‘ debt strikes back ’ or ‘ the return of the regulator ’? alex brazier executive director, financial director for financial stability strategy and risk member of the financial policy committee bank of england university of liverpool, institute for risk and uncertainty monday 24 july 2017 i am grateful to david baumslag, jonathan bridges, liam kirwin, iren levina, vas madouros, david seaward, sagar shah, gavin wallis and mina yau for their help in preparing these remarks. all speeches are available online at www. bankofengland. co. uk / speeches it is an honour to be invited to contribute to this lecture series here at the institute for risk and uncertainty. thinking about risk sometimes has a more derogatory description : worrying. and worrying has a bad name for itself as an unproductive, possibly harmful, activity. but intelligent worry – worry about what could go wrong and action to deal with it before it does – is central to the aim that this institute and the bank of england share : creating a safer world. so in much the same way that star wars fans must enjoy conventions that bring together like - minded people, whose interest is not always appreciated by others, it is a pleasure to be here with fellow intelligent worriers. with household debt at high levels and after a period in which consumer debt has increased very rapidly, my theme this evening draws inspiration from the star wars films. i ’ ll ask whether the economic galaxy is destined to be upended as debt strikes back, or whether there is new hope and the galaxy can be a safer place thanks to the return of the regulator. my conclusion will not surprise you. but before we get there, i want to take you back to a galaxy that may now seem far, far, away... crisis and recovery ten years ago, an unsafe financial system caused financial crisis and economic disaster. the western banking system had expanded rapidly. banks - and their regulators - had been blind to the basic fact that more debt meant greater risk of loss. after years of stability and good performance, few had considered what could go wrong. a false sense of security grew up. at royal bank of scotland – the most egregious case – that illusion meant the bank could be toppled by losses of less than one per cent of its assets. and so, come the reckoning, the western banking system just wasn ’ t able to absorb the losses it faced. in fact, it was structured in complex

. any solution must fall into one of those two categories. what does this mean in practice? consider the first approach. to reduce the likelihood of failure, regulators can impose capital requirements on a wide range of financial institutions related to the risks they are taking. this is the current approach underpinned by the basel regime. in essence, it makes banks build a buffer against adverse events. it has attractions but also problems. first, capital requirements reduce, but not eliminate, the need for taxpayers to provide catastrophe insurance. second, the “ riskiness ” of a bank ’ s activities and the liquidity of its funding can change suddenly and radically as market expectations shift. this means that what appeared to be an adequate capital or liquidity cushion one day appears wholly inadequate the next. indeed, the achilles heel of the basel regime is the assumption that there is a constant capital ratio which delivers the desired degree of stability of the banking system. after the experience of the past two years, and a decade or more in which capital ratios fell and leverage ratios rose to historically unprecedented levels, banks need more capital to persuade investors to fund them. a larger buffer gives new creditors greater comfort that their claims will be met in future, without resort to the public purse. and rather than pay out dividends or generous remuneration, banks should use earnings to build larger capital buffers. but how much larger? we simply don ’ t know. a higher ratio is safer than a lower one, but any fixed ratio is bound to be arbitrary. one way of dealing with this problem is to require banks to take out insurance in the form of “ contingent capital ”, that is capital in a form that automatically converts to common equity upon the trigger of a threshold that kicks in before a bank becomes insolvent. if a bank ’ s regulatory core tier 1 capital – common equity – remained above the threshold, nothing would happen. but if the regulatory core tier 1 capital fell below the threshold then the contingent capital would automatically be converted to common equity. when bank failures impose costs on the rest of the economy, it is reasonable to insist that banks themselves purchase a sufficient degree of insurance in the form of a large capital cushion available automatically before insolvency. such contingent capital instruments are very different from instruments, such as subordinated debt, which banks have been permitted to count as capital under the basel regime, but which do not provide a reliable capital buffer until too late – after the bank has failed. so at present the