Good afternoon ladies and gentlemen. KPMG are once again proud to be the premier sponsor of this important event.
History teaches us that our initial response to a huge shock is often not the best one and is over-done - it always needs to be re-evaluated in light of circumstances. Today I am here to discuss some of the potential unintended consequences of the global response to the financial crisis. I think it’s fair to say that banks, regulators, politicians and shareholders have differing views on what is an “unintended consequence”. I think this is because there is no common view on “what went wrong”. This is true not only from a “technical” perspective, but in the real world of human emotions, the challenge becomes much harder. Political agendas tend to be driven by public opinion, and for obvious reasons when it comes to the financial sector, emotions run high.
If you had just arrived from another planet you would be forgiven for thinking the crisis belonged to the banks alone. There is no doubt that banks were major contributors and amplified the collapse, but there were many fundamental factors driving the credit bubble over a long period of time.
There was a serious regulatory failure– at every level.
There was also a significant failure by many governments around the world.
More generally, it also represented a failing in many parts of western society and our appetite, or addiction, for the drug of debt.
This underlying premise allows Regulators, Central bankers, and Politicians to mask their level of culpability, which impairs their ability to be a more effective part of the response to the crisis.
If there are 12 stages for recovering addicts to beat the habit (and I speak from research rather than personal experience) I would say the banks are approaching level 8 while the other protagonists would score lower. It’s only when all the protagonists reach a similar trajectory will we mould a financial sector that is fit for purpose.
This is at the heart of my concern, are we really defining what good looks like? Are the current waves of global regulatory and rule change going to make the next crisis less likely, and make it easier to deal with? I hope so, but this is not clear 3 years post crisis. In fact it may be less clear. To move forward we need a greater acknowledgement of failure and to reflect on where we are going. Without collaborative action, we run the risk of not dealing with some of the dangers of unintended consequences that are emerging.
Banks are financial intermediaries of the supply and demand of money. They are an essential provider of credit to the real economy. In fulfilling this role they trade and manage risk, which can be broadly captured as market, credit, liquidity, and operational risks.
We need to have broader objectives for financial institutions that go beyond the shareholder and reflect their role in the domestic and international economy, an area where governments and regulators should be key in defining. At a minimum a “fit for purpose” system should ensure:
- That banks have a clear understanding of these risks, so they can effectively manage and mitigate them,
- That banks clearly align risk and reward for key stakeholders, and
- That banks risks are effectively supervised and that they are accurately and meaningfully reported.
The evolving regulatory agenda should be assessed against this framework.
I think there are 3 themes emerging from the global response that I would like to explore further.
- Firstly the need for moral hazard.
- Secondly the need for greater resilience and buffers, principally resulting in the need for more capital and tighter liquidity.
- And finally the need for improved supervision and reporting.
The collective impact of these changes and their unintended consequences may present serious dangers to a fragile economic environment.
Firstly - Moral hazard
We don’t want the taxpayer to bail out the banks again. An understandable response, but is it a realistic goal and at what price?
Should we or can we make the system future proof, especially right now? Could the impact of regulation offset the intent behind quantitative easing?
The key reforms here are the recovery and resolution planning proposals (so called living wills in the UK) -a subset of which are in part reflected in the interim findings of the ICB review.
A phrase by Mervyn King “banks live globally but die locally” captures the dilemma in a sentence. In some ways the world is saying we can’t supervise you globally so we will regulate you more intensely in each jurisdiction. We will break you up into parcels of systemically important functions and businesses.
According to the Financial Stability Board, Systemically Important Financial Institutions (SIFIs) are firms whose disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.
Absolutely true – the underlying operation of these groups are hugely complex and interconnected.
The FSB has indentified 24 Global SIFI’s (all banks) which was endorsed by the G20 late last year.
While country implementation may vary it is critical that systemically important functions be identified – by definition there should be many for GSIFI’s. The overriding aim is that these functions can be saved in the event of a banks death. So if a bank is critical to the repo market or dollar clearing or global payments etc that aspect of the business can be ring-fenced and the umbilical cord can be cut if necessary.
It is hard to see how this intent can work without legal separation. The restructuring required also creates enormous issues where banks are critically dependant on branches in different countries and the question of subsidiarisation rises to the top of the agenda. Subsidiarisation can severely restrict the flow of capital.
To imagine the 24 G-SIFI’S slicing and dicing a business in a legally enforceable and operationally effective way is like trying to unscramble an egg. It would be seeking to reverse decades of infrastructure and globalisation and splitting the bank into unmanageable parcels of functions and businesses - each supervised at a country level.
Moreover is the goal of allowing a G-Sifi to fail indulging in a fool’s paradise? By definition these banks are systemically important to the economy. To imagine one going down and not having an enormous impact on other financial institutions or the economy is a contradiction in terms. I would suggest “still too big to fail”. Because of maturity transformation banks will always be exposed to short term liquidity squeezes. If in the next crisis we confuse the legitimate provision for liquidity for a forbidden government rescue we will risk a credit crunch beyond anything we saw in 2008.
Is “too big” the right problem to solve? Bank’s invariably go down because of “concentration and/or leverage”. These are the two areas that critically need to be risk managed and regulated. Not size per se. History makes this clear. From the saving and loans disasters in the US in the 80’s, to HBOS and the problems in Ireland, Iceland and Landesbanks in Germany today. Northern Rock died from an overdose of both concentration and leverage – a lethal combination and unsurprisingly it was the first to go. Focusing religiously on “Too big to fail” is a red herring that inevitably takes our collective eye off the ball. More diversified banks tend to weather storms better.
The findings of the ICB interim paper echo SIFI themes such as separating systemically important activities for the UK banks. The recommendation attracting most debate is the separation of retail and investment banking. While it is unclear what this will actually mean until later in the year the broader debate arouses strong passions on both sides.
The CEO responses during the Treasury Select Committee hearings were largely predictable given the nature of the organisations they were representing. However I believe one of the most insightful observations came from the CEO of RBS who questioned whether separation could have the opposite effect and promote more moral hazard. Many of the bank failures highlighted above have nothing to do with investment banking, even RBS’s losses from vanilla lending exceeded complex investment banking losses. If recovery and resolution planning is to be implemented in this way, we run the risk of making banks less diversified which could increase concentration risk.
Now does this make ring fencing the right solution or a mis directed one? Is there not also a strong argument for discussing enforced diversification?
Global businesses require global service providers which bring scale, and offerings that simply aren’t sustainable on a standalone basis. If you zoom back on Google earth it will reveal GSIFI’s live on the same deck of a cross border ship.
One insightful lesson we have all better appreciated from the financial crisis is that the infrastructure (IT systems, people and processes) did not nearly keep up to speed with 20 years of explosive bank growth and product proliferation. As a result financial institutions are currently investing billions of pounds in infrastructure. An outcome of these rules may be that banks are spending money in the wrong direction. Banks are trying to make the systems more resilient and capable but ultimately these changes may force banks to do a U turn. This would result in a more fragmented operating model increasing the level of operational risk.
In preparing for death, from where we are today, we must ensure that we do not increase the chance of fatality, and avoid creating a sclerotic banking system impairing its ability to provide a free flow of credit. Turning big banks into national compartments will not necessarily save them. It will make them more challenging to supervise.
This leads me to MORE Capital and tighter Liquidity
Many economic commentators believe the best we can achieve in the next 3-5 years is anaemic economic growth. To limit the chances of a double dip recession, and to encourage growth we need to ensure a supply of credit at rates that are affordable while compensating for the risk that the lending implies.
The collective regulatory impact for most banks implies an increase in the level of capital required by about 3 times and liquidity by about 2 times. Moreover it’s an uneven playing field. The rules are being adopted differently in each country. The danger is that this regulatory brake is being applied too much and without much consistency especially in the UK where we are tougher on our approach in some areas compared too many continental countries.
For G SIFI’s there is also an additional capital buffer, which could be as much as 2.5% for some banks. An interesting piece of Morgan Stanley research suggests the changes will challenge the ability of banks to lend in downturns. In summary they conclude that the top 25 banks could approach likely GSIFI standards in 3-4 years, but at the cost of dividends, returns, or critically through more aggressive deleveraging.
Liquidity is a different challenge. The last crisis was not driven by liquidity but had a liquidity consequence. However our funding is precariously balanced especially for the UK, where we need to develop a savings culture. In the UK our deposits fall about £500bn short of our lending needs. We have a structural imbalance. Our deposit shortfall is a long term consequence of over-leverage in the economy and cannot be easily reversed – it can only be achieved by raising the cost of credit to encourage saving and discourage borrowing. We are in a Catch 22 where the prescribed medicine can only make the economic outlook worse – hence the current policy of life support while the patient slowly recovers. But for the reasons many have argued, this is not the time to hammer banks with these changes. A decisive implementation when credit markets return to more normal levels may be a better route. This allows banks to help the economy recover, and to ready themselves for more stringent requirements to come. Basel, and countries such as Japan, have recognised this need to a degree. In my view a much more extended timeline is needed in the UK.
I now turn to the promotion of greater choice and ease in switching current accounts. Retail deposits tend to be sticky. They are curiously loyal to a bank that offers them very low interest whatever the notice periods on accounts. The new liquidity regimes encourage retail funding which receives a better treatment because of its perceived stickiness. As a result firms are chasing down retail deposits, paying better rates to outbid the competition. A natural but unintended consequence of retail customers becoming more selective is they may become less sticky, therefore undermining the very behavioural characteristics that underlie the reform of the liquidity agenda.
Now to the final theme - The need for improved supervision and bank reporting
There is no doubt we need a more comprehensive and intensive regulatory regime than we had. Many would argue that while the rules may have been inadequate the ones that did exist were not properly supervised. To meet today’s and tomorrow’s challenge there is a critical need to improve the experience and quality of the regulators and the level of their co-ordination. We should find a way to make this happen. Notwithstanding confidentiality issues, some form of rolling program involving a cross representation of bankers and other industry professionals, could work with the regulator to improve the quality of supervision. This need has been made more acute by the spawning of new regulatory authorities and the fundamental shake up of existing ones such as the FSA and Bank of England, which presents its own integration challenges during a fragile economic period.
The volume of new regulation continues to grow. FATCA, new client asset rules, Basel III, securitisation rules, recovery and resolution plans and a whole new wave of accounting standards to name but a few. In the UK the Common Reporting Framework (COREP) is expected to increase the volume of reporting by up to 10 times! From my discussions with Bank Senior Management, they are focusing less on real risks. They are all consumed by detailed compliance, internal projects, and managing process. A parallel universe of managing compliance risk is emerging. Ironically the current nature of supervision is collectively impairing the bank’s ability to manage their real underlying risks.
It's like police red tape versus bobbies on the beat. It’s also a question of what sort of sustainable risk management environment is being created. In the long term we need a culture that is not just focused on policing but a more questioning function that reflects on “connecting the dots” to more effectively challenge and support management.
Let me move onto the Role of financial reporting – opacity reigns
During the crisis there was a great deal of criticism of financial reporting, particular fair value. This has recently taken a back seat relative to other key issues, such as governance, remuneration, capital and liquidity. Bank’s financial statements need to succinctly provide relevant information to allow stakeholders to hold institutions to account. However it seems these ongoing discussions, have lost some momentum. While some informative disclosure requirements have been introduced, accounts continue to grow in size and opacity. Increasing data, but not increasing knowledge. Given the extent of change and the uncertainty in the markets, improving the quality of bank reporting remains an urgent issue.
I recently hosted a bank investor group session at KPMG and it was clear that Bank accounts remain difficult to fully understand. One of the good ideas I heard was to have greater transparency in reconciling and explaining the banks total reported assets to its risk weighted assets and determination of capital. It is something we are exploring. Sadly global accounting authorities are struggling to move at the pace the market requires.
It is imperative that globally we move towards a single set of accounting standards. Governments and the IASB need to make a reality of the G20 promise. As I mentioned last year, general purpose financial statements may not be enough for financial institutions.
Stepping back from the 3 themes, I would like to look at 2 areas where the seeds of the next crisis may emerge as a result of the regulatory change. Central Clearing Parties (CCP’s) and the Shadow Banking System.
CCPs are the unglamorous parts of the post-trade infrastructure, the back-office. Policy makers have quite rightly focused on OTC markets. Reforms going on in Europe and the US will drive much more business into using CCPs for clearing. There are obvious benefits of greater transparency in markets through the use of CCPs. Further benefits include multi-lateral netting, tracking of exposures, and the mutualisation of losses. However there is no doubt that we are concentrating risk on a very few in the financial system. We must hope that the bodies responsible for CCP’s ensure they are adequately capitalised, managed, and supervised or we'll simply end up with a different and more concentrated set of ‘too big to fail’ entities.
A shadow banking market is being created. Money always finds a home and in the modern world this is happening at an accelerated rate. Higher risk activity, which banks are being regulated out of doing, will find another home as will the talent that works within it. In the past we had LTCM, a hedge fund that almost brought the entire system down and required a bailout.
The key questions are how many other LTCM’s are we going to be spawning? And crucially how are we going identify and monitor them? It is no surprise this was recognised in the ICB interim report - in effect more tight regulation of less.
What happened to one of the observations immediately post crisis? “If it smells like a bank and looks like a bank it is a bank and should be regulated like a bank”. Forgotten it seems.
I often raise the shadow banking threat with many of my clients who tend to fund them. I think it’s fair to say many seem less concerned than I am. They cite the fact that they have learned their lessons and will not fund hedge funds to pre-crisis levels ever again. Some funds were leveraged more than 60 times! All I can re-iterate is money finds a home, and that when banks are publically announcing double digit rates of return in their future plans one should be forgiven for remaining sceptical.
At the outset I emphasised the macro economic challenge is far broader than just focusing on the Banks. There is a need for Regulators, Central Bankers and Politicians to work together, critically they will need to reach step 12 on the road to rehabilitation, not just the banks.
This is acutely highlighted by the biggest threat to the banking sector, which has nothing directly to do with the reforms – the sovereign debt crisis. The debt problem has simply moved from the banks to the governments. It has not gone away.
Unless the economy miraculously grows then we won’t have cured our hangover, in fact it could turn into a much more permanent, pounding migraine.
I have discussed a number of unintended consequences. I believe the collective impact of these changes run the risk of restricting the availability of credit, raising the barriers to entry, increasing cost, and accelerating the chase for deposits. As a result it could reduce competition. Weaker organisations are less like to be taken over. This is one reason why many banks are trading from a discount to book value for the first time since the 1970’s.
The pressures will cause certain banks to grow as they chase funds and diversification – hopefully in a good way. But when the regulatory trajectory is pushing banks to restrict activity and prevent too big to fail its ironic that some banks may be become bigger and more crucial – in the same way that CCP’s and the shadow banking system may.
So “how do we create a banking system that is fit for purpose”? The response may vary by country and if it does you will have national approaches to national institutions. To develop a level playing field it is essential that cross border co-operation between the Regulators, Governments and the Industry is fundamentally improved. We need a greater level of trust between these groups.
The overriding issue is there needs to be a broader discussion around the cost/benefits of the rule changes including their second and third order impacts. Without such a debate the likelihood of the costs exceeding the benefits increases. Since the crisis the volume and complexity of rules continues to go in one steep direction.
In seeking to address systemic risk, we change the profile of risk without necessarily mitigating it. Addressing the symptoms not the cause. For example if you stop the retail banking division giving its surplus liquidity to its Investment Bank above large exposure limits, does it spread it around other banks? If they all do the same, does this web increase or reduce contagion risk? and if retail customers looking for better yield cannot get it from the retail bank where do they go? Money funds? And where do they place their money? - With higher risk Investment Banks? Is greater transparency enough to manage this?
If there is a lesson to be learned from other heavily regulated sectors such as utilities is that they are moving away from compliance to “output orientated” regulation. Ultimately regulators cannot manage the risk as they are too distant and the risk reward relationship breaks down The best way to get compliance is to keep it simple and if anything more regulation increases complexity.
What we are witnessing is the socialisation of banking. Many of these changes may be necessary or desirable, however there is a real danger that we will be hardening up the arteries to restrict the blood flow when the heart needs it the most.
Despite the understandable level of public emotion banks are critical to the economy to fund growth. With no silver growth linings on the economic horizon we need to seriously have moment for pause and shift the debate to another level. We need to collaboratively work together to solve our underlying economic challenges and to urgently help shape London’s role in a rapidly morphing 21st century Global Capital market.
One of the desired outcomes of the 12 steps to rehabilitation is "learning to live a new life with new codes of behaviour". Without a collective approach to re-assess the Regulatory Agenda, we are going to ensure we stay in the Global version of "The Priory" for some time to come. Thank you.