Ignazio Visco: The financial sector after the crisis
Lecture by Mr Ignazio Visco, Governor of the Bank of Italy, at the Imperial Business Insights,
Imperial College, London, 5 March 2013.
* * *
I wish to thank for useful discussions and help Fabrizio Balassone, Paolo Del Giovane, Alessio De Vincenzo and
Giuseppe Grande.
Introduction1
The financial crisis has brought to the fore a number of problems. It has been severe and
widespread, and has affected different economies in different and long-lasting ways.
Financial stability has once again become a fundamental objective of policy making, and
central banks are being heavily involved in this endeavour. This calls for a substantial
overhaul in financial regulation and supervision, and the financial system of tomorrow will
most likely be rather different from the one that has developed over the last two decades.
Scepticism has grown about the role of finance in the economic system, and especially its
apparent separation from, if not conflict with, the real economy. We should take stock of what
has gone wrong, and in so doing reflect on the way forward, as it is already taking shape, as
well as, perhaps, on how to better link our theories to real world developments.
In the decade before the financial crisis both the size of the financial system and its role and
pervasiveness in the economy increased dramatically. The process has only slowed down
with the crisis. In the euro area, the overall amount of financial resources collected by the
private sector (bank credit, bonds issued domestically and stock market capitalization) rose
from 160 per cent of GDP in 1996 to 240 in 2007, and then declined to 230 in 2011. A similar
pattern is found for the United States, where the ratio rose from 230 per cent in 1996 to 330
in 2007 and then declined to 260 in 2011, and for the UK, where the ratio increased from 240
to 330 per cent and then edged down to 320 per cent. The total outstanding notional amount
of over-the-counter (OTC) and exchange-traded derivatives has risen from about 94 trillion
U.S. dollars at the end of 1998 to around 486 trillion at the end of 2006, to reach 700 trillion
in June 2012.
Financial deepening, by allowing greater diversification of risk and making finance accessible
to larger numbers of countries and firms, can be instrumental to broadening economic
development. But there is a risk that finance turns into an end in itself, with consequences
that can be more damaging as the system becomes more interconnected and the potential
for externalities increases. The correct conduct of credit and financial business requires
competence and good faith on the part of intermediaries as well as appropriate regulatory
and supervisory regimes.
"Good" finance as a force for good
Finance has long been viewed as a morally dubious activity. My appeal to authority on this
matter is a reference to a lecture delivered by Amartya Sen more than twenty years ago as
the first Paolo Baffi Lecture on Money and Finance at the Banca d'Italia. Sen wondered:
"How is it possible that an activity that is so useful has been viewed as being morally so
dubious?".2 He recalled a series of historical episodes: Jesus driving the money lenders out
of the temple, Solon cancelling debts and prohibiting many types of lending in ancient
Greece, Aristotle describing interest as an unnatural and unjustified breeding of money from
money.
Superimposed on this "structural" mistrust, one can detect cyclical patterns in the public's
attitude towards finance, affected by the conditions of financial systems and shifts in the
political mood about state intervention in the economy. Until the 1970s it was taken for
granted that market failures required the presence and response of a regulator to avoid
suboptimal results. Then came the great inflation of the 1970s, combined with high
unemployment, and the emphasis shifted to government failures. Governments, central
banks and other regulators were blamed for failing to prevent these developments. This
eventually led to an ideological swing: a push to reduce the extent of state intervention. The
failures of the "regulated economy," the pace of technological advance and the rapid
expansion of international trade after the end of the Cold War fuelled a protracted process of
financial deregulation that was halted only by the financial crisis that broke out in 2007. The
latter triggered a move toward re-regulation - or better regulation - that is still under way.
The pendulum keeps swinging and will certainly continue to do so.
The global financial crisis, with its huge costs for the whole society, has caused a further
deep erosion of the trust in financial institutions. Witness to this are the widespread protests
against the financial industry, from the Occupy Wall Street movement to the "Indignados" in
Spain and their counterparts in other European countries. Anger has been fuelled not only by
the discovery of wrongdoings and perverse incentives, but also by a perceived lack of action
against those responsible, in a context of exceptionally high remunerations. The integrity of
financial intermediaries' codes of conduct has been called into question under many
dimensions: honesty, the ability to manage financial risks and the commitment to take care of
the interests of their clients.
In the first place, public attention was caught by cases of investment fraud, in which Ponzi
schemes or other types of malpractice and malfeasance led many people to lose their
savings. Feelings were exacerbated by the generous severance packages paid to top
managers after distressed financial institutions were rescued with taxpayer money. Dubious
practices were found in key junctures of the financial systems, such as credit ratings and
interbank reference rates, not to mention the allegations of financial institutions' involvement
in activities related to money laundering and other fraudulent practices.
Most importantly, the crisis has shown that market participants were not capable of
mastering the inherent complexity of the system that they themselves had contributed to
develop over the course of the last two decades. Favoured by the breakthroughs in
information technology and telecommunications, the securitization of banks' assets
expanded considerably, together with the supply of so-called structured financial instruments
(ABSs, CDOs, etc.). The traditional model of credit intermediation gave way, especially but
not only in the United States, to a system in which loans granted were rapidly transformed
into other financial products having these loans as collateral and sold on the market: the
socalled originate-to-distribute model (OTD). To the inherent difficulty of evaluating the quality
of loans, these developments added the problem of fully understanding the effective role of
structured financial products.
Structured finance products and the OTD intermediation model can facilitate risk
management. The granting of mortgages to households is favoured by the possibility of
managing the related interest-rate risk; the internationalization of firms depends crucially on
the possibility of hedging foreign exchange risk; and the provision of retirement saving
products at low cost over very long time horizons benefits from the ability to mitigate the
impact of fluctuations in security prices. With the OTD model, credit risk is not concentrated
in the banks' books, but is potentially dispersed among a multitude of investors. By making
bank loans tradable, it reduces their illiquidity premium thus decreasing their cost.
However, we now understand that structured finance and OTD intermediation, coupled with
lack of transparency, favoured excess risk taking and opportunistic behaviour. Transactions
often took place through scarcely regulated financial intermediaries characterized by high
leverage and risk exposure, in particular as regards their valuation (in which a crucial role
was played by rating agencies, without any particular control by regulatory authorities or
information providers), by means of statistical models and often carried out on the basis of
incomplete and insufficient data. In many instances complexity was instrumental to
opportunistic behaviour fuelled by a distorted system of incentives especially with reference
to executive compensation. The high leverage and complexity typical of structured financial
instruments allowed them to be used to take high-risk, speculative positions.
Unnecessarily complex and opaque assets were used to prevent a correct assessment of
creditworthiness or mask the economic impact of previous transactions, exploiting the ample
scope for interpretation allowed by accounting standards. Banks' misuse of these
instruments may also be linked to the drying-up of the sources of income from traditional
credit business. This may have triggered actions designed to conceal from the market and
from supervisors the real object of derivatives transactions.
The bottom line is that financial innovation can allow more efficient allocation of credit risk,
but it also entails a number of dangers, some of them intrinsic to its mechanism, others more
generally related to the greater interdependence of the financial system. The ongoing
process of financial consolidation and the OTD model have produced intermediaries that are
closely intertwined with the capital markets. This has had some important consequences for
financial stability: a more connected world improves risk diversification and can make
markets more resilient, but when contagion is actually set off, an interlinked financial system
heightens the risk that it may spread more widely.
But the negative perception of banking and finance should not lead to a blind backlash. As
Amartya Sen argued, "finance plays an important part in the prosperity and well-being of
nations".3 It is crucial for sharing and allocating risk, especially for poorer societies and
people, insofar as risk aversion decreases with wealth. It is crucial for transferring resources
over time and removing the liquidity constraints that hamper the economy and the
exploitation of ideas. It is very important in promoting economic growth, especially by
fostering innovation.
Indeed, we have countless historical examples of good financial innovations. Think, for
example, of the "letters of exchange" introduced by Italian merchants in the Middle Ages:
they were probably the first fiduciary money, and trade benefited enormously from this
financial instrument. More recently, consider the development of "micro-finance" in the
1970s: an innovation that has enhanced financial inclusion, helping poor borrowers to
smooth their income and cope with illness or other temporary shocks. And, in the last two
decades, recall the role of the "venture capital" industry in the promotion of successful
innovative corporations such as Apple, Intel and Google.
Some countries are now increasingly investing in efforts to improve the financial literacy of
the public, and this too is important. On the one hand, it helps to build the demand side of a
more inclusive finance. On the other, financially literate citizens are better able to understand
the efforts of regulators and policy makers to improve supervision and regulation, and less
likely to subscribe to the simplistic view that "finance is evil". But we should realise that - as
the case of Bernard Madoff and others in the US and elsewhere clearly show - this is no
panacea (Madoff's customers were surely much better educated than average). Therefore,
for purposes of consumer protection in the financial services industry, financial regulation
and good supervision are the necessary complements to financial education and inclusion.
Complexity was also used, somewhat perversely, as an argument in favour of a sort of
benign neglect on the part of regulators. The big financial players argued successfully that
financial innovation was too complex and too opaque for the regulators to get their heads
around. Indeed, they said, to safeguard the international financial system from systemic risk,
the main priority was promoting an "industry-led" effort to improve internal risk management
and related systems. This, in a nutshell, was the view espoused by the Group of Thirty report
following the outbreak of the Asian crisis.4 But this thesis was often accompanied by the
argument to the effect that "you, regulators and supervisors, will always be behind financial
innovation; it would be better to allow us, the big financial international players, to
selfregulate; we are grown-ups, we can take care of ourselves". And, after all, "if someone
makes mistakes some will gain what others lose; why can't we be left alone to play this
zerosum game of ours?"
The regulators did not, in fact, have either the ability, or the right incentives to acquire the
necessary information, for two reasons. First, the big financial players are global, and
national regulators had powers too narrow to be able to confront them. The difficulties in
coordinating the regulators' actions, in the face of a natural tendency to preserve each one's
particular sphere of influence, was a powerful drag on the ability to rise to the challenge
posed by a finance gone global. Second, the phenomenon of regulatory capture was a
definite reality. Powerful political and economic influences were at play, and in some cases
prevailed.
Accepting the idea that benign neglect was the right course of action was, however, a critical
mistake. The global financial crisis has highlighted the limits of the idea that self-regulation
and market discipline are sufficient to ensure stable financial systems. Financial regulation
and supervision have to keep pace with developments in the financial industry. National
authorities need to be aware of the risk that their powers become narrow compared to the
sphere of influence of the global financial players; the coordination of financial supervision
across borders and across sectors is a key condition for the stability of the global financial
system. More importantly, regulators and supervisors have to pay attention to keeping
financial industry lobbies at due distance.
All this calls for a major effort, at a national but especially at an international level, to adjust
and strengthen the regulatory and supervisory financial framework. And it explains why the
work that is carried out at various levels of relevance and responsibility in international fora is
so important. In what follows I will review and assess recent reforms in financial regulation,
highlighting those improvements that still need to be achieved. I will also discuss the
importance of advances in our analytical understanding of the workings of financial markets
and of its deviations from stationarity.
In search of a better regulatory and supervisory regime
Over the last few years the crisis has heightened appreciation of the benefits of a more
stringent regulatory regime. At an international level, under the political impulse of the G-20,
the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision
(BCBS) have introduced substantial regulatory changes to reduce the frequency of financial
crises and increase the resilience of economic systems. Much has been already achieved.
The quantity and quality of capital that banks need to hold has been significantly enhanced to
ensure that they operate on a safe and sound basis. Minimum capital requirements have
been raised. The improvement in the quality of capital aims to ensure that banks are better
able to absorb losses on both a going concern and a gone concern basis. The risk coverage
has been increased, in particular for trading activities, securitisations and exposures related
to off-balance sheet vehicles and arising from derivatives. An internationally harmonised
maximum leverage ratio is going to be introduced, to serve as a backstop to the risk-based
capital measure and to contain the build-up of excessive leverage in the system.
The BCBS has also introduced international standards for bank liquidity and funding,
designed to promote the resilience of banks to liquidity shocks. A milestone agreement was
recently reached among Central Bank Governors and Heads of Supervision to adopt a
minimum requirement for the ratio between high quality liquid assets and net liquidity
outflows that banks would face over a one-month horizon in stress conditions (Liquidity
Coverage Ratio - LCR). The minimum LCR will increase gradually in the coming years, so
as to ensure that the new liquidity standard will not hinder the ability of the global banking
system to finance recovery. And countries with distressed banking systems will have
flexibility in its application.
At the behest of the G-20, the FSB has promoted initiatives to strengthen the regulation of
the OTC derivatives market. The aim is to reinforce market infrastructures, in order to
minimise contagion and spill-over effects among players that have become more and more
interconnected. These initiatives increase market transparency through a number of
measures: contract standardization, the requirement to trade on regulated markets,
settlement through central counterparties, the reporting of the terms and conditions of
transactions to trade repositories.
But further progress is needed in important areas. Capital and liquidity regulation must be
accompanied by improvements in internal risk control arrangements and by actions aimed at
correcting incentives to excessive risk-taking. Board members and senior managers should
possess a thorough understanding of the bank's overall operational structure and risks. It is
also fundamental that supervisors regularly assess banks' corporate governance policies and
practices. Compensation policies also need to be revised, in order to better align
remuneration with risk-adjusted long-term performance and avoid excessive risk-taking and
short-termism. In particular, when designing compensation policies, banks should take into
account a number of issues: the variable portion of the compensation of risk takers must be
paid on the basis of individual, business-unit and firm-wide measures that adequately assess
risk-adjusted performance; bonuses must reward the achievement of stable earnings, not
simply the fruit of extraordinary operations; executives' severance packages too must be
clearly and effectively bound to the results attained, and reflect a more general evaluation of
the manager's performance; compensation must be deferred long enough to validate the true
quality of management.
The debate that has started with the so-called Volcker rule on the organizational structure of
banks and the need to separate traditional credit business from activity in the financial field
has been recently reinvigorated at a European level by the reports of the Vickers
Commission in the United Kingdom and the Liikanen Group for the European Commission.
Both the Volcker rule and the reports call for a much needed discussion around business
size and complexity in the financial sector; the experience of the crisis has indeed shown that
we should not be shy to thoroughly re-assess relative merits and costs of both (size and
complexity). These reports trace out possible lines of intervention. Protecting retail deposits
and taxpayers' money from the risks implicit in trading activities (what used to be called
"speculation") - the rationale behind these proposals - is crucial. The experience of the crisis
has shown that, even if no specific business model has performed particularly well or poorly,
the banks' organizational structure has an impact on the propensity of managers to engage
in excessively risky activities. We should recognize that both retail and investment banking,
even if organizationally or institutionally separate, should be properly regulated, and should
be careful not to have a too ample definition of market making activity.
At all events, in today's globalized world it is crucial to make sure that countries cooperate
and agree on the appropriate stringency of financial regulation. Countries should not
compete by relaxing rules in order to attract financial intermediaries, as this generates
negative externalities for other countries. This is a most delicate issue, and while a perfectly
level playing field may not be achievable, we have to be conscious of the consequences of a
"beggar-thy-neighbour" approach to regulation. The transition to a uniform system of rules
and oversight of the financial sector must be hastened. In the euro area, and in the European
Union at large, the plan for a banking union is ambitious, but it goes in the right direction.
Some progress has been made on the convergence towards a single set of global
accounting standards; but much remains to be done. The International Accounting Standards
Board and the US Financial Accounting Standards Board expect to make progress on the
two key outstanding issues of impairment of loans, where their deliberations should be
completed by the end of the year, and insurance contracts, where both Boards will be
holding public consultations this year. Of these two outstanding issues, the need for
convergence on a new forward-looking expected loss approach to provisioning is of most
immediate concern for end-users and from a financial stability perspective.
One element that is essential for guaranteeing systemic stability is the method of measuring
risk-weighted assets (RWA), the denominator of capital adequacy ratios. RWA measures
have recently attracted increasing attention from market analysts, banks and supervisory
authorities. It has been argued - and this seems to be actually the case - that the
methodologies for computing RWAs may not be comparable across institutions and,
especially, across jurisdictions, and that they should more properly reflect risk in order to
avoid ultimately jeopardising financial stability. These problems highlight the relevance of
supervisory practices in determining banks' capital requirements (for example, in validating
internal banks' models for calculating risk weights). Here, rigorous micro-prudential
supervision is essential. We really need to work out a single rulebook, to move with
determination towards taking joint responsibility and using peer reviews as much as possible
in our supervisory activity.
As for the initiatives to strengthen the regulation of the OTC derivatives market, these
complex reforms are taking somewhat longer than originally planned. It is therefore
necessary to pick up the pace, overcoming the difficulties of implementation and the
industry's resistance. Authorities must make all efforts to remove the uncertainties arising
when transactions involve a cross-border dimension, which is a recurrent condition in a
global market. This is necessary to pre-empt regulatory arbitrage and, ultimately, to achieve
the G20 objectives. Work is also in progress on other relevant issues at an international level
(capital requirements for exposures to central counterparties, margining standards for
noncentrally cleared transactions, guidance on resolution of central counterparties, as well as on
authorities' access to trade repository data) and at a regional and national level. In Europe, at
the end of next week a comprehensive set of standards for the implementation of the
European Market Infrastructure Regulation will enter into force, complementing the European
legal framework for the so-called "clearing obligation" embodied in the G20 statement of
September 2009. From a global perspective, however, the regulatory effort needs to be
carried out by the widest range of jurisdictions as made clear at the recent G20 meeting in
Moscow.
Significant efforts are also expected from the industry. The last FSB report on the
implementation of the OTC derivatives market reform estimates that "approximately 10 per
cent of outstanding credit default swaps and approximately 40 per cent of outstanding
interest rates derivatives had been centrally cleared as of end-August 2012".5 These shares
should grow rapidly, so as to leave to customized OTC derivatives the sole purpose of
meeting the specific hedging needs of financial and non financial counterparts which cannot
be met by standardised, clearing-eligible contracts.
It will be crucial to ensure that stricter regulation and supervision of banks will not push
banklike activities and risks towards non - or less - regulated institutions (the so-called "shadow
banking" sector). Let us not forget that the financial crisis originated in the US securitization
market, largely populated by unregulated or scantily regulated operators. While we have to
address bank-like risks to financial stability emerging from outside the regular banking
system, the approach should be proportionate, focussed on those activities that are material
to the system, using as a starting point those that were a source of risk during the crisis. The
FSB is currently refining the set of recommendations issued in November of last year. One
should bear in mind, however, that the new recommendations will be able to address the
specific risks that arose during the crisis, and we all recognise the ability of the shadow
banking sector to innovate.
Although new regulations on systemically important financial institutions have recently been
approved, the "too-big-to-fail" issue is still a major concern, and it merits strict monitoring.
Some progress is being made in developing and testing methodology for the identification of
global systemically important insurers (G-SIIs), and in developing appropriate supervision
guidelines. An identification methodology for all non-bank financial institutions of global
systemic relevance is also under preparation. For banking institutions (G-SIFI) the
implementation of the framework recently agreed upon has much farther to go; we need to
rapidly move forward.
Negative externalities associated with banks' behaviour (especially for large, interconnected
financial firms) must be taken into account. A broad consensus has emerged on the idea that
"macroprudential" policies directed towards preserving financial stability should limit systemic
risk by addressing both the cross-sectional dimension of the financial system, with the aim of
strengthening its resilience to adverse real or financial shocks, and its temporal dimension, to
contain the accumulation of risk over the business or financial cycle. Moreover, given the
complementarity between macroeconomic stability and financial stability, and that between
the instruments to pursue them, the exchange of information and the co-ordination between
macroprudential and monetary authorities are crucial to counter at the same time the risks for
price stability and the systemic risks for financial stability. I would dare to say that proper
understanding of how this can be effectively achieved is still in the making.6
Finally, even after the completion of the regulatory overhaul, it would be foolish to pretend
that defaults can always be avoided. They may be the result of imprudent behaviour or of
fraudulent operations. We need to be prepared for their occurrence, as the costs of public
support tend to be very high. According to the latest data gathered by the European
Commission, the outstanding amount of public recapitalizations as of June 2012 came to
0.1 per cent of GDP in France, 1.8 in Germany, 2.0 in Spain, 4.2 in the UK, 4.3 in Belgium,
5.2 per cent in the Netherlands, and over 40 per cent in Ireland. For Spain and Ireland these
amounts are at their highest since 2008, in the other countries they are lower than the peaks
reached in 2009. For the Spanish banks, a programme of recapitalization using European
funds of up to €100 billion was authorized in July, of which €41 billion (3.9 per cent of GDP)
has already been disbursed. In Italy, even taking into consideration the public support
provided last month to the Banca Monte dei Paschi di Siena, public recapitalizations have
been limited to 0.3 per cent of GDP. These figures indicate that the ongoing work on
resolution regimes is very important in this regard, and rapid progress should definitely be
made. This is particularly relevant in the euro area, where the new single supervisor
mechanism (the SSM) is being implemented.
Observations on the analytical implications of economic and financial instability
Economic systems constantly evolve and transform. Changes in institutional arrangements,
technological innovation and revisions in economic policy paradigms continuously reshape
the framework in which economic agents (consumers and businesses) make their decisions.
This in turn leads to changes in economic agents' behavioural patterns. When there is
marked discontinuity with the past, such changes may be far-reaching and the past fails to
provide enough guidance for the present (never mind the future). We should always
remember that the financial system is part of a richer social, economic and political
environment. The real world is subject to shocks that at times may have dramatic
consequences, such as those that we have experienced in the last twenty years or so, with
the end of the cold war, globalization and the sudden emergence of new major economic
actors, the ICT revolution, and substantial (not completely anticipated) demographic
changes.
However, a stationarity assumption of sorts underpins our theoretical and statistical models,
in the case of economic forecasting and (macro) policy making as well as in the case of
financial analysis and risk management. In general, the basic tenet is that future outcomes
will be drawn from the same population that generated past outcomes, so that the time
average of future outcomes cannot be persistently different from averages calculated from
past observations and future events can be predicted with a certain degree of statistical
accuracy. In non-ergodic environments, on the contrary, at least some economic processes
are such that expectations based on past probability distribution functions can differ
persistently from the time averages that will be generated as the future unfolds.7 In case of
acute uncertainty, no analysis of past data can provide reliable signals regarding future
prospects.
The challenges posed by the non-ergodic nature of economic systems may be met by
recognizing that our models are by necessity "local" approximations of very complex
economic and financial developments. One needs to be modest, using theory and empirical
models as starting points for, not straightjackets in, our decision making. And perhaps not
enough attention has been paid by the financial community to the need for establishing
institutional and behavioural norms to reign on patterns of instability and developing proper
learning devices to deal with major shocks and regime changes.
These challenges are compounded by another general characteristic of the quantitative
analysis of economic phenomena: the difficulty of running parallel worlds, i.e. producing data
through experiments designed and controlled by the researcher. Even when economic forces
do follow repetitive patterns, it may not be easy to spot empirical regularities, because
contingencies - especially the exceptional ones - cannot be re-created at will, in the
laboratory, for cognitive purposes. Our experience will always be limited, partial and episodic.
These aspects are not always taken into account in economics or finance. As Charles
Kindleberger noticed: "For historians each event is unique. Economics, however, maintains
that forces in society and nature behave in repetitive ways".8
Why is it that the parameters and laws governing economic systems tend to change over
time? A distinction can be made between exogenous uncertainty, when an individual's
actions do not affect the probability of an event occurring, and endogenous (or behavioural)
uncertainty, when they do.9 In economic systems, this second type of uncertainty can be
particularly important. This has not been sufficiently recognized, I believe, in the way
(applied) macroeconomics and finance have evolved since the 1980s, with the ascendency
of the rational expectations revolution in the former and the efficient market hypothesis in the
latter.
In macroeconomics this may have led to placing too much faith in the ability of dynamic
stochastic general equilibrium (DSGE) models to represent or sufficiently approximate the
real world on which economic policy is applied. These fundamentally linear models are the
result of the intertemporal optimization by representative agents of objective functions under
conditions of uncertainty, given technological and budget constraints and