Examination of Witnesses (Questions 40-49)
PROFESSOR ALAN
MORRISON, DR
ANDREW LILICO
AND DR
KERN ALEXANDER
23 JUNE 2009
Q40 Chairman: In terms of liquidity,
how do you define `liquidity', Professor Morrison?
Professor Morrison: It is a very
hard thing to define, which is why we do not have formal regulations
over it at the moment, so many people define a bank's liquidity
in terms of the asset base that it has, so, if it has lots and
lots of gilts on its book, then it is a very liquid institution.
The problem with liquidity, as I remarked earlier, is that it
is not a constant, but it is something that evolves in line with
market expectations and the beliefs of market participants. When
market participants stop believing in one another, liquidity dries
up, so I think perhaps a better way to think about liquidity would
be to think about the exposure a bank has to the drying up of
liquidity, and that is particularly to be measured in terms of
mismatches of maturities, so banks have always engaged in maturity
transformation and that is something that we would like banks
to do. When the maturity transformation is not between deposits
and long-term investment, but between short-term wholesale funding
and long-term investment, it seems that the liquidity risk is
much higher, so my inclination would be to measure liquidity in
terms of maturity mismatches on a bank's portfolio.
Q41 Chairman: Why, in Adair Turner's
words, did both economics and policy-makers "take their eye
off the ball" regarding liquidity?
Dr Alexander: I think that there
was an under-appreciation of the risk that liquidity risk poses
to the broader financial system. So much of the policy debate
and so many of the academic models looked at market risk and credit
risk, and then liquidity risk was under-appreciated. In fact,
Alan Greenspan praised the fact that we had a smoothing of risk
in the financial system and that securitisation helped facilitate
this, so the types of financial instruments that were being used
in the economy, credit risk transfer instruments like securitisation,
were seen as spreading risk throughout to those who were willing
to absorb the risk and, therefore, there was not an appreciation
that liquidity risk could arise in such circumstances, so the
academic models, the policy, the regulatory frameworks were built
upon the fact that credit risk transfer was promoting liquidity,
but what we did not count on was the fact that suddenly all the
institutional investors could just simply not want to roll over
their short-term investments and then the liquidity would dry
up. That was something that was not foreseen and it is a major
failing, I think, on the part of both academics, policy-makers
and of course the risk managers in the banks who should have seen
this.
Q42 Chairman: Dr Lilico, the FSA
has suggested a `core funding ratio' tailored to each bank. Now,
that might expose the FSA to the accusation of inconsistent regulation
across banks. How can it ensure adequate liquidity at each firm
whilst ensuring that each firm is treated fairly?
Dr Lilico: It seems to me that
the liquidity problem is a mistake, it is just a symptom of the
wider mis-pricing of risk, so, if you got your risk analysis of
how much risk there was and if you got your risk assessments right,
then the likely fluctuations of the requirements of liquidity
would have been less and the liquidity might have proved adequate,
so I think that the liquidity point is to be overstated. I think
it is important to distinguish between different kinds of crises,
so any kind of institution can have a crisis associated with just
not having enough cash, sometimes you can have insolvency associated
with past losses and sometimes you can have insolvency associated
with a lack of future profitability. I do not think that this
was just a liquidity crisis and I think that some of the liquidity
discussion is just a carryover from the early phases of the crisis
when we thought liquidity was a bigger issue, so, although I think
liquidity is worth looking at again, I am not convinced that we
need to change things all that much.
Q43 Nick Ainger: Following on from
that, the Turner Review sets out the figures in relation to structured
investment vehicles which show that in four years from 2003 to
2007 the growth of SIVs and their total assets tripled, and Turner
says that this was a major contributor to the highly leveraged
situation that certain institutions found themselves in. Dr Alexander,
you talked earlier about one of the banks' functions is maturity
transformation. How important are SIVs to maturity transformation?
Do we still actually need these SIVs?
Dr Alexander: I think securitisation
is an important component of our financial system and that we
should not throw it out, but it is how it is regulated and we
have to understand the risk that securitisation presents. Again,
many experts did not foresee the liquidity risk that an over-reliance
on securitisation funding could pose to the broader financial
system. I think that, if we properly regulate securitisation,
SIVs and the various conduit funding that banks have been using,
then they are appropriate ways to raise capital. They are a part
of financial innovation and we should not curtail financial innovation,
but we have to understand that the funding through SIVs is short-term
and that it can dry up quickly, just like in the old days there
was a bank run with depositors running for the exit, but now we
have got institutional investors that can turn off the funding
pretty quickly, and we have to think about how to regulate that
and what types of costs to impose on that.
Q44 Nick Ainger: Coming on to this
point about how to regulate, we have been told by academics and
practitioners in the financial services sector that part of the
problem is the complexity of these various vehicles, these CDOs
and CDOs squared, and we even had the Chairman of the Deutsche
Bank who did not even know what a CDO squared was. It is all very
well saying, "Yes, we should regulate and regulate them better",
but with the very fact that they are incredibly complex and that
the risk element is in their complexity, how do we expect regulators
to understand the risk involved and, therefore, point out to the
institutions, "You are at risk because of this" if the
institutions themselves do not even understand the risks involved?
Dr Alexander: Well, if they do
not understand it, they should not do it and the regulators should
not permit it. Right now under Basel II, regulators have to approve
the risk models that banks submit to them for review, for credit
risk, for market risk and now liquidity will be included in Basel
II, so regulators should not be approving these models as submitted
if the bank cannot explain the model and cannot demonstrate an
understanding of the model. This is part of the dialogue, the
interaction, that the regulator has to engage in with the banks,
but it is not the regulator's problem to figure it out. The bank
has to explain it and the regulator needs to have maybe advisory
experts there to test the models that the bank is submitting for
approval. If they have a model that is testable and it makes sense,
then they can approve it.
Q45 Nick Ainger: So what we need
is actually far more informed regulators who are able to make
an objective judgment of what they are being told by a particular
institution?
Dr Alexander: They need to be
able to make an objective judgment, but the burden is on the bank
to make that model work, to prove that under certain conditions
of stress-testing and various other ways, and the regulator has
to be there to be vigilant and it is not the regulator's job to
figure it out, but it is the bank's job to explain it and then
the regulator, I think, will rely on expertise to make sure before
deciding whether to approve it.
Q46 Nick Ainger: Do the others agree
with that?
Professor Morrison: Well, no one
could argue against a well-informed regulator, it is like arguing
against commonsense, but I think we need to be aware of our own
systemic limitations. Some of the models which were generated
were very elegant and very clever and had very little economic
content; they were essentially physics rather than economics.
We made the mistake of thinking that, as a physical model can
tell us what happens when water boils, these models would tell
us what happens when a default starts to occur in financial markets,
and sometimes the problem here was excessive reliance in the regulatory
arena upon models which were really intended as devices to help
managers to understand what was going on, so, to the extent that
there were regulatory failings, I think perhaps the regulatory
failings were in taking some of these models too seriously. When
you do that, the incentives to the people who create the models
are bifurcated. To some extent, they are concerned with creating
accurate models and, to some extent, they are just concerned with
reducing their capital charges, so one problem here was not appreciating
the limitations of some of the tools that were being used in regulation
and that, by using the regulation, it may have changed their nature,
and that is a big problem. Another problem was failing to recognise,
and this is a simple problem that can easily be fixed, but failing
to recognise that banks that provide backed-up lines of credit
to SIVs, even if those lines of credit are not legally binding,
actually find it very hard to walk away from them and, hence,
had a liquidity exposure that was not recognised.
Q47 Nick Ainger: You used the phrase
"physics, not economics", but what do you actually mean
by that?
Professor Morrison: What I mean
is that, if you take a simple model of a securitisation, say,
I have a securitisation where I take two loans that I have made
to a corporation, bundle them and then sell another piece of paper
that defaults when both of these loans default together, then,
in order to put a price on the securitised asset in the absence
of a liquid market, I have to make assumptions about how often
each of these loans will default individually and how often they
will default at the same time. People do this using elegant methods
that come from the mathematics of fluid mechanics originally,
so I have a model which shows the price of one of these things
moving up and down and another one and, when they both move down
far enough, we see a default, so those are models that have this
feeling of precision. You can calibrate them by going out and
gathering data and you get a figure for simultaneous defaults
and you get a figure for individual defaults and you treat those
things like physical constants in the same way that you have a
number that tells you when water freezes and when it boils, but
those things are not physical constants, they are economic numbers
that depend upon the behaviour and the expectations of market
participants. When market participants suddenly realise that everyone
is doing the same thing and they suddenly realise that, because
of the immense opaqueness of these markets, they do not know what
one another is doing and exactly what the exposure of different
people is, those parameters can change rapidly, so assumptions
built and hard-wired into models about correlation parameters
just turned out to be completely incorrect in 2007. It is not
that they had been estimated in the wrong way, the estimation
procedures were good, but there was a structural change in the
way that people saw the world. I think failure to understand these
feedback mechanisms as being integral to the way that financial
markets operate has got a lot to do with the misuse of these mathematical
models, so, when I say "physics, not economics", I mean
that in physics we have some things which are constants and we
can make predictions that are going to be correct over time, and
in economics we can make statements about how people react to
incentives, but straightforward correlation parameters are not
physical constants, they are summaries of how people respond to
incentives and what those incentives are.
Q48 Nick Ainger: Dr Lilico, alongside
the SIVs and so on, we also had the mutual funds and so on taking
part in maturity transformation as well, so this shadow banking
system developed. Turner says that this again added further risk
into the whole system and much of it appeared to be almost beyond
the regulator. Is that a fair analysis?
Dr Lilico: I do not think that
that is really right, no. It seems to me that a key discipline
for innovation in any sector is that you put a lot into some new,
fancy thing where you do not know what is going to happen about
it, you get it wrong and you go bust, but, if you do not have
that discipline that you go bust if you get it wrong, then you
should not expect innovation to be efficient, so that is one key
factor here. Also, I think that people have been a little bit
harsh on some of the SIVs in that, if the companies had actually
gone so far as going into liquidation, I do not believe that as
much would have come back on to the balance sheet as it actually
did because, when you have some legal separation, the creditors
of various bits would have objected to being lumped together with
creditors on other parts, so I think that that thought that it
is an entirely artificial separation is a mistake. I also think
that there is little evidence that actually hedge funds and the
wider sector contributed anything negative to the financial crisis.
I think that, in some cases, they were the canary in the mine
and, in other cases, they were the messenger, the bringer of bad
news and I think that, if you did not want to hear the bad message,
then you objected to the hedge fund and its practices, and I think
that is just a mistake.
Q49 Nick Ainger: Anyone else on shadow
banking?
Dr Alexander: I am less suspicious
of the structure of finance as it evolves. It evolves in response
to government concerns and the financial system has evolved because
of the regulation as well. What we have to do is try to ensure
that the regulators try to impose a proper cost on risk-taking,
and what we had not understood was the type of social cost that
this so-called `shadow' banking sector posed to the financial
system. It is not that that shadow banking sector is bad to have,
that we should prohibit it, but it is that we want to put a price
on it so that the risk-taking is internalising the costs that
it is creating, and that, the regulator had failed to do.
Professor Morrison: The shadow
banking sector, like most innovations, there are good things and
bad things about it. One needs to be careful in financial markets
to distinguish, although it is very hard to do so precisely, between
innovation which is there to encourage the efficient use of capital
and the efficient deployment of resources, which is what we would
like financial markets to accomplish, and innovation that is there
to get round regulation, and there is no doubt that a good proportion
of the shadow banking was about getting round regulation. This
may reflect the fact that regulation became excessively complex
and there were massive whole regulations and we are now aware
that this is a problem, and I suspect that it is being addressed,
but a good part of financial innovation is the response to poorly
designed regulation.
Chairman: Can I thank you for your evidence
this morning; it was very helpful to us in advance of Lord Turner's
appearance before us this morning, so thank you.
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