Bank regulation by the numbers

ONE cause of the current crisis
(1) The interaction of macroeconomic imbalances and financial innovation, prompted, in part, by those imbalances

TWO parts to it
(1) Those imbalances resulted in huge surpluses in China, Japan, other Asian countries and oil exporters
(2) Those surpluses were invested in risk-free assets, such as US treasury bonds, sharply forcing down the risk-free interest rate

TWO effects
(1) A credit boom, particularly in the UK and US housing sector, with much of that credit provided in new and risky securitised form
(2) A demand for an uplift in yield – 10, 20, 30 basis points over the risk-free rate

TWO false beliefs
(1) Securitised intermediation had increased the resilience of the banking system, taking credit risks off banks’ balance sheets to more diverse end investors, reducing the probability of bank failure; and
(2) The amplitude of economic cycles was also dampened

SIX reasons why systemic risk was actually hugely increased
(1) The securutised credit model not only grew in size and complexity but also ceased to be a ‘originate and distribute’ model, instead turning into an ‘acquire and arbitrage’ model with the vast majority of credit securities held on the trading books of the banks.
(2) An explosion of leverage, eg through structured investment vehicles
(3) The maturity transformation by which non-bank vehicles such as SIVs held long assets but short liabilities, based on the ‘liquidity through marketability’ belief that those assets could always be sold rapidly if necessary
(4) A misplaced reliance on sophisticated mathematics
(5) The way the system was hard-wired for procyclicality thr ough credit rating triggers and value-at-risk based collateral margin calls
(6) Insufficient bank capital

FIVE reasons why the UK was particularly vulnerable
(1) It was home to several leading banks involved in securitised credit trading
(2) A rapid growth of mortgage credit and a property price boom
(3) Fast credit growth funded in new ways, with securitised mortgages growing from 0 to 20% in ten years.
(4) Rapid growth in interbank lending from overseas, filling a customer funding gap as its extension of credit hugely outran its customer deposit base
(5) these new funding sources making possible the new mortgage banks – Northern Rock, Bradford & Bingley, HBoS

ONE global supervisory philosophy
(1) The belief that major global banks and investment banks should be allowed to gain the benefits of global scale

ONE local supervisory failure
(1) Global banks are global in life but national in death

FIVE questions (and suggested answers) from the Turner Review
(1) Financial markets are susceptible to irrational herd effects, and more liquid markets are not always better
(2) Securitised credit does create some risks, but it is here to stay
(3) Many risks cannot be managed by sophisticated maths at the firm level, but have to be constrained by regulation
(4) Much financial innovation has been of minimal social value
(5) Market discipline, expressed through market prices, is ineffective: as late as June 2007 bank credit default swap (CDS) spreads signalled that bank risks were at historically low levels

EIGHT sets of recommendations for regulatory reform, from the Review
(1) Changes in capital and liquidity regulation and in published accounts
(2) We cannot allow bank-like activities and systemically important forms to escape regulation
(3) Changes relating to credit ratings, remuneration and counterparty clearing in the CDS market
(4) The importance of macro-prudential analysis and intellectual challenge
(5) A more intensive approach to regulation by the FSA, and more focused on systemic issues
(6) Improvements in governance and risk management in firms
(7) Actions to ensure that commercial banks don’t take excessive proprietary trading risks
(8) Measures to improve supervision of cross-border banks

TWO reasons why it’s not possible to go back to a ‘Glass-Steagall’ type of separation of investment banks from commercial banks
(1) Bear Stearns and Lehman Brothers were not deposit takers, but were still systemically important
(2) Northern Rock, Washington Mutual and IndyMac were all ‘narrow bank’ failures

The only TWO intellectually pure approaches to European bank regulation
(1) No single market ‘branching’ rights; instead, fully subsidiarised operations capable of surviving the collapse of the holding company
(2) Full federalisation of European regulation, supervision and – if they get it wrong – European level fiscal support to prevent failure

The full speech can be downloaded here

The Turner Review can be downloaded here