This morning Luci Ellis, Head of Financial Stability Department at the RBA, gave a speech titled Stability, Efficiency, Diversity: Implications for the Financial Sector and Policy. It’s an elegant ramble through the philosophies of risk but there are really only two lines of argument that matter in the entire presentation. I’ve bolded them below:
More Stability Is a Choice
The global financial crisis spurred a huge, international effort to reform financial regulation. That work is ongoing, and will be for some years. I don’t think there is any doubt about why the crisis spurred such reforms. The events of the crisis showed that banks in many jurisdictions needed more capital; that governance and risk management needed to improve; and that risks in derivatives markets and shadow banking needed closer scrutiny. But at a more fundamental level, the crisis showed that the prior settings of regulatory policy in some countries had not achieved the degree of financial stability that society actually wanted.
Society has only so much appetite to impose risks on its members. In particular, it has only so much appetite to impose risks on people who had little or nothing to do with the creation of those risks. We therefore have laws, regulations and other measures to reduce the chance that a bad event might happen. Think of pool fences, guardrails on the sides of roads, or special car seats for children. We also have insurance, welfare systems and tort law to cushion the blow if a bad event does happen.
How much of each of these measures we as a society choose depends on how much risk we are willing to bear – or to impose on others – as well as on the price we are willing to pay to avoid or ameliorate those bad outcomes. Different countries make different choices about these issues. That is why the Australian authorities have consistently argued that international regulatory agreements need to be tailored to national circumstances. The global minimum standards, such as the Basel III framework, are just that – minimum standards. Countries are within their rights to choose to strengthen the local implementation of those minimum standards if need be.
Sometimes some additional conservatism is needed because of particular features of each country’s financial system. A good example of this is the longstanding tighter setting of prudential capital rules on housing loans in Australia, relative to what the Basel framework requires. Housing is a large part of the Australian banking system’s asset base. It therefore makes sense to allow for that concentration, even though housing loans are individually a lower risk than some other things banks could be doing with their balance sheets.
In other cases, the authorities might choose to be a bit more conservative to reflect that society is a bit more risk averse than in some other countries. As a central banker, I am not in the business of claiming to have insights into the national psyche. But it seems to me fair to say that Australia is not a society that tells people who have suffered misfortune that they are entirely on their own. Nor does our society apply the ‘caveat investor’ principle to all financial dealings. We have consumer and investor protection rules to protect non-experts. We also have regulation to reduce various kinds of abuse. We are also cognisant that actions that are rational for an individual can collectively result in a bad outcome. And that is where financial stability mandates become highly relevant.
At the same time, it would not be ideal if people were completely insulated from the risks that they knowingly and willingly take on. A financial stability mandate does not mean that policymakers should try to ensure that nobody anywhere ever loses money. It does not mean that nobody anywhere should ever default on their loans. And it certainly does not mean that no individual financial institution anywhere should ever fail. What it does mean is that the harm done to the real economy, to the innocent bystanders, should be as small as can be reasonably managed. That implies that policies to promote financial stability should include a mix of pre-emptive measures to head off trouble, and post-event responses to deal with trouble when it does occur. In other words, the authorities should both ‘lean’ against risk and ‘clean’ up the mess.
The global regulatory reform program has done a lot on the ‘lean’ phase. Banks hold more capital, so they are less likely to fail. Supervision has been enhanced in the countries where this was needed. And compensation practices in financial firms have been overhauled and attract more scrutiny from regulators.
There is still plenty of work that has been agreed internationally, and is in the process of being implemented in each country. Much of this work to be done relates to the ‘clean’ phase. For example, a lot is being done to ensure that banks, and other important parts of the financial system, can be resolved effectively if they do fail.
More Stability Might Not Mean Less Efficiency
As with any major regulatory reform, the reform program spurred by the crisis, especially the higher capital requirements, has met with claims that it might harm growth. That is, some commentators argue that the reforms are trading off stability and efficiency. It is sometimes claimed that requiring banks to hold more capital will hold back credit growth, and thus economic growth.
In my view there are a couple of problems with this argument. First, it assumes that credit growth causes economic growth. There is some truth to this. If credit supply is constrained, for example because the financial sector is weak, that can hold back growth. It would be a ‘credit crunch’, of the kind described by Chairman Bernanke in his earlier academic work. There does seem to be some element of a credit crunch in places like the United Kingdom and the euro area at the moment. But slow credit growth can also be the result of weak demand, not constrained supply. Causation doesn’t flow all one way.
Second, we should not assume that all financial activity needs encouragement. If a certain business line is only economic when too little capital is held to cover the risk it entails, it is not a business that should be pursued. For all the concerns about the financial system’s ability to serve the real economy, it must be remembered that banks also have extensive connections with other parts of the financial system. That includes their activities in plain vanilla wealth management, but also some of the more rarefied segments like hedge funds, structured investment vehicles and other parts of the so-called ‘shadow banking system’. In the lead-up to the crisis, this part of the business became increasingly important for some banks, especially a few in major financial centres. Some of this was legitimate redistribution of risk to those best placed to bear it, but I question whether it all was. Lending to the real economy need not be the business line that is most affected by regulatory reform.
Third, the recent crisis has shown how severe the costs of a crisis to the real economy can be. There is empirical evidence suggesting that recessions are deeper and longer if they are instigated by a banking crisis. A cost-benefit assessment suggests that society would be willing to pay some price to avoid those harms. The best available estimates of that trade-off, uncertain as they are, do imply that the regulatory reform program is a net benefit to society.
A final point about this issue is that some regulation is essential to create stability. There is no trade-off. Society benefits greatly from the existence of a safe, liquid asset that people can rely on to make payments, and which they can trust will not suddenly decline in nominal value. But we’ve learned over the centuries that the private sector cannot produce truly safe, truly liquid assets on its own. Without prudential supervision, central bank liquidity and some form of depositor protection, the private sector cannot offer an asset that is both safe and liquid even in bad times. The recent crisis was in part a story of people learning that assets they had been happy to treat as safe, weren’t completely safe. And they learned that lesson over and over in the crisis with repo finance, asset-backed commercial paper, super-senior collateralised debt obligation (CDO) tranches, auction rate securities, money market funds the list goes on.
All Creatures Risky and Even Riskier
Another, subtler, critique of financial regulation argues that stability carries the seeds of its own destruction. The idea behind this line of argument is that imbalances always build up during the good times. So the longer you go without a small crisis, the larger the crisis you will have eventually. Small, regular crises are therefore supposedly helpful and cleansing, and policymakers resist them at the economy’s peril. Having gone for more than 20 years without a serious recession or major banking problem, Australia is going to be a good test of this particular hypothesis – though hopefully not any time soon!
Underlying this argument must be some kind of model. Usually, it seems to be a metaphor as model – that of a forest fire. In a forest, the argument goes, kindling builds up over time. If it is not reduced through regular burn outs, expect a conflagration eventually.
It’s useful to put these kinds of verbal arguments back in terms of the model implicitly underlying them. You can then find all the previously unstated assumptions, and decide if they are appropriate to the question. In the case of the forest fire, I think the metaphor only goes so far, so I’m not convinced of the argument. For a start, this model assumes that kindling always builds up at the same rate. Is the forest that suffers few fires building up more kindling? Or is it just that some kinds of trees are less prone to burn? In Australia, we are only too aware that eucalyptus trees are more flammable than many other species. Perhaps some kinds of banks are more prone to burst into flames – metaphorically, that is – than others.
When we talk about different species of banks and other financial institutions, we are really talking about business models. Within the banking industry globally, there are many different kinds of banks with different niches, risks and balance sheet structures. You can classify them any number of ways, but one useful dimension to think about is a spectrum with investment banks at one end, commercial or retail banks at the other, and so-called ‘universal’ banks in the middle. This graph shows that those labels correspond to different balance sheet structures (Graph 1).
Investment banks, like Morgan Stanley as shown here, or Goldman Sachs, have a lot more trading assets than banks with different business models. Commercial banks like Wells Fargo mainly have loans. Universal banks like JPMorgan or Citigroup have a bit of both. You can see the same distinction on the liabilities side. Investment banks tend to have more wholesale and repo funding, commercial banks less so. Even starker are the differences in off-balance sheet business, which aren’t shown here. Investment banks tend to have larger and more complex derivatives positions than commercial banks, and depending on a country’s accounting rules, these positions are in some cases not on the balance sheet. The larger derivative positions of investment banks arise partly because of their own trading business and partly because they intermediate between other banks that wish to transfer risk or hedge particular exposures.
This distinction between different business models is a strategic choice, and not just an artefact of past restrictions built into the US regulatory structure. You can see it in banks around the world. In Australia, the big four banks are clearly at the commercial end of the spectrum. Much of their business involves servicing household and business customers in Australia and New Zealand. As the next graph shows, their trading books and other securities holdings are a relatively small part of their business (Graph 2).
What does this mean for financial stability analysis and policy? Certainly different business models lead to different balance sheet structures, and therefore different risk exposures. Unlike the trees in the forest fire model, these differences come from conscious choices, about their business models and strategy. Trees don’t choose how flammable they are, but banks can choose their risk profile. That said, tree species do evolve in response to the environments they face, just as individual banks and whole banking systems adjust to the incentives they face.
One of the most powerful sets of incentives for banks is, of course, the regulatory arrangements they are subject to. This brings me back to the international program of post-crisis regulatory reform. In designing these reforms, it has been essential to consider how the regulated industries and their counterparties will respond. Those responses can change not just financial firms’ behaviour but sometimes their entire business models.
This isn’t simply a concern that the reforms will push business out of the supervised banking industry and into the shadow banking system, though that’s part of the issue. It’s also a concern to ensure that the different elements of recent reforms are not in conflict with each other. There have been some elements that do seem rather at odds. For example, we want to ensure that financial institutions can absorb losses. Yet it would not make sense to demand that ‘bail-in-able’ wholesale debt should be so high that funding profiles became less stable. Likewise, we want derivatives markets to be safer and more transparent. But we do not want to change the incentives so far away from uncleared over-the-counter markets that it weakens risk management in other ways. Some risks cannot be adequately hedged by a standardised, clearable product. There will still need to be bespoke but uncleared transactions that better match those risks. An uncleared trade might reduce risk by more than an imperfect hedge, or worse still, not hedging the risk at all. There needs to be balance.
There is another issue in the international regulatory reform program that we should also be mindful of. The reforms have gone a long way to promote international consistency in financial regulation. For example, for the first time, the Basel Committee is assessing how faithful each country’s reforms have been to the agreed Basel III framework. And there will be further work on the consistency of risk weights across banks for the same exposure. This is important and helpful work. But in ensuring consistency, we do not want to create a monoculture, with all its members being vulnerable to the same risks because they face the same incentives. There is something to be said for allowing some diversity of business models, so the whole system doesn’t collapse from a particular shock. That is one kind of diversity that I think needs more attention. It also needs to be allowed for when we design regulation.
Another important dimension of diversity is that the financial system is made up of more than just banks. Insurance firms, pension funds, asset managers and financial infrastructure providers are all part of the landscape. They each have different capacities and face diverse risks. They, too, need to be regulated in ways that are adapted to that diversity.
Economists Are Not the Only Fruit
So far today, I’ve been talking about risk, regulation and different business models. None of that is a typical concern of macroeconomics and monetary policy, which are the usual fare at central banks. Macroeconomics doesn’t have a monopoly on wisdom when it comes to financial stability issues. Banking and finance are important sources of insight; so are disciplines like accounting, actuarial science, complex systems and industrial organisation. And we should never forget the lessons of economic and financial history.
Over the past few years at the Reserve Bank, we have found ourselves delving into areas as diverse as the mathematics of networks and the intricacies of tax law. None of that is taught in a conventional macroeconomics major. The things a financial stability policymaker typically needs to know don’t look much like conventional macro. In financial stability departments, being able to read a balance sheet is at least as useful as being able to solve for the rational expectations equilibrium of some macroeconomic model.
I don’t think there needs to be a special financial stability degree the way there are degrees in economics or finance or actuarial studies. Speaking as someone who did major in macroeconomics, I’ve found you can learn a lot of what you need on the job. Clearly though, the building blocks of financial stability education are already there. There is a lot the world already knows about financial analysis, about credit risk, about banking crises. There is also a lot already known about financial history, organisational behaviour and complex systems. And although it’s fair to say that we know rather less about asset pricing dynamics and how some of these micro-level behaviours build up to macro-level instability, I do believe that academics and practitioners can work together to expand the frontier of knowledge here, too.
Central banks need to harness those diverse sources of expertise in their financial stability function. That means that the monetary policy function, which naturally has an intellectual culture based on macroeconomics, mustn’t unduly overshadow contributions from other perspectives. Economics as a discipline has a bit of a reputation for colonising other domains, but central banks need to give space and respect to a range of disciplines.
I can see two ways to avoid problems around this issue, both of which are definitely practised here in Australia. One is to ensure that we recruit from a broader stream, including but not limited to macroeconomics. The fact that the Reserve Bank also has a longstanding policy mandate for payments system stability and efficiency helps here: that area needs microeconomists and lawyers as well as macro/finance skills.
Another way is to ensure that financial stability policy is a collective endeavour. The dominant economics culture of central banks finds a counterpoint in the accounting, finance and actuarial cultures of prudential supervisors, and in the more legal-oriented cultures of securities regulators. We can learn a lot from each other, and gain a lot from working together. Our mandates differ somewhat, but they are consistent.
Some diversity, with overall consistency. That sounds like something that would make a financial system, and the regulation that shapes it, strong enough to achieve stability.
I would summarise the speech thusly, Australia has a modest risk appetite as a nation which is why prudential standards for mortgages are so high and the international community can go to Hell if it thinks they should be altered.
The only problem with this is that it isn’t true. Australia’s largest banks do not hold conservative levels of capital against their mortgage books. Owing to mortgage rehypthecation the banks’ opaque internal risk models the capital is heavily discounted. MB’s last estimate was somewhere above 2% for the entire mortgage book including LMI discounts. This is what Chris Joye is referring to when he discusses the major banks huge “leverage”.
Advertisement
The Basel Committee has recently been moving to bring some transparency to these kind of regimes. Earlier this year it said:
Global regulators may impose restrictions on the way lenders model risk and assign capital after a review of banks’ trading practices found wide differences in their number crunching.
A probe of banks’ calculation of the riskiness of their assets found “material variation” across the industry, Stefan Ingves, chairman of the Basel Committee on Banking Supervision, said in a speech in Cape Town.
Regulators could respond with tougher disclosure rules or “limitations in the modelling choices for banks,” Ingves said in the prepared remarks today. “The committee’s work on how banks calculate risk weighted assets also feeds into a broader concern that, in pursuit of risk sensitivity, the Basel III framework has grown too complex.”
In short, today’s speech is another example of the RBA running interference with anyone aiming to understand the vulnerabilities of the Australian financial system.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
