We live in a joined-up world and the only way to make our banking and financial system safe is to collaborate, asserted Sir Paul Tucker, chairman of the Systemic Risk Council (SRC). Speaking at the 70th CFA Institute Annual Conference in Philadelphia on May 23, Tucker observed that policies needed to make the financial system resilient risk being undone. He urged asset managers and others to weigh in on the side of stability. If another crisis were to occur, he warned, the very survival of a market-based economy might be in jeopardy. To prevent this requires taking a medium-to-long term view. A vibrant system needs market discipline, and that falls largely to asset managers and their investing customers, Tucker said.
Ten years after the beginning of the global financial crisis in the summer of 2007, we about one-third of the way through the process of adjustment back to normality, Tucker suggested. As indicators of this, the Fed has only recently started to withdraw its extraordinary monetary stimulus, the ECB is still adding stimulus, the agreed core of the regulatory reform program is still being implemented and, in the US, parts of that program are being questioned by legislators and challenged by bankers.
Tucker emphasized that the core of the world’s banking system is more resilient now than before the crisis. “The banking system now has more tangible common equity than it did and would now be more resilient in the face of shocks.” Nevertheless, he maintained that “the global environment is probably less benign after 10 years than any of us that were sitting around the policy table back in 2009, 2010 would have thought.” The reformed regimes were not calibrated for conditions of weak trend growth and a badly depleted macroeconomic-policy arsenal, he explained. This was the wrong moment to dilute the resilience of the system. He warned, ominously, that in the event of a repeat of the global financial crisis within the next 10 -25 years, “the political backlash would be almost incalculable…The basic fabric of capitalism would be put under great strain.”
The role of the Systemic Risk Council, which was created in the wake of the crisis and basically comprises former policy makers from the US and Europe, was to help lean against self-destructive or short-sighted industry lobbying. This because its members believe in a market-based system for finance. “We care about [stability] very deeply, because of the social costs, the economic costs, the political costs if the financial system craters.”
Were another recession to occur in the Western world, he said, there is much less left in the macroeconomic arsenal to help smooth recovery than policymakers started with in those crucial months in late 2008/early 2009. He explained that back then all the major central banks could lower interest rates to zero from about 5%. “Whereas if you start off with interest rates at around zero, there’s not much room left to do that again.” And “such has been the scale of QE almost everywhere in the advanced world that it is not obvious that there’s a great deal left to buy without moving into buying more or less everything in the way the Japanese have done with equities.” This matters, he insisted, because over the very long run the probability of a recession in any given year is around 15%. “The nature of macroeconomic life is that sometimes economies, countries, regions, sometimes the whole world just get unlucky. And if we get unlucky there is just not much left in the tank to smooth thing over.” He worries that this is insufficiently discussed amongst market participants and beyond.
Tucker noted that much of the legislation that was passed to foster market changes in the wake of the crisis, such as Dodd-Frank in the US, have still not been fully implemented, and that now the debate in some corners has turned to rolling back those reforms.
Regarding current debates in Washington D.C. around repealing that part of Dodd-Frank that gave regulators in the U.S. the authority to resolve distressed financial institutions without taxpayer solvency support, Tucker said “it is very strange to take away from government some of the powers they may need to protect the American people” when that need not involve bailouts of fundamentally insolvent firms.
Tucker explained that earlier in the year as voices wanting to gamble with instability could again be heard on both sides of the Atlantic, the SRC decided to articulate what it sees as the core pillars of the program for making the financial system more resilient. The pillars are:
- The core of the banking system carrying more tangible common equity — with intermediaries needing to be more resilient — the greater the social costs of their failure;
- The system being much less exposed to liquidity risk;
- Taking a system-wide view, with less fixation with legal form as opposed to the economic substance of different types of intermediation and services;
- To simplify the network of counter-party credit exposures among financial intermediaries;
- To introduce enhanced resolution policies for financial intermediaries so that all can be sorted out without devastating interruptions to the provision of vital services, but without government bailing out fundamentally bust firms, the equity investors and bondholders.
These policies are about making banks and financial intermediaries part of capitalism again, “as opposed to this semi-socialized system where they get the winnings, but when things go wrong the costs are spread over the tax payers.” Tucker continued, “This means that banks and dealers fail – and, actually, failure is an important part of a market process. We should celebrate orderly failure since it allows for the reallocation of resources that allows the economy to move on.”
Tucker explained that the strategy involves not relying on government regulators to always spot where the market or firms may be failing. Instead, the idea was to “harness market forces where you as the manager of portfolios of bonds know that you will be in line after equity is exhausted and therefore you have incentives to price bank bonds and dealer bonds on that basis. And to demand from them the kind of information you need to make those determinations.”
A functional Approach to Stability, Regulation, and Supervision
Tucker said policy makers had struggled to distinguish between those parts of the financial markets that could seriously jeopardize stability and those that are to be celebrated because of the efficient resource allocation that they bring. The SRC would not urge the authorities to suppress innovation, but instead to focus on structural vulnerabilities. “The idea that finance sectors can be put in boxes—banking, insurance, capital markets—is for the birds! If we continue with anything like the current world we must accept the need for a system-wide view and that financial regulators of all kinds have a responsibility for ensuring financial stability. And that means the statutory mandates of all financial regulators must include stability. It was a mistake not to do that in 2010.”
While nations had to vet international accords in line with their own local systems and processes, the only alternative to shared international minimum standards was financial autarky, he said. “No country on this earth, no matter how big, can ensure its financial system is safe for its own citizens without cooperating with its international peers, unless it reintroduced the kind of comprehensive capital controls that existed until the 1970s.”
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