Banking Crisis - Treasury Contents

Examination of Witnesses (Questions 680-699)


13 JANUARY 2009

  Q680  Mr Todd: In other words, it is back to human beings and understanding what seems like a rational approach to access to cash essentially?

  Dr Danielsson: I could not agree more.

  Professor Goodhart: Going back to the Chairman's opening position, I think that the lack of concern with liquidity that had been shown previously, particularly by regulators, was out of a belief that the wholesale markets, where most banks went to get their marginal funding, were very efficient and would work and would be open under all circumstances as long as the banks had sufficient capital, and it was that belief that wholesale markets will always work efficiently, subject to the banks abiding by the capital requirements, which was shown not to succeed from August 2007 onwards, and those wholesale markets are still not working properly. The banks' search for liquidity has consistently shifted from holding liquid assets to the belief that they could obtain additional funding by going to these wholesale markets. It was the failure of these wholesale markets that brought concern about liquidity back to the centre of the stage.

  Q681  Mr Todd: So what should a regulatory system for liquidity look like?

  Professor Goodhart: Well, there very nearly was such a system introduced in fact in the 1980s. At the same time as the Basel Committee was introducing an accord on capital they were searching for an accord on liquidity, but that search ran into difficulties, and effectively got dropped in the 1980s, it became too difficult for them to proceed, and the process went on then continuously whereby the banks turned for their additional funding, their liquidity, to the wholesale markets and more and more got rid of their lower yielding but highly liquid public sector debt, to the point where the British banks entered the crisis in 2007 holding a really minimal amount of highly liquid British government debt.

  Q682  Mr Todd: Fine, so you are suggesting in terms of a regulatory environment for the future?

  Professor Goodhart: We would need to go back to look at an appropriate regime for liquidity.

  Q683  Mr Todd: And Basel II—back to the drawing board?

  Professor Goodhart: Basel II has got a lot of good features. I think it is the best system that I know for trying to ensure the capital adequacy and the constraint on risk-taking of the individual system. Where it fell down completely was in looking at the systemic risk, the macro prudential, compared to the micro prudential risk. It is not that Basel II is wrong or bad; it is just totally and completely insufficient in that it did not look appropriately at the systemic issues. To take a particular and very obvious example, for an individual institution which is running into difficulties with insufficient capital, the obvious thing for it to do is to cut back its total size by reducing its loans and refusing to make additional loans, but if everybody does that, as is very obvious now, the system and the economy runs into extraordinary difficulties, so what is sensible and prudent for the individual bank and individual institution frequently makes no sense at all for the system as a whole, and it is systemic issues that Basel II did not deal with.

  Q684  Mr Todd: Just one last point, if we tighten controls on liquidity, is not one of the inevitable consequences that we will actually slow the recovery from the current credit crunch because we will have a more conservative set of instruments which will require banks to hold more assets in readily convertible forms?

  Professor Goodhart: That is actually a generalised problem in the sense that at a time of crisis the tendency of the regulators is to tighten up on everything, but the more that you tighten up, whether it is on capital, liquidity or anything else, the less easy it is for the banks to undertake expansion because you are tightening the controls, and I think that is of greater concern on the capital side than it is on the liquidity side because at the moment there are no real liquidity constraints. The FSA did introduce a 9% requirement very recently, but apart from the FSA's recent measures the constraints have been on the capital side, and the desire has been to raise capital ratios up to 12%, and now everyone is saying, "We did not really mean 12. 12 is fully what we would like to have but under pressure we would be perfectly happy for you to go down." Indeed, one of the issues here is that what you want in your regulation generally is counter-cyclical so that they really tighten and prevent the banks going crazy during these asset price booms and bubbles and then when everything gets difficult in the bust and everyone is incredibly cautious anyhow then the regulations get eased.

  Q685  Chairman: Professor Buiter, welcome to the Committee.

  Professor Buiter: My apologies for being late.

  Q686  Chairman: We are grateful that you are here and, as you know, this is the first evidence session of the banking crisis inquiry. I asked your fellow panellists before you came in: what is a financial sector for and what is the role of the banking sector within the financial sector?

  Professor Buiter: The banking sector intermediates between savers and investors and it allocates financial portfolios and allows the trading of risk. It is an essential part of the transmission mechanism for monetary policy and indeed also to an extent for fiscal policy, and when it malfunctions the real economy suffers grievously, as you see. It depends how you define banks. I am talking here about highly leveraged institutions that are very much more liquid on the liability side than they are on the asset side. Deposit-taking and making loans would be the classical bank example, but generally I think anything that is highly leveraged and uses a lot of borrowed money compared to its own resources and that funds itself short and liquid (normally) and invests long and illiquid is a bank. My description means that there is no such thing as a safe bank, of course. The only reason that banks, which are institutions that have big signs on them "please start your run on me", survive is because they have an implicit or explicit guarantee at the very least of funding provided from the ultimate source of liquidity, which is the central bank, should the liquidity of their normal funding suddenly dry up. No bank can be safe unless it has a market maker of last resort and a lender of last resort standing by. That said, as regards the liquidity issue I think we have to be very careful that we do not end up in a world where banks and other financial institutions are required to always hold the liquidity required to cope with the worst contingency. Liquidity is to a large extent a public good. It is a property of assets that can disappear when trust and confidence disappear. Certain assets are almost always liquid. Government assets tend to have that property, although if you go to Zimbabwe even public assets, even public money, is not liquid any more. It means that although banks and private institutions could provide for their own liquidity by holding large amounts of treasury bills, I think it would be highly inefficient to do so because they would not be able to engage in their socially useful function of borrowing short and lending illiquid, rather than lending liquid, which they would be doing, or investing liquid if they invested in treasury securities. Sure, they will need some but banks should not be required to hold more inherently liquid assets than is necessary for the ordinary conduct of business during ordinary market conditions. For the rest the central bank has to be on stand-by. The Bank of England was not, and part of the problems that we are seeing is because of that. They now are better attuned to the job. They should therefore see to it that the public good of liquidity is to a large extent publicly provided in an emergency rather than force banks to provide it privately always.

  Q687  Chairman: In this banking crisis inquiry we are looking at how we arrived at this situation, how we get ourselves through the present situation, and what the regulatory environment will look like in the future. On the first point of how did we get into this situation, could you give us your views?

  Professor Buiter: In many ways it is a classic credit and asset boom; excessive lending and excessive leverage which became more and more risky. That is how credit booms and credit busts happen. It took some new forms and it was regionally more widespread. We had securitisation problems in the US which of course were not restricted to the subprime market, but became an issue there first, but there were country-specific financial excesses in most countries in the North Atlantic area. British households had debt equal to 170% of disposable income and that had very little to do with US subprime debt, and there was general regulatory failure because of the growing belief that self-regulation would suffice and that, if intervention was required, the so-called principles-based light-touch regulation would be sufficient. I think that is and was an illusion. Financial markets are very useful but inherently fragile and dangerous institutions, and the notion that they could be self-regulating was always ludicrous. Even Mr Greenspan recognises that now, somewhat belatedly. There was a general lowering of regulatory standards. The fact that finance—and I am talking here about the finance of border-crossing financial institutions of which there may be 60 to 80 institutions that matter globally—the fact that the domain of the market and the range over which these institutions roam is global and regulation is national means that, whatever you do, these firms and financial innovation will be running rings around the regulators. The logic of a global market is to have a global regulator. You cannot have that, I recognise that, but that has implications that you will always be in an environment where regulatory arbitrage will undercut regulatory effectiveness, not just because of innovation within a nation but competition between nations. Lowering of regulatory standards were used to attract financial business.

  Q688  Chairman: So from what you are saying it seems as if there was a misplaced faith in that market mechanism in the past few years?

  Professor Buiter: Yes, in the self-regulating sense.

  Q689  Chairman: How does the current crisis then compare to that, say, of Japan in the mid-1990s and the Wall Street Crash of 1929? Are there any comparisons?

  Professor Buiter: In many ways they are very similar. The Japanese boom was of course much bigger than anything we have seen and the bust has been much, much bigger than anything I hope will see. Their stock market came down 90%, was it?

  Professor Goodhart: Nikkei was at 38,000 at its height; it is now at about 8,400.

  Professor Buiter: So that is a healthy decline! A massive asset boom and bubble and a massive bust, and in Japan of course that was followed by spectacular policy incompetence. There was no serious attempt to address the toxic asset issue for seven years. The recapitalisations that took place really were late and inadequate and the banks were allowed to go on making zombie loans to zombie institutions rather than trying to clear the debt. I hope that Japan provides an example at least as regards the policy response on how not to do things. They did certain things right. Keeping the zero interest policy and engaging in quantitative easing is clearly something that will have to be emulated here, as is the case already in the United States, but their reluctance to clear or to ring-fence the toxic assets, to recapitalise the banks, and their willingness to let the overhang of bad assets become a tax on new lending to potentially profitable enterprises are all warnings of what we should avoid, and we have done so far. The US in the 1920s was again just a big bubble that burst and a very perverse monetary policy response where monetary policy actually tightened.

  Professor Goodhart: And in all three cases the real economy had behaved very well in the years up to that. The 1920s were years of low inflation and steady growth in the US. The 1980s in Japan was a golden era. The period between 1992 and 2007 was probably the best years of economic developments that the world has ever seen and this had led people to believe that risks generally had declined, that we would not see future problems, so everyone poured into asset markets because risk had gone, and of course risk had not gone.

  Q690  Chairman: It was a great moderation.

  Professor Buiter: There were also great moderations in the 1920s and in Japan as well.

  Q691  Mr Crabb: Professor Buiter, you describe the general regulatory failure: do you think that the international architecture for financial regulation now needs to change given the current crisis?

  Professor Buiter: It needs to but it will be extremely difficult. In any regulatory regime that one can think of one will have the US doing its own thing because they are not going to be agreeable to being bound by international agreements and certainly not to being regulated by a foreign entity. I think the best we can hope for is that we come to a single European regulator for the European Union for border-crossing institutions. That would take care of 27 dimensions of regulatory arbitrage—not enough, but it is a lot easier to reach agreement between a single EU regulator for border-crossing financial institutions and the Americans and the Japanese and maybe the Chinese and the Indians. At the moment I think there are just too many unco-ordinated, mutually undercutting regulatory regimes.

  Q692  Mr Crabb: Professor Goodhart, would you share that view?

  Professor Goodhart: I do not think a single European regulator is feasible at the moment, even if it is desirable. As everyone has seen, when a crisis comes you need to recapitalise the banks. Recapitalisation is enormously expensive, so you need to have a regulator that has access to funds via a ministry of finance or treasury. There is not a federal ministry of finance or treasury who could provide such funds. Without such European funding, without a European fiscal competence in that respect, effectively the exercise of trying to ensure that their banking systems remain viable has unfortunately got to remain within the nation state. I fear that under these circumstances with a global system and national regulators what is actually going to be needed is to have rather more power to the national regulator rather than less, so that the national regulator can see the development of asset price bubbles and credit bubbles in their own economy and take the appropriate steps to prevent that making their own country's financial system become at risk.

  Q693  Mr Crabb: Do you think that the current crisis reveals a failure on the part of the IMF in terms of sending out warning signals?

  Professor Goodhart: No, they did send out warnings. This idea that there were no warning signals from central banks, there were loads of warning signals, particularly from the BIS. This stuff about early warning signals is actually pure nonsense. It is not that there were not enough early warning signals. Everybody forecast that the situation was getting dangerous because risk was being underpriced; the problem was not the lack of early warnings. The problem was the lack of both instruments and willingness to do anything about it.

  Q694  Mr Crabb: So how should we improve those instruments to ensure that sovereign states take heed of the warnings?

  Professor Goodhart: That is very difficult because in a boom everyone loves it and the idea that you are going to have a regulator saying, "I am sorry, we are not going to have 100% or 125% loan to value ratios; Northern Rock, you are not allowed to behave that way, you are not allowed to do subprime mortgages based on nothing except the expectation that housing prices will go on rising, you are not allowed to do that," runs counter to the wishes of the lenders, the borrowers, and virtually every politician at the time during the boom, so what you are asking regulators to do is effectively to take the punch bowl away when the party is going, and that is not a popular activity.

  Professor Buiter: The regulators were not terribly keen, to be honest. During a big asset boom/credit boom there is universal capture of the regulators and the political process by the financial sector. You can see that because who argues with success? People who take home $50 million a year must be doing something right. It is very hard to interrupt that spiral until it is done by brute force through an implosion of the bubble. There is no willingness among the regulators or among the political classes to interfere with an asset boom or a credit boom. I have never seen that.

  Professor Goodhart: The subprime market was regarded as a triumph in 2004-2006. It was providing access to home ownership for the disadvantaged class in America. This was regarded as one of the great triumphs of finance.

  Professor Buiter: Finance as social engineering—it was.

  Q695  Sir Peter Viggers: The crisis is of course worldwide. Was the UK economy in better or worse shape to cope with the problems a couple of years ago?

  Professor Buiter: Compared to?

  Q696  Sir Peter Viggers: Compared with other countries?

  Professor Buiter: Probably in the worst shape maybe after the US. It has the largest financial sector relative to size of economy of the major industrial countries. Only much smaller countries have balance sheets with 400-450% of GDP for their banking sector. It had this long-standing boom which had resulted in this very highly leveraged housing sector. The corporate non-financial sector is actually in quite good shape but is squeezed between the banking sector and its inherent fragility, the over-leveraged households, and I think also the stretched public finances. The pro-cyclical fiscal behaviour of the second part of the Labour administration made the boom larger than it would have been and also made it more difficult of course to respond effectively with counter-cyclical measures once this becomes necessary as it is now. Britain of all the larger countries was probably the most vulnerable; it was not Iceland but it was not as it should have been.

  Q697  Sir Peter Viggers: Professor Buiter, you made a passing reference to ring-fencing toxic assets which sparked my thinking that the nearest analogue to the present situation is of Lloyd's of London in the 1990s where scrupulous efforts were made to identify and isolate toxic assets. Is this something which is being done sufficiently? Is it important and what messages are there here?

  Professor Buiter: In the US also it is the one part of the Government's arsenal that has not really been used yet. The TARP was set up to buy up toxic assets. In fact it has not been used for that. The only successful example of toxic asset ring-fencing inside an institution in this case is in the Citigroup deal where $200 billion or $300 billion-worth of dodgy assets is insured now by the Treasury so that if their value falls below a certain level they go in, so that is a way of providing financial support for that. I think that one wants these assets either off the books or ring-fenced on the books in such a way that they can be dealt with, their true value, or lack of it, is revealed, that the remaining uncertainty is taken away and then that the state, if it is the only one who can carry that load, can take them on its books and try to make in the long run as much money out of them as it can. They may have to be held to maturity.

  Q698  Sir Peter Viggers: The question of the future of securitisation, the model of `originate-to-distribute', which has been a very important part of our system and of course the boom, to what extent will the system self-regulate? To what extent will people who have had their fingers burnt withdraw from this field? And to what extent will further regulation be needed?

  Professor Buiter: For three years they will withdraw. That is the half-life of memory in the financial markets. There is nothing wrong with securitisation. It is a wonderful invention to make the illiquid liquid and the non-tradable tradable. The problem is that when you commoditise relationships, which effectively you do, and make them tradable, you tend to destroy the incentive for gathering information or at least weaken that incentive, from the original borrower. What information is gathered is no longer traded with the instruments when they get bundled with 7,000 other instruments. Some of the CDOs apparently if you were to read all the documentation that ought to go with it it ran into four million pages which even the very well-paid lawyer would not have time to deal with. The lesson is very simple: we can have securitisation; we will have it again; it is an important source of finance, but we need to force the originator to hold onto a sizable chunk of the first-loss or equity tranche of the securitised commodities. That keeps the incentive for gathering the information and monitoring the relationship intact.

  Dr Danielsson: Securitisation is something that we would sorely miss if we did not have it. It does provide quite a useful function. In addition to what Willem said, there are a couple of things about securitisation that went wrong in the crisis. Most of these instruments are what are called over-the-counter. They are bilateral agreements between one bank and one client. Therefore there is no way to figure out what exactly is an appropriate market price for these instruments and when there is a problem there is no way to add up all the exposures of the entities. I would think in the future the focus on regulation will be to make all these instruments transparent and liquid and traded on an exchange. If we had taken many of the CDOs and the subprime assets and CDSs, if all of this stuff was traded on an exchange like the London Stock Exchange or some other exchange, then you would have a couple of benefits. Number one, you could immediately figure out what exactly is the exposure of an individual institution. Somebody buying the stuff could figure out what is the appropriate market price, and in trouble, especially like the Lehman Brothers, when they went under they had a few hundred billion dollars worth of CDSs and the problem is nobody really knew what was the net exposure of Lehman's. After they defaulted you could finally sit down and do the calculation. They figured out that the net exposure of Lehman was $6 billion, a lot smaller than anybody suspected. If these instruments had been traded on an exchange, that would have been known prior to the default of Lehman's so they might still be alive. In the future we need to keep those instruments, they are useful, but they do need to be traded on an exchange so that they are transparent, we understand the risk, and any buyers get an appropriate price and can dispose of them if need be.

  Chairman: Thank you very much. We are hoping to finish for 11 o'clock. The answers are fascinating but if you could make them a little bit shorter, thank you. Jim?

  Q699  Jim Cousins: I am a little confused by what we are being told. Professor Goodhart and Professor Buiter, are you telling us that those in charge of the financial system did not see the problem or that they did not warn people effectively enough about it or just that they did not have the guts to stop the party?

  Professor Goodhart: Basically the last. The BIS and the Bank of England and most other central banks knew that risk was underpriced and they were worried before the event that there would be some kind of severe reversal. They did not know where it was going to come from, they did not know the exact trigger, but they were aware that there were problems, but I do not think that they were prepared to take the tough actions and they did not really have the instruments to do so. They were not able to turn round to the banks and building societies and say, "You shouldn't make loans at such high loan-to-value ratios," for example.

  Professor Buiter: I do not think that regulators saw what was coming. There were general warnings. Indeed, the risk premium rates had become ridiculously low and things were unsustainable but nobody foresaw the complete freezing up of all wholesale markets that mattered and nobody anticipated that the world's leading banks would be socialised or living under a government umbrella by the end of 2008, so I think the magnitude of what was going wrong was not seen by anybody, at least nobody that went on the record. There were warnings and they were not heeded. They were not heeded basically because people feel that they cannot argue with billions.

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