Speech by Adair Turner, Chairman, FSA
British Embassy, Paris
30 November 2009
The financial crisis of 2007/08 was the worst for at least 70 years. Economic catastrophe was only prevented by extreme policy responses: even with these responses, the world has faced huge economic cost. We must therefore identify the root causes as well as the symptoms.
To ensure that, we must recognise that what occurred was not just a crisis of specific institutions and regulations, but of an intellectual theory of rational and self-equilibrating markets.
We must be willing to consider a wide range of policy options to ensure greater alignment between private action and beneficial social effect.
And we must recognise that there are some key questions to which we do not yet have clear answers.
This afternoon I will therefore do three things:
- First, review the causes of the crisis.
- Second, highlight that this was not just a crisis of specific institutions or regulations, but of economic theory.
- Third, explore two issues where we have more thinking to do.
There is now considerable consensus on what went wrong, described in, for instance my own Review and reports by Jacques de Larosiere for the European Commission, and by Paul Volcker for the G30. Five points are particularly important:
- First, there was a macroeconomic context, large current account imbalances (Exhibit 1) which, combined with fixed exchange rate policies, drove huge accumulation of official holdings of low risk government securities (Exhibit 2), driving real risk-free interest rates down to historically low levels.
- Second, these low interest rates in turn drove a frantic search for yield uplift among investors seeking apparently low-risk return. A demand which was met by financial innovation – the explosion of securitized credit, structured credits and credit derivatives, the alphabet soup of Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDOs) and CDO squareds.
- Third, financial innovation, combined with low interest rates, drove rapid credit growth in several countries, with lowering credit standards in many markets, particularly in residential and commercial real estate.
- Fourth, leverage increased across the system, (Exhibit 3) both within institutions – banks and investment banks – and embedded within products.
- Fifth, there were profound changes in the scale and nature of maturity transformation in the system – with increasing reliance on: the idea that, contractually, long assets could be considered liquid because they are saleable in liquid markets; potentially volatile wholesale funding; and increasing maturity transformation not on bank balance sheets, but in off-balance sheets (SIVs and conduits), on investment bank balance sheets and in mutual funds.
These factors greatly increased systemic risk and made the system highly susceptible to a surge of irrational exuberance and highly vulnerable when that exuberance turned to doubt and then despair.
We need to build a more stable system for the future. But to do that we must recognise that what failed last year was not just specific institutions or regulatory approaches, but the intellectual theory of automatically self-correcting and equilibrating markets, based on an efficient market hypothesis in which the rational behaviour of agents would lead necessarily to beneficial and stable results.
Three points illustrate that failure.
First, CDS spreads and equity prices for major banks from 2002 to 2008 (Exhibit 4). In efficient market theory, market prices are meant to capture thoughtful rational expectations of future events, provide information that leads to better decision-making and ensure market discipline. And even today, many market commentators quote CDS spreads for banks as providing useful information about the degree of risk in the financial system – ‘CDS spreads have reduced, therefore we infer that risk has reduced’.
But CDS spreads and equity prices for major banks provided us with no forewarning of the crisis: indeed, those who used CDS spreads to infer from the wisdom of markets the level and appropriate price of risk, would have concluded from these figures that the financial system had reached a point of historically low risk in spring 2007, the point we now recognise as that of maximum unrevealed fragility.
The idea that market prices are always in some efficient market sense ‘correct’ should have died and been buried in this crisis. And instead we need to recognise that market prices in liquid-traded markets can be subject to herd and momentum affects, to self-reinforcing cycles of exuberance and then despair.
A second illustration is a quote from the International Monetary Fund (IMF) Global Financial Stability Report in April 2006 (Exhibit 5), which mirrored the confidence which those low CDS spreads both reflected and reinforced.
‘There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient.
The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks.’
And the IMF was not alone. The assumption that financial innovation had made the world safer was a dominant conventional wisdom, an explanation for what looked to many economists like the ‘Great Moderation’. It reflected a confidence that, even if few people understood the intricacies of structured credit and credit derivatives trading, they must in some way be adding value and dispersing risk as any innovation that did not would not survive in a competitive marketplace. A confidence we might reasonably label the Greenspan doctrine.
And third (Exhibit 6), figures that chart rapidly increasing income leverage within the US and UK economies, increasing debt to GDP. But also the intriguing fact that while there was some increase in the leverage of household and commercial sectors, in their debt to GDP, the increase in the size of the financial systems balance sheets is far bigger than can be explained by this effect. Instead the most striking fact is the dramatic increase in intra-financial system claims, an explosion matched by huge increases in trading volumes relative to underlying real activities.
If we accept the Greenspan doctrine, then by definition all of this increased activity was economically useful, truly valuable. But if we do not, at least some of this increased financial activity may have reflected economic rent extraction rather than value added.
In the aftermath of the crisis, we must therefore be willing to challenge two assumptions:
- first, that all markets are by definition self-correcting and in some sense rational;1and
- second, that financial innovation resulting from market competition is by definition useful.
And we must ask whether the financial system is delivering its economic functions as efficiently as possible, or whether parts of it before the crisis had swollen beyond their economically efficient size.
In light of answers to these questions, we must design our regulatory response. Much of what is needed is clear:
- capital and liquidity regulation reforms to make the banking system a shock absorber rather than shock amplifier in the economy: more capital and more liquidity, and countercyclical capital built up in the good times and able to be drawn down in bad;
- reforms to deal with large systemically important, potentially too-big-to-fail banks, with possible capital surcharges for the largest and most interconnected, and/or resolution procedures that would enable controlled wind-down; and
- action to reduce interconnectedness in Over- the-Counter (OTC) derivative markets, migrating as many contracts as possible to central counterparty clearing systems, and ensuring adequate capital and collateral against the remaining bilateral contracts.
Those elements of the agenda are already agreed and being pursued at both national and international levels. But I will concentrate today on two issues where appropriate policy is not yet clear, or where regulation alone might be insufficient:
- first, the optimal level of capital in the banking system and of leverage across the economy; and
- second, the optimal size of the wholesale financial services industry and in particular of trading activities.
Optimal capital requirements and leverage
On capital, there is very strong consensus that the global banking system should in future run with more capital and lower leverage than in the past – but how much more? Is the optimal capital ratio roughly 5%, or roughly 10%, or roughly 20%?
Two things are striking about that question.
The first is how absent it was from past regulatory debates, for example:
- when the Basel 1 capital regime was introduced in the 1980s, there was a clear objective to level up capital ratios to best international practice level, but the latter was interpreted as being simply the level that existed in the countries with somewhat higher capital ratios – there was little debate about whether this level was optimal; and
- while the design of Basel 2 involved immensely complex consideration of what relative risk weight to attach to different assets, when it came to the aggregate level of capital, the overt approach was to leave the overall level broadly unchanged.
The second striking fact is that comparisons across countries and periods show that banking systems can perform their economic functions with very different levels of capital. In both the UK and the US, there were past periods when banks had not just slightly but much higher capital ratios than today, and much lower leverage (Exhibit 7), but they still managed to perform credit intermediation functions in growing market economies.
So it is certainly possible to run banking systems with much higher levels of capital than today. And higher capital ratios should mean a more stable financial system.
But it also seems obvious that higher capital requirements would increase the cost of credit intermediation. Bank capital is more expensive than senior debt or deposits: bank equity capital is more expensive than debt capital. Therefore the more capital regulators demand, the higher the margin that banks need to charge between deposit rates and lending rates. And that might impose a cost on the economy, restraining lending through increasing its price.
But while that must be true to a degree, two caveats must be made:
- The first reflects Modigliani and Miller’s famous insight on the impact of capital structure on a firm’s cost of capital, which notes that while lower leverage might seem to increase capital/funding costs by raising the proportion of more expensive equity capital, this effect is offset because as leverage falls, debts becomes safer and therefore less expensive and equity returns become less volatile and the cost of equity falls.2 The tax deductibility of interest payments, of course, means that these offsets are not complete, so that a private incentive to seek higher leverage still remains. But that raises the issue of whether our tax systems are sensibly designed.
- The second is that an increased cost and decreased volume of lending is only harmful if we are confident the extra lending that would occur in a more lightly capitalised banking system would be beneficial. Constrained lending could be at the expense of useful investment projects, but decreased lending might also constrain wasteful projects and unaffordable borrowing commitments, particularly in an irrationally exuberant upswing. So we cannot decide the optimal leverage of the financial sector without considering the optimal leverage of the household and corporate sectors, and whether we can rely on those sectors to choose optimal debt levels.
So the reason why the world’s regulatory authorities have evaded the fundamental question of the optimal level of capital is simply that it’s very difficult to answer. And our decisions on how much to increase capital will therefore be inevitably judgmental.
But one of the key insights on optimal capital structures may relate not to regulation but to tax. In Modiglaini and Miller’s analysis, the one factor that clearly makes it rational for either banks or corporates to increase their leverage is that in almost all corporate tax regimes across the world, returns to debt providers are tax deductible, but returns to equity providers not. Even, therefore, if we had sufficient confidence in free market rationality to assume that both corporate and banks in an unbiased world would chose capital structures that optimally balance equity and debt, tax regimes have introduced a huge bias towards sub-optimally high leverage. Changing those tax regimes now may be impossibly difficult. But we do at least need to understand that the bias exists and that our regulatory approach needs to lean against it.
Trading and market liquidity
My second open issue is the optimal scale of trading activities. Exhibit 6 highlighted the dramatic growth of financial sector assets and liabilities as percent of GDP, with the most rapid growth being claims between the financial institutions, rather than between the financial sector and the rest of the economy.
This growth of financial activity relative to real economic activity is also seen in measures of trading volume:
- in the 1970s, world trade and long-term investment flows were supported by foreign exchange transactions that were roughly double the value of those real flows – today they are about 50 times more, with short-term capital flows being the dominant driver;
- the value of interest rate derivatives has increased from $18 trillion in 1995 to $400 trillion today – a 20 times increase against a three times increase in nominal global GDP;
- in 1990 credit derivatives did not exist – in 2007, about $60 trillion of gross nominal value was outstanding, a huge multiple of the value of the underlying credit instruments hedged through the derivatives markets; and
- the value of daily oil trading on major exchanges in 1990 amounted to roughly the same as the value of underlying oil produced in the world – it is now ten times more.
A crucial question is whether this increased trading has made the economy more efficient or less. The dominant conventional wisdom of the last 20 years denied that this is even a legitimate question. If you trust the rationality of the efficient market and the wisdom of corporate treasurers only to buy financial products that make sense, then this expansion in trading volume must be axiomatically beneficial. But after this crisis that argument by axiom is no longer adequate. We have to ask fundamental questions about the real economic value of trading activity.
Some level of trading activity is clearly beneficial to the real economy. There is an economic value in market liquidity, in customers being able to buy and sell contracts in liquid efficient markets at fine bid-offer spreads. Economically beneficial trade is lubricated by forward foreign exchange markets, and you cannot have a liquid forward market without position takers, which means speculators. Speculators are not exactly the most favoured citizens today, but they do play a useful role in a market economy.
But the fact that market liquidity has an economic value does not mean that more market liquidity, supported by more speculation, is limitlessly beneficial in all markets. Liquidity provision, like most economic activities, is subject to diminishing marginal value. As Benjamin Friedman put it in an article in the Financial Times in August, it is difficult to discern the economic value of devoting high intelligence and large computing power to the task of anticipating market movements a few seconds before the rest of the market anticipates them.3 And as Professor John Eatwell has noted, global trade was actually growing faster in the 1970s, when FX volumes were only twice the volume of underlying trade and investment than today, when they are 50 times more.4
There may indeed be a point beyond which increased trading activities delivers not just diminishing marginal returns, but negative returns for the non-financial sector, inducing instability and extracting economic rents.
- All liquid financial markets can be subject to herd effects, and the greater the volume of trading, the greater may be the potential for those herd effects. More trading can under some circumstances produce more volatility not less – volatility against which the non-financial sector then has to hedge, paying the financial sector for the service. The financial sector thus has a unique capability to create demand for its own services.
- And the financial sector has a peculiar capability to charge high but hidden margins for some of its services. In its market-making activities, position-taking profits can be made by exploiting superior knowledge of underlying flows, which is a hidden form of margin.
- And as Paul Woolley of the London School of Economics has shown that complex principal/agent relationships, combined with opaque products, create further large opportunities for rent extraction.5
Some categories of wholesale financial services, particularly but not exclusively those linked to the trading of complex instruments, such as structured credit and credit derivates, if left entirely to the free market, may have an inherent tendency not only to create instability but to grow beyond their economically optimal size.
And if they do that, they will tend to produce remuneration that some will see as excessive, and that while accepted in good economic times will become a focus of extreme resentment in recessions.
The question is then, what if any policy levers can be used to address the potential for trading activity to swell beyond its economically efficient size, for trading related profits to be supernormal, and for remuneration to appear excessive.
I will consider three:
- the first is popular, indeed populist, but unlikely to be effective – direct regulation of bonuses;
- the second is clearly appropriate and the essence of the regulatory response – higher capital requirements; and
- the third may in practice be impossible to agree but should not be excluded from debate– financial transaction taxes.
- Direct regulation of pay: The populist policy is to limit bankers’ bonuses. If we suggest that some banking activity is unnecessary, and if traders get paid enormous sums for trading these products, why not just limit the bonuses by setting a maximum percentage pay out rate of investment bank profits?Such a policy would clearly be politically appealing in the current climate.But in the long run this sector-specific incomes policy would be unenforceable. It would take investment banks no time at all to work out ways round such rules, such as shifting people from employee to self-employed status.If super normal profits are being made, they will flow into the pocket of employees as well as shareholders. If you think that there is no problem of super normal profits, then you should accept bankers’ bonuses as earned for useful activity. If you think there is a problem, we have to address it at the level of pre-remuneration profit, not by asking regulators to do the impossible job of regulating pay levels.
- Appropriate capital standards: A second policy option clearly required, and the core element in our policy response, is higher capital requirements on trading activity. The past capital regime for trading activity was not just a bit wrong, but radically wrong, based on simplistic faith in value-at-risk models simplistically applied, and on the unjustified assumption that presently liquid markets would always remain so. It allowed major trading banks to trade complex and risky instruments with clearly inadequate capital support.Changes to the trading book capital regime already agreed for implementation by January 2011 will increase requirements over three times on some categories of trading activity, and among the Basel Committee’s most important agenda items is a fundamental review of the whole trading book capital regime. Higher capital against trading activity will greatly reduce the risks of financial instability; if it also reduces the volume of trading in some instruments and the aggregate remuneration of some traders that may be a perfectly acceptable side effect.
- Financial transaction taxes: But even with higher capital requirements, financial trading activity may continue to grow both within the banking system and outside it, and those high levels of trading activity may continue to support unnecessary rent extraction by the financial sector, and may generate economic instability. If that is the case, and if society is worried about the consequences, either for financial instability or for the size and remuneration of the financial sector, then it should not exclude consideration of taxes on financial transactions. Anyone who thinks such taxes would prevent all or even most rent extraction in the financial sector, or that they could be designed to tune the liquidity of markets to precisely its optimal level – neither too liquid nor insufficiently liquid – is fooling themselves. But in the real world of imperfect instruments with which we seek results at least a bit better than those we see today, they should not be excluded from consideration.
But my objective today is not to propose specific policy measures – other than those related to capital and liquidity on which the global regulatory community is already actively engaged – but to stress the need, after this huge financial crisis to ask searching questions about the functions finance performs in our economy, about optimal levels of leverage in the whole economy as well as in the financial system itself, and about optimal levels of trading activity. These are questions we used to avoid, because a dominant ideology said that they were invalid or irrelevant, with the level of leverage and the scale of trading activity axiomatically optimal because chosen by free markets. In the face of this financial crisis, we can no longer avoid them.
1.The use of the word ‘irrational’ to describe herd and momentum effects can be challenged on the grounds that such effects can derive from actions that are rational at the level of individual agents. George Soros, for instance, making this case prefers to say that markets have no tendency to reach equilibrium, rather than that they are irrational.
2. Miller M and Modigliani F.: The cost of capital, corporation finance and the theory of investment, American Economics Review, 1958, 48:3, pp 261-297; Corporate income taxes and the cost of capital: a correction, American Economics Review, 53:3, 1963 pp 443-453
3. Benjamin Friedman’s article Overmighty Finance Levies a tithe of Growth, Financial Times, 26 August 2009
4.John Eatwell, Why Turner is Right, Prospect Magazine, Issue 164, 21 October 2009
5.Bruro Biais, Jean-Chartes Rochet and Paul Wooley, Rents, learning and risk in the financial sector and other innovative industries, September 2009