21 February 2011
The Bank of England’s Andy Haldane gave a fresh perspective on the causes of the global financial crisis and ran through the UK central bank’s favoured cures at a recent lecture he gave to Irish thinktank the Institute of International and European Affairs.
Haldane, the BoE’s executive director of financial stability, who also sits on the Basel Committee, kicked off by reminding his audience of the severity of the crisis and why another one is literally unaffordable.
He said that the permanent loss of output caused by the global financial crisis is between $50 trillion ($50,000bn) and $200 trillion. That’s between one and four years’ global production of goods and services globally. He also put the amount of money thrown at the problem (in bailouts etc) by governments around the world at $15 trillion and counting — 13% of world GDP.
Charting the reasons for the global financial collapse, Haldane said UK and US banks (and those in certain other countries) had been allowed to grow too big. He described how they had ballooned their balance sheets in 2000-07 largely by lending vast sums to each other — as opposed to the real economy. When combined with the ‘amplifier effects’ of the “implicit government guarantee” provided to too-big-to-fail banks and the increasingly concentrated nature of the banking market, increased illiquidity of bank assets and increased inter-connectedness, Haldane said it was little surprise disaster had struck.
Picking up on some of the themes of his July 2010 speech (The contribution of the financial sector — miracle or mirage?), Haldane added that, despite the ‘moral hazard’ of implicit government guarantees, these and massive state subsidies remain firmly in place. He said the annual government subsidy handed to UK banks was £100bn in 2009 alone, or “roughly what we spend on our National Health Service.” Haldane then said the “existing regulatory apparatus” is inadequate and unlikely to prevent future crises.
His (micro-prudential) silver bullet for taming bank and banker recklessness is wider use of contingent convertible securities (CoCos). CoCos are a hybrid form of debt that converts to equity should the issuing institution into difficulties — thereby bolstering its capital strength, and causing investors’ pain, at critical times. He believes wider use of CoCos to reward both staff and shareholders — via bonuses/dividends paid in CoCos as opposed to in cash of shares — would lead owners and executives to monitor institutional behaviour much more closely and make them more likely to keep bank boards on the straight and narrow. Haldane argued that wider use of CoCos would make banks “much more resilient and less likely to fail” and might have meant the global financial crisis was averted.
He said: “It lines up incentives. The pay-off profile of these CoCos is such that, in the good times, you get paid, and in the bad times, your claim gets diluted — so you bear the downside risk of your actions. That will make both shareholders in banks and staff in banks much more risk-sensitive, much less likely to bet the ranch next time round.”
He concluded by arguing that the raft of new macro-prudential regulatory bodies that are sprouting up around the world — which include the Financial Stability Oversight Council (FSOC) in the US, the European Systemic Risk Board (ESRB) in Europe and Financial Policy Committee (FPC )in the UK — should have the capacity to tame the credit cycle and tackle too-big-to-fail banks. He said these newly formed macro-prudential organisations would force the so-called “super-spreaders” — big and inter-connected banks like Lehman Brothers — to hold bigger capital buffers. Haldane then segued into describing the merits of “bail-ins” and resolution regimes including “living wills”.
(Added March 12th, 2011) I’m not convinced the measures outlined by Haldane will be enough. For a start he did not mention ethics — and in my view the key reason for the global financial crisis was the absence of ethics across the banking and financial services sector. Another cure he fails to prescribe is the break-up of “universal” banks through an enforced separation of “casino” activities including most investment banking from “utility” ones including commercial banking and retail deposit-taking. Liam Halligan has written an excellent piece “History’s lesson is the investment and retail banking must be separate” along these lines tomorrow’s Sunday Telegraph.
Update February 21st 2011, 11pm:-
Writing in today’s Financial Times, Haldane and zoology professor Robert May argue that scaling up risks in complex organizations may cause them to cascade rather than cancel each other out, because size and complexity boost the chances of cross-contamination (summary via Bloomberg)
History offers no evidence that big, complex banks are less likely to fail than smaller ones, but even if it did, there would still be a strong case for big banks holding higher levels of loss-absorbing capital, because of their system-wide impact, Haldane and May said. Epidemiology teaches that the optimal strategy for preventing the spread of disease is to concentrate on “super- spreaders,” that is, not those most likely to die, but those with the greatest capacity to infect counterparties, they said. Big, complex banks are the super-spreaders of the financial world, with “mind-boggling” numbers of counterparties; when Lehman Brothers collapsed it had more than 1 million such relationships, Haldane and May said.