Examination of Witnesses (Questions 1-19)
PROFESSOR ALAN
MORRISON, DR
ANDREW LILICO
AND DR
KERN ALEXANDER
23 JUNE 2009
Q1 Chairman: Good morning and welcome
to our inquiry into banking and supervisory regulation. If I can
start with yourself, Dr Alexander, could you introduce yourself
for the shorthandwriter please and say where you come from.
Dr Alexander: I
am Kern Alexander from the Centre for Financial Analysis and Policy
at the University of Cambridge.
Professor Morrison: I am Alan
Morrison from the Said Business School at the University of Oxford.
Dr Lilico: I am Andrew Lilico
from Europe Economics and Policy Exchange.
Q2 Chairman: Now, there are quite
a number of things we want to get through this morning, capital
and liquidity regulation, cross-border supervision, macro-prudential
tools and narrow banking, so these are the issues that we would
like to focus on before Lord Turner comes in at 10.30. Talking
about Lord Turner, how culpable is the FSA in the development
of the financial crisis, and what has been its biggest failing?
What can it take forward as a lesson?
Professor Morrison: It is hard
to say precisely who is responsible for the financial crisis,
but there were clearly some failings in some supervisory institutions
and one of those was the FSA. I should say that, to the extent
that it experienced problems, those problems came from two sources.
The first was the fact that it has culpability both for conduct
of business and for financial supervision and, to some extent,
and the FSA has acknowledged this in recent years, it over-emphasised
the conduct of business at the expense of financial supervision.
The second problem the FSA had, which it has also acknowledged,
is that, possibly by virtue of the way that it is constituted,
it was concerned largely with understanding the risks at the level
of the individual firm and, whilst the risks at the level of an
individual firm could each look perfectly acceptable, combining
those things and thinking about them in the aggregate could sometimes
generate a picture that was much less attractive, and I think
the FSA and other supervisors in this country sometimes failed
to focus on the aggregate picture or the macro-picture, what we
now call the `macro-prudential'.
Q3 Chairman: Dr Alexander, what should
be the priorities for financial regulation in the future?
Dr Alexander: Well, I think financial
regulation needs to focus more on the broader financial system,
as we have seen it set forth in the Turner Report, focusing on
systemic risk. One of the major failures in regulation over the
last ten years certainly in the US and in the UK has been that
the regulation was too market-sensitive, it focused on the individual
institution and did not take into account the level of risk or
leverage building up in the total financial system. The regulator
thought that, if individual firms were okay and seemed to be managing
the risk appropriately, then everything was fine. We now need
to link that, and micro-prudential regulation is fine, but it
needs to be linked with a robust macro-prudential framework.
Q4 Chairman: Dr Lilico, the next
financial crisis is likely to arise from the same source as this
one. Lord Turner, on 18 March, set out his stall for the future,
but are the FSA just closing the stable door after the horse has
bolted, or is it ahead of the curve here?
Dr Lilico: I think it is always
very difficult to anticipate what the next financial crisis is
going to look like. My view is that the Turner Review has drawn
some of the wrong sorts of lessons in ways which mean that it
is unable to see the right kinds of lessons, so, in particular,
I think that it is a mistake. We have a set of financial regulations
which grew out of certain assumptions which were then interpreted
through economic theory so as to produce some recommendations,
so he decided that those recommendations did not produce the results
he liked, and what the Turner Review then did was to ditch the
economics. I would rather have kept the economics and challenged
the assumptions. In particular, I think there are two kinds of
assumptions worth challenging. One is the idea that it is a net
gain to replace individual diversified analysis by shareholders,
depositors, purchasers of retail financial products with regulatory
badging, and the other is that you reduce systemic risk by co-ordinating
internationally.
Q5 Mr Fallon: One of the other aspects
of Turner, which now seems incredibly fashionable, is that capital
should be held on a counter-cyclical basis. How should that be
done? Should that be done in a discretionary way, or should it
be more formulaic, as is done in Spain?
Dr Alexander: I think that you
have to have a combination of rules and discretion, and the rules
need to provide reference points or guidelines for regulators.
The reason I say that is that in other jurisdictions in Europe
the regulators, by law, are required to have more rules-based
regulatory regimes and the regulators are not allowed so much
discretion as, say, the FSA has, and this is because of principles
of due process and constitutional law, so, when we get into the
rules versus discretion debate, I think we have to have a balance
between both. I would simply say that Europe needs to be working
from the same playbook and you need to have a rules-based framework
in place, but yet it needs to be flexible enough to change as
market conditions change, but regulators need to learn as markets
evolve and take advantage of innovations that occur in the market.
Q6 Mr Fallon: Yes, but the rules
did not change in Spain or in Canada; they were simple and fairly
straightforward and people kept to them.
Dr Alexander: Well, the regulators
did change them, I think, in 2004 because of pressure from the
banking industry, but you are right, that generally Spain had
counter-cyclical rules which basically led to their banks having
more capital than other banks in Europe and, therefore, they were
able to withstand the crisis much better, they were not getting
bail-outs from the Central Bank. I would suggest that the FSA
in the UK and other Member States in the EU ought to have counter-cyclical
rules as well, and they need to be formulaic somewhat, but there
needs to be discretion built into it to adjust to market conditions
as they change.
Professor Morrison: I agree that
there is a need for a focus on rules-based systems, and ideally
they should be as simple as possible and as hard to bend as possible,
but one very good reason for rules-based regulation is the one
that has been pointed to by people like Charles Goodhart, that
in times of boom it is incredibly difficult to put the brakes
on when a rule gives you something to refer to and, to the extent
that discretion is built into the system, it is incredibly important
that the people have the right to exercise discretion, have the
right incentives and are accountable, otherwise, I suspect, counter-cyclical
regulation will simply have little effect.
Q7 Mr Fallon: How do we reflect counter-cyclical
requirements in the banks' accounts?
Dr Alexander: In the accounting
standards for reporting?
Q8 Mr Fallon: Yes.
Dr Alexander: I am not an accounting
expert, but I believe that one of the things the banks are going
to raise is that, if they have to set extra capital aside, they
do not have to report it as profit and pay tax on it if they are
just having to hold it, so, if we could allow them some flexibility
to set capital aside, reserve capital, and not to have to report
it and pay tax on it, then they may be more willing to do that.
If they, however, put this in the profit and loss statement and
pay tax, then they are going to want to pay dividends, so I think
we need to be flexible on how we allow the banks to set aside
reserve capital.
Q9 Mr Fallon: So the accounting treatment
for banks is going to have to change? Is that right?
Dr Alexander: Possibly, yes, for
banks that are subject to prudential regulation, we need to change
it in this situation.
Q10 Mr Fallon: Overall, Dr Lilico,
are we going to be, or should we be, seeing banks holding much
more capital than in the past?
Dr Lilico: I think the likelihood
is that we will see banks holding more capital than in the past,
but, as much as anything, I think that that would be a reaction
by the market to the circumstances that other people have learnt
some lessons, and one should be wary of over-reacting at the regulatory
level until you have some idea of how the market itself is going
to react to circumstances.
Q11 Sir Peter Viggers: You have,
quite interestingly, danced away from the question, saying the
market should lead, but I just wonder what you can bring to the
table in terms of assessing how much capital banks should have.
Can you contribute by suggesting what is the optimal level of
capital for a bank?
Dr Lilico: My view is that it
is useful to have rules, but what I think it is more useful to
have is guidance numbers, so I think that prudential regulation
is the proper pair to the lender of last resort function. What
is happening in prudential regulation is that the Central Bank
is deciding whether the institution that it is supervising is
a worthy recipient of lender of last resort at a pinch, so I think
that means that in normal times it is useful to have some guidance
as to what you think is about right for people to hold, and that
is a judgment, but that, once you come to difficult periods, such
as that from 2007 onwards, I do not believe that formulaic capital
adequacy requirements have any role at all and I think that they
should be abandoned, so I do not think you could hope to devise
a rule that would apply in good times and bad.
Q12 Sir Peter Viggers: But Basel
I and of course the Turner Review are looking at ratios for core
tier one and tier one capital and so on, but you would not place
a great deal of reliance on those?
Dr Lilico: I think that those
are useful indicators. I think that it is a mistake to try to
have exactly the same rule apply everywhere in the world. The
Basel I framework arose at a time when there was some scepticism
about the way that the Japanese were treating their capital and
I am not convinced that it turned out that the Basel I framework
improved the situation for Japan. I think that there is an issue
of discretion which is around how the Central Bank interacts with
its own system of banks that it is overseeing.
Q13 Sir Peter Viggers: Dr Alexander
and Professor Morrison, would you agree with that?
Professor Morrison: I agree with
much of it. The capital regulation, I think, should be as simple
as possible. There is a case for some simple rules on things like
tier one and core tier one ratios and, at the same time, one should
be prepared to relax those requirements in an extreme crisis.
However, in an extreme crisis those ratios never bite; the market
demands far higher capital requirements before it is comfortable
with a bank in a time of crisis than the regulators do. Actually,
this is one of the problems with counter-cyclical regulation,
that, when you attempt to relax capital requirements, the regulator
relaxes capital requirements and it may have very little effect
because the market is requiring such massive levels of core capital.
One of the problems we have had, however, with capital regulation
has been an excessive reliance on highly technical models that
feel like the national science's, but in fact are not, so we rely
on parameter estimations and things like correlations and so on
and this is according a level of scientific validity to these
theories which they do not have. They are very useful tools for
managers, but whether they should be hard-wired into regulation
is a very moot point, in my opinion.
Q14 Sir Peter Viggers: Just moving
on a bit, what types of capital should feature in the calculations?
Dr Alexander: I think core tier
one capital should be expanded, and of course the definition of
`core tier one capital' should be the ability of the capital to
absorb losses fully, and that is mainly common equity shares.
If you get into preferred shares or subordinated debt, those types
of capital have a more limited ability to absorb losses. What
we want banks to have is not necessarily such high capital charges,
but that they have good-quality tier one capital that composes
most of the regulatory capital that they are holding. One of the
problems in Europe is that you get different definitions of the
type of capital that banks hold across Member States in the EU
and the Capital Requirements Directive does not adequately address
that. The point is that the definition of `capital' should be
linked to its ability to absorb losses.
Q15 Sir Peter Viggers: What I am
hearing is a message that an abstract approach to this issue should
be treated with extreme caution, but the Turner Review suggests
that trading book capital requirements might increase by a factor
of three. Would you like to comment on that rather specific and
concrete suggestion?
Professor Morrison: There is not
doubt that trading book capital requirements, I think, are too
low. The rationale for having lower levels of capital for trading
book instruments is that a troubled bank can sell those instruments
rapidly and, hence, does not retail as much capital, but actually
we have discovered recently that, at the time you most need to
sell those assets, they may be extremely illiquid because no other
bank is prepared to purchase them, so that is one reason why more
capital against those instruments might be held. Another is that
the liquidity of these instruments is not a fixed and permanent
number, it is something that depends on the expectations and the
behaviour of market participants and those expectations and behaviour
change in response to things like capital regulation, so it is
quite conceivable that more capital will actually up the liquidity.
Whether the right number is three, two or four, I do not know,
but I believe that capital requirements should be much higher
for the trading book.
Q16 Sir Peter Viggers: From your
earlier remarks, would you agree that the financial sector has
relied too heavily on abstract models developed by mathematical
experts at the expense of old-fashioned commonsense?
Dr Lilico: I think that mathematical
models can be very valuable and that they can provide important
insights to those who are making regulatory judgments and are
useful guidance, so I think it is a mistake to think that the
crisis tells us that the mathematical theories and the mathematics
of economics should all be abandoned and are proven to be invalid,
but, on the other hand, I think that it is always useful in regulation
to be humble and to understand that there are limits to your understanding
as a regulator, so you must not think that you can produce some
model which enables you to decide on exactly what the right kind
of thing to happen is.
Q17 Sir Peter Viggers: As to the
division between the banking book, old-fashioned banking, if you
like, and the trading book, which has been called the `casino'
element of banking, when one puts to bankers that there might
be some kind of division more clearly drawn between these two
aspects, the banks tend to say, "Well, it's actually much
more complicated than that. It's all shades of grey rather than
black and white". How would you comment on that?
Dr Lilico: I do not think that
it is necessary or desirable to divide up the casino banking from
the utility banking. I also think that it is a mistake to imagine
that the utility banking is likely to remain unchanged by these
events. I offer, for example, the point that, even if you go back
to before the madness of the bonds market to 2004, 30% of income
to the European banking sector from the non-wholesale customers
was mortgages, and I do not think that that is going to continue
in the future.
Q18 Mr Fallon: If we could return
to European regulation, whilst the fiscal responsibility for bail-outs
and depositor protection remains national, why should we accept
some supra-national power to override national regulators and
their responsibilities?
Dr Alexander: I would say because
the externality is cross-border. Banks have exposure to each other
throughout Europe in the money markets through a variety of risk
exposures, and European policy-making needs to begin to have better
surveillance of the systemic risk posed by certain banking groups
and financial institutions that operate in Europe. It does not
mean that we displace national regulators, it simply means that
we involve regulators at the national level having more accountability
to a committee of supervisors consisting of the Member State regulators
themselves so that there is more co-ordination at the European
level.
Q19 Mr Fallon: But that is not the
proposal. The proposal is not just for surveillance, the proposal
is that, under certain circumstances, the national regulator should
be overridden and there should be binding mediation on the Latvian
regulator or whoever it is. It is not just surveillance, what
is being proposed, it is override.
Dr Alexander: Well, it is override
regarding the application of EU law. If there is a dispute regarding
how the Capital Requirements Directive is being applied, there
certainly needs to be a European policy input regarding how the
CRD is being implemented by, say, the UK or Spain or Poland. In
the past, it has just been up to the Member State to do whatever
they wanted to do for the most part and it has been impractical
to call a Member State to account.
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