Examination of Witnesses (Questions 680-699)|
13 JANUARY 2009
Q680 Mr Todd: In other words, it
is back to human beings and understanding what seems like a rational
approach to access to cash essentially?
Dr Danielsson: I could not agree
Professor Goodhart: Going back
to the Chairman's opening position, I think that the lack of concern
with liquidity that had been shown previously, particularly by
regulators, was out of a belief that the wholesale markets, where
most banks went to get their marginal funding, were very efficient
and would work and would be open under all circumstances as long
as the banks had sufficient capital, and it was that belief that
wholesale markets will always work efficiently, subject to the
banks abiding by the capital requirements, which was shown not
to succeed from August 2007 onwards, and those wholesale markets
are still not working properly. The banks' search for liquidity
has consistently shifted from holding liquid assets to the belief
that they could obtain additional funding by going to these wholesale
markets. It was the failure of these wholesale markets that brought
concern about liquidity back to the centre of the stage.
Q681 Mr Todd: So what should a regulatory
system for liquidity look like?
Professor Goodhart: Well, there
very nearly was such a system introduced in fact in the 1980s.
At the same time as the Basel Committee was introducing an accord
on capital they were searching for an accord on liquidity, but
that search ran into difficulties, and effectively got dropped
in the 1980s, it became too difficult for them to proceed, and
the process went on then continuously whereby the banks turned
for their additional funding, their liquidity, to the wholesale
markets and more and more got rid of their lower yielding but
highly liquid public sector debt, to the point where the British
banks entered the crisis in 2007 holding a really minimal amount
of highly liquid British government debt.
Q682 Mr Todd: Fine, so you are suggesting
in terms of a regulatory environment for the future?
Professor Goodhart: We would need
to go back to look at an appropriate regime for liquidity.
Q683 Mr Todd: And Basel IIback
to the drawing board?
Professor Goodhart: Basel II has
got a lot of good features. I think it is the best system that
I know for trying to ensure the capital adequacy and the constraint
on risk-taking of the individual system. Where it fell down completely
was in looking at the systemic risk, the macro prudential, compared
to the micro prudential risk. It is not that Basel II is wrong
or bad; it is just totally and completely insufficient in that
it did not look appropriately at the systemic issues. To take
a particular and very obvious example, for an individual institution
which is running into difficulties with insufficient capital,
the obvious thing for it to do is to cut back its total size by
reducing its loans and refusing to make additional loans, but
if everybody does that, as is very obvious now, the system and
the economy runs into extraordinary difficulties, so what is sensible
and prudent for the individual bank and individual institution
frequently makes no sense at all for the system as a whole, and
it is systemic issues that Basel II did not deal with.
Q684 Mr Todd: Just one last point,
if we tighten controls on liquidity, is not one of the inevitable
consequences that we will actually slow the recovery from the
current credit crunch because we will have a more conservative
set of instruments which will require banks to hold more assets
in readily convertible forms?
Professor Goodhart: That is actually
a generalised problem in the sense that at a time of crisis the
tendency of the regulators is to tighten up on everything, but
the more that you tighten up, whether it is on capital, liquidity
or anything else, the less easy it is for the banks to undertake
expansion because you are tightening the controls, and I think
that is of greater concern on the capital side than it is on the
liquidity side because at the moment there are no real liquidity
constraints. The FSA did introduce a 9% requirement very recently,
but apart from the FSA's recent measures the constraints have
been on the capital side, and the desire has been to raise capital
ratios up to 12%, and now everyone is saying, "We did not
really mean 12. 12 is fully what we would like to have but under
pressure we would be perfectly happy for you to go down."
Indeed, one of the issues here is that what you want in your regulation
generally is counter-cyclical so that they really tighten and
prevent the banks going crazy during these asset price booms and
bubbles and then when everything gets difficult in the bust and
everyone is incredibly cautious anyhow then the regulations get
Q685 Chairman: Professor Buiter,
welcome to the Committee.
Professor Buiter: My apologies
for being late.
Q686 Chairman: We are grateful that
you are here and, as you know, this is the first evidence session
of the banking crisis inquiry. I asked your fellow panellists
before you came in: what is a financial sector for and what is
the role of the banking sector within the financial sector?
Professor Buiter: The banking
sector intermediates between savers and investors and it allocates
financial portfolios and allows the trading of risk. It is an
essential part of the transmission mechanism for monetary policy
and indeed also to an extent for fiscal policy, and when it malfunctions
the real economy suffers grievously, as you see. It depends how
you define banks. I am talking here about highly leveraged institutions
that are very much more liquid on the liability side than they
are on the asset side. Deposit-taking and making loans would be
the classical bank example, but generally I think anything that
is highly leveraged and uses a lot of borrowed money compared
to its own resources and that funds itself short and liquid (normally)
and invests long and illiquid is a bank. My description means
that there is no such thing as a safe bank, of course. The only
reason that banks, which are institutions that have big signs
on them "please start your run on me", survive is because
they have an implicit or explicit guarantee at the very least
of funding provided from the ultimate source of liquidity, which
is the central bank, should the liquidity of their normal funding
suddenly dry up. No bank can be safe unless it has a market maker
of last resort and a lender of last resort standing by. That said,
as regards the liquidity issue I think we have to be very careful
that we do not end up in a world where banks and other financial
institutions are required to always hold the liquidity required
to cope with the worst contingency. Liquidity is to a large extent
a public good. It is a property of assets that can disappear when
trust and confidence disappear. Certain assets are almost always
liquid. Government assets tend to have that property, although
if you go to Zimbabwe even public assets, even public money, is
not liquid any more. It means that although banks and private
institutions could provide for their own liquidity by holding
large amounts of treasury bills, I think it would be highly inefficient
to do so because they would not be able to engage in their socially
useful function of borrowing short and lending illiquid, rather
than lending liquid, which they would be doing, or investing liquid
if they invested in treasury securities. Sure, they will need
some but banks should not be required to hold more inherently
liquid assets than is necessary for the ordinary conduct of business
during ordinary market conditions. For the rest the central bank
has to be on stand-by. The Bank of England was not, and part of
the problems that we are seeing is because of that. They now are
better attuned to the job. They should therefore see to it that
the public good of liquidity is to a large extent publicly provided
in an emergency rather than force banks to provide it privately
Q687 Chairman: In this banking crisis
inquiry we are looking at how we arrived at this situation, how
we get ourselves through the present situation, and what the regulatory
environment will look like in the future. On the first point of
how did we get into this situation, could you give us your views?
Professor Buiter: In many ways
it is a classic credit and asset boom; excessive lending and excessive
leverage which became more and more risky. That is how credit
booms and credit busts happen. It took some new forms and it was
regionally more widespread. We had securitisation problems in
the US which of course were not restricted to the subprime market,
but became an issue there first, but there were country-specific
financial excesses in most countries in the North Atlantic area.
British households had debt equal to 170% of disposable income
and that had very little to do with US subprime debt, and there
was general regulatory failure because of the growing belief that
self-regulation would suffice and that, if intervention was required,
the so-called principles-based light-touch regulation would be
sufficient. I think that is and was an illusion. Financial markets
are very useful but inherently fragile and dangerous institutions,
and the notion that they could be self-regulating was always ludicrous.
Even Mr Greenspan recognises that now, somewhat belatedly. There
was a general lowering of regulatory standards. The fact that
financeand I am talking here about the finance of border-crossing
financial institutions of which there may be 60 to 80 institutions
that matter globallythe fact that the domain of the market
and the range over which these institutions roam is global and
regulation is national means that, whatever you do, these firms
and financial innovation will be running rings around the regulators.
The logic of a global market is to have a global regulator. You
cannot have that, I recognise that, but that has implications
that you will always be in an environment where regulatory arbitrage
will undercut regulatory effectiveness, not just because of innovation
within a nation but competition between nations. Lowering of regulatory
standards were used to attract financial business.
Q688 Chairman: So from what you are
saying it seems as if there was a misplaced faith in that market
mechanism in the past few years?
Professor Buiter: Yes, in the
Q689 Chairman: How does the current
crisis then compare to that, say, of Japan in the mid-1990s and
the Wall Street Crash of 1929? Are there any comparisons?
Professor Buiter: In many ways
they are very similar. The Japanese boom was of course much bigger
than anything we have seen and the bust has been much, much bigger
than anything I hope will see. Their stock market came down 90%,
Professor Goodhart: Nikkei was
at 38,000 at its height; it is now at about 8,400.
Professor Buiter: So that is a
healthy decline! A massive asset boom and bubble and a massive
bust, and in Japan of course that was followed by spectacular
policy incompetence. There was no serious attempt to address the
toxic asset issue for seven years. The recapitalisations that
took place really were late and inadequate and the banks were
allowed to go on making zombie loans to zombie institutions rather
than trying to clear the debt. I hope that Japan provides an example
at least as regards the policy response on how not to do things.
They did certain things right. Keeping the zero interest policy
and engaging in quantitative easing is clearly something that
will have to be emulated here, as is the case already in the United
States, but their reluctance to clear or to ring-fence the toxic
assets, to recapitalise the banks, and their willingness to let
the overhang of bad assets become a tax on new lending to potentially
profitable enterprises are all warnings of what we should avoid,
and we have done so far. The US in the 1920s was again just a
big bubble that burst and a very perverse monetary policy response
where monetary policy actually tightened.
Professor Goodhart: And in all
three cases the real economy had behaved very well in the years
up to that. The 1920s were years of low inflation and steady growth
in the US. The 1980s in Japan was a golden era. The period between
1992 and 2007 was probably the best years of economic developments
that the world has ever seen and this had led people to believe
that risks generally had declined, that we would not see future
problems, so everyone poured into asset markets because risk had
gone, and of course risk had not gone.
Q690 Chairman: It was a great moderation.
Professor Buiter: There were also
great moderations in the 1920s and in Japan as well.
Q691 Mr Crabb: Professor Buiter,
you describe the general regulatory failure: do you think that
the international architecture for financial regulation now needs
to change given the current crisis?
Professor Buiter: It needs to
but it will be extremely difficult. In any regulatory regime that
one can think of one will have the US doing its own thing because
they are not going to be agreeable to being bound by international
agreements and certainly not to being regulated by a foreign entity.
I think the best we can hope for is that we come to a single European
regulator for the European Union for border-crossing institutions.
That would take care of 27 dimensions of regulatory arbitragenot
enough, but it is a lot easier to reach agreement between a single
EU regulator for border-crossing financial institutions and the
Americans and the Japanese and maybe the Chinese and the Indians.
At the moment I think there are just too many unco-ordinated,
mutually undercutting regulatory regimes.
Q692 Mr Crabb: Professor Goodhart,
would you share that view?
Professor Goodhart: I do not think
a single European regulator is feasible at the moment, even if
it is desirable. As everyone has seen, when a crisis comes you
need to recapitalise the banks. Recapitalisation is enormously
expensive, so you need to have a regulator that has access to
funds via a ministry of finance or treasury. There is not a federal
ministry of finance or treasury who could provide such funds.
Without such European funding, without a European fiscal competence
in that respect, effectively the exercise of trying to ensure
that their banking systems remain viable has unfortunately got
to remain within the nation state. I fear that under these circumstances
with a global system and national regulators what is actually
going to be needed is to have rather more power to the national
regulator rather than less, so that the national regulator can
see the development of asset price bubbles and credit bubbles
in their own economy and take the appropriate steps to prevent
that making their own country's financial system become at risk.
Q693 Mr Crabb: Do you think that
the current crisis reveals a failure on the part of the IMF in
terms of sending out warning signals?
Professor Goodhart: No, they did
send out warnings. This idea that there were no warning signals
from central banks, there were loads of warning signals, particularly
from the BIS. This stuff about early warning signals is actually
pure nonsense. It is not that there were not enough early warning
signals. Everybody forecast that the situation was getting dangerous
because risk was being underpriced; the problem was not the lack
of early warnings. The problem was the lack of both instruments
and willingness to do anything about it.
Q694 Mr Crabb: So how should we improve
those instruments to ensure that sovereign states take heed of
Professor Goodhart: That is very
difficult because in a boom everyone loves it and the idea that
you are going to have a regulator saying, "I am sorry, we
are not going to have 100% or 125% loan to value ratios; Northern
Rock, you are not allowed to behave that way, you are not allowed
to do subprime mortgages based on nothing except the expectation
that housing prices will go on rising, you are not allowed to
do that," runs counter to the wishes of the lenders, the
borrowers, and virtually every politician at the time during the
boom, so what you are asking regulators to do is effectively to
take the punch bowl away when the party is going, and that is
not a popular activity.
Professor Buiter: The regulators
were not terribly keen, to be honest. During a big asset boom/credit
boom there is universal capture of the regulators and the political
process by the financial sector. You can see that because who
argues with success? People who take home $50 million a year must
be doing something right. It is very hard to interrupt that spiral
until it is done by brute force through an implosion of the bubble.
There is no willingness among the regulators or among the political
classes to interfere with an asset boom or a credit boom. I have
never seen that.
Professor Goodhart: The subprime
market was regarded as a triumph in 2004-2006. It was providing
access to home ownership for the disadvantaged class in America.
This was regarded as one of the great triumphs of finance.
Professor Buiter: Finance as social
Q695 Sir Peter Viggers: The crisis
is of course worldwide. Was the UK economy in better or worse
shape to cope with the problems a couple of years ago?
Professor Buiter: Compared to?
Q696 Sir Peter Viggers: Compared
with other countries?
Professor Buiter: Probably in
the worst shape maybe after the US. It has the largest financial
sector relative to size of economy of the major industrial countries.
Only much smaller countries have balance sheets with 400-450%
of GDP for their banking sector. It had this long-standing boom
which had resulted in this very highly leveraged housing sector.
The corporate non-financial sector is actually in quite good shape
but is squeezed between the banking sector and its inherent fragility,
the over-leveraged households, and I think also the stretched
public finances. The pro-cyclical fiscal behaviour of the second
part of the Labour administration made the boom larger than it
would have been and also made it more difficult of course to respond
effectively with counter-cyclical measures once this becomes necessary
as it is now. Britain of all the larger countries was probably
the most vulnerable; it was not Iceland but it was not as it should
Q697 Sir Peter Viggers: Professor
Buiter, you made a passing reference to ring-fencing toxic assets
which sparked my thinking that the nearest analogue to the present
situation is of Lloyd's of London in the 1990s where scrupulous
efforts were made to identify and isolate toxic assets. Is this
something which is being done sufficiently? Is it important and
what messages are there here?
Professor Buiter: In the US also
it is the one part of the Government's arsenal that has not really
been used yet. The TARP was set up to buy up toxic assets. In
fact it has not been used for that. The only successful example
of toxic asset ring-fencing inside an institution in this case
is in the Citigroup deal where $200 billion or $300 billion-worth
of dodgy assets is insured now by the Treasury so that if their
value falls below a certain level they go in, so that is a way
of providing financial support for that. I think that one wants
these assets either off the books or ring-fenced on the books
in such a way that they can be dealt with, their true value, or
lack of it, is revealed, that the remaining uncertainty is taken
away and then that the state, if it is the only one who can carry
that load, can take them on its books and try to make in the long
run as much money out of them as it can. They may have to be held
Q698 Sir Peter Viggers: The question
of the future of securitisation, the model of `originate-to-distribute',
which has been a very important part of our system and of course
the boom, to what extent will the system self-regulate? To what
extent will people who have had their fingers burnt withdraw from
this field? And to what extent will further regulation be needed?
Professor Buiter: For three years
they will withdraw. That is the half-life of memory in the financial
markets. There is nothing wrong with securitisation. It is a wonderful
invention to make the illiquid liquid and the non-tradable tradable.
The problem is that when you commoditise relationships, which
effectively you do, and make them tradable, you tend to destroy
the incentive for gathering information or at least weaken that
incentive, from the original borrower. What information is gathered
is no longer traded with the instruments when they get bundled
with 7,000 other instruments. Some of the CDOs apparently if you
were to read all the documentation that ought to go with it it
ran into four million pages which even the very well-paid lawyer
would not have time to deal with. The lesson is very simple: we
can have securitisation; we will have it again; it is an important
source of finance, but we need to force the originator to hold
onto a sizable chunk of the first-loss or equity tranche of the
securitised commodities. That keeps the incentive for gathering
the information and monitoring the relationship intact.
Dr Danielsson: Securitisation
is something that we would sorely miss if we did not have it.
It does provide quite a useful function. In addition to what Willem
said, there are a couple of things about securitisation that went
wrong in the crisis. Most of these instruments are what are called
over-the-counter. They are bilateral agreements between one bank
and one client. Therefore there is no way to figure out what exactly
is an appropriate market price for these instruments and when
there is a problem there is no way to add up all the exposures
of the entities. I would think in the future the focus on regulation
will be to make all these instruments transparent and liquid and
traded on an exchange. If we had taken many of the CDOs and the
subprime assets and CDSs, if all of this stuff was traded on an
exchange like the London Stock Exchange or some other exchange,
then you would have a couple of benefits. Number one, you could
immediately figure out what exactly is the exposure of an individual
institution. Somebody buying the stuff could figure out what is
the appropriate market price, and in trouble, especially like
the Lehman Brothers, when they went under they had a few hundred
billion dollars worth of CDSs and the problem is nobody really
knew what was the net exposure of Lehman's. After they defaulted
you could finally sit down and do the calculation. They figured
out that the net exposure of Lehman was $6 billion, a lot smaller
than anybody suspected. If these instruments had been traded on
an exchange, that would have been known prior to the default of
Lehman's so they might still be alive. In the future we need to
keep those instruments, they are useful, but they do need to be
traded on an exchange so that they are transparent, we understand
the risk, and any buyers get an appropriate price and can dispose
of them if need be.
Chairman: Thank you very much. We are
hoping to finish for 11 o'clock. The answers are fascinating but
if you could make them a little bit shorter, thank you. Jim?
Q699 Jim Cousins: I am a little confused
by what we are being told. Professor Goodhart and Professor Buiter,
are you telling us that those in charge of the financial system
did not see the problem or that they did not warn people effectively
enough about it or just that they did not have the guts to stop
Professor Goodhart: Basically
the last. The BIS and the Bank of England and most other central
banks knew that risk was underpriced and they were worried before
the event that there would be some kind of severe reversal. They
did not know where it was going to come from, they did not know
the exact trigger, but they were aware that there were problems,
but I do not think that they were prepared to take the tough actions
and they did not really have the instruments to do so. They were
not able to turn round to the banks and building societies and
say, "You shouldn't make loans at such high loan-to-value
ratios," for example.
Professor Buiter: I do not think
that regulators saw what was coming. There were general warnings.
Indeed, the risk premium rates had become ridiculously low and
things were unsustainable but nobody foresaw the complete freezing
up of all wholesale markets that mattered and nobody anticipated
that the world's leading banks would be socialised or living under
a government umbrella by the end of 2008, so I think the magnitude
of what was going wrong was not seen by anybody, at least nobody
that went on the record. There were warnings and they were not
heeded. They were not heeded basically because people feel that
they cannot argue with billions.