I think everybody is out there enjoying the refreshments
from what I can hear
but there are a few hardy survivors, good.
I've been thinking about
all this great visionary innovation stuff
that we've been listening to
and now suddenly we get to the misery of finance
and I've been trying to think about the nature of the link
and it's suppose it's pretty obvious
that if we are trying to think of an area
where the innovative propensities of humanity
as lauded by one or two people, not so long ago
went seriously wrong, then I suppose
the object lesson is finance.
And so if we can fix that, tame that,
make it work for us rather than against us,
it will be a major social achievement.
We have an incredibly distinguished panel
I'm looking forward very much to what they have to say
and I think we should have a really very good discussion.
I would however, I would feel really very guilty
if I didn't at least make a few comments
about what I think are the issues very very briefly
before we start.
We're going to discuss have we repaired
financial regulation since Lehman.
I prefer have we fixed it because repair suggests
that it actually did exist before Lehman
and of course there was nothing to repair, we discovered.
There just wasn't anything there at all that worked.
So repair is clearly the wrong verb.
So we'll forget that and just think about
whether we fixed it.
This raises an incredibly wide range of issues
about the role of finance in our society,
what it's fundamentally for and how it fits in
within our monetary systems, the values it embodies,
the sorts of institutions it needs
but beyond that very big set of questions
and I and will be very happy
if any of the panelists discuss them,
I think there are five very swift points that I would make
about what we've been trying to do
in the last five or six years since the crisis.
The first is clearly this is one of the biggest
stable door closing exercises in the history of humanity
and that it looks like it too
and that's really my second major point.
In essence, my reading of the situation is that
they have basically decided and it's not surprising
that they want to keep the system they had before
but just make it more resilient than it was before
and less macro economically destructive
and I think a really big question is
was that a good objective?
Was that really what we should have been trying to do?
And the third point to make is that in the process
of making it a more resilient stable door closed
sort of system, that we have without doubt
ended up with bigger banks
and a much more concentrated financial system than before.
Now you can think of that as the law
of unintended consequences or intended consequences
but it's clearly a consequence.
The fourth point which I owe particularly to Andy Haldane
so I've taken away one of his points
which will allow him to be briefer is
but I'm sure he won't take the opportunity
is that the regulatory process we've created
is unbelievably complicated.
And for those of us like me, who think
that keep it simple stupid is a pretty good motto,
this is enough reason to doubt whether it's going to work,
whether it's fixed and in addition to that,
in addition to that, we've tried to embed
the regulation of the financial system
deeply within macroeconomic policy
and particularly monetary policy.
And the interface between those two things
is really untried territory.
So those are sort of my introductory points
about where I think we are and so I'm now going to ask
our panelists in order to say up to 15 minutes
on have we fixed the financial system since Lehman
and I'm going to start with Anatad Marty
whom I've known with enormous pleasure
since the crisis began and I'm reasonably confident
that I know her answer to this question.
- Thank you Martin and he sits in front of me
so I have to thank personally both Rob Johnson and Aine
for allowing me for I think the fourth time
to well, to scream but try to keep my voice low here.
So it's not gonna be exactly the same talk
but there's gonna be some themes
and the title tells my answer which was maybe anticipated.
So I'm gonna go more into here.
We are in a little bit bewildered about why
although I guess when you get used to things,
you kind of think that's
how come you didn't figure it out before.
So here's the diagnosis and I think maybe some of you
have heard it before, just all the bullets of what's wrong.
System is extremely fragile, it's extremely dangerous,
the public is exposed to risk
they don't have to be exposed to.
Some risks we want, some risks we're exposed to anyway.
Some of these risks are entirely
unproductive unnecessary risks, the economy gets distorted,
severe governance problems throughout this system
and all the way to those who manage it and control it,
also outside the banks and a system
that cannot be functioning well without regulations.
Good regulation, not just any regulation,
any complex regulation but effective regulation
goes to what needs to be done and why we're regulating it.
As a result of all these problems,
this is a system that's continually a drag on the economy.
Just an inefficient system and dangerous.
Now what makes it so fragile?
A lot of debt which causes sort of quick distress
or insolvency at least concerns about it,
not just any debt short-term debt that is runnable,
that creates liquidity problems and huge interconnectedness.
I'm going to show you some more pictures today
which creates any kind of number of the contagion effects
and we discussed this before.
And then the regulation has all these things
that are wrong with it.
It doesn't look at the right things,
a lot of things are hidden, it allows all kinds of ways
to evade it and get around it.
It has not yet fixed this massive risk hiding in derivatives
it uses systems of risk weights
that have been completely ineffective and actually harmful.
So here is sort of the way you can think about
financial intermediation today.
Layers upon layers, upon layers of somebody wanted to create
an institution outside the other institution
and connect them all together.
So instead of having a system where there's an intermediary,
we now have this Ruth Goldberg machine.
Ruth Goldberg machine with thousands of layers
and when you look at the big posters
of the shadow banking system, you're like
where does it begin and where does it end and why.
So somebody wanted to create these and in each one of them
somehow they kind of make money in some way
for the people involved, otherwise they wouldn't do it.
So you have to wonder about whether we're getting
kind of value out of each of these nodes.
That's what happens when one of these things starts cracking
and here is just from last week's IMF report,
just a picture.
There are many of those kinds of pictures.
I'll show you another one.
This is flow across country.
So this is the way it's global
and the thickness of the line is sort of
how much connection these countries have
and this is important because it's particularly important
for example for the possibility of failure
because you fail in different legal regimes.
Here I'm going to show you the picture
from the cover page of this.
Iceland was a little tiny laboratory
where the entire system collapsed in 2008.
This was the growth of this system before
to 10 times GDP or whatever.
Whoa, sorry and this is a book that was translating
part of their report, the Commission report,
asking trying to ask how, why.
Why didn't anybody stop it and what can we learn from that?
That's translated 2,400 pages plus appendix in Icelandic
to a little book that tries to tell the story.
Here is from that report.
This is 300,000 people interconnected
because they could get a hold of all the transactions
for five years and these are cross ownerships
just in Iceland itself, 300,000 people.
The company that owns more than one percent
of another company going around in circles,
all not just a total sort of pyramid schemes
and all of that.
This system becomes incredibly distorted.
One of the big evidence, the pieces exhibits for that
is the persistent and by now everybody admits it.
Of these impossible to fail without harming everybody
entities, whatever you call them, to blank to blank,
there are many variations on this thing.
Being in this position gives you perverse subsidies
that you can increase of course
and I'll talk some more about that.
For the real economy, what also matters
is the fact that the system in the end of all of this
doesn't make efficient lending decision.
It is subject to booms and busts,
it makes too much and too little lending,
sometimes at the same time,
sometimes one after the other and part of that
is precisely because of the leverage
and I'm gonna talk about that.
The governance problem are always of the sort
of who makes the decision and who is impacted
and whether those that are impacted have control.
And here we have a fundamental problem
that those who take the risks benefit from it
and all those that are harmed
or many of those that are harmed have no control over this.
What to do?
Well there's various directions and I don't have time
to go through all of that,
but they come to let them fail somehow,
find a way to let them fail or let's break up
green fence, Volker, split them up in some way,
Potentially not handling the interconnectedness either
which was there before.
So we're just stuck with this system.
Is this the best we can do
because we can't live without this system.
My analogies have to do with pollution
and the fact that we subsidize pollution
when we have a clean alternatives.
Can we change that somehow?
The other one is a speeding analogy which fits very well.
Big loaded truck speeding through residential neighborhoods
at 90 miles an hour telling you that's a natural speed,
they are really good drivers
and we then might send the ambulances when they implode
and say oh we sent the ambulances,
the best kind of ambulances just for you,
we did it just for you.
And the question is can we put it in for speed limits
for these trucks so we don't have the collateral damage
when they implode?
If you ask why the drivers drive this fast,
because they have special ways
to get out before it implodes.
So one of the solutions that's a absolute no-brainer
is to have them be more resilient.
If you could do that but in a dramatic way.
When they loss chops up the egg,
the assets there's a touch to be concerned.
Maybe the bank is insolvent.
Everybody runs for the door and now we might bail them out
but along the way, we had a credit crunch,
we had disruption to the economy,
we're still recovering from that.
This is from Andy Hellands, one of Andy Helland's
many many papers on this.
I'm very well aware that the fortress
seemed just as fortress sees through the crisis
and we didn't see anything on those accounting numbers.
So the fortress balance sheet of Jamie Dimon
is a complete myth.
How much equity?
Well, these are the numbers that we're talking about
and they're very proud in the US
that this week they finalized a somewhat
tougher leverage ratio, five percent, six percent,
a number that does not have the right number of digits in it
and because nobody in the economy lives like that
and why should the most dangerous entities live like that?
What's wrong with going to equity investors
and showing them what you've got
and getting whatever they they pay you?
Or maybe you can't because you're a zombie bank.
So the confusion start from not understanding
what side of the balance sheet we're even talking about.
This debate is not about their reserves or what they hold
that I'm going to just put in the warning right now
because that's when you really start listening
to I can't lend the dollar, it's sitting in a vault,
they hold the capital.
No, no, no.
We're talking about how they fund
and how much debt and equity they have
and so this confusion is insidious and pervasive
and it helps the lobbyists a great deal.
So we have Basel III and maybe it's like tweak
some Basel III, Martin Wolf is my idea
of my favorite quote on that.
Tripling almost nothing doesn't give you a high number
and John Cochran in a review of a book I wrote
captured the essence of what we're trying to do there.
Until it doesn't matter.
Until their risk is back on that balance sheet
and not with the rest of us.
At least the downside risk is there
whether it's 20 or 30 or 50%.
Here are the facts.
Banks tell you that they're very special
but they're not special in making risky investments.
Lots of companies where the part of the world I come from
in Silicon Valley make much riskier investments
that don't even pay interest every month when they are able
and they might end up in a total loss in the US market
or equity markets are good
and when you can always retain your earnings,
everybody can do that.
Most companies have no problem funding with equity
and we even why they don't borrow more.
Large share holders come to tell them
to take advantage of tax benefits of debt.
So retained earnings is the first source of funding
in the pecking order, not so for banks.
Banks, Berkshire Hathaway, a very profitable company
doesn't ever make payouts.
They just keep investing and the share price
keeps going up and up and up.
There's a lot of digits in that stock price by now
of Warren Buffett but banks have very little equity
and they keep paying out.
Perfectly good money that they earned
just now they were approved again.
Why they love to borrow?
It works for them is the answer.
It works for them.
I don't have time to go through all the economics of it
but basically once you borrow a lot,
you become a little bit addicted to it.
If your previous creditors allow it, you will keep borrowing
and who are the previous creditors of the banks?
We go into the bank and give them the dollar
and we don't give a contract constraints what they do.
We hope the regulators will do that.
We encourage that by the tax code
and then we stand ready to catch them if they fall
and they know it and everybody else knows it
then they design compensation structures that chase returns
without adjusting for risk
which this captures everything that's wrong,
paying them to gamble.
So banks can get funding from different sources
and if they use a lot of debt, they pollute the economy.
What do we do?
We give them subsidies and incentives to choose more debt
and therefore they respond and pollute our economy.
Do they pass on these subsidies?
We throw blanket subsidies
and they do whatever they want to do.
If they like derivatives more because more ROE,
they go there.
The business loan is not exciting enough,
not enough upside, that's a clear that overhang effect.
What do we get from that?
Booms and busts and an inefficient system.
Subsidies are distortive and are huge.
There's no economies of scale in banking
beyond 100 billion dollars.
There's no proof of this.
Once you correct for the subsidies that you get
once you become very large and benefit
from the fact that you failed with everybody else
or you will drag everybody into the failure
and these subsidies are large
however you try to measure them which is tricky
but it's big debates about that
right now all over the place.
The banks of course yesterday in a lobbying document denied.
Large is beautiful for the clearing house.
So what ends up being the result?
Is we perversely encourage financial pollution
which ends up with more and more and more inefficiency
and recklessness and too big to prosecute
and no accountability whatsoever.
100 billion dollars of fine
and no problem for the people there.
I believe one of the panelists will talk about stress test
because he's been researching that.
I can tell you that when they say,
oh we just passed the stress test,
don't buy it for a number of reasons.
The stress tests are complicated and totally numbing.
The stress tests are based on assumptions
that do not capture what's really going on.
We do not have that interconnected map
to know what's going to happen.
Two more minutes okay, so now I want to get to my pictures.
My pictures are the following.
We have a shadily reconstructed building.
The system persists.
Here are quotes from a book called,
Why Wall Street Always Wins.
Unfortunately for America, Obama and Biden
were both financially illiterate.
This is somebody who worked with Biden
and then with Ted Kaufman and I quote Volcker
in a conversation saying, "Just about whatever you propose
"no matter what it is, the banks would come out
"and claim it will restrict credit and harm the economy."
"He took a long pause while Ted and I leaned closer,"
This is Ted Kaufman, "to hear what he said next.
"It's all bullshit."
This was confirmed by the New Yorker
and Volker apparently said he remembered saying BS,
so they checked it off.
So I can debunk all of that.
Will it ever change?
I have quotes in the slides which you can look at later.
Going back to Larry Summers in 2000
saying the root cause of crisis
is increasing salience of long-term
panics and runs are now driven by sunspot,
it's the extent of fundamental weakness.
He talks about crony capitalism.
Preventing crisis will depend
on strengthening core institutions
and other fundamentals.
This time is not different.
Here we are if you go to the very end of the book by
(mumbles) they say we've come a full circle
to the concept of financial fragility
in economies with massive indebtedness,
highly leveraged economies seldom survive forever
particularly if leverage continues to go unchecked.
Encouragingly they say, they were hopeful in 2009 or 10
when they wrote it, history does permeate warning signs
that policymakers can look at to assess risk
if only they do not become too drunk
with their credit bubble fueled success.
So the political economy of nonsense
starts with the epigraph of chapter eight
in the book I wrote.
It's difficult to get a man to understand...
Okay so I will just say that they have a lot of narratives
and that we don't have safety in the system
because we don't have black boxes to tell us what's going on
and that my effort here is to explain these issues
because I always run out of time
and empower more people to be able to speak up
so they don't get intimidated by banking emperors
and there are copies of this book outside
which I hope you will take
if you think you can make use of it.
- I'm sorry I cut you off
but we're gonna have a great discussion.
Great discussion and you gave them enough,
very potent slides to look at.
Richard Busch Daiba.
- Thank you.
I need to give a disclaimer before I begin
that my remarks are my own and don't reflect
the views of the Treasury.
I'll have slides a little later on
because I want to demonstrate some points
but these won't be relevant for a little bit.
If you were a risk manager
over the course of the 2008 crisis,
managed to still be standing towards the end of it,
the thing that you would have been confronted with
over and over again is what was the problem
with value at risk?
You kept on showing me that my value at risk
was such that I would only lose at the five percent
or one percent level 50 million dollars
and now I've suddenly lost 400 million.
How could that be?
There is a real castigation about value at risk
and most risk managers understood that value at risk
only made sense if the assumptions behind it
were followed namely if the future was drawn
from the same distribution as the past.
So the value at risk measures were useful
if the future looked like the past
which meant that they were good about 98% of the time
and unfortunately the time that they weren't very good
was when you really needed them, during times of crisis.
Unfortunately the management of most banks
didn't understand that or were happy
not to bother to understand it
because it would get in the way of leveraging
and keeping up with other banks
in their pursuit of levered earnings.
So after the crisis, as the dust settled,
in terms of fixing the system, people said okay,
we can't use value risk.
What are we going to use instead?
And they said well we know that the problem
with value at risk among other things was that
it only made sense that the future looked like the past.
Obviously when you have a crisis,
it doesn't look like the past.
So we need a measure that can untether us
from our dependence on the variance-covariance matrix
that's existed historically.
And so people started to use stress testing more and more
and it became derigueur with the regulators.
So you have C Carr and so on.
So what we've done and by the way,
stress testing did exist even at the trading desk level
for years beforehand but it ended up being more dominant
for sort of bank level and regulatory level risk management.
So now the problem with VAR, with value risk methodology
which I call risk management version 1.0
was that again it's good in normal times.
It's not good in crisis.
Although I'd have to say if somebody put a gun to my head
and said, "Give me one number to tell me
"what the likely risk is of my portfolio
"or if my inventory of the bank over the next month,"
I'd still use value at risk.
But what we did, we moved from value risk
in response to the crisis to the distressed tests
which ended up being basically this version 2.0
which had their own problem and the main problem they had
is not so much that they only named certain scenarios.
So what are the odds that one of the scenarios
that you would have put into a stress test before 2008
was a problem with subprime mortgages?
The problem is that it's static in the following sense.
I'm a regulator and I go to bank A.
I say, "Here's the stress.
"What happens if this occurs?"
"Oh we lose five billion dollars."
I go to bank B, what'll happen to you?
I'll lose seven billion.
Bank C, I'll lose 12 billion.
The next thing you have to ask is okay,
four billion, five billion, 12 billion.
When all that money is lost, then what happens?
And that's the thing that's missing
from this risk management version 2.0.
It's not looking at the next order effect that occurs
when you have this sort of a crisis
and so in terms of repairing the issues from 2008,
I'd argue in this very narrow setting
of getting a good risk management structure,
we have not repaired it
because we're missing the essential dynamics
and they're essential because they are what is behind
the major crises that occur.
There's two types of dynamics that I would focus on.
One is called an asset-based fire sale,
the other is called a funding-based fire sale.
An asset-based fire sale and if you go back to history
of say, LTC on this was sort of the canonical case of this,
you have a shock to some asset market.
People who are highly leveraged suddenly get a margin call
they have to liquidate in that market.
Well, if that mark is already dropped a lot,
they probably can't liquidate very well in it
so if you can't sell what you want to sell,
you want to sell whatever you can
so they start to liquidate in another market.
Now that price drops.
So everybody who happens to hold that asset
suddenly gets margin calls, they start to sell
and you have this cascade and contagion
from one asset to another.
A funding-based fire sale is the same sort of contagion
in cascade except it starts not from a shock to an asset
but from a funding shock.
For some reason funding is withdrawn typically from a bank.
That withdrawal funding forces them to liquidate assets
which leads to an asset-fire sale.
Other banks seeing what's going on, start to hoard liquidity
so they're not willing to make a market.
So liquidity drops which precipitates even more of a drop.
This is a sort of dynamic that you have to capture
if you're going to deal with systemic events.
So how do we do that?
How do we get to what I call risk management version 3.0?
Well, one technique which I'm involved in developing
at the Office of Financial Research
to assess financial vulnerabilities
is what's called agent-based modeling.
There's a paper if you want to just google
OFR books taper agent-based,
you'll see a paper that I wrote on it
that sort of introduces it as a methodology
and I don't want to spend too much time on it here
but the key thing about agent-based modeling
versus neoclassical methods are the following:
Unlike the typical neoclassical methods
which have a representative agent,
you can have heterogeneous agents for an agent-based model.
You can have a Goldman Sachs and Morgan Stanley
and a Citibank each of which have
their own best behavior rules.
They observe and react so that you get feedback.
When the environment changes because of actions,
people observe or the entities,
the agents observe what's happening
and take action based on that.
You can have rules that are heuristics
rather than optimization.
You can have influencing each other and your own behavior.
So all these things that and by the way,
you don't have regularity assumptions
and partial equilibrium and frameworks to that
if the train starts go off the tracks
there's not some mystical force
that puts it back on the tracks again.
Now what I want to do is show you
from the agent-base model that we're developing,
a couple of slides which will kind of illustrate
how this can be employed.
Now, this is basically a schematic of a network
where we have investors to cash providers to the bank dealer
who pass this flows of funding to hedge funds and others
and going the other way is securities and collateral.
Now of course there's more than one cash provider,
there's more than one bank dealer,
there's more than one hedge fund asset manager.
So this is kind of one segment of the broader network
and I've sort of exploded the view of the bank dealer
to illustrate that actually the bank dealer
has a whole bunch of sub agents.
It has a prime broker who provides
a credit funding transformation to hedge funds.
It has a trading desk that provides
a little liquidity transformation to the asset managers.
It has a derivatives desk that provides
a risk transformation.
The key point in this is I'm not representing
just a network.
As the flows go from one node to the other,
things were happening to those flows.
There's risk transformations, credit transformations
and so on and unless you take those into account,
you can't get a good indication of what's going on.
Networks are very interesting
and I'm glad that we can see
the complexity of the system based on them
but they really don't do a lot more
than sort of boy that was really cool.
Oh look how complicated that is.
You need something that can get to the dynamics.
Now what I want to show you is with a very simple model
of the agent-based model.
I'm just going to have three assets, two hedge funds,
two bank dealers, one cash provider in this simple diagram.
The hedge funds are circles, the three assets are squares,
the bank dealers are triangles pointing up,
the cash providers pointing down,
they're laid out in this particular way
just because you'll see it's easier to visualize things
and the arrows are trying to do double duty.
They obviously show the direction
of the flows of the effect.
The thickness will show in the following charts,
the degree to which an aggregate, the influence occurs
how much a hedge fund it's influencing price
and the color will indicate how emergent
or current that influence is.
Also the size of the color within the object,
the square, the triangle will show
the capital of that particular agent.
Now what I'm doing is to demonstrate this,
I'm going to impose a shock.
So think of a model where I impose a shock in assets zero.
You can see that there's a little white area
around that square.
Prices have dropped about 10%.
When that occurs, that affects the cash provider
because collateral is now not as as good
so it's going to reduce funding, it affects the bank dealer
because it holds inventory and assets zero
and affects hedge fund one
because it has exposure to asset zero.
It's not affecting bank dealer two or hedge fund two
because in the models I've structured it,
they don't have exposure to this asset.
So if we did a static stress test, we'd be done right now.
We'd say oh the bank dealer lost four billion dollars.
Oh the hedge fund lost one billion dollars,
okay, that's the end of it but it isn't the end of it
because as we go from period zero to period two,
I'm just skipping a couple of periods here,
things move forward.
Basically hedge fund one having had the shock
now is forced to liquidate it happens also hold asset two
so you see a big shock of movement
from its selling to asset one and asset one starts to drop.
The cash provider now reduces its funding
which feeds back to the bank dealer
and now you see that hedge fund two is getting affected
because it had exposure to asset one.
So now you see the start of the the cascade occurring.
Hedge fund one is shocked, it liquidates.
It liquidates at the other assets it holds,
hedge fund two has it, now it's embroiled through contagion.
Now we're looking period two to period four.
Now you can see that we now have washed up
to even where asset two is starting to get affected.
Because in this particular model,
hedge fund two has both asset one and asset two.
It now has been shocked to a point it has to liquidate.
It can't liquidate enough of an asset one
because it's so much under pressure
that now it starts to sell asset two
so now asset two is getting affected by the market
and it starts to drop in price.
Meanwhile, the cash provider is starting to reduce funding
not only to the bank dealer number one
that was embroiled initially
because it had exposure to the shocked asset,
but it's also affecting bank dealer two
and bank dealer one is having an effect on bank dealer two
because bank dealer two has counterpart exposure
to bank dealer one.
So now you've washed all the way over and finally,
the effect is completed.
Timing is pretty good on this.
So finally you get to the last case
where the effect has washed you through the system
and what just happened?
You had a shock to one asset and the final result
if you look at it, this is a pretty dramatic case
but you might notice that there's no color left
in hedge fund one, bank dealer one or hedge fund two.
So hedge fund two is sitting there saying, "What happened?
"I didn't even have asset zero in my portfolio.
"I did my stress test and there's no result.
"I didn't lose anything yet I'm out of business."
So this I think is the failing that exists right now
in terms of the stress testing that is occurring
when you are at the level of systemic risk.
These second-order effects
and the way things wash through the system
is really critical.
Let me just go back.
I'm just going to go through this.
Just watch how things kind of move from right to left
as you go through this.
That's the type of analysis that's necessary
to get the sense of where effects can move into the market
and how a stress ultimately can lead to an asset-based
or funding-based fire sale.
Now this last slide just illustrates another point
which is you need to stress more than assets.
You can have a price shock which is on the upper left
which is what I just did but you can have a funding shock
where the cash provider just pulls away
and reduces funding.
You can have a credit shock, where basically
the bank dealer has a credit issue
and has a counterparty risk that passes to bank dealer two
and has a funding effect for the cash provider
or you can have a redemption shock,
not so much with hedge funds
because they have gates and so on
but if suddenly everybody pulls out
of some big asset manager in a day for some pick a reason,
for some reason, you can have a funding redemption shock.
So that's also the last slide fortunately
but the main point and I'm focusing
on a very small aspect of the market
but one that I'm intimately involved in now
is that in terms of risk management and monitoring,
although we are moving from version 1.0 to 2.0
in stress testing, we need the tools
and the modeling capability to go the next step
and to deal with these types of dynamic and contagion
and the one area for doing that I believe
is using these sorts of agent-based models.
- That's very interesting.
I think it will raise lots of questions.
So nice discussion.
- Thank you Martin and thank you to Rob and to Inet
for having me back.
It's always a real thrill to be here.
So today I want to try and answer this question
as simply as possible.
I do want to show you some pictures, some facts
on the extent to which the financial system
has reshaped itself in the light of the reforms
over the last five or six years.
I want to assess that reshaping
by looking along two dimensions.
One dimension is this structure.
The underlying topology of that system
and the second are the incentives
embedded within that system.
Because if performance is to be durable,
if it is to durably curtail systemic risk,
you need to act on either or both of the structure of
or incentives within that system.
So I'm gonna give you some pictures.
The facts should I hope speak for themselves.
It's you to reach the judgment
on how reshaped our financial system really is.
Let me start though just by giving you some sense
of what the reform program has been.
I list here some of the initiatives,
some of the bigger initiatives.
There are many and various and I've scored them here
in terms of how far we have got from design
through to full implementation.
Some are further progressed than others.
None I would say are yet fully complete.
I'd say we're roughly halfway maybe a bit more than halfway
towards having fully implemented that which we have set out.
Martin called this the closing of the stable door.
For someone who's been there doing some of this,
it's felt much much less glamorous than that.
More a sort of shoveling of the...
More of shoveling of the stable
than a closing of the door.
Nonetheless, we have not been thanked for our shoveling
by the financial sector.
Each one of these initiatives at various times
has been said to be potentially life-threatening
to the financial system.
It would cripple balance sheets,
it would squeeze the juice out of business models,
it would bring the system to its knees.
Let's see whether that has been true.
I want to focus in particular
on the fortunes of the world's biggest banks
because fortunately, the Financial Stability Board
has designated 29 such banks as GSIBS
that is globally systemically important banks.
They've gone further and identified
the structural characteristics of those banks
that make them systemically important.
Things like size, things like connectivity
and things like complexity
and those are the three dimensions
along which I now want to assess the big banks.
So this picture subscribe it for a second.
The blobs are banks.
The blobs are the 28 G-SIBS.
The flags of nationalities of those banks,
the sizes of the blobs
measure a set of structural characteristics,
in this case size and the green blob at the bottom
measures the average across that population of 28 blobs.
This measures the asset base back in 2006 pre-crisis
the average G-SIB had a balance sheet
of around 1.35 trillion dollars,
roughly the size of an average G7 country.
How crippled have those balance sheets been
over the intervening period during which that slew of reform
has taken place?
Well fast forward, seven years here's the position today
at the end of last year in 2013.
You'd have seen that the blobs haven't shrunk.
The blobs have continued to if anything,
inflate the average blob is now has a balance sheet
of around 1.76 trillion dollars, particularly large growth
for example in some of the Chinese banks
in the far right hand side.
Size, if anything bigger.
What about interconnectivity?
There's no perfect way of measuring that.
The FSB, 0.212 metrics, this is one
which this is the size of the derivatives books
of those big banks measured here in notional value cents.
Back in 2006, the average global SIB
had a notional value of derivatives outstanding
of a rather remarkable 19 trillion dollars
or roughly a third of global GDP.
What has happened with the intervening period?
This is what has happened.
That derivatives portfolio has grown by roughly 50%
to an average be around just over 30 trillion dollars
for each bank within this population.
Different metrics of interconnectivity
sell a slightly more optimistic picture.
Here's a measure that looks at the the wholesale funding
of those G-SIBs back in 2006, slightly more than half
of the balance sheet of banks was wholesale funded.
How has that improved?
Well, a bit but not much.
Still roughly half of those now bigger balance sheets
are funded from entities elsewhere in the financial system.
What of the third dimension which is complexity,
again a tough thing to measure.
Here is one potential metric.
The number of distinct legal entities
within each of these banking groups.
Back in 2006, on average each of these firms
had in excess of 300 distinct legal entities.
Some had 10 times that number.
Fast forward to 2014, that number is roughly
exactly where it was back then,
if anything slightly North of what it was back then.
This metric speaks to complexity of balance sheets.
If you look at the complexity of assets for example,
the fraction of the balance sheet
that is more complex traded.
Instruments back in 2006, that was on average around 20%.
Seven years forward, it remains around 20%.
The one structural dimension along which
there has been quite a shift and in some ways
perhaps the most important has been leveraged back in 2006
the average global systemically important bank
had leverage of an eye-watering 32 times.
Initiatives like Basel III and leverage ratios
have brought that down.
Today it's just North of 20 as a leverage ratio.
How comfortable should that make us feel?
Well to provide some context, if you're 20 times leveraged
then if the value of your assets falls by five percent,
you are in the gutter.
How often would you expect the assets of a bank
to adjust to fall by five percentage points?
Well if history is any guide, roughly every 20 to 25 years
we're five years on for the crisis
so if we're lucky we'll have a repeat performance
sometime in the next 20 years at these levels of leverage.
How comfortable does that make us all feel?
So much for the structural characteristics.
What of the incentives?
Incentives are a tricky thing to get a metric of
but one clear diagnostic on incentives
indeed on distorted incentives is the extent to which
the market is underpricing risk
by dint of banks having an expectation
of being bailed out by the government.
We can begin to measure as an Anat mentioned,
those such implicit subsidies.
One way of doing that is looking to our friends
in the rating agencies who have assigned
different notches of support to the probability
of the government riding to the rescue.
Back in 2006, the average global SIB
benefited from around half a notch of implied support
from the government.
As we lived through the crisis
and look at the situation today, in March of this year
that implied degree of support has risen
to in excess of two notches.
Now there's some good news here
which is our friends at Moody,
Moody's at the end of last year
decided that at least for US banks,
they would remove that expectation of support
but other rating agencies have reached a different judgment
and what's more if you'd use a different metric
of implicit subsidies, this is one that the IMF
have developed based upon bond prices
rather than on rating agency ratings.
That would have said this is the IMF's analysis
that back in 2006-2007, those implicit subsidies
across the GC banking population
would have been something like 12 billion per region
or more like 60 billion across the world.
Today, those implicit subsidies are more like 600 billion
which is comfortably excess of the total profits
of the banking system.
Incentives haven't very obviously been reshaped
in a positive direction from this evidence.
Another metric on incentives might come from looking at pay.
Pay matters a lot to risk-taking incentives.
Back in 2006, the average CEO of the global SIBs
paid themselves a reasonably comfortable salary
of 20 million dollars per year,
some a lot more than that especially if you lived in America
judging by the sizes of the blobs.
The good news is that fast forward
and as of at least last year, the average big bank CEO pay
had shrunk quite materially
to something close to the minimum wage
at a mere nine million dollars per year.
Over that period of course bank profits and revenues
also went through the floor.
You might want to rescale
this by that shrinkage in revenues.
If you do that as this chart does,
the totals are expensive over total revenues.
Back in 2006 bank staff and the biggest banks
were paying themselves roughly 40% of revenues.
Today, it remains at around exactly the same level.
Relatively little evidence here of pay or comp
or risk-taking incentives
having been too fundamentally reshaped.
I said I would let the facts speak for themselves
so I will not provide a conclusion.
Beyond saying, beyond saying plainly, plainly,
plainly there is unfinished business.
When you look at structure or incentives,
we have not seen very much repair.
We have seen little by way of reshaping.
We have seen almost no radical reformation of the system
that we inherited back in there.
Two more minutes, I'll be done in one Martin.
I'll have my one-minute back later on.
If after having completed this reform agenda
we find ourselves in the same situation,
I hope, I hope that we'll have the intellectual courage
to look again and to do more if more is necessary.
I say all that without having even touched upon
other parts of the financial system that may themselves
be a repository of systemic risk in future.
I've said nothing of shadow banks.
I've said nothing of clearing houses.
I've said nothing of asset managers.
Each and any of them may in future
themselves be a time bomb waiting to explode.
We are still in the intellectual foothills
of thinking about those risks and nowhere close
to having fully reformed them.
The good news is that that will keep regulators like me
in a job whether the remaining seven billion people
on the planet will be benefiting from that,
it remains to be seen Martin.
Let me stop there, thank you.
- So I'm Ed Cane.
I hope my slides are up.
I have a very complicated title
I want to make sure you understand
that those of you who aren't for the US might not recognize
this is about a story of a rabbit
that is captured by animals that want to eat him
but says rather than eating me,
throwing me in the briar patch
would be much greater penalty.
So whatever you do don't throw me that briar patch
and of course they do and then he laughs at them
because that's where he lives.
So the other part is the word flummery.
What does flummery mean?
Well, it's Shakespearean English for bullshit.
So if they will give you the next slide here,
this really sums up my view of Dodd Frank, Basel III
and global swaps rulemaking
and what it does is it shows an elephant
whose pillar is labeled regulators
and a hog whose pillar is labeled mega banks
and I think the cartoonists chose the elephant
for the long pinocchio-like nose and I know he chose the pig
because it's the most voracious
and intelligent creature in the animal kingdom
and that you may know in the United States
that while pigs are feared creatures in many regions,
certainly in Arizona where I live now.
So the main point of the cartoon
is that financial regulation is a rigged game.
The principal players are regulated institutions,
regulators and I include with them politicians
and then tax payers who are the ones
who are playing at a disadvantage.
We have ethically challenged institutions
that build political clout and feel absolutely entitled
to hide salient information from other players
and to do this, they use a number
of time-tested tricks in accounting
and also always a bunch of innovative ways
and the regulators often helped them invent innovative ways.
Any of you who know about the SNL mess,
we had something there called
regulatory accounting principles; RAP
and the only thing that was established
if I can use an offensive word again
is that RAP is crap that they did everything to hide losses
to delay their recognition and allow
insolvent zombie institutions to go on for a very long time.
Now, regulators are playing both sides.
After all the people that appoint them
are connected to some degree to the tax payers
but they also ran a partial coalition with the regulated
as I've just said not only to help them with the concealment
but also to cooperate in overstating the effectiveness
and fairness of the regulator's own place.
Capital requirements are a perfect example of this.
The regulator's express way too much confidence
in their control strategies such as capital requirements
and then they overstate the enforceability
of things like capital requirements.
We've got all kinds of rules.
There was never really anything terribly wrong
with the rules we had for banking and investment banks.
What was missing was supervision both within the firms
and from government.
So it really was a problem of the supervision
rather than deregulation.
You've got to get to the next slide at some point
because I'm almost through reading it.
But anyway, think about this, the taxpayers
actually own the regulatory agencies
but they're deceived by accounting
and examination procedures that force them to play
from a poorly informed disequilibrium condition.
They would never play this way if they really understood
how the game is rigged against them.
But what I'm going to argue is that we need to reconcieve
taxpayers role in the regulatory game,
that they are actually equity investors of last resort
but they're denied the protective rights of disclosure
and redress that are accorded explicit shareholders,
even minority shareholders in the United States
are treated much better than taxpayers
and we'll get back to this.
Now, I have another cartoon and the whole presentation
is built around three cartoons and in this next one,
I argue that the banks use regulators
to run a protection racket which results
in theft by safety net.
And so what we have in this picture
is a gleeful mega bank executive holding a gun
on a combination of Uncle Sam and John Bolt
to get across the two most important
financial regulators of the world
and very dutifully the regulator is picking the pocket
of a helpless taxpayer.
So the main point to make is that
the bailouts are being framed by regulators, by politicians,
by bankers as the kind of insurance payout
or even a loan but that's a very poor way realistically
to portray them.
They are actually coerced wealth transfers
which is a very good definition of theft.
So the regulators actually provide
loss-absorbing equity funding to zombie firms.
Zombie firms, meaning firms that would be declared dead
and buried by the creditors if they didn't enjoy
the government guarantees.
So they provide this funding when private parties
are running for the exits.
So this means that whereas insurance and loans
are things that we talk about as being risky
in the 90 and sense of risk, but what they require us
as taxpayers to handle is the 90 and uncertainty.
The uncertainty where you can't put down the probabilities
that you're going to be hit but you know
you're in a bad position.
So they're ready availability of government credit support
to zombie firms, subsidizes destructive tail risk
and you don't see any time you take such a risk
when you put it on your balance sheet, it's a plus.
It looks like you're doing fine.
It's when it falls apart that things go bad.
So we need to take the supervisory process
which is very broken and re-engineering it
to attack the subsidies.
That is the theft says we would attack any other crime
as we have to have laws with penalties for criminals.
I'm saying that these people that pursue tail risk
at the expense of taxpayers are de-facto career criminals
and we have to stop treating them
as the elite of our countries
when they bring the taxpayers into this kind of mess.
So the tail risk can be increased
in ways that really make it impossible
for capital requirements to be the answer.
That tail risks can be increased
without showing in the capital
and the accounts of insolvent firms have shown themselves
to be very creative in finding ways to hide losses
until things are too late.
So let me explain to you how awful
the taxpayers equity position is.
It's inferior to that of shareholders in at least five ways.
The first is taxpayers cannot trade their positions away
that you've got it, you're stuck with it
and even hedging it is very hard.
The best way to hedge it is to buy stock
in firms like AIG and Fannie Mae and Freddie Mac
when they're in the bottom of a crisis
because if they're allowed to keep going,
they will come back.
In AIG you know it never hits zero the stock
and is now back exactly to its peak
or in the range of its peak.
Now secondly, ordinary stock has limited liability
and unlimited upside but the taxpayer downside liability
is not limited, but the upside is.
As soon as the firm starts to recover
using this cheap capital it gets from taxpayers,
then the gains go more and more to the shareholders.
Third, the taxpayer positions carry
no procedural or disclosure safeguards.
In fact, people are trying very hard to hide it
and they're also not even recognized as legally
as an equitable interest.
We couldn't have a class action
on their part in the United States.
Protected firms can exploit them
without worrying about lawsuits and finally,
managers can and do abuse taxpayers further
by blocking or delaying recovery and resolution.
So what am I saying?
I'm saying that there isn't a way
to improve the system tremendously
and that is for the worst firms
and managers to be prosecuted as criminals
but the firms, it's enough to do the firms
that we were talking about how banking firms up.
The genuine reform would compel that in the United States
the Department of Justice to prosecute
these mega bank holding companies
that engaged in easy to document securities fraud.
What would be the consequences?
What's the evidence of it first?
Well the evidence is they have many representations
and warranties that are demonstrably false
and you can show men all of five tests of fraud,
deliberate deception, intent to benefit,
deception is material, intent is to get taxpayers
and investors to rely on the misrepresentation
and finally, investors and taxpayers did rely.
So this evidence is strong and then
if they were convicted felons, the companies,
they would have to break themselves up
because in the United States
subsidiaries of felonious companies
could no longer take insured deposits
or act as broker dealer firms and futures merchants.
Now, you may think well you can't do this to companies
because they're not persons
but corporations actually fought very hard
to get the Supreme Court in the United States
to declare that they were persons.
So we can have a tremendous change in our incentives
if we can broke up some firms
convicted of this felonious misrepresentation fraud
and it should give a huge incitement
to behave better in the future for those that are left.
Now finally, we have to understand that capital requirements
have actually failed us again and again.
It's been the keystone of regulation in the United States
since about 1966 but eventually,
governments must measure and service
these safety net subsidies directly.
That is if we taxpayers are equity investors of last resort,
we deserve to have that measured and surface.
That's what we do for any other stockholder.
So let me just summarize the themes of my presentation.
First its align incentives corporate law
for giant financial institutions
should recognize that the safety net makes taxpayers
unfairly compensated and coerced equity investors.
So we should get better returns on our position
than ordinary shareholders.
Secondly, taxpayers deserve to be protected
from this appropriation just by simple fairness
of rule of law but regulators have been assigned
other and conflicting goals that keep this
from being uppermost
especially when institutions are in trouble.
So there are several things we could do.
One of the points I've been emphasizing
in other presentations is the top regulators
need to be trained and recruited in a more apt fashion.
In the United States, what you need
to become a top regulator first and foremost is connections
and these connections leave a trail of debt
which can be used to manipulate regulators.
Second, we could actually establish a single-purpose
trusteeship at all of these G-SIFs
or I call them G-SIFs for institutions
but once we designate them as this,
then there should be a trustee.
I'm in good shape.
So then these trusteeships would have the power
to require managers to see that tax payer equity stakes
are calculated honestly.
That isn't to say perfectly accurately.
In fact one of the things that bothers me
when people talk about valued risk
is they talk about a single number.
It's just six one you learn
there are no point estimates of any value.
You need the interval estimate.
So for someone to say it's five billion dollars
when it could be a reasonable interval,
we extend out to 500 billion,
there's a very serious misrepresentation
of what it's supposed to accomplish.
We really need this to be serviced.
Now I have one final cartoon which really gets back
to how I would have titled this session
that not that have we repaired
financial regulation since Lehman
but how have we renegotiated
financial regulations since Lehman and we haven't done much.
First I wouldn't say dated from Lehman.
I think AIG was the most mistaken event that occurred
but certainly you want to combine it as the Fannie,
Freddie, Lehman, AIG event
because it was like a double U-turn in policy.
First we helped Fannie and Freddie's,
then we butchered Lehman and then we decided,
no, we wouldn't do anything to the creditors of AIG.
Anyway, the point of this cartoon
is this is a mega banker,
he's explaining that mega institution criminals
are fighting to keep taxpayer equity positions undisclosed
and certainly unserviced as there's no dividends on them.
And this man is simply telling us
it's just good business to do that.
- In some ways, this has been
really quite a simple discussion
because we have an unambiguous unanimous
answer to the question which doesn't often happen.
Have we repaired the financial regulations since Lehman?
The answer is no.
That's not very surprising.
There are however I think just a couple of two or three
sort of interesting questions that arise
out of the presentations which I'd just like to touch upon.
So try and give reasonably quick answers
so we can get to the floor in about five, 10 minutes.
The first question which I think I'd like to start with Andy
but Anaton might want to comment on it too
is the point that Ed has made at the end
which is clearly correct.
There is an enormous it's implicit in your own points
and yours, there's an enormous implicit
tax payer equity here which is and I've written this myself
the regulators stand for the taxpayer
and the regulator has completely failed
to perform their function in prosecuting malfeasance
and indeed is part of the problem.
First Andy, do you agree with that analysis?
Second, do you think which I'm trying to understand
what Ed said.
That legal mechanisms and explicit articulation
of the tax payer position is a way to go,
are a way to go and that one of the great failings
of this whole process to put it very crudely
is one, nobody's going to prison and two,
even though they have admitted malfeasance in many cases
and too that the explicit and clear interest
of the taxpayers not recognized
as being part of the balance sheet of the banks.
- Thank you Martin.
So to the first part if it correctly.
Regulators were plainly a large part and parcel of that
but they're in good company
including academics and journalists.
But not all.
With one or two honorable exceptions to my left.
We roughly speaking all got it wrong a bit
and most of us got it wrong a lot.
I think prudential regulation, the notion of systemic risk
was not really in the bloodstream
of any of the regulations we drew up.
So for sure we were partly culpable.
As for legal mechanisms and if you like
how best to reshape incentives and the language...
- That is just another way of putting the same point.
It a central part of the reshaping of incentives?
- Well I take to be one of the most powerful aspects
of the Admati Helbig thesis is not just the accounting fact
that you have more equity there,
it's the incentive effects that flow from it
and actually correct me, that I view as as important
in delivering a safer system.
I have to say for me, and you know this Martin
because you actually commented on the paper.
I think one of the dogs that has not barked,
one of the reform proposals that see no real progress
has been the governance question
within banking institutions.
A situation where we let the stakeholders
typically representing less than
five percent of the balance sheet
dictate the fortunes of the firm
doesn't sound the right way around to me.
So asking some basic questions about the PLC model,
the governance model as it applies to banking
is a thorough that so far is unplowed
and I think rather than being in court all the time,
might be a structural mechanism
that would reshape incentives
in ways that wouldn't assess it.
- Anat, what what would you like to add on that?
- What I would like to add is completely
that it's entirely our diagnosis.
This it's a big governance problem and precisely
as you said and we were in a conference together
where I said exactly this.
What kind of show the governance is it
when most of the money is not to shareholders' money
that is being invested?
One way to handle this is maybe to really have
board presentation of essentially of deposits
of the deposit insurance which is focused on the downside
and would need to have a voice maybe in what happens
including whatever boards decide.
That's something that can happen in principle
or by law or some other way.
Certainly there's a governance problem, a very deep one.
Our idea was that maybe nudge shareholders
into caring a little bit more about the downside
but I agree with the numbers were talking about,
that's nothing completely.
- Does this mean I mean I've thought about this.
Ed, perhaps some
Should the FDIC have a seat on the board
as a shareholder representing the public?
I presume we have an FDIC in the US.
I thought about this quite a bit.
There are pretty clear conflicts
between your role as a shareholder
and the role as a regulator.
So could you be a bit more clear about
how you'd handle these governance questions.
- I've done a lot of work thinking about the trusteeship
because the problems is if you give the FDIC this role,
it may very well affect who can be the head of the FDIC
and maybe your Sheila Bair could never be appointed
because she would be too aligned with the taxpayer.
So the idea of the trusteeship with individuals
would be at risk.
I was a trustee for a teachers insurance
which is the big pension fund and they bought insurance
but still the insurance costs a lot
so that is going to also lead to the better the trustees,
the better they're aligned,
the less this directors and officers insurance would cost
but there's a lot of people say
my age, only a little bit younger
at the end of their careers who would be happy
and want to leave this as the legacy
that they would be a trustee and as you say,
they be board members too
but they would have clear responsibilities
to manage on behalf of this set of shareholders
that aren't recognized today.
- Can I just follow up with Richard now
because it's another angle of this
and if you want to add on this which is
the way I read what you say is essentially
the risks are so complex and interwoven.
You have the simplest possible model there.
Three assets and two players and two burger teas
and you still would be pretty difficult to work out
where you were going to be hit and indeed
when I look back on the crisis in a way to me
the shocking thing is really the event
that caused this utter meltdown was a trivial event.
So really trivial.
So isn't the conclusion from your own analysis
that actually assessing the risk
of the system is impossible.
The only thing we can do is simply enormously
to increase its resilience which takes us
in that sort of direction and maybe liquidity crime
and so forth and abandon the stress test approach
because it actually can't be done.
Own once you get to N dimensions
of this complicated matrix through time,
surely you won't be able to solve it.
- Right now we have a broader model that we're testing.
So in theory the nice thing with an agent-based model
is we could have 80 banks some 4000 hedge funds
and if you have the CPU, you can do it.
So the question is how many do you really need
to get a reasonable picture
and how much is a reasonable picture?
So given that we have no clue right now
in any quantitative sense of my view what the dynamics are,
if you can illuminate it even 20%,
you're 20% better than you were otherwise
and the thing is that the nature of what we're trying to do
which is systemic risks,
the nature of systemic risk is first of all,
whatever is causing it has to be pretty big
and readily manifest.
It's not like something happens in one day
and I don't think although we see
these extremely complex networks of many many banks,
my goal initially is to say,
let's first do it for the five or six
big money center banks in the US,
let's add to it the biggest
hedge funds asset management firms,
maybe you have 15 to 20 asset classes.
Does that solve the problem
or are you gonna capture everything?
No, but I don't think that the object of this model
say oh my gosh this is such a mess and so complex.
I guess we can't figure it out.
My hope is that we would be able to over time,
get a better and a better sense
of what sorts of shocks,
essentially what you want to worry about
something that can strike into the heart of the system
and it tends to be the funding side of the system.
So there's a lot of shocks which would just dissipate out
without much of a concern.
- Yes and be very very brief because for some reason
you all apparently want to go to a cocktail
instead of listening to this fascinating discussion
and I'm told I have to stop very soon
which is very depressing.
So I'm not very quickly in Ed and then I'll go to the floor.
- I want to ask why all of this effort.
That's my question.
From where we are right now, what is the purpose
of deciding that we can just measure this speed
on this corner of the neighborhood
to be 87.7 might get us through the next thing.
What's the problem that we're trying to solve?
These institutions cannot go through bankruptcy.
They fail title one living will requirement.
We gotta do something to change it.
The entire approach takes the system is given
and that's what I don't understand why we're doing.
What forced us to accept this system?
- [Martin] Ed.
- Consider the stock market value in this firm.
Now that's a very difficult job
but the stock market does on average a fairly good job
and they don't try to build it up unnecessarily in this way.
They're lucky in terms of profitability
and where the sources are.
I define systemic risk as the value
of taxpayers position in a firm
and I have actually spent a lot of time with colleagues
to develop numerical estimates of at least the value
quarter by quarter over 36 years and again,
you got to put a confidence interval around it
but when it gets big
and the upper end of that interval gets big,
you know there's need for more intervention.
Again if you think of this as crime, a crime wave,
you put police in where the trouble is occurring.
- [Martin] Andy.
- I have a dream Martin.
And because finance is complicated
but it's no more complicated than the web.
It's no more complicated in some respects than the weather
but actually we can track the web
and we can track the weather and my dream is that one day,
maybe in the not-too-distant future,
someone we sat there in a Star Trek chair like this
with a screen about that size
watching the contours of global finance
in close to real-time in the same way as we do for weather,
in the same way as we do for the web.
If you've got that, then you can run a stress test
and you can walk this through the system.
I think that's that's well within our technical grasp.
- I think weather is a good example of this
because 15 or 20 years ago,
if you could get a good prediction
of whether it would rain tomorrow, that was great.
Now you have 10 day forecasts.
So obviously dealing with institutions
is different than dealing with physical system
but to not start along that path
because it seems too complex,
you can really look at what's going on
with weather prediction over the last 30 years.
I'm going to take a couple of questions.
I can't take up to three.
They will be questions they will be very brief
and then I'll go to the audience.
I can't see very clearly.
Somebody there, yeah.
Please stand up, say who you are and ask a question.
- Hello, Dennis Kelleher Abettor markets.
Andy, great presentation on the facts
but they show that you haven't taken care
of what's going on with Lehman
and yet you then say you haven't even touched shadow banking
asset managers and others and yet IOSCO and OFR
are now going into the asset management business
looking at them.
Don't you think you should get done the known systemic risks
that have already materialized
before you start moving into other areas?
They're all important but there's only a few of you,
you limited resources and people.
Shouldn't you be prioritizing and then attacking things
as you move down rather than now before the job's done
going into different areas?
- Okay, another question.
Someone down here.
Somewhere at the back.
There's somewhere at the back there.
I can see someone with their hand up, stand up.
Yeah, yeah, yep.
Can you get the mic to him I think?
Very dark out there.
The question that I have and--
- Who are you?
- Sorry, Dave Kinthorn for CJ.
The question I have is why haven't we repeated
the financial system?
Is it the fact that regulators
have insufficient statutory authority
or is it because financial regulators
haven't got their dream list of items
that they need to repeat the financial system?
- Okay, that's a good question.
Yeah, yeah you.
- Federico Fubini.
My question is on central banks.
How do you relate the persistent riskiness of banks
with the ballooning size of the balance sheet
of central banks?
I'm asking this because this is something
that is considered desirable.
We don't think central banks
should shrink their balance sheets even we think
some of them should keep increasing their size.
- So this is the financial instability consequent
on the expansion of the balance sheet of the central banks?
Well all these questions seem to be for Andy.
The first question really is
why aren't you dealing with the known material?
The known systemic risks and worrying about
all these irrelevances.
Well, not irrelevant.
Things you don't really know about.
So have you got your priorities correct?
Andy that is for you.
- That's for me.
I don't know but one thing I always get kicked for
as a regulator maybe rightly so it's fighting the last war
and we're meant to be just a little bit forward-looking.
What might happen next?
What might go wrong next and that's why we're peering into
some of the murkier corners.
Asset management you mentioned.
I'm impressed by asset management industry actually.
You give a speech on potential risks from them
the other Friday.
When I give a speech on banks,
it usually takes at least a couple of months
before the hate mail starts coming in.
Asset management, two days and they were right at it.
I mean really quick off the mark
with the detailed prescriptions of why I was wrong.
So maybe you're right, maybe that's a good sign
that they are alert and wide-awake
but I'm not convinced we should completely
take our eye off off the ball
because next time will be different.
- [Martin] Richard.
- You know just came back to what I was talking about
with funding-based fire sales or asset-based fire sales.
I think what matters ultimately is liquidity and leverage.
So if you have something that sucks liquidity
out of the market, at the very time
that people are forced to sell, you've got a problem.
So then if you start with that,
you want to ask where does the fuel of funding come from
and if that gets cut off and constricted,
can the engine continue and if people are forced to sell
what are the dynamics are the mechanics
of the markets that they have to sell into
and will suddenly the liquidity dry up
at the very time that they need to be in them.
And it could be asset management firms,
it could be hedge funds.
We've seen it with hedge funds but really,
banks tend to be at the center of a lot of this
through their market making activity on the one hand
and through their funding of asset management firms
and hedge funds on the other.
- Okay, do you want to add on that
because then we should move on.
- Tail risk is what's important.
To focus on liquidity,
liquidity comes very close to solvency per se
that is when the accountants interval
on your true economic net worth
begins to include negative values,
it's harder to roll things over
and that's when a trivial event can trigger a meltdown
but there was a lot of decisions before that
and there was time to do something about it
and it's a tail risk that we must focus on
if we want to because that's what's destructive.
Taking risk isn't destructive
but taking tail risk is.
- I'm going to ask you from your hard work at this,
why have we failed to repair the system?
- It's called willful blindness.
The risk is abstract.
I was having some slides about that.
The risk is abstract, we're doing the black boxes,
there is the narratives, there is the word liquidity.
It was just a plumbing problem,
completely disagree with that and a story about
how it was 100-year flood and they get away with that
those stories that start with how they sent the ambulances
instead of starting from their own failures before.
And the politicians often push the regulators,
it's part of the big problem and I've seen this in the US
and it's happening in UK and elsewhere.
So when I see regulators in the US budgets are cut for CFTC
budgets cuts for SEC and then they throw 1500 rules at them
and then they go to court and so I saw regulators
in front of Congress and they're reading
from the lobby statements yelling at the regulators.
So it's very political is my answer.
That's what I've seen
and there's a lot of just things people prefer to believe
within the system or the people working on it
that they find ways to tell themselves
that somehow well anyway it's not their fault.
That's for sure.
- People are asking where will the next problem come from?
Well the greatest danger is in the swaps
and derivatives arena and this is where the regulation
is considerably underbudgeted and misfocused.
- Andy, final question because it says here wrap up.
I don't intend to be too worried about this.
What can they do?
Shoot us all?
So they can all go off for their drink of course
being polite but why would they?
Why would they?
Okay, you've expanded the balance sheet
of the central bank's massively
and that is also true of the Bank of England
which relative to GDP is roughly
where the US Fed is at the moment
though the Fed is still very actively expanding
if it a slower rate.
What is that doing to the financial system?
Is that part of the next round of crises?
- How long have we got Martin?
- I've already said it.
We can talk to one another and they might cut off the sound
but we could probably do so.
I'm sure the audience wants to hear your answer
and we'll wait for their drink.
- So what to say and keep my job.
No one's had any doubt that we're in deep
and you wouldn't start from here
but we've got plenty of time.
We've got time on our side
and it's hardly as if it will be a surprise.
Central banks have been telegraphing how they'll do it
if not when they'll do it.
So for sure it'd be bumpy but hopefully not,
hopefully not too bumpy.
It was done with the best of intentions
and that was to inflate risk-taking
at a time when it was deflated.
There's no question that if that was the purpose going in
then the act of going out will put that into reverse
but provided we do it in a stage managed and graduated way,
I'm pretty confident that we won't be
the source of the risk next time around.
But don't hold me to that.
- Okay both statements say...
I will take both statements on that
and I think you got out of the question reasonably neatly.
It's the job of the moderator to summarize the discussion
and in this case there'll be a particular pleasure
and anyway, nobody can answer back.
I think there is complete consensus on this panel
that the answer the question as I said is no
which is pretty disturbing given the range of views
on other matters on the panel
and I share the view and I think
it's really rather frightening
because and I distressed this point,
we barely afforded this crisis.
I don't think the Western world
is in a position to cope with another one
and it would be I think I understand Larry Summers
has been talking about our being in 1914.
Well, I don't want to go there but we just escaped 1929
and we can't go through this again.
So this is a very very big issue.
The second thing that comes out,
I think there's no disagreement
from anyone who talked about this
that there is obviously some good say more about it,
there is a gigantic political problem here.
Inside or outside a problem of the extreme form,
both in terms of information and knowledge
and in terms of political presence.
It's a Mansor Olson problem on the absolutely enormous scale
and my sense is this is certainly not got better
and probably worse.
The third is I think there is a consensus
or nearer consensus.
I don't think anyone who'd say it was not part of the answer
that having a hell of a lot more capital
in these institutions would be really a good thing
and we could live with that and it seems to me clear
that that is direction.
It seems to be pretty obvious from what Andy said
that having all our major financial institutions
unable to bear a loss of five percent
of the value of their balance sheet is simply insane.
It is structurally insane.
It's just asking for trouble.
We can have a debate about how much more
but it clearly it's much more.
There is some disagreement on how far
clever regulation, better knowledge of the operation
of the financial system and a combination
of pretty brutal incentives would also go
to improve the system.
My own view is clearly putting beyond banker in jail
would have been a good idea
and I loved the idea.
I really love the idea particularly relevant in the US
that if you really are going to say
that corporations are people,
then there are certain consequences of being a person
and one of them is you can go to prison.
So that seems to be quite important but of course,
it's perfectly obvious they are people
when it's convenient for them to be
and not people when it's inconvenient for them to be.
So there's this incentive side.
I personally I have to say,
hope that better supervisory procedures,
better understanding of the risk map,
Andy's dream of the full knowledge of the system
will be possible but I have to say at the moment at least,
I am profoundly skeptical
that that's going to be very effective in the near term
but that's just my view and what does that count for?
Nothing at all.
But I think we had a wonderful discussion.
It was reasonably brought together
and if anyone has gone away feeling optimistic
and cheerful about the state of the financial system
and therefore of our entire global economy,
that person is seriously deluded.