John Gieve: Rebuilding confidence in the financial system
Speech by Sir John Gieve, Deputy Governor of the Bank of England, at the BBA's 12th
Annual Supervision Conference, London, 28 October 2008.
* * *
We are publishing today our bi-annual Financial Stability Report, and so I want to start my
presentation by looking at the wider context of the debate on supervision, on which this
conference is focusing.
The word unprecedented is used too frequently. But the instability in financial markets over
the last year - culminating in the seizure of money markets in recent weeks (Chart 1) - has
been the most severe in living memory.
It did not come out of the blue. The price of risk especially in credit markets had fallen to
unsustainable levels by summer 2007 and many banks and other institutions had become
reliant on sustained liquidity in new markets which had never had been tested by a downturn.
In the July 2006 FSR, for example the Bank warned of "UK banks' increasing dependence on
wholesale funding" and, in April 2007, we noted that: "if UK banks were unable to securitise
existing assets, new lending would need to be financed through other wholesale sources,
which may be difficult or costly to access during times of stress." So it proved.
But the Bank was not alone in pointing to the vulnerabilities in the financial system in 2006
and 2007. Other commentators and authorities gave similar warnings. And many market
participants were also expecting a correction at some point; but they generally felt they were
well placed to handle it. In fact the severity and breadth of the downswing has surprised
markets, commentators, and policymakers alike.
In the light of subsequent developments, a number of commentators have concluded that the
problem was simply a lack of attention and short memories. I don't think it was quite as
simple as that. I am with Mark Twain who said "History doesn't repeat itself, but it does
rhyme." While the current crisis has some similarities to previous downswings - in the early
90s or of the 70s for example - there are some significant differences too.
For example the last three recessions in the UK (in the 70s, 80s and early 90s) were
preceded by sharp rises in consumption and activity and earnings to well above sustainable
rates. As Chart 2 shows that was not true of the last few years when consumption, output
and earnings all seemed unusually stable.
Again in previous recessions, stress in the banking sector has tended to follow on from
defaults and losses on domestic loans as interest rates rise and the economy slows down.
But this time the downturn started in the banking sector - last summer when losses in the US
property market not only led to losses in UK banks trading and treasury books but closed
important sources of finance to them. The downturn in the housing market and then the wider
economy followed. Domestic default rates, while beginning to rise, are still low by historical
standards, despite the fact that we are more than a year into the crisis.
Those differences reflect the most important distinguishing feature of this downturn, namely
its roots in global imbalances not just in trade but in the financial system.
The growth and savings in emerging economies led to an extraordinary flow of funds back to
the developed world and to the US in particular. That in turn kept interest rates low, allowing
the rapid growth of credit and fuelling a sharp rise in asset prices and an increasingly risky
search for yield - for example in sub prime housing in the US.
The impact in the UK was different but no less marked. Here too the low cost of credit fuelled
a spectacular expansion of bank balance sheets (Chart 3) and with it a growth in leverage
(Chart 4). And, as Chart 5 shows, while savings rates fell in the UK, limiting the growth of
retail deposits, banks financed that lending by tapping wholesale markets. The gap between
customer lending and deposits moved from zero at the turn of the century to over £700 billion
in 2008 H1.
Much of that funding was ultimately sourced overseas. In particular, the United States acted
as an intermediary, attracting capital inflows from the rest of the world and exporting these
funds to other countries. Road shows to investors in the US and Europe ceased to be the
preserve of the international giants and became common among smaller players whose
whole asset base was in the UK.
As the difficulties in the financial system have persisted and worsened, it has become clear
that these developments have created real structural weaknesses in the banking sector. In
particular:
•
inflated aggregate balance sheets, whose expansion had outpaced growth in the
real economy;
•
expansion into assets whose underlying value, credit quality and liquidity were
uncertain;
• liability structures which were overly reliant on sustained availability of wholesale
funding whose maturity was often short;
• capital and liquidity buffers which became too low , given these asset and liability
risks; and
• underappreciated, but potent interconnections between firms in the global financial
system.
Policy response
For most of the last year, the Bank has adopted a twin track approach, as part of the
Tripartite partnership with the FSA and the Treasury. The first track has been to provide
liquidity to the market in order to give most banks time to make the necessary adjustments -
including by raising capital. That has involved an increasing range of measures including
long term repos on a wide range of collateral and the introduction of the Special Liquidity
Scheme which allows banks to swap illiquid assets for Treasury Bills for periods of up to
three years. The recent dollar swaps and further extensions of the SLS and eligible collateral
are further steps in that direction. And we recently announced a more permanent structure of
money market operations including the introduction of a discount window.
The second track has been to work closely with the FSA and Treasury to limit the
repercussions from the failure of banks which do not have an independent future whether
through arranging mergers or managing closure. Northern Rock was the first in line and led
to a lot of criticism of the tripartite. I think we have learned a great deal over the year and
have shown more skill and speed with subsequent cases including Bradford and Bingley
recently.
But in the last 6 weeks it became clear that this case by case approach was not enough
either at home or internationally. Despite the provision of additional liquidity to the system,
market conditions got worse over the summer as worries grew about the downturn in the
broader economy and its consequences for bank losses.
Once again the triggers for a further downward lurch came in the US. First Fannie Mae and
Freddie Mac were taken into conservatorship and then, the following weekend, Lehman
Brothers proved unable to find a buyer and filed for bankruptcy. That shook markets which
had expected it to be saved by the State, if necessary, as had been the case with Bear
Stearns earlier in the year.
Within a day, AIG had to be rescued following rumours about the size of its losses on CDS
contracts and pressures grew on the remaining securities dealers. Later in the week,
Secretary Paulson announced his initial $700 billion plan to purchase assets to support the
banking sector. It didn't entirely still the doubts.
The pressures were also felt in Europe. At the end of September Dexia, Fortis and Hypo
Real Estate all had to receive emergency capital injections, mostly government supplied. In
the UK the authorities facilitated a rapid consolidation in the mortgage sector with Abbey
Santander buying Alliance and Leicester, some mergers in the building society sector, and
the proposed merger of LTSB and HBOS. Finally, in late September the Tripartite authorities
intervened to resolve growing difficulties in Bradford and Bingley by transferring the deposits
and branch network to Abbey Santander and taking the remaining assets and liabilities into
public ownership for orderly wind down.
But the loss of confidence went wider than a subset of vulnerable banks. Our report
estimates the total US and European marked to market losses on credit assets at nearly $2.8
trillion. While these will not all fall on banks and may exaggerate the losses to those who can
hold debt to maturity, investors and counterparties became worried about the extent of the
likely losses on banking and trading books in a wider range of institutions and in their ability
to continue to finance their businesses. The focus of their concerns shifted from future
profitability to future survival. CDS premia rose to unprecedented levels (Chart 6), bank
equity prices fell sharply and the money markets seized up. Interbank lending spreads
widened dramatically (Chart 7) and lending became almost entirely concentrated in the
overnight market. The shortening of interbank maturities generated a dangerous "snowball"
effect as maturing term funding had to be rolled overnight.
It was to tackle that wider loss of confidence that the UK authorities announced on 8th of
October its comprehensive package of support for recapitalisation, guaranteed funding and
enhanced liquidity. It was designed to remove solvency fears by ensuring that banks had
more than sufficient capital to survive a severe economic downturn and thus to enable them
to continue to lend on normal criteria to good credits.
The new capital and the government guaranteed borrowing and liquidity support was
designed to ensure and be seen to ensure that banks would be able to sustain their
businesses through a downturn. With the banking system fully solvent, guarantees could be
extended without exposing taxpayer to unacceptable risks. In a remarkable show of
international consensus, a similar approach was quickly adopted by many other countries
both in the US and EU and more widely.
Looking ahead
The early signs suggest that the package is underpinning the banking system both directly
and as a demonstration of the authorities' determination to do whatever is needed to
reestablish confidence. In particular CDS premia for banks have fallen markedly (Chart 6)
since the package was announced. And progress on guarantees, while gradual, has also
been encouraging, with a number of banks issuing bonds even without the use of the
guarantee. Libor spreads have also edged down and are now expected to fall a bit further
and faster than before the package (Chart 8). Many banks continue to face a period of
deleveraging and rebalancing to reduce their dependence on Central Bank finance and on
short term wholesale funding. However a stronger capital and financing position will make it
possible for them to do that over a period of some years, which will diminish the squeeze on
lending in the short run.
More widely, of course, the financial system remains under acute strain. The falls in equity
markets, corporate bond prices and the prices for leveraged loans is hitting both long term
institutional investors and leveraged investors, including hedge funds. Some are being forced
to sell into a falling market in response to margin calls and redemptions.
And there are growing signs of stress in many emerging market economies. We have
already seen a banking sector and currency crisis in Iceland and in the past few days the
IMF has also announced loan packages for the Ukraine and Hungary.
In short, the package of measures introduced in the UK and elsewhere has improved the
prospects significantly, especially for banks but it is too soon to declare the crisis over.
Authorities worldwide need to remain vigilant and to be ready to step in again if necessary.
The medium term agenda
We all have lessons to learn from the turmoil of the last fifteen months. I would like to pick
out three in particular, two of which are international and one UK specific:
•
the need to develop new "macro prudential" policies to bridge the gap between
monetary policy and the regulation of particular institutions and markets;
•
the need to establish a more effective regime in the UK for handling failing banks;
and
•
the need to improve the handling of cross border crises and bank failures.
Central Banks have always paid close attention to asset prices and credit growth in deciding
monetary policy but they are setting interest rates for the whole economy and there is no
guarantee that the rate or the rapid changes in rates that could be needed to dampen asset
price growth will be appropriate more widely.
On the other side, regulation and supervision are focused on the resilience and conduct of
individual institutions: their management, risks controls, capital and liquidity and so on. What
we have found in the last few years is that the sum of what makes sense at the level of
individual institutions does not necessarily add up to what is needed for the system as a
whole.
We need to develop what are called "macro prudential" policies to bridge that gap. In
particular we need to establish stronger restraints on the build up of risks in the financial
system over the cycle with the dangers they bring to the wider economy. That means not just
increasing capital and liquidity requirements for individual institutions but relating them to the
cyclical pressures in the system more broadly.
One way of doing that has been developed in Spain. It is called "dynamic provisioning". Chart
9 illustrates how it works. It requires banks to build up a general loss reserve during good
times, based on past experience of likely losses on new lending. The effect is to build up
reserves when loans are originated which can then be drawn down when the economy
begins to deteriorate and actual losses are incurred. That would lessen the need to raise
capital in downturns. And as draw downs on these general provisions would be automatic,
the market should not view this as negatively as reductions in regulatory capital ratios.
The second lesson comes directly from our experience with Northern Rock where even after
the bank had become totally dependent on the State, there was no legal framework for
resolving its future quickly and effectively. No regulatory regime can prevent all bank failures.
So it is important, for financial stability, that any such failures are orderly. That is the role of
the Special Resolution Regime, a key component of the Banking Bill.
The SRR gives four tools to the three Tripartite Authorities to cope with failing institutions:
•
First, the transfer of all or part of a bank's business to a private sector purchaser;
something we have already seen used in the resolution of Bradford and Bingley and
Kaupthing under the Special Provisions Act.
•
Second, the transfer of the viable part of a bank's business to a temporary bridge
bank owned by the Bank of England. This would allow continuity of banking services
for its customers whilst enabling due diligence by potential private sector purchasers
and providing for the orderly wind down of the rump.
• Third, temporary public ownership which would give the treasury the power to transfer
the shares of a failing bank to a nominee of the Treasury. This power would be used
in cases where significant amounts of public sector funds are required to stabilise the
failing bank or where long term restructuring of the bank is necessary.
•
Fourth bank insolvency procedures - a last resort. This would look much like a
standard company insolvency but with the important difference that the liquidator's
primary objective would be to assist the FSCS in protecting depositors.
I can understand why there has been some nervousness among banks and investors about
this regime and particularly about the powers to split failing banks into "good" and "bad"
parts. But equally I think they can see that when a bank is failing it is in everyone's interests
to resolve the situation quickly and cleanly. I hope that they will be reassured by the
extensive safeguards we are now proposing, including the guarantee that no creditor will be
made worse off in such a split than they would have been in a conventional insolvency and
protection of netting and set-off.
Finally, the financial turmoil has also revealed the need for better international crisis
management. The experience of Lehmans has shown once again the problems that arise in
the insolvency of a large international bank with operations in many countries. We also saw
in late September and early October the danger emerging, of the banking equivalent of the
old beggar thy neighbour policy on currency depreciation, as individual countries began to
guarantee their own banks' debt. On the other side, recent events have also demonstrated
how effective international action can be: the coordinated interest rate cuts on the 8th of
October; the provision of dollar liquidity by central banks and the adoption of national
measures to support banks at international meetings during the weekend of 11/12 October.
International groups such as the Financial Stability Forum (FSF) have already started to take
action. It has begun to develop a practical checklist of issues and principles that should guide
the management of a distressed cross-border institution.
Having started with Mark Twain I want to finish with another quote this time from Santayana:
"A man's memory may ...become the art of continually varying and
misrepresenting his past, according to his interests in the present."1
One lesson from recent events is the need for rigour, balance and transparency in policy
making and risk assessment. I hope that the Bank can play a part in that in future as it has in
the past.
Chart 1: Financial market liquidity Chart 2: Household consumption growth: what
happened to the boom?
Percentage changes on a year earlier
Liquidity index
1.0
10
1973 Q3 8
0.5
1980 Q1
+
6
1990 Q3
0.0
2008 Q3
4
0.5
-
2
1.0
0
-2
1.5
-4
2.0
-6
2.5
-16 -12 -8 -4 0 4 8 12 16
92 94 96 98 00 02 04 06 08 Quarters
Sources: Bank of England. Bloomberg, Chicago Board Options
Exchange, Debt Management Office, London Stock Exchange, Merrill
Lynch, Thomson Datastream and Bank calculations
Chart 3: Bank lending to households and Chart 4: Major UK banks' leverage ratio
nonfinancial companies in the UK
Percentage Percentage of of GDP GDP
100 100
90 90
80 80
Households Households
70 70
60 60
50 50
40 40
30 30
20 20
10 10
Non-financial Non-financial companies companies
0 0
70 70 74 74 78 78 82 82 86 86 90 90 94 94 98 98 02 02 06 06
Sources: Sources: Bank Bank of of England, England, Thomson Thomson Datastream Datastream and and Bank Bank
calculations. calculations.
Sources: Published accounts and Bank calculations
Chart 5: Major UK banks' customer funding Chart 6: Major UK banks' and LCFIs' credit
gap, household saving ratio and foreign default swap premia
interbank deposits
Major UK banks Basis points
700
US commercial banks (c)
650
US securities houses
600
550
European LCFIs
500
450
400
350
300
250
200
150
100
50
0
Jul. Sep. Nov. Jan. Mar. May. Jul. Sep.
2007 08
Sources: Markit Group Limited , Thomson Datastream, published
Sources: Bank of England, Dealogic, ONS, published accounts
accounts and Bank calculations.
and Bank calculations.
Chart 7: Three-month interbank rates relative Chart 8: Three-month UK interbank rate relative
to expected policy rates to expected policy rates
Basis points
250
Basis points
Sterling US dollar Euro
400
200
350
300 150
(d)(e)
250
Forward spread on
(c)
100
200 7 October 2008(c)
150
Forward spread on
50
100
20 October 2008(c)
50
0
0
Jul. Sep. Nov. Jan. Mar. May. Jul.
Jan. Apr. Jul. Oct. Jan. Apr. Jul. Oct.
09
2008
Sources: Bloomberg and Bank calculations.
08
2007
Sources: Bloomberg and Bank calculations
Chart 9: Dynamic provisioning
Specific provisions as a percentage of total loans
General provisions as a percentage of total loans
Per cent of total loans
Total provisions as a percentage of total loans
Upswing Downturn
0
Time
Table 1: Key actions to improve resilience
• Macroprudential tools are needed to guard against systemic risk
• Capital levels need to rise and need to be of sufficient quality
• Liquidity standards should be strengthened
• Strengthen the legal framework for depositor protection and bank
resolution
• Better management of cross-border financial institutions
• More disclosure, including potential future balance sheet volatility
• Developing centralised infrastructures for over-the-counter
instruments