. It is because the relevant risks are often impossible to
assess in terms of fixed probabilities. Events can take place that we could not have
envisaged, let alone to which we could attach probabilities. If only banks were playing in a
casino then we probably could calculate appropriate risk weights. Unfortunately, the world is
more complicated. So the regulatory framework needs to contain elements that are robust
with respect to changes in the appropriate risk weights, and that is why the Bank of England
advocated a simple leverage ratio as a key backstop to capital requirements.
Third, the Basel framework still focuses largely on the assets side of a bank's balance sheet.
Basel II excluded consideration of the liquidity and liability structure of the balance sheet, so
much so that when the UK adopted Basel II in 2007, of all the major banks the one with the
highest capital ratio was, believe it or not, Northern Rock. Within weeks of announcing that it
intended to return excess capital to its shareholders, Northern Rock ran out of money. Basel
II was based on a judgement that mortgages were the safest form of lending irrespective of
how they were financed. If a business model is based around a particular funding model that
suddenly becomes unviable, then the business model becomes unviable too, as events in
2007 showed. Whether the measures included in Basel III will be able to deal properly with
the risks that result from inadequate levels of liquid assets and a risky structure of liabilities
remains to be seen.
One criticism of Basel III with which I have no truck is the length of the transition period.
Banks have up to 2019 to adjust fully to the new requirements. Although some of the
calculations of the alleged economic cost of higher capital requirements presented by the
industry seem to me exaggerated (Institute of International Finance, 2010), I do believe that it
is important in the present phase of de-leveraging not to exacerbate the challenge banks
face in raising capital today. Banks should take advantage of opportunities to raise
lossabsorbing capital, and should recognise the importance of using profits to rebuild capital
rather than pay out higher dividends and compensation. But we must not forget the principle
underlying the Basel approach: asking banks to maintain a buffer of capital above the
minimum requirement allows them to run the buffer down in circumstances like the present.
Rebuilding the buffer is a task for the future. So even though the Bank of England would
have preferred an agreement to set capital ratios at higher levels in the long run, we have no
intention of asking UK banks to adopt a faster timetable for implementation of Basel III. That
logic should apply to any reforms we choose to implement. We should not expect to change
the financial system for the better overnight. Rather we need radical reforms that will give us
a much more robust system in the long run, accepting that it may take a period of many
years to get there.
As with a bank levy, it is no criticism of Basel III to say that it is not a "silver bullet". The
difficulty of identifying and calibrating the difference between the private and social costs of
maturity transformation means that there is merit in having a basket of different measures to
rein in excessive risk-taking. In the area of financial stability, it makes sense to have both belt
and braces.
6. Large institutions
The implicit subsidy to banks that are perceived as "too important to fail" can be important to
banks of any size but is usually seen as bigger for large institutions for which existing bank
resolution procedures either do or could not apply. Moreover, most large complex financial
institutions are global - at least in life if not in death. So a major international effort is
underway to try to work out how best to deal with such institutions, initiated by heads of
government at the G-20 Summit in Pittsburgh in 2009. Much of this work is being led by the
Financial Stability Board. Ideas agreed in principle or under consideration include an addition
to the Basel III capital requirement of an extra layer of either equity or other loss-absorbing
capital, a special resolution regime for large institutions that would allow losses to be shared
among creditors as well as equity-holders, and tentative steps towards international
harmonisation of resolution procedures on which my colleague Paul Tucker and others are
engaged.
Some countries have already started down the road of augmenting the Basel calibration with
additional requirements of their own for large banks. Earlier this month the Swiss authorities
announced just such a requirement for their two current systemically important banks - UBS
and Credit Suisse. In future, they will have to hold additional amounts of both equity capital
and loss-bearing contingent capital which takes their total holding of equity-like capital to
19%, compared with the Basel standard of 7%.
But in most other countries, identifying in advance a group of financial institutions whose
failure would be intolerable, and so are "too important to fail", is a hazardous undertaking. In
itself it would simply increase the subsidy by making it explicit. And it is hard to see why
institutions whose failure cannot be contemplated should be in the private sector in the first
place. But if international regulators failed to agree on higher capital requirements in general,
adding to the loss-absorbing capacity of large institutions could be a second-best outcome.
Solving the "too important to fail" problem will require ultimately that every financial sector
entity can be left to fail without risk of threatening the functioning of the economy. So it is
natural that improved resolution procedures is part of the overall strategy - and within many
countries big steps forward have already been taken. But the successful resolution of a large
institution would, in the absence of an implausibly large deposit insurance fund, require the
ability to bail-in creditors. Yet that possibility would give an incentive to the bank to increase
its dependence on short-term funding so that more creditors might get out in time. That might
increase rather than decrease the fragility of the institution. So there would need to be
restrictions on the maturity structure of its liabilities. Resolution would naturally go
hand-inhand with a greater reliance on instruments such as contingent capital. And there would be
enormous challenges in resolving global banks that span countries with different legal
jurisdictions. Extending resolution procedures to large institutions is a necessary but not
sufficient condition for stability of the banking system.
7. More radical reforms
All of these potential reforms would be steps in the right direction. They would all help to put
more of the costs of maturity mismatch on the shoulders of those who reap the benefits. But
taxes, the Basel capital requirements, special arrangements for systemically important
financial institutions and enhanced resolution procedures all have drawbacks and are
unlikely to do the job perfectly. So, if we cannot rely solely on these types of measures, are
there more fundamental directions in which we could move that would align costs and
benefits more effectively?
One simple solution, advocated by my colleague David Miles, would be to move to very
much higher levels of capital requir