[Diggers350] know your enemy

[Richard Chisnall]

On 3 December 2010 13:45, james armstrong <james36armstrong at hotmail.com>wrote:

>
>
> On October 10th The Governor of the Bank of England told American bankers,
>
> In New York,
>
> “Of all the possible ways of organising a banking system, the worst is the
> one we have to-day.”
>
>
Here's the full text of his speech:

===============

Speech by MERVYN KING
GOVERNOR OF THE BANK OF ENGLAND
“Banking: From Bagehot to Basel, and Back Again”
The Second Bagehot Lecture
Buttonwood Gathering, New York City
on Monday 25 October 2010

I am indebted to Stephen Burgess, Philip Evans, Andy Haldane, Andrew Hauser,
Vicky
Saporta, Jenny Scott, Paul Tucker and especially to Iain de Weymarn for
their useful
comments and suggestions on earlier drafts.

2
1. Introduction
Walter Bagehot was a brilliant observer and writer on contemporary economic
and
financial matters. In his remarkable book Lombard Street, Bagehot brought
together his
own observations with the analysis of earlier thinkers such as Henry
Thornton to provide
a critique of central banking as practised by the Bank of England and a
manifesto for how
central banks could handle financial crises in future by acting as a lender
of last resort.
The present financial crisis dwarfs any of those witnessed by Bagehot. What
lessons can
we draw from recent and current experience to update Bagehot’s vision of
finance and
central banking?
Surely the most important lesson from the financial crisis is the importance
of a resilient
and robust banking system. The countries most affected by the banking crisis
have
experienced the worst economic crisis since the 1930s. Output is somewhere
between
5% and 10% below where it would have been had there not been a crisis.
Unemployment
is up, businesses have closed, and the direct and indirect costs to the
taxpayer have
resulted in fiscal deficits in several countries of over 10% of GDP – the
largest peacetime
deficits ever.
At the heart of this crisis was the expansion and subsequent contraction of
the balance
sheet of the banking system. Other parts of the financial system in general
functioned
normally. And we saw in 1987 and again in the early 2000s, that a sharp fall
in equity
values did not cause the same damage as did the banking crisis. Equity
markets provide a
natural safety valve, and when they suffer sharp falls, economic policy can
respond. But
when the banking system failed in September 2008, not even massive
injections of both
liquidity and capital by the state could prevent a devastating collapse of
confidence and
output around the world. So it is imperative that we find an answer to the
question of
how to make our banking system more stable.

3
As Bagehot knew only too well, banking crises are endemic to the market
economy that
has evolved since the Industrial Revolution. The words “banking” and
“crises” are
natural bedfellows. If love and marriage go together like a horse and
carriage, then
banking and crisis go together like Oxford and the Isis, intertwined for as
long as anyone
can remember. Unfortunately, such crises are occurring more frequently and
on an ever
larger scale. Why?
2. The practice of banking:
For almost a century after Bagehot wrote Lombard Street, the size of the
banking sector
in the UK, relative to GDP, was broadly stable at around 50%. But, over the
past fifty
years, bank balance sheets have grown so fast that today they are over five
times annual
GDP. The size of the US banking industry has grown from around 20% in
Bagehot’s
time to around 100% of GDP today. And, until recently, the true scale of
balance sheets
was understated by these figures because banks were allowed to put exposures
to entities
such as special purpose vehicles off balance sheet.
Surprisingly, such an extraordinary rate of expansion has been accompanied
by
increasing concentration: the largest institutions have expanded the most.
Table 1 shows
that the asset holdings of the top ten banks in the UK amount to over 450%
of GDP, with
RBS, Barclays and HSBC each individually having assets in excess of UK GDP.
Table 2
shows that in the US, the top ten banks amount to over 60% of GDP, six times
larger than
the top ten fifty years ago. Bank of America today accounts for the same
proportion of
the US banking system as all of the top 10 banks put together in 1960.
While banks’ balance sheets have exploded, so have the risks associated with
those
balance sheets. Bagehot would have been used to banks with leverage ratios
(total assets,
or liabilities, to capital) of around six to one. But capital ratios have
declined and
leverage has risen. Immediately prior to the crisis, leverage in the banking
system of the
industrialised world had increased to astronomical levels. Simple leverage
ratios of close

4
to 50 or more could be found in the US, UK, and the continent of Europe,
driven in part
by the expansion of trading books (Brennan, Haldane and Madouros, 2010).
And banks resorted to using more short-term, wholesale funding. The average
maturity
of wholesale funding issued by banks has declined by two thirds in the UK
and by around
three quarters in the US over the past thirty years – at the same time as
reliance on
wholesale funding has increased. As a result, they have run a higher degree
of maturity
mismatch between their long-dated assets and short-term funding. To cap it
all, they held
a lower proportion of liquid assets on their balance sheets, so they were
more exposed if
some of the short-term funding dried up. In less than fifty years, the share
of highly
liquid assets that UK banks hold has declined from around a third of their
assets to less
than 2% last year (Bank of England, 2009). Banks tested the limits of where
the
risk-return trade-off was located, in all parts of their operations. As John
Kay wrote
about his experience on the board of HBoS, the problems began “on the day it
was
decided that treasury should be a profit centre in its own right rather than
an ancillary
activity” (Kay, 2008).
Moreover, the size of the balance sheet is no longer limited by the scale of
opportunities
to lend to companies or individuals in the real economy. So-called
‘financial
engineering’ allows banks to manufacture additional assets without limit.
And in the
run-up to the crisis, they were aided and abetted in this endeavour by a
host of vehicles
and funds in the so-called shadow banking system, which in the US grew in
gross terms
to be larger than the traditional banking sector. This shadow banking
system, as well as
holding securitised debt and a host of manufactured – or ‘synthetic’ –
exposures was also
a significant source of funding for the conventional banking system. Money
market
funds and other similar entities had call liabilities totalling over $7
trillion. And they on
lent very significant amounts to banks, both directly and indirectly via
chains of
transactions.
This has had two consequences. First, the financial system has become
enormously more
interconnected. This means that promoting stability of the system as a whole
using a

5
regime of regulation of individual institutions is much less likely to be
successful than
hitherto. Maturity mismatch can grow through chains of transactions –
without any
significant amount being located in any one institution – a risk described
many years ago
by Martin Hellwig (Hellwig, 1995). Second, although many of these positions
net out
when the financial system is seen as a whole, gross balance sheets are not
restricted by
the scale of the real economy and so banks were able to expand at a
remarkable pace. So
when the crisis began in 2007, uncertainty about where losses would
ultimately fall led
confidence in banks to seep away. This was obvious through the crisis.
Almost no
institution was immune from suspicion, the result of the knock-on
consequences so
eloquently described by Bagehot when he wrote:
“At first, incipient panic amounts to a kind of vague conversation: Is A. B.
as good as he
used to be? Has not C. D. lost money? and a thousand such questions. A
hundred people
are talked about, and a thousand think, 'Am I talked about, or am I not?'
'Is my credit as
good as it used to be, or is it less?' And every day, as a panic grows, this
floating
suspicion becomes both more intense and more diffused; it attacks more
persons; and
attacks them all more virulently than at first. All men of experience,
therefore, try to
'strengthen themselves,' as it is called, in the early stage of a panic;
they borrow money
while they can; they come to their banker and offer bills for discount,
which commonly
they would not have offered for days or weeks to come. And if the merchant
be a regular
customer, a banker does not like to refuse, because if he does he will be
said, or may be
said, to be in want of money, and so may attract the panic to himself.”
This sentiment is described more prosaically in Tables 3 and 4. They show
that the risk
premia demanded by investors to lend to all large banks rose very sharply
during the
crisis. For most banks the spreads on their senior unsecured debt had more
than trebled
in October 2008 relative to their levels at the start of 2007. Similarly,
credit default swap
premia – the cost of insuring a bank’s debt – shot up. All banks,
irrespective of the
precise nature of their business and balance sheet, were tarred with the
same brush.
Moreover spreads and CDS premia remain elevated today – almost universally,
large UK

6
and US banks face much higher borrowing charges compared to risk-free rates,
and are
seen as riskier entities, than prior to the crisis.
The size, concentration and riskiness of banks have increased in an
extraordinary fashion
and would be unrecognisable to Bagehot. Higher reported rates of return on
equity were
superficial hallmarks of success. These higher rates of return were required
by, and a
consequence of, the change in the pattern of banks’ funding with increased
leverage and
more short-term funding. They did not represent a significant improvement in
the overall
rate of return on assets. Not merely were banks’ own reported profits
exaggerating the
contribution of the financial sector to the economy, so were the national
accounts.
In the US, the share of gross value added of the financial sector as a share
of GDP rose
from around 2-3% in the decade after World War II to about 8% in 2008,
driven in large
part by a rise in the gross operating surplus of financial intermediaries.
And in the UK, in
the past decade, the measured scale of the financial sector, compared to
GDP, has
roughly doubled to around 10%. But this exaggerates the contribution of
financial
services. Banks do not always charge directly for the services they provide.
So the value
added of the financial sector is measured by official statisticians (using
the United
Nations System of National Accounts) as the difference between interest
receipts and
payments of a "reference rate of interest" which attempts to measure the
pure cost of
borrowing funds. This convention overstates the true value added of the
financial sector
because it includes the return to risky lending represented by the
difference between the
hypothetical pure cost of borrowing funds and the return that is earned. But
the fact that
risk is channelled through an intermediation industry does not mean that the
value added
from risk-bearing in the economy is solely attributable to the existence of
an
intermediation sector. If companies financed themselves directly from
households, the
statisticians would regard the return on risk-bearing as value added created
in that
industry. Financial intermediation does add value, but not as much as the
statistical
convention would suggest.

 7
Moreover, a financial sector that takes on risk with the implicit support of
the tax-payer
can generate measured value added that reflects not genuine risk-bearing but
the upside
profits from the implicit subsidy. And even without an implicit subsidy the
return to
risk-bearing can be mismeasured. It is widely understood that an insurance
company
should not count as profits the receipt of premia on an insurance policy
that will pay out
only when a low-frequency event occurs at some point in the future. But part
of the value
added of the financial sector prior to the crisis reflected temporary
profits from taking
risk and it was only after September 2008 that much of that so-called
economic activity
resulted in enormous reported losses by banks.
It is possible to make a very rough estimate of the possible size of this
distortion in the
reported financial sector output data. If we assume that true labour and
capital
productivity in the financial services industry grew in line with that in
the wider economy
in the 10 years prior to the crisis, then, given the inputs of capital and
labour over that
period, the official estimate might have overstated UK financial sector
value added by
almost £30 billion up to 2007 – around half of the growth in the official
measure. The
impact of this adjustment on overall GDP is likely to be relatively small
because much of
the output of the financial sector is treated as intermediate inputs to
other sectors in the
economy. Such an estimate is supported by the finding of my Bank of England
colleagues that the increase in rates of return on equity earned by banks
were accounted
for almost entirely by an increase in leverage, capital gains on assets in
trading books and
the reported profits on contracts that produced losses only after the crisis
occurred. And
it is consistent with the estimates calculated by Colangelo and Inklaar
(2010) for the euro
area. They found that around 40% of measured financial sector value added
probably
captured compensation for bearing risk.
3. The theory of banking
Why are banks so risky? The starting point is that banks make heavy use of
short-term
debt. Short-term debt holders can always run if they start to have doubts
about an
institution. Equity holders and long-term debt holders cannot cut and run so
easily.

 8
Douglas Diamond and Philip Dybvig showed nearly thirty years ago that this
can create
fragile institutions even in the absence of risk associated with the assets
that a bank holds.
All that is required is a cost to the liquidation of long-term assets and
that banks serve
customers on a first-come, first-served basis (Diamond and Dybvig, 1983).
Nevertheless,
there are benefits to this maturity transformation – funds can be pooled
allowing a greater
proportion to be directed to long-term illiquid investments, and less held
back to meet
individual needs for liquidity. And from Diamond’s and Dybvig’s insights,
flows an
intellectual foundation for many of the policy structures that we have today
– especially
deposit insurance and Bagehot’s time-honoured key principle of central banks
acting as
lender of last resort in a crisis. If the only problem is one of illiquidity
leading to
fragility, then central banks can easily act to ward off problems. By
demonstrating a
willingness to step in to provide temporary liquidity support, then the
likelihood of
problems arising in the first place is dramatically diminished. It was
wholly appropriate
that this was the focus of Bagehot’s writings – at the time, the structure
of the banking
system meant that illiquidity was often the key problem. And central banks
did not
appreciate the importance of the role that they could play. Bagehot’s whole
purpose was
to convince the Bank of England to fulfil this role. But the changes in the
banking
system over the past fifty years mean that a much more diverse range of
problems can
strike today. In September 2007, everyone thought that the crisis was one of
liquidity
and as a result there was an expectation central banks could provide the
solution. But it
quickly became clear that it was in fact a crisis of solvency.
Diamond and Dybvig’s analysis consciously omitted the fact that, in reality,
banks’ assets
are risky. And not only are banks’ assets risky, but banks are highly
leveraged
institutions. This leaves them heavily exposed – with very high debt-equity
ratios, small
movements in asset valuations are enough to wipe out their equity and leave
banks
insolvent. That means the distinction between illiquidity and solvency can
be difficult in
practice – the difference in timing might be just a few days. If a crisis is
in fact one of
insolvency, brought on by excessive leverage and risk, then central bank
liquidity

 9
provision cannot provide the answer. Central banks can offer liquidity
insurance only to
solvent institutions or as a bridge to a more permanent solution.
It is this structure, in which risky long-term assets are funded by
short-term deposits, that
makes banks so hazardous. Yet many treat loans to banks as if they were
riskless. In
isolation, this would be akin to a belief in alchemy – risk-free deposits
can never be
supported by long-term risky investments in isolation. To work, financial
alchemy
requires the implicit support of the tax payer.
When all the functions of the financial system are heavily interconnected,
any problems
that arise can end up playing havoc with services vital to the functioning
of the economy
– the payments system, the services of money and the provision of working
capital to
industry. If such services are materially threatened, governments will never
be able to sit
idly by. Institutions supplying such services are quite simply too important
to fail.
Everyone knows it. So, highly risky banking institutions enjoy implicit
public sector
support. In turn, public support incentivises banks to take on yet more
risk, knowing that,
if things go well, they will reap the rewards while the public sector will
foot the bill if
things go wrong. Greater risk begets greater size, most probably greater
importance to
the functioning of the economy, higher implicit public subsidies, and hence
yet larger
incentives to take risk – described by Martin Wolf as the “financial
doomsday machine”.
The failure in the crisis was not one of intellectual imagination or
economic science to
understand these issues. Economists recognised that distorted incentives,
whether arising
from implicit public subsidies, asymmetric information or a host of other
imperfections,
will cause a market-based outcome to be sub-optimal from the perspective of
society.
This idea has been at the centre of modern economics since the extraordinary
series of
papers written by Arrow and Debreu in the 1950s (Arrow, 1951; Debreu, 1951;
Arrow
and Debreu, 1954).
The real failure was a lapse into hubris – we came to believe that crises
created by
massive maturity transformation were problems that no longer applied to
modern

 10
banking, that they belonged to an era in which people wore whiskers and top
hats. There
was an inability to see through the veil of modern finance to the fact that
the balance
sheets of too many banks were an accident waiting to happen, with levels of
leverage on
a scale that could not resist even the slightest tremor to confidence about
the uncertain
value of bank assets. For all the clever innovation in the financial system,
its Achilles
heel was, and remains, simply the extraordinary – indeed absurd – levels of
leverage
represented by a heavy reliance on short-term debt.
Modern financiers are now invoking other dubious claims to resist reforms
that might
limit the public subsidies they have enjoyed in the past. No one should
blame them for
that – indeed, we should not expect anything else. They are responding to
incentives.
Some claim that reducing leverage and holding more equity capital would be
expensive.
But, as economists, such as my colleague David Miles (2010) and Anat Admati
and her
colleagues (Admati et. al., 2010), have argued, the cost of capital overall
is much less
sensitive to changes in the amount of debt in a bank’s balance sheet than
many bankers
claim – a proposition demonstrated forcefully by Professors Modigliani and
Miller over
fifty years ago (Modigliani and Miller, 1958). And the benefits to society,
most
obviously through greater financial stability, but also through factors such
as higher tax
revenue, are likely to swamp any change in the private costs faced by banks.
What does
reduce the cost of capital is the ability to borrow short to lend long. But
the scale of
maturity transformation undertaken today produces private benefits and
social costs. We
have seen from the experience of first Iceland, and now Ireland, the results
that can
follow from allowing a banking system to become too large relative to
national output
without having first solved the "too important to fail" problem.
4. Finding a Solution
Many remedies for reducing the riskiness of our financial system have been
proposed,
ranging from higher capital requirements on banks to functional separation
and other
more radical ideas. The guiding principle of any change should be to ensure
that the
costs of maturity transformation – the costs of periodic financial crises –
fall on those

 11
who enjoy the benefits of maturity transformation – the reduced cost of
financial
intermediation. All proposals should be evaluated by this simple criterion.
The first, and most obvious, response to the divergence between private
benefits and
social costs is the imposition of a permanent tax on the activity of
maturity
transformation to “internalise the externalities”. Such a tax, or levy, has
been discussed
by the G7, and introduced in the UK. The principle that the “polluter pays”
for the costs
they impose on others is an old one, going back at least to Pigou in the
1920s. The main
practical problem is to calibrate the costs to maturity transformation. The
loss of world
output from the financial crisis is enormous, even though such a crisis
might be
considered a once in a generation, or even once in a century, event. It is
not difficult to
see that a crisis that reduces output by between 5% and 10% for a number of
years, and
occurs once every fifty years, amounts to an annual cost several multiples
of the revenue
that will be generated by the UK bank levy (Haldane, 2010). But how can we
be certain
of correctly establishing what the tax should be when we are trying to
internalise costs
that occur so infrequently? So although there is a sound case for a levy
directed at the
size of short-term borrowing, it would be foolish to regard that as the main
tool to align
costs and benefits of risky balance sheet activity.
If setting the appropriate price is hard, then some form of controls on
quantities might be
a better answer (Weitzman, 1974). For example, limits on leverage have much
to
commend them. And for a generation, the quantitative control of this type
that regulators
have embraced was embodied in the capital standards set within the Basel
framework.
Last month a new concordat on such standards was reached in Basel – the
so-called Basel
III requirements. The challenge here is to set the requirements in a way
that will
materially affect the probability of a crisis.
Other forms of quantitative intervention include functional separation to
reduce the costs
of maturity transformation by ring-fencing those activities that we are most
concerned to
safeguard from disruption. If successful, the costs of any failure of
financial institutions
would be reduced. The challenge with this approach is to prevent the costs
associated

 12
with the activity of maturity transformation from gravitating to another set
of institutions
– the “shadow” banking system.
Whatever solution is adopted, the aim must be to align private and social
costs.
5. Why Basel III is not a complete answer
Lauded as a new standard, Basel III is seen by some as the answer to the
failure of
regulation to prevent the financial crisis. It is certainly a step in the
right direction, an
improvement on both Basel I and the ill-fated Basel II, and we should all
welcome it.
But if it is a giant leap for the regulators of the world, it is only a
small step for mankind.
Basel III on its own will not prevent another crisis for a number of
reasons.
First, even the new levels of capital are insufficient to prevent another
crisis. Calibrating
required capital by reference to the losses incurred during the recent
crisis takes
inadequate account of the benefits to banks of massive government
intervention and the
implicit guarantee. More fundamentally, it fails to recognise that when
sentiment
changes only very high levels of capital would be sufficient to enable banks
to obtain
funding on anything like normal spreads to policy rates, as we can see at
present. When
investors change their view about the unknowable future – as they will
occasionally in
sudden and discontinuous ways – banks that were perceived as
well-capitalised can seem
under-capitalised with concerns over their solvency. That is what happened
in 2007-08.
As the IMF have pointed out differences in capital ratios failed to predict
which financial
institutions would be vulnerable in the crisis (IMF, 2009). Only very much
higher levels
of capital – levels that would be seen by the industry as wildly excessive
most of the time
– would prevent such a crisis.
Second, the Basel approach calculates the amount of capital required by
using a measure
of “risk-weighted” assets. Those risk weights are computed from past
experience. Yet
the circumstances in which capital needs to be available to absorb potential
losses are
precisely those when earlier judgements about the risk of different assets
and their

 13
correlation are shown to be wrong. One might well say that a financial
crisis occurs
when the Basel risk weights turn out to be poor estimates of underlying
risk. And that is
not because investors, banks or regulators are incompetent. It is because
the relevant
risks are often impossible to assess in terms of fixed probabilities. Events
can take place
that we could not have envisaged, let alone to which we could attach
probabilities. If
only banks were playing in a casino then we probably could calculate
appropriate risk
weights. Unfortunately, the world is more complicated. So the regulatory
framework
needs to contain elements that are robust with respect to changes in the
appropriate risk
weights, and that is why the Bank of England advocated a simple leverage
ratio as a key
backstop to capital requirements.
Third, the Basel framework still focuses largely on the assets side of a
bank’s balance
sheet. Basel II excluded consideration of the liquidity and liability
structure of the
balance sheet, so much so that when the UK adopted Basel II in 2007, of all
the major
banks the one with the highest capital ratio was, believe it or not,
Northern Rock. Within
weeks of announcing that it intended to return excess capital to its
shareholders, Northern
Rock ran out of money. Basel II was based on a judgement that mortgages were
the
safest form of lending irrespective of how they were financed. If a business
model is
based around a particular funding model that suddenly becomes unviable, then
the
business model becomes unviable too, as events in 2007 showed. Whether the
measures
included in Basel III will be able to deal properly with the risks that
result from
inadequate levels of liquid assets and a risky structure of liabilities
remains to be seen.
One criticism of Basel III with which I have no truck is the length of the
transition period.
Banks have up to 2019 to adjust fully to the new requirements. Although some
of the
calculations of the alleged economic cost of higher capital requirements
presented by the
industry seem to me exaggerated (Institute of International Finance, 2010),
I do believe
that it is important in the present phase of de-leveraging not to exacerbate
the challenge
banks face in raising capital today. Banks should take advantage of
opportunities to raise
loss-absorbing capital, and should recognise the importance of using profits
to rebuild
capital rather than pay out higher dividends and compensation. But we must
not forget

 14
the principle underlying the Basel approach: asking banks to maintain a
buffer of capital
above the minimum requirement allows them to run the buffer down in
circumstances
like the present. Rebuilding the buffer is a task for the future. So even
though the Bank
of England would have preferred an agreement to set capital ratios at higher
levels in the
long run, we have no intention of asking UK banks to adopt a faster
timetable for
implementation of Basel III. That logic should apply to any reforms we
choose to
implement. We should not expect to change the financial system for the
better overnight.
Rather we need radical reforms that will give us a much more robust system
in the long
run, accepting that it may take a period of many years to get there.
As with a bank levy, it is no criticism of Basel III to say that it is not a
“silver bullet”.
The difficulty of identifying and calibrating the difference between the
private and social
costs of maturity transformation means that there is merit in having a
basket of different
measures to rein in excessive risk-taking. In the area of financial
stability, it makes sense
to have both belt and braces.
6. Large Institutions
The implicit subsidy to banks that are perceived as “too important to fail”
can be
important to banks of any size but is usually seen as bigger for large
institutions for
which existing bank resolution procedures either do or could not apply.
Moreover, most
large complex financial institutions are global – at least in life if not in
death. So a major
international effort is underway to try to work out how best to deal with
such institutions,
initiated by heads of government at the G-20 Summit in Pittsburgh in 2009.
Much of this
work is being led by the Financial Stability Board. Ideas agreed in
principle or under
consideration include an addition to the Basel III capital requirement of an
extra layer of
either equity or other loss-absorbing capital, a special resolution regime
for large
institutions that would allow losses to be shared among creditors as well as
equity-holders, and tentative steps towards international harmonisation of
resolution
procedures on which my colleague Paul Tucker and others are engaged.

 15
Some countries have already started down the road of augmenting the Basel
calibration
with additional requirements of their own for large banks. Earlier this
month the Swiss
authorities announced just such a requirement for their two current
systemically
important banks – UBS and Credit Suisse. In future, they will have to hold
additional
amounts of both equity capital and loss-bearing contingent capital which
takes their total
holding of equity-like capital to 19%, compared with the Basel standard of
7%.
But in most other countries, identifying in advance a group of financial
institutions whose
failure would be intolerable, and so are “too important to fail”, is a
hazardous
undertaking. In itself it would simply increase the subsidy by making it
explicit. And it
is hard to see why institutions whose failure cannot be contemplated should
be in the
private sector in the first place. But if international regulators failed to
agree on higher
capital requirements in general, adding to the loss-absorbing capacity of
large institutions
could be a second-best outcome.
Solving the “too important to fail” problem will require ultimately that
every financial
sector entity can be left to fail without risk of threatening the
functioning of the economy.
So it is natural that improved resolution procedures is part of the overall
strategy – and
within many countries big steps forward have already been taken. But the
successful
resolution of a large institution would, in the absence of an implausibly
large deposit
insurance fund, require the ability to bail-in creditors. Yet that
possibility would give an
incentive to the bank to increase its dependence on short-term funding so
that more
creditors might get out in time. That might increase rather than decrease
the fragility of
the institution. So there would need to be restrictions on the maturity
structure of its
liabilities. Resolution would naturally go hand-in-hand with a greater
reliance on
instruments such as contingent capital. And there would be enormous
challenges in
resolving global banks that span countries with different legal
jurisdictions. Extending
resolution procedures to large institutions is a necessary but not
sufficient condition for
stability of the banking system.

 16
7. More radical reforms
All of these potential reforms would be steps in the right direction. They
would all help
to put more of the costs of maturity mismatch on the shoulders of those who
reap the
benefits. But taxes, the Basel capital requirements, special arrangements
for systemically
important financial institutions and enhanced resolution procedures all have
drawbacks
and are unlikely to do the job perfectly. So, if we cannot rely solely on
these types of
measures, are there more fundamental directions in which we could move that
would
align costs and benefits more effectively?
One simple solution, advocated by my colleague David Miles, would be to move
to very
much higher levels of capital requirements – several orders of magnitude
higher. A
related proposal is to ensure there are large amounts of contingent capital
in a bank’s
liability structure. Much more loss-absorbing capital – actual or contingent
– can
substantially reduce the size of costs that might be borne outside of a
financial firm. But
unless complete, capital requirements will never be able to guarantee that
costs will not
spill over elsewhere. This leads to the limiting case of proposals such as
Professor
Kotlikoff’s idea to introduce what he calls "limited purpose banking"
(Kotlikoff, 2010).
That would ensure that each pool of investments made by a bank is turned
into a mutual
fund with no maturity mismatch. There is no possibility of alchemy. It is an
idea worthy
of further study.
Another avenue of reform is some form of functional separation. The Volcker
Rule is
one example. Another, more fundamental, example would be to divorce the
payment
system from risky lending activity – that is to prevent fractional reserve
banking (for
example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more
recently
by Kay, 2009).
In essence these proposals recognise that if banks undertake risky
activities then it is
highly dangerous to allow such “gambling” to take place on the same balance
sheet as is
used to support the payments system, and other crucial parts of the
financial

 17
infrastructure. And eliminating fractional reserve banking explicitly
recognises that the
pretence that risk-free deposits can be supported by risky assets is
alchemy. If there is a
need for genuinely safe deposits the only way they can be provided, while
ensuring costs
and benefits are fully aligned, is to insist such deposits do not coexist
with risky assets.
The advantage of these types of more fundamental proposals is that no tax or
capital
requirement needs to be calibrated. And if successfully enforced then they
certainly
would be robust measures. But a key challenge is to ensure that maturity
transformation
does not simply migrate outside of the regulated perimeter, and end up
benefiting from an
implicit public subsidy (Tucker, 2010b). That is difficult because it is the
nature of the
services – not the institutions – that is the concern. Ultimately, we need a
system
whereby the suppliers of funds to risky activities, whether intermediated
via banks or any
other entity, must understand that they will not be protected from loss by
taxpayer
bailouts. Creditors should know that they will bear losses in the event of
failure.
We certainly cannot rely on being able to expand the scope of regulation
without limit to
prevent the migration of maturity mismatch. Regulators will never be able to
keep up
with the pace and scale of financial innovation. Nor should we want to
restrict
innovation. But it should be undertaken by investors using their own money
not by
intermediaries who also provide crucial services to the economy, allowing
them to reap
an implicit public subsidy. It will not be possible to regulate all parts of
the financial
system as if they were banks. As Jeffrey Lacker, President of the Federal
Reserve Bank
of Richmond, has argued, “merely expanding the scope of regulation to chase
those firms
that extract implicit guarantees by engaging in maturity transformation
would be an
interminable journey with yet more financial instability in its wake”
(Lacker, 2010). In
the end, clarity about the regulatory perimeter is both desirable and
unavoidable – a task
given to the Financial Policy Committee as part of the Bank of England’s new
responsibilities. And the attraction of the more radical solutions is that
they offer the
hope of avoiding the seemingly inevitable drift to ever more complex and
costly
regulation.

 18
The broad answer to the problem is likely to be remarkably simple. Banks
should be
financed much more heavily by equity rather than short-term debt. Much, much
more
equity; much, much less short-term debt. Risky investments cannot be
financed in any
other way. What we cannot countenance is a continuation of the system in
which bank
executives trade and take risks on their own account, and yet those who
finance them are
protected from loss by the implicit taxpayer guarantees. The difficulty is
in finding the
right practical way to achieve that. Some of the solutions that economists
have proposed
have been dismissed by some as impractical and pie in the sky. But I am
reminded of
Keynes’ dictum that “practical men who believe themselves to be quite exempt
from any
intellectual influence are usually the slaves of some defunct economist”
(Keynes, 1936).
Of all the many ways of organising banking, the worst is the one we have
today.
I have suggested a number of ways in which the system could be reformed. But
making
the right choice will take much careful thought and a good deal of time. So
I do not want
today to offer a blueprint – and indeed that is for others to do. In the UK
we are
fortunate. The Independent Commission on Banking was set up earlier this
year. It has
outstanding members. I am sure they will lead us to the right solution, and
I look forward
to their findings.
8. Conclusions
There is no simple answer to the to important to fail nature of banks.
Maturity
transformation brings economic benefits but it creates real economic costs.
The problem
is that the costs do not fall on those who enjoy the benefits. The damaging
externalities
created by excessive maturity transformation and risk-taking must be
internalised.
A market economy has proved to be the most reliable means for a society to
expand its
standard of living. But ever since the Industrial Revolution we have not
cracked the
problem of how to ensure a more stable banking system. We know that there
will always
be sharp and unpredictable movements in expectations, sentiment and hence
valuations of
financial assets. They represent our best guess as to what the future holds,
and views

 19
about the future can change radically and unpredictably. It is a phenomenon
that we must
learn to live with. But changes in expectations can create havoc with the
banking system
because it relies so heavily on transforming short-term debt into long-term
risky assets.
For a society to base its financial system on alchemy is a poor
advertisement for its
rationality.
Change is, I believe, inevitable. The question is only whether we can think
our way
through to a better outcome before the next generation is damaged by a
future and bigger
crisis. This crisis has already left a legacy of debt to the next
generation. We must not
leave them the legacy of a fragile banking system too.
I have explained the principles on which a successful reform of the system
should rest. It
is a program that will take many years, if not decades. But, as Bagehot
concluded in
Lombard Street, “I have written in vain if I require to say now that the
problem is
delicate, that the solution is varying and difficult, and that the result is
inestimable to us
all.”

===============

-- 
/Richard

Open your arms to change, but don't let go of your values - Dalai Lama
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