Notes for a talk at the Alamos Alliance, Mexico
BANKING REGULATION AFTER THE GLOBAL FINANCIAL CRISIS
Notes for talk at Alamos, 19 February 2010
In many parts of the world, the popular media, and far too many politicians, blame the global financial crisis on the greed of bankers. And when it's announced that bankers have been paid tens of millions of dollars despite driving the institutions which they've run into serious trouble, and that, in the UK, government support for seriously troubled banks now amounts to close to two-thirds of British GDP, it's easy to understand why banks make very easy targets. Even I, myself a director of the largest bank in New Zealand, feel outraged!
I don't want to excuse the bankers. It seems undeniable that many bankers, motivated by what motivates most people in a market economy, took enormous gambles using money belonging to other people in the belief that they could make themselves very rich indeed in the process.
But it probably won't surprise many people here that many other factors were also involved, and many of those factors were the fault of successive governments and the policies they supported. Specifically:
Again in the 1960s, the US federal government embarked on a programme designed to encourage home ownership by giving poor families access to federally-insured loans that required minimal deposits. The end result was an avalanche of foreclosures among ill-prepared owners that some years later cost the taxpayer dearly.
Stan Liebowitz wrote a fascinating paper in October 2008, in which he concluded that "in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the (US) government undertook an attack on (mortgage) underwriting standards starting in the early 1990s. Regulators, academic specialists, GSEs (the government-sponsored enterprises Fannie Mae, Freddie Mac and Ginnie Mae), and housing activists universally praised the decline in mortgage-underwriting standards as an 'innovation' in mortgage lending. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble."
Richard Salsman argued that the real problem was what he called the "morality of altruism". He argued that "altruism has motivated the utter debasement of lending standards in the past decade... Highlighting the legal-coercive backing of Washington's altruistic credit policies, the Federal Reserve Bank has for years distributed a booklet to mortgage lenders - Closing the Gap: A Guide to Equal Opportunity Lending - which includes sidebar reminders that fines and jail terms await those found to be deficient in fighting 'discrimination' by (not) lending to the less-than-creditworthy. The booklet, still distributed today, derides as 'arbitrary and unreasonable' such traditional credit standards as a 20 percent down payment..., an above-par credit score, a history of paying one's bills on time, and a steady job yielding an income sufficient to make monthly mortgage payments".
I have never forgotten a conversation I had in Washington in September 1992, at the time of the World Bank/IMF annual meetings. I found myself at one of those dinners which make the annual meetings so enjoyable sitting beside a man who, after a long and successful career in the British Treasury, had just become a director of one of the major British clearing banks. I asked him how he found being a director of a bank after a lifetime in the Treasury. Funny you should ask that he said. I've always thought that banking was all about measuring and pricing risk, and of course I've had no experience of that in the Treasury. But I'm relieved to discover that all I have to worry about is whether we are complying with the Bank of England's rules. (This was, of course, before the FSA was established.)
When in the mid-nineties we in New Zealand introduced a system of bank regulation involving minimal rules and regulations, but instead imposing a requirement that all bank directors had to sign off a statement quarterly attesting to the fact that, in their opinion, their banks had adequate risk control systems in place, and that those systems were working appropriately, the CEO of the Australian owner of one of the largest banks in New Zealand flew from Australia to tell me in no uncertain terms that what we were proposing to do was totally unrealistic. Most bank directors, he told me firmly, simply had no understanding of banking. For that reason, he wanted me, as the head of our central bank (which was and is also the banking regulator), to continue laying down a series of rules and regulations. In other words, he wanted the banking regulator to make all the key decisions which would minimise his bank's risks. I told him, equally firmly, that I had no intention whatsoever of doing that.
Mervyn King has noted that "forty years ago, the clearing banks in London held around 30% of their assets in short-term liquid instruments. Today that liquid assets ratio is about 1%. For the major UK banks, almost 25% of customer loans are now funded by short-term borrowing in wholesale markets. At the turn of the new century it was close to zero."
Of course, bank CEOs are under huge competitive pressure. At monthly board meetings, directors are keen to know whether their bank has won additional market share or lost it. A CEO who has to report that his bank has lost market share several months in a row is under enormous pressure to "do something about it". So if competing banks have won market share by relaxing underwriting standards, the pressure on him to do likewise is very intense, particularly if he can assume with a reasonable degree of confidence that the central bank will be there to help if something goes wrong.
So I find it hard to avoid the conclusion that part of the reason that banks have felt able to adopt much riskier balance sheets is their belief that, in a crisis, the regulator - which has laid down most of the rules by which banks must operate - would look after them. And of course, that belief has now been amply justified.
Before turning to the question of how we seek to avoid crises like the one which has dominated our thinking over the last two years, it is interesting to reflect briefly on why we in Australia and New Zealand did not experience the kind of crisis experienced in most of the rest of the developed world.
It would be nice to believe that we got through the recent crisis because of our superior approach to banking regulation. I certainly believe that the approach we in New Zealand adopted in the mid-nineties - with a high level of mandatory disclosure of financial information to the market, backed up by quarterly director attestations, minimum capital ratios and restrictions on credit exposure to connected parties, but with no rules covering most of the things which are covered by rules elsewhere, such as risk concentration, open foreign exchange positions, liquidity ratios, and so on - was the right one. I made a presentation on the New Zealand approach to bank regulation at the annual meeting of the Bank for International Settlements in Basel in the mid-nineties, and had the satisfaction of being told by both Alan Greenspan and Helmut Schlesinger that we were definitely on the right track, even though political considerations meant that they had little chance of following us in the US or Germany.
But alas, New Zealand was not, and is not, a good laboratory for such a new approach to bank regulation. The overwhelming bulk of the assets in the New Zealand banking sector is held by subsidiaries of the four large Australian banks, and to a large extent therefore the regulatory environment within which the New Zealand banking sector operates is determined as much by the Australian regulator (APRA) as by the New Zealand regulator (the Reserve Bank of New Zealand).
Well, why didn't the Australian banking sector get into trouble? Part of the reason was that the Australian regulator took a tougher approach to securitization than US regulators did (and New Zealand's approach was tougher again). There was also rather more regulatory pressure against high loan-to-valuation ratio loans in both countries than in the US. And of course, there wasn't the multiplicity of regulatory bodies responsible for the banking sector in either Australia or New Zealand that there was in the US, so there was less scope for banking activities to disappear below the radar screen than there seems to have been in the US.
But with those important differences, the approach taken by the Australian bank regulator, APRA, was largely consistent with the approach taken by bank regulators in other western countries.
There is not yet any unanimously agreed view on why the Australian banks didn't get into trouble, but the former Governor of the Reserve Bank of Australia, Ian Macfarlane, believes that the reasons may relate to two factors which have nothing to do with bank regulation.
First, successive Australian Governments have held firm to the so-called "four pillars policy", a policy which has to date blocked any mergers between the four dominant Australian banks. Perhaps because of this policy, Mr Macfarlane has argued, the four large Australian banks have not felt under such intense competitive pressure as banks in some other jurisdictions have done, and have therefore not felt compelled to take on as much risk as banks in other jurisdictions.
Second, because Australian banks, like those in New Zealand, have more demand for loans from domestic borrowers than they can fund from their domestic deposit base, they depend quite heavily for a large minority of their funding on money raised in international markets. This may have made them less inclined to invest in sub-prime mortgages and related securities from the US market (though of course that dependence also left them potentially vulnerable after international markets seized up after the collapse of Lehmans).
To these factors, I would add a third. Even though there has been an enormous increase in house prices in both Australia and New Zealand in recent years, the fall in house prices over the last two years has been very small, and in some cities virtually non-existent. If we were to see, in either country, the kind of fall in house prices which has so hurt the US banking sector over the last two years, it is not at all clear that the Australian banks would be nearly as strongly capitalised as they are now.
So how should we all avoid crises like the present one occurring again?
There is of course an enormous amount of ink being spilt trying to answer this question and almost every week brings some new policy proposal from either the US or from Basel. Quite apart from desisting from some of the things which have caused the crisis - like putting huge political pressure on banks to lower their credit standards, and keeping tight restrictions on the supply of residential land in some urban areas - in my view, there is a need for a totally different approach to bank regulation than in the recent past.
At the present time, the tendency is to extend the scope of regulation and supervision to almost any institution accepting deposits from the public, no matter how small the institution concerned. And the strong tendency is to make that regulation and supervision ever more intrusive. If banks got into trouble notwithstanding the degree of regulation which prevailed before, then surely, it is argued, we must intensify that regulation still further to make sure that they never get into serious trouble again.
Even in New Zealand, where as I've mentioned we've traditionally had a regime based heavily on public disclosure and director attestations, with the bare minimum of other rules and regulations, there has been a strong tendency to increase the intensity of bank regulation. In recent years, for example, the Reserve Bank has taken responsibility for approving all the directors of banks, the CEO, and all the first reports to the CEO. If I were a depositor with a bank which got into trouble, I know where I'd be looking to lay the blame and from whom I'd be demanding compensation.
Moreover, we've also seen policy changes to extend Reserve Bank supervision from its previous exclusive focus on banks to include a much wider range of non-bank deposit takers, as already happens in many other countries.
And there has been strong pressure from Basel and the IMF to extend this highly intrusive approach to supervision to all countries, no matter how small or how unsophisticated their financial systems. I undertook an assignment looking at the approach to bank regulation adopted by the 14 member countries of the Pacific Island Forum in 2008, and was dismayed to find that they had been advised by a person funded by the IMF that "international bodies have developed frameworks that outline minimum standards for sound supervisory practices and are considered universally applicable regardless of the size and degree of sophistication of a country's financial system". This may sound a reasonable statement as we sit here in Mexico, but in my opinion it is utterly ridiculous for most of the countries of the Pacific Island Forum - many of which have total populations of fewer than 50,000 and one of which has a population of fewer than 2,000! - and few of which have any banks which are not the subsidiaries of large international banks.
But the logic of trying to supervise all deposit-taking institutions, no matter how small and insignificant, is not at all obvious. For a great many people, particularly perhaps low income people, deposit balances at their local bank are only a small part of their total wealth, which will mainly consist of their home and their motor vehicle. If they have financial assets, those assets will likely include corporate bonds and shares, as well as bank deposits. Yet there is no suggestion that the state needs to supervise home building, or car manufacture, or corporates which issue bonds and shares, with the same intensity as it's now assumed the state should be supervising deposit-takers.
I think there would be a great deal of merit in the state backing right away from the supervision of small deposit-takers and making it widely known that those depositing with such institutions are reliant on the same private sector rules that apply to other forms of investment - the legal obligations on company directors to disclose relevant information, the legal obligations on auditors to audit that information, and the strong incentives on rating agencies to assess that information as objectively as they know how - backed up by a legal obligation on financial advisers to disclose the nature of any financial interest in their advice. To emphasise that point, deposit-taking institutions which were not subject to public sector supervision would need to make that fact explicit in any advertising material, or other material soliciting investments.
It seems to me that the effect of this approach would be to place a great deal more responsibility on directors, auditors, and credit rating agencies than is true at the moment. All would be liable to legal action if they failed in that responsibility. This would almost certainly lead to institutions which are no longer subject to public sector supervision carrying a significantly higher level of both capital and liquidity than currently, and that would certainly be no bad thing.
But I have reluctantly come to the conclusion that, while there is no obvious public policy need to supervise every small deposit-taking institution, the present situation with regard to systemically-important institutions is totally unsatisfactory.
When I was at the Reserve Bank of New Zealand, we devoted quite a lot of effort to thinking through what we would do if one of the four dominant banks in New Zealand were to get into serious trouble. I was very keen not to acknowledge, even to myself, that any institution was too big to fail, but try as I might I could not escape the conclusion that the closure of any one of the four would have unthinkably grave consequences for the New Zealand economy as a whole, and would not - indeed, should not - be tolerated by any New Zealand government.
In New Zealand, some 90% of all banking assets are under the control of four large banks. In Australia, Canada, and even the United Kingdom, the situation is similar. Even in the United States, just four companies - Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo - command 46% of the assets of all FDIC-insured banks.
The reality is that, in many countries, some banks are too big to be allowed to close, and that has been amply demonstrated in recent months. The problem is that too many bank directors and bank managers have traded on that belief, and will continue to trade on that belief. They have operated on the basis that they can take very large risks (sometimes even larger than they were aware of): if their gambles pay off, they reap very substantial personal rewards, and rewards also for their shareholders; if their gambles do not pay off, they may still reap substantial rewards in the form of "separation payments"; shareholders may get hurt, but at least depositors will be bailed out by taxpayers. That is no doubt an important reason for the enormous expansion of the banking industry in most developed countries over the last few decades - relative to the size of the British economy, for example, UK banks are now ten times larger than they were just 40 years ago.
That is a totally unsatisfactory situation. I have some sympathy with the view of Nassim Nicholas Taleb, the author of The Black Swan, who early in 2009 wrote "Nothing should ever become too big to fail... Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing".
And indeed, this idea that perhaps some banks have become too big seems to be under serious consideration, at least in the UK. Mervyn King in a speech last June said that "if some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big". He made a similar point in a speech to Scottish business organisations in October last year when he said that "it is hard to see how the existence of institutions that are 'too important to fail' is consistent with their being in the private sector".
So are we forced to the conclusion that systemically-important institutions should be owned by the state? I am very reluctant to come to that conclusion, knowing something of the inefficiency of state institutions in almost every country. Moreover, state-owned banks in several countries have not had a distinguished record of prudent risk-taking.
As I've mentioned, when I was at the Reserve Bank of New Zealand we gave a lot of thought to this issue. We made a distinction between being too big to fail and being too big to close. It was clear that there were at least four banks which were too big to close for more than the briefest of time because of the consequential damage to the entire economy, not least through the impact which their closure would have had on the payments system. But perhaps they were not too big to "fail"? We did quite a bit of work on what we termed BCR, or Bank Creditor Recapitalization, making a distinction between closing a bank (which we could not see as being feasible) and failing it (which we were keen to be able to do). We envisaged a situation where a bank got into serious trouble and had insufficient equity to continue. We envisaged closing the bank for, say, 24 or 48 hours, and re-opening it having recapitalized it by applying a "hair-cut" to all the bank's creditors. We saw this as having all the right incentives - it would effectively impose a total loss on the bank's shareholders, and would emphasise to bank creditors (including depositors) that no bank was guaranteed by the state - while not inflicting huge damage on the rest of the economy.
I understand that the concept of Bank Creditor Recapitalization remains one of the options which the Reserve Bank would contemplate in the event of a single-bank-specific crisis - where factors peculiar to that bank are seen to be leading to that bank's particular difficulties. But it is evident that this arrangement would have major difficulties in a systemic crisis affecting the banking system as a whole by creating a real risk that depositors in other banks would seek to withdraw their deposits to avoid suffering a hair-cut themselves. In those circumstances it would almost inevitably be necessary to throw a comprehensive guarantee across all deposits, at least all deposits at systemically important institutions.
On balance, I have come to the conclusion that systemically important institutions do need to be supervised by the state because they are too important to be allowed to close. In effect, this provides a state guarantee for all depositors with such institutions, and enables those institutions to attract deposits at lower cost than other institutions.
The intensity of that supervision can at least to some extent be determined by the rules applied by the regulator as they relate to the minimum capital ratio to be maintained by systemically important banks.
Banks willing to maintain a very high level of high quality capital, a high level of liquidity, and a high level of public disclosure of important financial information related to the risks being incurred, should presumably be subject to much less intrusive supervision than banks with a lower level of capital. In that situation, if bank directors and shareholders fail to manage their risks appropriately it is they who incur most or all of any loss as a consequence of their bank getting into trouble.
Conversely, banks unable or unwilling to maintain a high level of high quality capital and a high level of liquidity should be subject to more intensive supervision, with tighter rules restricting the risks which they can incur.
What do I mean by a "very high level of high quality capital"? I'm not dogmatic on that, but clearly it is something a lot higher than the 4% Tier I capital ratio required by Basel I. Ten or 15 per cent of Tier I capital perhaps? Certainly, the ratio of bank capital to total assets was very much higher than it currently is little more than a century ago, when supervision was minimal or non-existent - over 15% on average in the UK and nearly 25% on average in the US.
Nor am I dogmatic about the meaning of "a high level of liquidity". But as the comments I noted from Mervyn King earlier illustrate, banks have hugely reduced their liquid assets in recent decades, presumably as they became more and more confident that the central bank would always be willing to provide liquidity in case of need. That is a trend which needs to be reversed, and of course regulators in several countries, including New Zealand, are already moving in that direction.
In my view, there would also be considerable merit in ensuring that systemically important banks carry an additional layer of obligations which could, under defined circumstances, suffer loss in order to protect taxpayers who would otherwise incur the cost of effectively guaranteeing the bank's depositors. This was the original intention of the so-called Tier II obligations. The problem with Tier II instruments, as explained in a recent article in The Economist, is that "if they end up bearing losses, the entire bank is usually judged to be in default, causing a stampede of counterparties, depositors and other senior creditors who fear they will lose too as the bank is wound up, destabilizing the system as a whole. In the jargon, these instruments are unable to bear losses while a bank is a 'going concern'.... The alternative is to force banks to issue bonds that would automatically suffer partial losses in the event of state intervention, a little like (contingent convertible capital). Either way, the objective would be to guarantee enough of an institution's balance-sheet to avoid a run, while leaving enough of it without a guarantee to protect taxpayers from even the outlier banks."
Of course, how big this "additional layer" needs to be will depend a great deal on the size of a bank's equity capital: if the bank's equity is big enough, there may be no "additional layer" required. The key need is to ensure that there is an ample buffer to protect taxpayers against loss if systemically important banks get into serious trouble.
And we need one more thing. I am a strong advocate of inflation targeting, especially where the inflation target is a matter of agreement between the central bank and the executive branch of government. But the asset price bubbles of the last decade have convinced me that keeping consumer price inflation under tight control, while necessary, is not sufficient.
The 1999 annual report of the Federal Reserve Bank of Cleveland contained an article - widely attributed to its then president, Jerry Jordan - which highlighted the combination of moderate consumer price inflation and an asset price bubble in the 'twenties, and noted the strong growth of money and credit during that decade. We've seen the same phenomenon over the last two decades - moderate consumer price inflation but strong growth in money and credit aggregates. In the five years to 2007, for example, consumer price inflation in the UK was well contained close to the Bank of England's 2% target, but the balance sheets of the largest UK banks nearly trebled.
To me - somebody not at all enthusiastic about government rules and regulations - there is therefore a need to supplement the supervision of systemically important institutions and the use of monetary policy to keep consumer price inflation low and stable with some form of macro-prudential rule, a rule which would seek to restrain excessive growth in money and credit aggregates.
What form might that rule take? I'm not sure but where the regulator believes that growth in the money and credit aggregates has diverged markedly from what the fundamentals appear to justify - perhaps evidenced by a large increase in asset prices - I believe there is a strong case for varying the minimum capital requirement applying to systemically important institutions, or the minimum liquidity ratio they must meet. Yes, it's uncomfortable making those judgements, but surely no more uncomfortable than the judgements central bankers have to make all the time about the appropriate stance of monetary policy. (And to the extent that varying the minimum capital requirement, or the minimum liquidity ratio, can take the place of a change in the policy interest rate, that may have the additional advantage of lowering the amplitude of fluctuations in the exchange rate.) And yes, one of the consequences of such measures to restrain the growth in the money and credit aggregates may be to drive consumer price inflation temporarily below whatever the target for such inflation is.
Incidentally, there are those who doubt the efficacy of varying the minimum capital ratio, or the minimum liquidity ratio. As a bank director, I don't doubt the efficacy of doing that. When a bank is obliged to hold more capital, or more liquidity, the cost of making loans goes up. That inevitably means that fewer loans get made.
So, in summary, my recommendations are as follows:
None of these measures will guarantee that there'll never be another banking crisis of course. But together they should materially reduce the risk of such a crisis, and reduce the cost to taxpayers when it occurs.
Former Governor of the Reserve Bank of New Zealand, 1988-2002
Adjunct Professor of Banking, AUT University, Auckland
 Speech by Mervyn King to Scottish business organisations, Edinburgh, 20 October 2009.
 Of course, in principle floating exchange rate regimes should have meant that the US could run monetary policy independently of China. But running tighter monetary policy might well have pushed US consumer price inflation below zero, which at very least would have posed political challenges.
 "How did a few dodgy housing loans precipitate the biggest financial crisis since the Great Depression?", in Competition and Regulation Times, November 2009.
 Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Stan J. Liebowitz, The Independent Institute, 3 October 2008.
 Altruism: The Moral Root of the Financial Crisis, The Objective Standard, Spring 2009.
 Losing Ground: Gramm-Leach-Bliley and the Future of Banking, Peter J Wallison, in AEI Financial Services Outlook, November-December 2009.
 Finance: A Return from Risk, a speech at the Mansion House by Mervyn King, 17 March 2009.
 Financial Sector Reform, Financial Sector Regulation and Supervision in Forum Island Countries, pp. 9-10.
 The Economist, 23 January 2009.
 Speech by Mervyn King at the Lord Mayor's Banquet for Bankers and Merchants of the City of London at the Mansion House, 17 June 2009.
 Op. cit., Edinburgh, 20 October 2009.
 Banking on the State, by Piergiorgio Alessandri and Andrew Haldane, Bank of England, November 2009.
 The Economist, 23 January 2009.
 Speech by the Governor of the Bank of England, Mervyn King, at the University of Exeter, 19 January 2010.
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