andrew g haldane : small lessons from a big crisis remarks by mr andrew g haldane, executive director, financial stability, bank of england, at the federal reserve bank of chicago 45th annual conference “ reforming financial regulation ”, chicago, 8 may 2009. i would like to thank andrew mason, adrian chiu, david gregory and nick vause for comments and contributions. * * * macro - prudential policy is a new ideology and a big idea. that befits what is, without question, a big crisis. there are a great many unanswered questions before this ideology can be put into practice. these questions will shape the intellectual and public policy debate over the next several decades, just as the great depression shaped the macroeconomic policy debate from the 1940s to the early 1970s. but there are already some smaller lessons to be drawn from crisis events. that is the purpose of these comments. seven issues arising from the crisis are discussed and their implications for policymakers and practitioners assessed. if there is a unifying theme, it is informational failure. this has been a crisis borne of, and prolonged by, lack of information. that fog of uncertainty remains dense 18 months on. because financial markets are, first and foremost, a market in information, these informational failures have generated prolonged paralysis in financial markets. tackling them is priority number one. lesson 1 : finance is no golden goose imagine having placed a hedged bet back in 1900. a £100 long bet is placed on uk financial sector equities together with a £100 short bet on general uk equities. in effect, this is a gamble on the uk financial sector outperforming the market. how would that bet have performed over the intervening 110 or so years? chart 1 provides the answer. for around the first 85 years, this gamble looks like a rather staid strategy. by 1985, it would have delivered a capital sum of £500, at a modest annual average return of around 2 % per year. there were periods of both over - performance ( 19001944 ) and under - performance ( 1971 - 1986 ) by the financial sector over this period. but, give or take, this was close to a break - even strategy. the following twenty year period, from 1986 to 2006, transformed that picture. by the end of 2006, the once - staid strategy would have delivered a capital sum of over £10, 000, at an annual average return of over 16 %. banking

roe – both the rise to around 24 % in 2007 and the subsequent fall into negative territory in 2008. chart 3 looks at the same decomposition across a panel of 70 global banks at the end of 2007. the vertical axis measures return on assets and the horizontal axis leverage. the curves are iso - roe lines, drawn at 5 %, 20 % and 40 %. the distribution of points lies along a downward - sloping curve. two implications follow from this. first, the downward slope is consistent with global banks targeting a roe, perhaps benchmarked by peers ’ performance. the bank ’ s market intelligence in the run - up to crisis suggested that such “ keeping up with the jones ’ s ” was an important cultural influence on banks ’ decision - making. second, chart 3 suggests that banks kept up in this competitive race by gearing - up. banks unable to deliver sufficiently high returns on assets to meet their roe targets resorted instead to leveraging their balance sheets. during the golden era, competition simultaneously drove down returns on assets and drove up target returns on equity. caught in this cross - fire, higher leverage became banks ’ only means of keeping up with the jones ’ s. management resorted to the roulette wheel. as firms collectively migrated south - east in chart 3, leverage increased across the financial system as a whole. having bet the bank on black, many financial firms ended up in the red. two lessons for the future suggest themselves from this prognosis. first, when evaluating banks and their management, there is a need for greater focus on returns on assets rather than on equity. good luck and good management need to be better distinguished. put differently, returns to investors and managers need to be more accurately risk - adjusted if the right balance between risk and return is to be struck for individual firms and for the financial system as a whole. second, there is a need to place much stricter system - wide limits on leverage. these limits should aim to prevent the south - easterly migration by banks under competitive pressure. charles mckay ( 1841 ), “ memoirs of extraordinary popular delusions and the madness of crowds ”, london : richard bentley. that suggests these ratios will need to be state - dependent, rising as the temperature rises across the financial system as a whole. some have called this a counter - cyclical regime. given its source, it might better be called a counter - cultural regime. lesson 3 : size does matter the “ 80 / 20 rule ” has its