Mark Carney: The future of financial reform
Speech by Mr Mark Carney, Governor of the Bank of England and Chairman of the Financial
Stability Board, at the 2014 Monetary Authority of Singapore Lecture, Singapore,
17 November 2014.
* * *
Accompanying tables and charts can be found at the end of the speech.
Introduction
It is now more than seven years since the first tremors of the earthquake that was to rock the
financial system in 2008.
After the blood of the crisis, years of sweat and toil from authorities across the globe, and not
a few tears from the financial sector, the job of agreeing measures to fix the fault lines on
which the financial system had been built is now substantially completed.
The financial system today is vastly different from its pre-crisis self. That change didn't "just
happen": it is the intended, positive result of the G20/FSB reform agenda.
The Brisbane G20 Leaders' summit just completed was a landmark. The prudential
requirements and supervisory framework for banks are largely settled. There will be
adjustments, if necessary, but from a prudential perspective, banks now know what they
need to do. It is now a question of implementation.
The result of the agreed reforms will be that:
The system is safer. Banks were woefully undercapitalised - many of the largest banks were
levered 40 to 50 times. They are now much more resilient. As banking systems around the
globe implement fully the new framework, a system that was built precariously on sand will
stand more firmly on rock.
The system is simpler. Before the crisis, risks were hidden and financing chains were
fiendishly complex. Banks were complacent, building business models on the belief that "this
time is different" and assuming markets would be continuous and deep.
They were enthralled by models to the extent that every bank that failed or was rescued by
the state reported on the eve of their collapse that it substantially exceeded the Basel
riskweighted capital requirements. Now, disclosure standards have been significantly improved,
contingent exposures are on the balance sheet, essential wholesale markets are more
reliable, and capital standards are more robust.
The system is fairer. Banks were in receipt of large public subsidies. In Brisbane we reached
a watershed in ending too big to fail, with agreements to take forward proposals on total loss
absorbing capacity for globally systemic banks. Globally systemic banks that fail will in future
be resolved without recourse to the taxpayer and without jeopardising financial stability.
Does that mean the job of financial reform is complete?
No. Implementation must follow agreement. Our perspective cannot be only to look back.
Just avoiding the repeat of past failures is not a recipe for success. Agreeing to measures to
fix the fault lines is necessary and important, but not sufficient.
We must now consolidate our progress to build a financial system that can deliver strong,
sustainable and balanced growth for all economies: large or small; advanced or emerging;
home to large financial institutions or host to them.
Success would be a global financial system that maximises its full potential to ensure that:
The payments infrastructure is efficient and reliable;
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Companies can access the working capital they need to operate;
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Liquid savings are transformed into long-term loans;
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Core markets function continuously to allow risks to be diversified and managed;
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and
Capital is allocated efficiently across the globe.
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Achieving these ends requires a financial system supported by three pillars: diversity, trust
and openness. Building these pillars should be the focus of the future reform agenda.
A diverse system, with market-based as well as bank-based finance, can best support a
wide variety of investment from infrastructure to SMEs that is necessary to create the jobs
our citizens deserve.
A trusted system can retain its social licence to support the real economy in innovative and
efficient ways.
An open system can avoid the risk of Balkanised finance, which would reduce the efficiency
with which savings are matched to investment and lead to a global misallocation of scarce
capital.
This is a daunting agenda and some might feel that, having apparently reached the finish
line, the race has been extended. Indeed there will be inevitable calls by some vested
interests to turn back.
To give in, to drop out, would be a tragedy.
The prize for running the longer race is great. By fixing the fault lines that caused the last
crisis we have created strong foundations for a truly global financial system that can benefit
us all. Now we must have the courage to seize that opportunity and build on those
foundations.
Today I will refresh the case for financial reform and set out what I believe should be the
drivers of the future reform agenda. But before turning to that next stage, allow me to take
stock of the immense amount that has been accomplished since the crisis.1
Completing the job of fixing the fault lines
A safer financial system
Banks are now much more resilient. They have more capital, more liquidity and are less
susceptible to procyclical spirals.
Capital requirements for banks are much higher, as are risk weights and the quality of bank
capital. In all, new capital requirements are at least seven times the pre-crisis standards for
most banks. For globally systemic banks, they are more than ten times.2 Large internationally
active banks are on course to meet the new requirements 4 years ahead of the 2019
deadline. Despite the scale of the changes, the aggregate shortfall of those banks that still
have shortfalls was €15bn at end 2013, having been €115bn two years ago.
It is just as clear that banks' liquidity positions before the crisis were precarious.
Now, for the first time, global standards have been agreed to place requirements on the
liquid asset buffers banks must hold and on the extent of maturity transformation in which
they can engage.
The rapid contagion during the crisis showed how the system magnified shocks. Two
particular fault lines made the system procyclical.
First, banks were heavily exposed to movements in market prices and volatility around them,
creating a cycle in which falls in prices caused banks to retrench and reduce their positions,
leading to further falls in asset prices.
That issue has been addressed through strengthening regulatory requirements on trading
books - a move that has contributed to the share of banks' assets accounted for by trading
assets almost halving.3
Second, banks and shadow banks were entwined in a dangerous funding spiral. Incredibly
low initial margins on repo transactions facilitated the build-up of excessive leverage and
maturity mismatches in shadow banks. The first wave of losses led banks to tighten margin
requirements, effectively reducing financing available to the non-bank financial system,
causing those institutions to deleverage through asset sales, driving a death spiral of falling
asset prices and rising margin requirements.
Such dynamics have now been mitigated through agreed minimum haircuts for securities
financing transactions and the net stable funding ratio for banks.
A simpler financial system
As the crisis highlighted, opacity hides frailty. Why was subprime not contained? How did
$200bn in credit losses ultimately cause well over $1trn in market losses?
Because complexity obscured the link between ultimate creditor and debtor, it allowed false
assumptions to develop that, when disabused, prompted panic. The mortgage originated by
a bank was repackaged by a SIV, that financed it through ABCP, that was bought by a MMF,
into which a retail investor placed their savings. It occurred to no one in the chain that the
absence of a monitor would influence credit performance.
The whole model was based on continual rollover. When subprime losses exposed the
misalignment of incentives between loan originators and investors in asset-based securities,
the whole system collapsed, imploding core funding markets for banks.
Risks that had ostensibly been moved outside the banking system or diversified away were
in fact just hiding and, when crisis struck, they came crashing back onto the balance sheets
at the core of the system.
This complexity is being addressed.
To protect against risks that banks think are low but are in fact not, a global definition of a
simple leverage ratio has been agreed. In the UK, the Bank of England has just
recommended powers to set a simple leverage ratio for domestically-regulated banks,
building societies and investment firms. This will enhance the resilience of banks against
risks that are hard to model.4 And it will ensure off-balance sheet exposures are properly
capitalised.
Retention and capital requirements for securitisations now have more closely aligned
incentives between originators and investors. New requirements for money market funds
have closed the gap between retail investors' perceptions and their exposures. International
standards are agreed to capture properly and limit off-balance sheet exposures. And the
Basel Committee is developing the capital framework to ensure implicit offers of contingent
support by banks, for example to their SIVs, will be properly capitalised.
Interconnections created by derivatives are being reduced and made transparent.
Requirements are being imposed, and incentives created, for banks to centrally clear
derivative trades, helping to replace the complex web of bilateral deals with a central model.
Trade reporting and margining requirements are being strengthened.
More broadly, overall disclosure has been enhanced on the key risks arising from business
models, sources of funding, market risk measures and loan forbearance policies.5
Through such initiatives, complexity and obscurity are being replaced by simplicity and
transparency.
A fairer financial system
That goes some way towards increasing the effectiveness of market discipline. But that
discipline will never be felt fully if markets believe that creditors and shareholders will be
bailed out in a crisis because banks are too big to fail.
Expectation of bail out was validated comprehensively last time. The US authorities sought to
make Lehman Brothers a test case of moral hazard. Instead, this exception proved the rule.
AIG was rescued within twenty four hours. As Barney Frank observed, the free market lasted
for a day.
This "heads-I-win-tails-you-lose" environment for the world's largest banks struck right at the
heart of the sense of fairness in our societies.
It simply had to be fixed.
Tackling the rampant moral hazard at the core of the system has not been easy but, at the
Brisbane Summit, G20 Leaders marked a watershed in our efforts.
Many jurisdictions have in place statutory regimes to allow the resolution of failing banks. But
until now, the potential use of those regimes on systemic and cross-border institutions has
been in doubt.
G20 Leaders endorsed two proposals that will allow global systemically-important banks to
be resolved when they fail, without the need for taxpayer support and without disruption to
the wider financial system or real economy.
The first is an agreement, catalysed by the FSB, between ISDA and an initial group of
18 global derivatives dealers.
This new Protocol prevents derivative contracts being terminated disruptively in the event of
a bank entering resolution.
It is a crucial step to closing off the risk that foreign counterparties take their money and run.
Most jurisdictions already have legislation that achieves this nationally, but for global banks
national solutions aren't sufficient. This new agreement fills the gap by extending the
approach across borders. Together with existing legislation that applies stays domestically,
the ISDA agreement means that over 90% of the dealer banks' OTC bilateral trading activity
will be covered by either contractual or statutory stays.
The second initiative is yet more significant.
It is a proposal for a common international standard on the total loss absorbing capacity that
globally systemic banks must have.6
It will ensure that shareholders and creditors who benefit in the normal course of business
also absorb losses when banks fail.
It will establish a level playing field between global systemic banks, while taking into account
differences in national resolution regimes.
It will set clear roles for home and host regulators in a resolution. And it will give host nations
the confidence that they won't again be side-swiped by the failure of a large foreign bank.
It will ensure globally systemic banks finally have the quantum of total loss absorbing
capacity that minimises the costs of an unsafe banking system. And, by removing the implicit
subsidy that systemic banks have long enjoyed, it will re-establish market discipline.
This proposal will of course be subject to public consultation and comprehensive impact
assessments.
Markets and rating agencies are already adjusting to the determination of authorities to end
too big to fail. Credit ratings for globally systemic banks have been downgraded to reflect the
much lower probability of state support.
Market prices suggest the implied subsidy has been substantially reduced as the expectation
of public bail-outs dies away.7 However, we have more to do in order to make cross-border
resolution the only expected outcome in the event an institution fails.
The TLAC standards must be finalised next year and then implemented fully. Resolution
plans for individual firms must be finalised and legal and operational impediments removed.
Arrangements for the funding of firms in resolution must be put in place. Legislation must be
enacted to allow regulators to give effect to the resolution actions of authorities in other
jurisdictions.
And the solution of the too big to fail problem in banks must be broadened to include all
systemic institutions, including insurers and critical financial market infrastructures, through
designation, more intensive supervision and standards for loss absorbing capacity.
We recognise that our success can never be absolute. Specifically, we can't expect to
insulate fully all institutions from all external shocks, however large. But we can change the
system so that systemically important institutions, their shareholders and their creditors bear
the cost of their own actions and the risks they take.
The future of reform
With a safer, simpler and fairer system in place, the FSB can begin to look ahead to how,
collectively, we will engage in the next phase of reform and regulate and supervise the global
system.
The foundations are laid. The next stage of reform should build a system that serves
households and businesses to its full potential. Such a system must be supported by pillars
of diversity, trust and openness.
Diverse
Although banking remains the most important business by some margin, the increase in the
relative price of bank-based intermediation has encouraged a shift towards market-based
intermediation. Virtually all net credit growth since the crisis has been in bond rather than
bank finance.8
Non-bank financial sector assets have grown by 130% over the past decade and are now
equivalent to 120% of global GDP.9 Managed properly, that represents a welcome increase
in diversity within the global financial system. If banking again comes under stress, these
markets could act as a safety valve.
For there to be diversity under adversity, the connection between banks and markets must
be appropriately sized and durable. I noted how pre-crisis links meant that the collapse of
subprime spilled over into the core of the system. The post-crisis connection must be wired
differently, but not severed completely.
Banks are needed to overcome the information asymmetries that prevent direct market
access for smaller borrowers. But with the right standards an appropriate boundary between
banking and securitisation can be drawn and financing capacity increased. With
securitisation markets effectively closed, even in Europe where loss rates on
consumerrelated securitisations were one twentieth of those in the US, smaller borrowers are not being
served by market-based finance.10
In response, the Bank of England and ECB are working to promote a sustainable model of
securitisation that is Simple, Transparent and Comparable.11 In other words, one that allows
banks to originate and distribute assets for which credit assessment can be most readily
performed in the market. Simple, transparent and comparable securitisations will support
improved calibration of risk weights and retention requirements for banks and prudential
standards for insurers that Ravi Menon has advocated.12
Greater reliance on market-based finance will need to be matched with measures to ensure
its resilience. The international community will need to shift focus to new risks and
vulnerabilities, many of which will emerge outside the banking system. As Deputy Prime
Minister Tharman Shanmugaratnam has noted, the safety of finance will depend "on whether
we stay intensely alert to the risks of the future, including especially the risks we do not yet
see or know, rather than focus only on preventing the last crisis from recurring."13
The FSB has set up a broad-based network for information-sharing and reporting on the
scale of shadow banking activity. This work is far from academic because, although you
wouldn't necessarily know from a reading of financial market indicators, these are riskier
times. There is a disconnect between developments in real economies and the degree of
financial risk taking.
It is particularly notable how the search for yield has compressed liquidity premia across
markets. This is unlikely to be sustainable over the medium term because it exists against a
backdrop of much-reduced market-making activity.14 Fundamentally, liquidity has become
more scarce in secondary fixed income markets. It just appears that it hasn't.
The reasons for the changes are clear however. New prudential requirements have reduced
incentives for banks to warehouse risk positions. Dealer inventories in fixed income have
declined by 70% since the pre-crisis period, while the stock of fixed income assets
outstanding has doubled. And the Value-at-Risk in banks' trading books has retreated to
2002 levels. The time to liquidate a given position is now seven times as long as in 2008,
reflecting much smaller trade sizes in fixed income markets.
In part the current liquidity illusion is a product of the risk asymmetries implied by the zero
lower bound on interest rates, excess reserves in the system, and perceived central bank
reaction functions. However, interest rates in advanced economies won't remain this low
forever. Once the process of normalisation begins or perhaps if market perceptions shift and
it is expected to begin, a re-pricing can be expected.
The orderliness of that transition is an open question.
Certainly, conventional leverage and liquidity cycles - while dampened by reforms - can be
expected to operate. High volatility, combined with lower prices, will tighten financing
conditions, forcing some asset sales, dampening prices and increasing volatility further. An
overshoot is possible.
Some have argued there is an additional risk arising from pricing and asset allocations based
on an illusion of liquidity. This could lead to "redemption risk" as detailed by Hyun Shin and
others.15
Their argument begins with the observation that much of the shift towards market-based
finance has been accompanied by an increase in assets under management.
We know that almost half of the $70 trillion in managed assets globally are in funds that offer
their investors redemption at short notice.16 At the same time, funds are investing
increasingly in higher-yielding, less liquid assets. One example of this has been the
exponential growth in "liquid alternatives", giving retail mutual fund investors access to hedge
fund-like strategies.17
The compression of liquidity risk premia suggests that investors are assuming any future
withdrawals from funds will be conducted in an environment of continuous market liquidity
and that the value of their fund holdings will not fall substantially when they exit.
The risks to that assumption are in only one direction.
The dynamic that fund under-performance tends to be punished with outflows creates the
possibility of the sorts of spirals that were previously associated with leveraged investors.
That potential procyclicality is reinforced by the selling of volatility-linked products by funds
seeking to boost income through insuring tail risks.
Although they were short-lived, the bouts of market turmoil in the past year have illustrated
how there can be sudden and sharp outflows, particularly from high-yield and emerging
market funds, resulting in illiquidity in the markets for those instruments.18
The macroprudential risk is that any revelation that continuous liquidity is illusory could
generate potentially sharp changes in asset allocation. With net credit creation being largely
reliant on bond finance, such a reallocation could generate a sharp deterioration in credit
conditions for corporates and the risk may be particularly pronounced for cross-border flows
to emerging markets.
But what, beyond talking about it, can be done about this risk?
Managing the risks in markets will require global co-ordination. The FSB provides the
platform for authorities to monitor, analyse and address risks in a timely way. It brings all the
relevant bodies together to develop this substantial body of work. Anticipating and managing
market risk channels will be core to the future financial reform agenda.
This point is relevant to work, currently underway, to develop a framework for identifying
globally systemic non-bank non-insurer financial institutions.
The fund management industry has become more concentrated, with the top 10 firms now
accounting for almost one fifth of assets under management. However, size will not
necessarily be the best indicator of systemic importance. It seems plausible that large
unlevered funds with little maturity mismatch could pose few systemic risks. At the same
time, smaller funds could be systemic if clusters of them conduct similar activities that do
pose risks. Those activities include concentrated investments in illiquid assets, the potential
for large short-term redemptions, and leverage, whether financial or embedded.
As such, there may be merit in this activity-based systemic risk assessment over and above
a purelyfirm-focussed approach to systemic designation.
Of course, identifying systemic firms is just the first step in managing risks to global stability.
To manage those risks, authorities can do more to work with market intermediaries to
enhance transparency and understanding around secondary market liquidity.
Securities market regulators may have an important role to play in developing
globallyconsistent best practices in liquidity risk management and valuations. Liquidity buffers and
redemption schemes should be assessed. And greater standardisation of debt securities will
also need to be supported.
The need to ensure resilience in the non-bank financial sector also raises questions about
the nature of central bank operations. The maintenance of an effective monetary
transmission mechanism now requires backstops for both banks and markets. Bagehot will
need to be updated for the 21st century, with central banks standing ready to operate
frequently, against a wide range of collateral and a broader range of counterparties.
In short, diversity will reap rewards, but resilient diversity will require a significant programme
of reform and alertness to new risks.
Trusted
The second pillar of the future of reform is to rebuild trust in finance.
Trust between institutions, counterparties and investors is central to maintaining the ability of
finance to function.
Trust between regulators across jurisdictions is needed to maintain an open global system.
And most fundamentally, trust between the public and the financial system is needed to
maintain the social licence for finance to operate.
It has been severely tested by: taxpayer bail-outs of systemic institutions; rewards perceived
as undeserved; a perception that clients have become counterparties; and egregious
examples of misconduct and rigging of markets.
Without that licence, the door will be opened to a level of regulation that constrains the ability
of finance to innovate and support growth and trade efficiently. The licence will require
consistent exemplary behaviour, and finance to have a clear sense of its purpose not as an
end in itself, but as a means to promote investment, innovation, growth and prosperity.
It is not merely that we should want to follow Churchill's wish to see "finance less proud and
industry more content".
We want to see industry content and finance taking justifiable pride in its contribution to
society.
That is far from straightforward when, even six years on from the crisis and public bailouts,
triggers for public opprobrium are plentiful. Last week, the UK's Financial Conduct Authority,
US CFTC and Swiss FINMA fined six banks $3.3bn for misconduct in FX markets:
misconduct that went on long after banks had already been fined for abusing interbank
interest rate benchmarks.
The repeated nature of these fines demonstrates that financial penalties alone are not
sufficient to address the issues raised. Fundamental change is needed to institutional culture,
to compensation arrangements and to markets.19
As Bill Dudley and my colleague Minouche Shafik have argued, the succession of scandals
mean it is simply untenable now to argue that the problem is one of a few bad apples. The
issue is with the barrels in which they are stored.20
Leaders and senior managers must be personally responsible for setting the cultural norms
of their institutions. But in some parts of the financial sector the link between seniority and
accountability had become blurred and, in some cases, severed.
The public were rightly angered that so many of the leaders and senior managers who were
responsible for sowing the seeds of the crisis and for allowing cultures to develop in which
gross misconduct took place have walked away from their actions or inactions.
In the UK, Parliament has established a stronger regulatory framework to allocate
responsibilities to individual executives and board members and to give regulators the tools
to hold them to account. The excuse of having delegated a responsibility simply will not
wash.
The public bail outs and the fact that few of the consequences of scandal have been borne
by those who were directly responsible revealed a great deal about the balance of risk and
rewards for those who worked in in financial services.
Compensation schemes overvalued the present and heavily discounted the future,
encouraging imprudent risk taking and short-termism.
To align better incentives with the long-term interests of the firm - and, more broadly, society
- major changes have been made. At the request of G20 Leaders, the FSB has developed
principles and standards for sound compensation practices.
In the UK, we have introduced a remuneration code prescribing that payment of bonuses
must be deferred for a minimum of three years and, after payment, be exposed to clawback
for up to seven years. Bonuses can be reduced - or clawed back - if evidence emerges of
employee misconduct or failures of risk management.
We are consulting on extending deferral periods, widening the scope for groups of
employees to have their bonuses reduced where there are more pervasive issues of
performance or risk management, and considering options to prevent individuals
sidestepping these rules.
In an international labour market there is a particular role for international standards and
coordination to ensure a level playing field. It is unfortunate, for example, that new European
rules to cap bonuses to half (or with shareholder approval, two-thirds) of total pay have the
undesirable side effect of limiting the scope for remuneration to be cut back. This makes the
case for additional reforms to ensure that the burden of excessive risk-taking and misconduct
by staff can still be borne by those staff.
Standards may need to be developed to put non-bonus or fixed pay at risk. That could
potentially be achieved through payment in instruments other than cash. Bill Dudley's recent
proposal for certain staff to be paid partly in "performance bonds" is worthy of investigation
as a potentially elegant solution.21
Senior manager accountability and new compensation structures will help to rebuild trust in
financial institutions. In a diverse financial system, trust must also be rebuilt in markets.
That is why in the UK in June, Chancellor George Osborne and I launched the Fair and
Effective Markets Review.22 Far from seeking to constrain markets, the Review is seeking to
restore true and competitive markets with open access to all and competitive prices.
Behaviours that aim to undercut market mechanisms, such as collusion, the misuse of
confidential information, or the manipulation of market prices and benchmarks, must be
stamped out.
The Review has already recommended that further market benchmarks be brought within the
scope of UK regulation, alongside a criminal charge for manipulation of such benchmarks. In
that respect it complements the FSB work to reform and strengthen benchmarks
internationally.23
The Review is now consulting widely before reporting next June. It is asking questions about
deficiencies in two major areas: market structure and conduct. The Review is examining
where structures exist that encourage excessive concentration, raise potential conflicts of
interest or expose benchmarks to the potential for manipulation. And it is considering where
voluntary codes of conduct seem inadequate, poorly understood or simply provide individuals
with justification to judge their actions by the exact letter of the code rather than by more
generally accepted norms.
The Review will explore ways to improve market transparency, competition and trading
infrastructure. Principles of fair markets, codes of conduct for specific markets, and even
regulatory obligations can all help. There must be clear consequences - including
professional ostracism - for failing to behave properly.
In global markets, these are not things that any country can achieve on its own. Global
solutions are needed. That is where the FSB, working with IOSCO and others, can play a
role in delivering fair and effective markets on the global stage by forging international
agreement on common standards and structures and co-operation between authorities.
International firms must play their part too.
Only with such global action can we begin to move on decisively from the scandals of recent
years to slowly rebuild slowly the trust of society in finance.
We must build trust in other ways too, including the trust of financial markets in the safety
and soundness of the firms operating in those same markets. Banks' internal models proved
woefully inadequate in the crisis, and there remain worryingly large differences in banks'
RWA calculations that cannot be adequately explained. That is why the plan the Basel
Committee announced earlier this month to address these differences and to balance the
risk-sensitivity and complexity of capital calculations is so important. Of course, the leverage
ratio will play an important as a simple backstop against overreliance on models and past
statistical relationships.
Open
Trust is also needed in a wider context: trust between countries in their supervisory and
regulatory frameworks so as to support an open and stable financial system.
To achieve its full potential, the financial system must remain global. Fragmentation will
reduce the efficiency with which savings are allocated to investments, and potentially lead to
misallocation of capital on a global scale. All economies would be harmed by this, whether
advanced, emerging or developing.
This is a real risk. Since the crisis, measures of capital market integration have declined
notably.24 A clear home bias remains in investment. The crisis was a vivid reminder that
openness must be built on the foundation of stability and trust in the foundations of the global
financial system.
For an open system, trust between authorities is therefore fundamental.
Although markets and many financial institutions are global, regulation remains national or
regional and concerns about spillovers from failures of foreign institutions, or market
contagion starting elsewhere, can prompt jurisdictions to safeguard themselves