Practice English Speaking&Listening with: Have We Repaired Financial Regulations Since Lehman?

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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.

Beyond that.

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,

the activities.

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.

That's possible.

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.

How much?

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.

Okay, good.

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, okay.

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.

Thank you.


- 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.

Why structure?

Why incentives?

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.

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.

Everyone failed.

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.

Very brief.

- 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.

- Hi.

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.

That's fine

- Federico Fubini.


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?

- Right.

- Okay.

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.

It's disgraceful.

- 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.

Thank you.



The Description of Have We Repaired Financial Regulations Since Lehman?