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Now it seems, given we're in the autumn of 2013 to do something of a stocktake on where we have got to in the process of banking reform.

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And when I say where we have got to. There are different levels to that.

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There is. What's the UK doing? That's what I was most closely involved with through chairing the the ECB,

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the Independent Commission on Banking, and we finished our work just over two years ago.

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So we're already two years on and more from from that.

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But I want to think about especially being here in intensity and want to think about how are we doing more broadly than just about the UK.

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So I'll have some remarks on European reform more generally and indeed on the reform process internationally,

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which is convened by the processes under the auspices of Basel.

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So I'll be talking quite a bit about internationally agreed baselines and how some countries and regions are or are not going beyond that.

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Now, my plan, my sort of topics, a few remarks, I mean, we've all got views on how did it all go so wrong?

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I don't want to dwell on that,

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but I think a few minutes just to get across or remind you of some facts which I think have particular salience because they

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provide the bank the factual backdrop along with lots and lots of other facts for recommendations of the kind which the ECB made.

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And I think there are different aspects of how did it all go so wrong, depending what it is in your mind.

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So I want to draw out some points about that.

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Then I'll do a quick a quick summary of where the reform process domestically and internationally has got to.

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There are so many strands to it that I will not be comprehensive, but I'll I'll indicate the particular focus as I go along.

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Then the main blocks, the third and fourth.

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There are the two headings where I think there's still a long way to go.

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One is the question of capital, but not just capital.

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Other other types of loss of solvency by banks.

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And then. The next unfinished business heading is the question of structural reform.

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And then I will make some interim and somewhat tentative conclusions on what to make of the last five years,

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which I hope are the first five years of banking reform.

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So how did it all go so wrong?

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Well, the following points are basic, but they do lay the ground for the reform initiatives that I want to be talking about now.

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The the financial system. As we all learned really to our cost five years ago, is of absolutely fundamental importance,

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not only to commercial life, economic life more generally, but indeed to how society operates.

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I mean, just imagine the calamity that would have occurred if high street bankers all called them, if they had gone down,

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and if the government had either decided not to rescue them or had been incapable of rescuing them because

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of the financial commitment that involves the disaster that that would herald is almost unthinkable.

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But five years ago, we we weren't far from the edge of that cliff.

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So if that had happened, we would have had appalling disruption of payment systems.

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So transactions, salaries, pensions, benefits and all that.

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If that had seized up, there would have been horrendous consequences.

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And that did not seize up that were worked comparatively smoothly.

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We also have the financial system and with banks at its heart providing deposit, taking facilities.

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So as well as means of transacting, you can store some of your savings there in the form of deposits.

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And I think until five years ago, maybe six years ago, bearing in mind Northern Rock in 2007,

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the idea that there was any risk to the money I had in my current account was,

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I mean, it wouldn't have crossed my mind except as a theoretical proposition.

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But that became quite a real possibility in that period.

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And we've seen in some places, for example, in Cyprus not long ago, more than a possibility.

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You've also got the financial system and other the key things it does for economy and society is extending credit,

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risk management and so on and all those things that the financial system does.

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Banks are absolutely fundamental to, particularly in the European economies.

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It's true also in the US, but in the US you have more non-bank capacity doing some of those things.

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For example, money market mutual funds do some of these things.

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You've got deeper capital markets for corporate finance in the US than you have you have in the UK.

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So banks are absolutely fundamental and yet they proved to be very, very risky kinds of institutions.

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I mean what we were doing in fact was running market capitalism on the basis of

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some very fragile plumbing the way we had the banking system five years ago.

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Now, banks are always going to be subject to risk. And I'm not sympathetic to those who say, oh, you shouldn't let banks do anything that's risky,

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because that would merely relocate the problem somewhere else and in a very inefficient way.

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I mean, to say that banks should do should avoid all risk is to say they should never lend to small businesses.

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They should never lend mortgages, they shouldn't do overdrafts.

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I mean, because all those things involve risk, credit, risk that you're not going to be repaid.

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And a lot of the good that banks do comes from when things work satisfactorily, from them taking on in a measured and robust way, risks of that kind.

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Just as a lot of good, in my view, comes from what's called maturity transformation.

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That is, banks funding themselves in all sorts of ways, but including a big slap of slab of deposits which you can get back at will.

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As an individual small business and using that to fund a lot of longer term lending, that's a sort of almost economic magic.

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If it all works fine. But it does mean that when things don't work fine, these very vital functions are at risk.

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And a very striking point, as I'll show you in a minute,

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is that banks operate with massively more debt in proportion to what they do than non-financial firms.

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So a typical engineering firm, I actually don't know, but my guess would be might have a debt equity mix of financing 50,

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50, something like that, or a ratio of equity would be half the whole.

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But with banks, that number was a lot less, as I'll show you in a moment.

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But first. This is why the issue is even bigger in the UK than it is on average.

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This is the size of bank balance sheet relative to GDP of the country in which the bank is headquartered.

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It's as things were about four years ago.

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Of course, bank balance sheets have come down a bit.

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So unfortunately, as UK GDP over that period that you'd be looking at a pretty similar ratio now with the UK and these sort of OECD type countries,

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UK, that would be a factor of five. So if our banking system falls over, that is a particular problem for us.

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US nearly over on the left hand side, it's a ratio of about 1 to 1.

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And that difference reflects, first of all, the sheer size of the US, which is half a continent.

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And smaller countries tend to have bigger ratios.

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But it's also the point I just mentioned that the US has more non-bank financial capacity than the UK does or a lot of other European countries.

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Switzerland has another big ratio. They indeed have two institutions, Credit Suisse and UBS, which individually would be way bigger than Swiss GDP.

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We were comparing stocks and flows, but it's still, I think, a useful comparison.

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We indeed bsx its balance sheet, for example, bigger than a year's GDP of the entire economy.

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Continental European countries France, Germany, Spain. Ratio sort of in between.

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More like 3 to 1. Now leverage next.

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This is the ratio of the banks balance sheets to the capital of the owners of the banks.

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So this is the equity capital. So it is a first approximation, but only as a first approximation.

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You can think of the value of the bank as the value of its assets, all the loans it's made minus the value of its liabilities.

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That's the shareholder value. And the difference between the two is equity capital.

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Simplifying a bit. And that number, that ratio, how much bigger the balance sheet is as a as a multiple of equity.

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That used to be about 20 for the much of the post-war period.

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I'll go back much further in time in a later chart, but it bobbled around around 20, so 5% would be equity capital now if you knew nothing about it,

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which would actually be not a bad starting point,

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you might have then you might have the intuition that only 5% of equity isn't the safest possible situation.

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Because if I'm a bank, 5% equity, i.e. 20 times leverage, I've only got to lose 5% on my asset side and I'm underwater.

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So 20 might strike you as quite a big number.

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But in the run up to the crisis and as you see, this really ramped up from the very late nineties for about a decade,

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that number doubled for a lot of very well-known institutions.

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So they were operating with two and a half percent equity relative to their asset value.

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And, you know, in those terms, if your intuition says, well, no wonder there was a crisis, that's not a bad intuition to have.

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And there really are questions about why more alarm bells weren't ringing more loudly in more heads.

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And I mean, not just in the financial industry, the regulatory community, but also in a spirit of my culture.

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I think among academic economists, I think the short answer why the bell wasn't in my head, I had no idea this was the fact of the matter.

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And I don't say that as a defence.

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I feel even guilty of not having had any idea that this was the case that than had I known, but not worried about it.

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So you had this enormous ramp up in leverage.

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And what the international community is now trying to do as a backstop measure is to get that down to 33 times.

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And I was once giving one of these talks, an audience member who had not been paying attention said, Good Lord, 33 times.

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No wonder there was a crisis. And I had to remind them that this was where we were trying to get to in a few years time from now.

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So far, too little equity, I think, is obviously part of what went wrong and an answer to how did it all go so wrong?

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But there is more to it than that.

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And here I want to lead into the question of interconnectedness, not only between institutions, but also within institutions.

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To my mind, the sub US subprime crisis was a big shock for the world economy, but not a gigantic shock yet.

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It and related things. It wasn't just the US. You had property markets crashing in Spain, Ireland.

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Commercial property tanked in a lot of places, including in the southern hemisphere and Australia, for example.

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But the the damage I think was shockingly great relative to the size of the, albeit large shock.

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And I think that part of that is that we had almost like contagion run through the system with the dominoes.

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That metaphor was overdone, but the sort of crashing into each other.

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And you had in a space of very few weeks from sort of mid-September and you had Lehman going down,

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then the AIG issue that imperilled it, literally Oxford High Street institutions in a really shocking way.

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Because of this interconnectedness, most of the losses of the UK banks were overseas.

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That's not altogether surprising when you remember that 5 to 1 ratio,

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which reflects in many ways the success of London as an international financial centre.

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But you had a situation where losses connected with assets or derivatives based on those assets,

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nothing to do with the UK or even Europe were imperilling these institutions and

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there were no firebreaks either really between all within these institutions.

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So if our IBS, which is now 80 plus percent owned by the taxpayer or other institutions, were.

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You know, they lost tons of money on these things.

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And that was imperilling some very basic services with no fire breaks or whatever metaphor you want to apply within them.

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And that left governments in the position where you either had to rescue the

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entirety of a bank like IBS or give sort of generic support to the to the sector.

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And there was no scope to say, well, look, you're trading operations.

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Those can go to the wolves, but we want to rescue the retail banking.

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Governments were not in a position to to do selective measures.

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The whole thing was all or nothing. So there was no no structural ability to do that.

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Moreover, the a puzzle momentarily when it happened was although the equity holders,

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the shareholders lost loads of money and maybe you're among them directly or indirectly.

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The very little loss was borne by providers of debt financed to these banks, of bondholders, even unsecured bondholders.

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And the reason for that is the place where bondholders lose money is called bankruptcy.

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And governments could not let these institutions or felt,

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and I think correctly felt they could not let these institutions go bankrupt in the circumstances at the time.

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And because that state was staved off, the bondholders often came out with 100 pence in the pound,

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cents in the dollar or whatever, which is not how a market system should operate.

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Consequences of all this, a horrible macroeconomic situation even worse in the in the eurozone,

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but horrendous fiscal issues arising in lots of places, including in the UK.

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So just a reminder on that. This is these are quarterly billions, in case you're wondering about the units.

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Don't worry about that. We had extraordinarily steady growth from the early nineties until 2008 in the UK economy chugging along.

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Two and a half percent a year GDP growth, maybe a touch less than that, but, you know, unbroken, we didn't have a quarter of negative growth.

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And given the inevitable, there's always a bit of noise in the statistics that's really remarkable.

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And that went on for, you know, 15 years and more, 60 plus quarters of positive growth.

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The hit to GDP was about 7% when the crisis happened.

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So peak to trough is 7%. And even now, we're only about halfway back.

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So the you know, if if the trend line had continued and I'm not saying it would have done,

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but if it had, we'd have had five years of at least 2% growth.

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So we'd probably be at least 10% above previous peak and as it is, with 3% below.

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So relative to that counterfactual where I'm, you know, in the 12, 13%,

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arguably even more below and then the number of schools and hospitals and whatever that that adds up to is absolutely enormous.

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Now, even if one shades that number, even if you halve it, that is an enormous GDP loss.

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And much of it is down to this crisis.

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It's not just a thing that would have happened in any event.

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So it's horrific for the public finances. We're running a GDP deficit here, more than ten percentage points of GDP.

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Even now, we're only in the sevens. Everyone talks about austerity.

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I mean, still running a 7% of GDP deficit. It's you know, there are more austere things than that.

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So that's where we are in the UK and in the eurozone. You had it really in the spring of and there others in the room there.

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Much more about this in the spring of 2010.

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So 18 months after the crisis you had the market realisation of what that meant for the credit worthiness of some eurozone members.

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This is not a chart with Greece, Ireland, Portugal still there, Cyprus on it.

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This is Spain and Italy.

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And you saw there and with with further twist in 1112 where the wedge between that debt and German debt was about five percentage points.

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So and that's against with even all the expectation of the Eurozone coming to the rescue of these countries.

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So that's a measure of how scary things got on that front.

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And part of it was this doom loop score between the banks and the sovereigns where the sovereigns, like in Spain, felt they had to rescue the banks.

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And but then that that can drag the sovereign down. And the debate on European banking is about how to break through that doom loop,

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that wedge given ECB measures and gentle recovery, that wedge is sort of two ish rather than five as it was before.

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So those are some features of how it went wrong.

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And I hope in saying all these things, I've laid the ground a little bit for themes of the reform initiative.

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Which has many, many strands. So one of the the first things that the UK Government,

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when it was elected in spring 2010 did was to reshape the financial regulatory

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architecture with the FSA functions being split into into two prudential regulation.

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On the one hand, going back to the central bank and the Financial Conduct Authority, on the other hand, then you had the addition of the third leg,

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which is macroprudential regulation, which we've not explicitly had before, and similar things happening in other countries.

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There are lots of questions about shadow banking, about market infrastructure trading,

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derivatives, trying to shift over-the-counter on to more centralised exchanges.

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But again, you've got to do that carefully. Otherwise you're creating a new pocket of risk there.

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There's a lot one could say, I'm not going to about accounting standards, about ratings, ratings agencies and all the rest.

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But I want to focus on the the the banking bit.

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And within that, I'm going to focus on the two bold and bold and bits.

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A lot of lessons about how the supervision of banks not going to talk about that loss of solvency structure reform.

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I'll come to I won't I won't say much about liquidity regulation.

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There are very close links to loss absorbency. We can pick all that up in questions if you like.

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And I'll say a bit about recovery and resolution. I'll explain what that means to those not familiar and how that links, in my view,

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to questions of structural reform, competition, competition between banks.

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That was a casualty of the crisis as well. And one of the elements of the work of the ECB was all about those competition issues.

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I'm on to be done by win ten by six at the very latest.

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Yeah. Yes. Okay. Okay. Here is. No, no.

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But I like I like I like I said, I'm. Again.

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Let's keep competition for questions if you are if you want to ask on that.

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There there are.

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A number of very, I think, very important questions about corporate governance, remuneration practices, culture in the sector and so on.

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And the following our commission, as I'll say more about this,

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there's been this at the British Parliamentary Commission on Banking Standards, chaired by Andrew Tyrie, and that had two jobs.

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One was to do pre-legislative scrutiny of the Government's implementation more or less of our recommendations.

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The other bit in the wake of libel and a lot of other scandals was about those issues, about that I've just mentioned.

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And also like sanctions on individuals and otherwise for misconduct.

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We we were very conscious in my commission of the culture issues and the pay issues, but we thought, given our remit,

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the fundamental things that it made sense for us to focus on were those two in bold, which now come on to.

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So loss absorbing capacity. I do not want to be too techie, but I need to be a little bit more than I have been.

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So the Basel process, the Basel accords on banking regulation go back some time.

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We had also one, Basel two, now we've got Basel three not fully implemented, but agreed.

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And as part of this is the internationally agreed aim.

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By the end of 2008. So we've still five years to run, so that'll be ten years from the crisis to get bank capital up.

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How far up? Well, the basic requirement is that equity capital has to be at least 7% of risk weighted assets.

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Now, that shifts the question to what is a risk weighted assets?

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Well, the way that this thing works is and this is common sense up to a point, but there are a number of question marks then descend on us.

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Some things that banks banks do are more risky than other things. So if something is deemed to be very low risk, then it is given a low risk weight.

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So instead of lending, you know, if it's a 100 million of low risk stuff, then that might be accorded a weight of, let's say, a quarter.

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So then I don't I would need the same amount of capital as I would for backing 25 billion of risky stuff that had a risk weight of one.

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So if you didn't make this sensitive to risk weights, you'd be giving the banks incentives to do risky stuff at the expense of non risky stuff.

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So risk weights are an attempt to offset that.

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The the problem is and you may be wondering, why were banks in the UK and elsewhere able to go from 20 times, leave it up to 40, even 50 times?

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The reason is that the risk weights inverted commas all over the place.

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We're going down and down and down. So the deemed risk of these activities were going down and down in that decade that preceded the crisis,

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when in fact, as we now know, the true risk was going up and up and up.

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So, for example, some of these securitised mortgages, subprime, were sliced and trounced into the risky, the medium mezzanine, the low risk and so on.

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And then you'd have a ratings agency and say, what about well, that slice is so far from actually having to bear loss.

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We'll call that triple-A, as you know, very low risk.

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What's the chance that house prices will go down appreciably across the entire United States?

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No chance and so on. So a lot of that gearing up of leverage was the tolerance of low risk rates.

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And the banks themselves are increasingly allowed to do models, economist, chair models, to assess the riskiness of what they're doing.

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And a lot of those models said actually very low risk.

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You don't need much capital behind that. Now, a number of people have made the point that, of course, the banks can game the system.

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They can pick a model that says that asset portfolio is low risk.

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And I think that is a major policy problem. But I'm as worried about the bank that genuinely believes that it's low risk.

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It seems to me that's as great a risk as the bank that knows it's riskier than they're making out.

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And I think that you've got both those problems.

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So in the face of all this, the Basel agreement, international baseline is equal to at least 7% of risk weighted assets.

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And then there's a supplementary thing for the globally systemically important banks known in the trade as G sibs,

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sometimes G SyFy's systemically important financial institutions, and they have to go higher up to for the very big US nine and a half percent.

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And that was in I think summer of 2011. That bet was agreed very near the end of our work.

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But in addition to that, there's an internationally agreed backstop on leverage.

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And the leverage number I showed numbers I showed you before did not have risk weights applied.

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So with no risk weights, there's a backstop of 33 times and the average risk weight see the 7% that would translate to 14.

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So the average risk weight, if you had that leverage backstop binding would be kind of what the number is,

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something like an average risk weight of 0.35.

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There's a super nerdy techie point, which is that the leverage backstop applies to a slightly wider definition of capital than equity capital.

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So it translates in equity terms to a number that's in the higher thirties rather than the 33.

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And I think by any you know, I believe that is a very unambitious number.

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But in the work of the U.K. commission, that was the international backdrop.

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And if you're in a hostile in trying to do socialism in one country, so we were trying to do capitalism in one country.

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If you're against that backdrop,

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you can't sensibly go massively above the international baseline without real risk of activity migrating from the U.K. to riskier places,

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which would have been counterproductive.

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There was even a risk in the EU processes, which lots of you know much about that in the name of the single market.

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The EU would not let any country go above the baseline.

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That would have, in my mind been absolute lunatic.

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It would be the equivalent of a thing on CO2 emissions that says no country is allowed to restrict emissions more than a certain amount.

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I mean, it just would be limiting and it seems to be safer.

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Banks in member state x is a good thing for Member States W, Y, Z, and so on.

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Not a bad thing, but and I give the Chancellor credit for this.

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He fought very hard and successfully in,

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in the European Council for a full scope for the UK to go beyond the international baseline and have a higher one.

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And that's what we recommended. The Swiss had had a commission that went similarly.

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So on equity, there's more to loss absorbency than that.

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What we recommended for the for the UK retail banks, the big UK retail banks was a 10% minimum.

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We had great difficulty keeping that low because we thought the whole thing was too low.

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But we we nevertheless thought that was the right thing to do.

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Taking the international backdrop as given and some of my academic friends think we wimped out.

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I think we did not. I think we were looking at a very constrained problem, which is what should the UK do relative to others?

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And I completely with at least directionally with my academic friends who would think the whole baseline should be much higher on equity.

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There are two other reasons for pausing and one is the macroeconomic situation is fragile.

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And if you if you try and go too fast, too far, too fast, you can have counterproductive effects.

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The other is this issue I just touched on before about shadow banking.

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The banks become very, very regulated and non-banks doing substitute activities.

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Don't you can again just relocate the problem. So there's got to be an initiative on shadow banking too.

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But because that is such an international thing, with exceptions like us money market funds,

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there wasn't much we in the UK unilaterally could do about the shadow banking area.

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But that's very important and we thought the leverage backstop is kind of no brainer,

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that you should tighten that in step with a higher equity requirement.

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The Americans. In July, we had their authorities come out with capital rules, which are, I think, if anything, the tight,

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tight end of the Basel process they were talking about for the depository institutions, 6% equity.

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And now that translates to 16 and a bit 17 times leverage.

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But accounting conventions are different in the US and the UK and for many reasons the biggest being the netting of derivatives on balance sheet.

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So you get a net position rather than a gross one and that might knock a quarter of a I mean that banks are very,

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very, very little, but might knock a quarter of the balance sheet. So this US 6% is probably more like four and a half percent in European terms.

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So is actually quite similar to our. 25 times.

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Backstop. In my view, unfortunately, the government here has not yet agreed with our 25 times back stop even though I'm embarrassed.

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25.

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Such a big number that show that some things internationally aren't just mentioned as a senator's Brown and Vitter bipartisan bill before the Senate.

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Proposing much higher equity requirements.

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I I'm told that it's unlikely that that will gain traction, but I think it's good that that debate is still live now structure.

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Well, I think there's been extraordinarily little debate on this for me, although I regard capital and other loss absorbency.

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And I'll cut our losses obviously shortly as. Absolutely fundamental to addressing these problems.

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I do think there are structural issues as well.

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And the US is well known for two things, having got rid of the Glass-Steagall prohibition in the late nineties,

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that's the prohibition on having retail deposit banking on the one hand and investment banking under the same ownership roof.

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That was the 1930s FDR legislation following that banking crisis in the in the early thirties.

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That was a provision of that.

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It just got eroded over time because the language of the statute was things like primarily engaged in and there was a lot of wiggle room around that.

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So it had already it hadn't become a dead letter by the time of its repeal in the late nineties,

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but it had been substantially watered down in practice and was then repealed.

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But in the US, even though that prohibition is gone, there was no repeal of the requirement that retail banking,

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deposit banking being a separate affiliate from investment banking within the same group.

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And this is a. Fact of first order importance.

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And it's just not widely known in Europe, because the other well-known thing about the start of reform in the US is the Volcker Rule.

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Tremendously likeable, admirable figure, Paul Volcker.

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He proposed that proprietary trading, sort of speculative trading, should be banned from these big banks.

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And a lot of people in Europe thinks that think that's the approach to structural regulation in the US,

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but it's not what they're doing in the US is adding that to this separate

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affiliates provision and we in Europe have had no separate affiliates provision.

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So the ring fencing recommendation that we did in the UK,

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which is to say you've got to have your retail operations in a separate entity which can be within a wider group.

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So we didn't go for Glass-Steagall prohibition.

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That is very much in the same family as the US separate affiliate provisions which have been on the statute book in the US since the 1930s.

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Just that while the Glass-Steagall prohibition was in place there, that prohibition was the front line.

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And so that that's where the and there are other developments in the US as well to try and strengthen that regulation of separate affiliates.

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And there's a thing called the swaps push out. So.

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The U.S. has done Volcker and strengthening of the affiliate separation.

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We recommended and the government has accepted ring fencing, as we call it in Europe so far.

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Sorry, in the rest of Europe so far. Just edit that on the podcast.

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The I think it's very disappointing little action. France and Germany have gone for ultralight version of the Volcker Rule,

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not separating that speculative trading from the groups, but requiring that being a separate bit of those entities.

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But numbers I've seen suggest it only touches 1 to 3% of the balance sheet of the banks affected.

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So it doesn't go very far at all.

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And then last year, the EU had this report chaired by the government Bank of Finland, actually Cannon, which recommended, and I'll say more later,

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something really similar to our ring fencing recommendation, but that the Commission hasn't come forward yet with its position on that.

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And internationally we haven't really had any debate at all of the serious kind about structure.

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And that's Christine Lagarde a year ago saying we need one. And I completely agree.

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And maybe five years on is high time. So a bit more on those two elements.

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First, loss, absorbency and then structure. I've already made the point here that although the equity holders lost money,

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bond holders, even unsecured bond holders didn't because they lose money in bankruptcy.

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Governments weren't gonna let that happen. It was also because.

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Their claims typically ranked pari passu, that is to say, equal rate of loss and insolvency as other kinds of funding,

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such as retail deposits of you and me and government insured deposits.

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So even if they had borne losses, it would have been at the same rate as depositors, though of course,

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if you've got insurance from your government, it's the government, not you, that takes that loss.

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So instead of what what sort of should have happened, which is equity holders are wiped out, then the unsecured bond holders,

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then on and on, you had taxpayers come and take loss and take on contingent liabilities immediately after the equity holders.

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And that has left us with a massive implicit subsidy, these and the taxpayer on the hook for these entities.

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And that is a gross distortion of their funding because so long as that situation is perceived to persist,

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then the bond holders can take a free ride on on the public subsidy.

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And that means they have no incentive to discipline what the banks are up to.

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So it's a hopeless incentive system. So it's very important for loss of solvency, in my view, not only to get a lot more equity,

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but also to try and make these other kinds of funding bear loss in a future crisis.

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Can you do that for sure? No. Can you greatly increase the odds?

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I think you can. Moreover, this public subsidy isn't just the things that the public might be willing to backstop, like high street banking.

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But if you've got no structures within banks, that subsidy leaks to everything the trading book, the derivatives book, and so on and so forth.

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So the lack of structure makes this implicit subsidy problem far greater and can double or triple the scope of that subsidy.

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Now, the banks not only in the UK come back and say, But look, if you require us to have more equity, that's very costly.

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Equity's an extremely costly form of funding for us. We have to pass that cost on to borrowers.

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So you will be pushing up the cost of borrowing and that will be bad for the economy.

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So there's a great debate on whether equity is costly or not.

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Is it costly for the banks? I think the only answers one can have for that is, yes, it is a relatively costly form of funding.

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And part of the reason is precisely the implicit subsidy I've been talking about.

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Equity funding is not subsidised. Other kinds of funding are.

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Therefore, equity is relatively more costly. But that by itself is not a social cost of requiring more equity, and it's a benefit to society.

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If you get funding sources more risk reflective, there are other reasons why banks are reluctant to issue equity.

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One is that, bizarrely, the tax system encourages debt finance rather than equity finance.

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Because there's a deductibility of interest payments in most tax systems is

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kind of complicated because when you work it through the personal tax system,

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the wedge isn't as big as it looks at first sight, but it's still an issue. And then just think of the debt overhang.

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And the subsidy I've just mentioned is an element of that, which is if a troubled bank raises more equity, that is getting bondholders,

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depositors and in particular the government less exposed to the risks of the bank because

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it's putting a bigger capital buffer between those individuals and organisations and loss.

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So. The banks will be doing a favour to those creditor groups and government if they issue more equity.

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And it would be a favour for which they would not get compensated so that they wouldn't be they're reluctant to do it.

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So I think you've just got to force banks to issue more equity in this situation.

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There is a very big wedge between their private interest and the public interest, particularly just after you've had a crisis.

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Because when they've got wafer thin equity, this divergence between public and social interest is particularly good.

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Is there a cost to the economy of more equity?

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Well, there's a famous theorem due to Modigliani and Miller and then which says if you assume blah, blah,

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blah, then the cost of funding for an institution is the same no matter what the mix of debt and equity is.

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And part of that logic is if you issue more equity as a firm or a bank, then you'll be there'll be more buffer of risk.

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So you'll be able to raise further funding more cheaply, and it'll all wash out.

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And then the bank censors say, but look, the real world is nothing like the assumptions of the Modigliani Miller Theorem.

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And that is true. But when you list the main reasons why the world is different from the Modigliani Miller Theorem, you get even more reasons.

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From a public policy point of view, why you should require the banks to have more equity.

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So in our interim report we had, because this issue was flying around quite well, we had a treatment of those issues.

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The way to cut to the chase was a very nice very Martin Wolf had in discussions with the some

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of the banks where he said you what you say you've got to give your equity holders a real,

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real terms return of 15% on equity, they say yes, but it's come down from 2020.

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And he would say, wait a minute, what's the risk free rate at the moment?

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And the risk free rate of return is approximately zero.

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So you need 15. The risk free rate is 20.

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You must be running a [INAUDIBLE] of a risky bank.

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Otherwise, no way in the world would you need to give the holders of your bank equity a 15% real return so you're condemned out of your own mouth.

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That was his line. And that it's put in the form of rhetoric, but it's correct as a point.

384
00:40:10,890 --> 00:40:15,960
Now, however, I'm not in the crowd that says you should get equity higher and higher and higher.

385
00:40:16,950 --> 00:40:22,920
Some take the view. I mean, one of our trenchant critics is a very good economist, Larry Cut Lakoff.

386
00:40:23,160 --> 00:40:32,760
He would essentially abolish banking and have it all done by mutual funds and a mutual fund where you wouldn't have a bank deposit,

387
00:40:32,760 --> 00:40:36,060
you'd have a share in a mutual fund that would go up and down with the market and so on.

388
00:40:36,390 --> 00:40:42,960
So that abolishes problems in banking by abolishing banking, which I suppose does in a sense does the trick.

389
00:40:43,080 --> 00:40:48,690
But I think you'd I think a lot would go out of the window if you did that, a lot of socially and economically very desirable things.

390
00:40:49,080 --> 00:40:56,640
So I'm not more and more and more and more equity, but I think we're in a place where undoubtedly more is better,

391
00:40:57,150 --> 00:40:58,920
or at least in terms of where we should try to get to.

392
00:40:58,920 --> 00:41:06,000
I wouldn't want to do it tomorrow, but we should have, in my view, a much more ambitious trajectory than that in the Basel processes.

393
00:41:07,850 --> 00:41:16,130
Why then, did we stay as low as our 10%? Well, I've already indicated it's partly because we were recommending for the UK taking the world as given.

394
00:41:16,580 --> 00:41:20,900
So that's the geographic arbitrage risk. There's also this risk of stuff going to non-banks.

395
00:41:21,170 --> 00:41:24,050
And the macroeconomic problem of how do you get from here to there?

396
00:41:24,570 --> 00:41:35,720
And if you think that the 7% equity number should actually be 30%, you can't sensibly say and they've got to do it within the next five years.

397
00:41:36,230 --> 00:41:41,610
And we didn't think you could credibly say they've got to get to 30% and they've got to do it by 2042.

398
00:41:41,650 --> 00:41:45,470
You know, that's just not a you can't straight face really get away with that.

399
00:41:45,740 --> 00:41:50,300
Now, had we not faced those constraints and I've been asked quite a bit, what would my number been?

400
00:41:50,810 --> 00:41:58,610
I would have gone. I haven't calibrated it precisely, but my my feeling is double what we did.

401
00:41:58,940 --> 00:42:04,940
So 20% in relation to risk weighted assets and 12 times as leveraged cap.

402
00:42:05,120 --> 00:42:11,149
But we are not in a blue skies world. And even though I'm an academic, I'm I think it's irresponsible to say, well,

403
00:42:11,150 --> 00:42:15,890
I'm going to pretend we are and go out there and say the numbers should be twice as high when I know perfectly well we're not.

404
00:42:16,070 --> 00:42:22,520
There are these constraints. Now, the second thing is that we tried hard to get loss.

405
00:42:22,520 --> 00:42:28,370
Absorbency greatly increased not only by higher equity, but also by other means.

406
00:42:29,660 --> 00:42:33,080
Before I get onto that, I think this is fascinating.

407
00:42:33,080 --> 00:42:41,480
I showed you earlier a chart showing that 20 times or in these terms, 5% equity ratios in the period from sort of 1960 onwards.

408
00:42:41,780 --> 00:42:49,340
If you go back a century earlier, you see that the banks in the UK, in the US, they were often operating on four or five times leverage.

409
00:42:49,880 --> 00:42:57,770
And I'm not an economic historian, but I believe the United States economy did quite well in the in the late 19th century and so on.

410
00:42:58,210 --> 00:43:00,320
Now it's true. They had lots of banking crises still.

411
00:43:00,650 --> 00:43:07,940
But you can you can perfectly well have very good growth with much, much less leverage in the system.

412
00:43:07,940 --> 00:43:12,740
And anyone says the only way to run capitalism is on 30, 40 times leverage.

413
00:43:13,010 --> 00:43:18,860
I think that's just utter nonsense and a recipe for the demise of the system.

414
00:43:18,860 --> 00:43:24,050
If you have enough of the crisis, you can only have so many without all sorts of sovereigns going down.

415
00:43:24,950 --> 00:43:33,170
Now, what about the other the other bits of loss of so you'll see this is picking up the point at the bottom and I don't have slides on it.

416
00:43:33,890 --> 00:43:39,830
We had this. We said, you've got to articulate the hierarchy of loss absorbency rather than everything being equal.

417
00:43:40,460 --> 00:43:47,180
So we said there should be a sufficient slab and we put numbers on it of what we call primary loss absorbing capacity.

418
00:43:47,690 --> 00:43:59,420
So each big bank would need, in addition to equity, at least a further 7 to 10% risk weighted assets of some that had to be unsecured.

419
00:44:01,070 --> 00:44:08,090
More than a year to run and subject at the point of failure to a regulatory bail in power.

420
00:44:08,510 --> 00:44:12,920
Well, that means bail in the opposite of bail out. Is that the regulator?

421
00:44:13,070 --> 00:44:22,190
Without bankruptcy happening, without the legal state of insolvency being entered into, could impose losses on the holders of such stuff.

422
00:44:22,550 --> 00:44:27,350
And by that means we went got on for doubling what we recommended.

423
00:44:27,350 --> 00:44:32,810
So when I said my blue skies, we couple this with proposals to have a big slab of such debt.

424
00:44:33,050 --> 00:44:39,170
And a big thing missing from the international debate until about now is what

425
00:44:39,170 --> 00:44:44,510
should be the internationally agreed baseline on how much of that in our terms,

426
00:44:44,510 --> 00:44:49,280
primary loss absorbing capacity in some of the Basel jargon that's called gone concern,

427
00:44:49,640 --> 00:44:53,750
loss absorbing capacity or g lack, we call it P like, but it's the same thing.

428
00:44:54,320 --> 00:44:55,730
How much should there be?

429
00:44:56,360 --> 00:45:03,560
And the other thing we did was to say that ordinary deposits, the ones with government, government backed those should be senior.

430
00:45:03,950 --> 00:45:11,150
So the furthest from having to take loss to get away from this problem of everything having to be eaten into at the same rate.

431
00:45:13,360 --> 00:45:19,839
Right structure, loss absorbing capacity, which I've been talking about, and structure reform.

432
00:45:19,840 --> 00:45:23,740
Those are the two main dimensions apart from competition that the ICP looked at.

433
00:45:27,160 --> 00:45:32,860
We thought, as I've indicated, if you go super high on structure, you run into sorry, in capital.

434
00:45:33,190 --> 00:45:34,630
You run into all sorts of problems.

435
00:45:35,580 --> 00:45:41,130
If you try and do it all by structural reform and some voices would say, look, go for Glass-Steagall, total separation.

436
00:45:41,820 --> 00:45:48,120
I think that by itself would be very much inadequate by itself as a remedy.

437
00:45:48,840 --> 00:45:53,760
We we sort of went in the crosshairs of that diagram and with.

438
00:45:55,170 --> 00:46:01,710
Non extreme measures on both fronts. I think our package is as radical as anybody's anywhere.

439
00:46:01,750 --> 00:46:04,080
They get a lot of attacks for not having gone far enough.

440
00:46:04,590 --> 00:46:11,280
But we weren't we weren't super radical in either dimension and very deliberately so did that considered reasons.

441
00:46:11,640 --> 00:46:13,350
And we went for this thing called ring fencing,

442
00:46:13,350 --> 00:46:22,620
which is the separate subsidiary idea for retail banking that would have to have its own equity cushion and enhanced from 7 to 10% for the big banks,

443
00:46:23,100 --> 00:46:29,009
its own loss, absorbing debt on top, it would have to meet its own liquidity requirements.

444
00:46:29,010 --> 00:46:33,690
It would have independent governance structures from the rest of the group,

445
00:46:34,440 --> 00:46:39,239
and it would be able to deal with the rest of the group only on a third party basis.

446
00:46:39,240 --> 00:46:43,380
So lots of restrictions to stop the fence being undermined.

447
00:46:44,010 --> 00:46:47,540
Why do this? Three reasons.

448
00:46:47,900 --> 00:46:55,610
One is insulation. It gives you something of a firebreak between saying outside the UK or outside Europe shock.

449
00:46:57,080 --> 00:47:01,980
And retail banking services. You can imagine a crisis which is somewhere else in the world.

450
00:47:02,000 --> 00:47:05,240
It might make UK banks lose a ton of money on their trading books.

451
00:47:05,690 --> 00:47:09,080
It might even bankrupt their non-retail operations.

452
00:47:09,350 --> 00:47:14,960
But if you've got this insulated, it gives you some safety in a different context.

453
00:47:17,150 --> 00:47:24,470
The Spanish banks, they operate in a geographically subsidiary structure Santander UK, which is a very big player in UK retail.

454
00:47:24,890 --> 00:47:32,600
I think even when the Spanish woes were at their height, there was no real question over Santander UK because it had that degree of insulation.

455
00:47:33,770 --> 00:47:36,920
I think Santander in Spain was it was like the cars.

456
00:47:37,190 --> 00:47:40,370
But I think that's just a reassuring insulation benefit.

457
00:47:40,610 --> 00:47:46,440
Will that give you insulation against all future crises? No, but I think a big chunk of them it would.

458
00:47:46,460 --> 00:47:52,220
So it shifts the odds. Second thing I said a few times that the government had no option.

459
00:47:52,640 --> 00:47:58,400
To say, Well, we'll have this approach, we'll keep the retail stuff going, but we'll let the trading book or derivatives go down.

460
00:47:58,640 --> 00:48:05,540
It couldn't do that because it was all intermingled in one big lump. If you've got separate bits, you can have separate policies for separate bits.

461
00:48:06,080 --> 00:48:11,899
And a big theme of the International Reform Initiative is to enhance the ease of what's called resolution.

462
00:48:11,900 --> 00:48:17,150
This is the orderly unwinding of a banks when these crises happen.

463
00:48:17,360 --> 00:48:23,899
Horrendously complicated geographically because they are operating in multi jurisdictions with different bankruptcy laws but are very,

464
00:48:23,900 --> 00:48:25,370
very different functionally as well.

465
00:48:25,950 --> 00:48:36,410
But I'm very strongly of the view that for complex institutions, resolution is credible only if you have some pre structure in the institutions.

466
00:48:36,680 --> 00:48:42,320
The idea you can unscramble this totally intermingled thing without that I think is ridiculous.

467
00:48:42,590 --> 00:48:48,350
So the irony is we've got, you know, more or less everyone in principle agrees we need much better resolution.

468
00:48:48,530 --> 00:48:56,270
But we've had very little debate other than in the UK and Volcker in the US and now with Lincoln and in Europe on structural reform.

469
00:48:56,360 --> 00:49:03,170
But without that, I don't see how this resolution is credible in the case of the complex institutions.

470
00:49:03,530 --> 00:49:10,560
Now, in the US, the FDIC has wound up lots of banks over the years, but a,

471
00:49:10,610 --> 00:49:17,780
they have been much simpler institutions than some of the global banks and B, they have had this separate affiliate structure in them.

472
00:49:17,780 --> 00:49:21,260
So they have been able to say, well, this bit will have a breach bank to keep that going.

473
00:49:21,440 --> 00:49:22,700
This bit we won't and so on.

474
00:49:23,510 --> 00:49:31,040
Third benefit in this matters a lot for us given and I think if in questions we want to talk about some of the domestic politics around reform.

475
00:49:31,040 --> 00:49:36,860
I think that's important by having ring fencing you and and separation of structure.

476
00:49:37,070 --> 00:49:40,730
You could have higher capital requirements in retail than in non-retail.

477
00:49:41,390 --> 00:49:45,440
Why? Why would you want that? Somebody said it was ridiculous because investment bank is a risky bet.

478
00:49:45,740 --> 00:49:50,810
Well, it's not entirely true. There's a lot of risks in retail banking to a number of countries around Europe illustrate that.

479
00:49:51,290 --> 00:49:55,459
But the reason was that the in international banks,

480
00:49:55,460 --> 00:50:02,900
slightly different regulatory requirements can trigger a big move internationally of activities, and that is undesirable.

481
00:50:02,900 --> 00:50:10,430
So ring fencing gave us a way to have safer UK banking without screwing up the international position of UK banks.

482
00:50:11,360 --> 00:50:15,710
And I think all in all, it gives a sound framework for lending to the real economy.

483
00:50:16,920 --> 00:50:23,010
Okay. So you're going to ring fencing. How do you design it? You've got to have a strong fence, otherwise no point.

484
00:50:23,670 --> 00:50:27,090
Where do you put the fence? Speaking metaphorically,

485
00:50:27,690 --> 00:50:31,379
rather than draw a line and say Everything on the left hand side has to be in the

486
00:50:31,380 --> 00:50:33,930
retail bit and everything on the right hand side has to be in the other bit.

487
00:50:34,560 --> 00:50:42,860
Our logic took us to a place where we said some things should be permissible by banks only in ring fenced entities.

488
00:50:42,870 --> 00:50:50,219
That's the core bit. Some activities should not be allowed in there, but there's a big middle swathe.

489
00:50:50,220 --> 00:50:55,799
You can think of it as commercial banking more generally. Where on the logic could be either side.

490
00:50:55,800 --> 00:50:58,860
So why not let the banks and their customers choose that?

491
00:50:59,040 --> 00:51:04,710
And indeed it might be quite desirable if different banks adopted different solutions for reasons of ecosystem diversity.

492
00:51:05,190 --> 00:51:09,030
Now the logic of the legislation is actually very much in line with that.

493
00:51:09,210 --> 00:51:18,270
The detail isn't entirely. There are some outside things which the government is going to allow in the fence trade, finance and so on.

494
00:51:18,270 --> 00:51:23,250
And I think on that the government is right. Actually, we didn't we only had 15 months, didn't claim to get every detail right.

495
00:51:23,610 --> 00:51:26,970
But on that, I think it's a perfectly reasonable view that the Government has taken.

496
00:51:28,660 --> 00:51:32,740
Frequently asked question number one, why didn't we go for Glass-Steagall in the full break up?

497
00:51:33,220 --> 00:51:39,580
Short answer is, I think it would have been much more costly and for very unclear benefit.

498
00:51:40,600 --> 00:51:42,820
I go back to my ecosystem diversity point.

499
00:51:43,090 --> 00:51:53,530
If retail banks, if you create a an ecology of completely standalone domestic retail banks and if the next crisis or the one after is domestic,

500
00:51:53,530 --> 00:51:58,209
say it's a big crash in commercial property prices in the U.K., you are in a worse position,

501
00:51:58,210 --> 00:52:05,830
having done a full split than having done ring fencing, because with ring fencing, there's a possibility that the rest of the banking groups,

502
00:52:05,830 --> 00:52:13,030
if the Western world is doing okay, have resources to fight the fire in the U.K. And if you go for a full split, you have lost that benefit.

503
00:52:14,050 --> 00:52:19,750
Now, the some on the parliamentary commission, parliamentary commission, this is an amazing body chaired by Andrew Tyrie.

504
00:52:20,200 --> 00:52:22,450
I think it's six MP, six members of the House of Lords.

505
00:52:23,320 --> 00:52:29,320
Nigel Lawson I think your former student fees and we see no, no, no, you don't take credit for everything.

506
00:52:29,590 --> 00:52:39,520
Anyway, he's, um, he, he is he would, I think, go for a more radical measure.

507
00:52:40,030 --> 00:52:43,900
But they've not actually recommended that they propose what's called electrifying the fence.

508
00:52:44,650 --> 00:52:48,790
They're worried that it will be eroded over time, which is a perfectly reasonable thing to worry about.

509
00:52:49,330 --> 00:52:56,500
And so into the legislation is being put a reserve power for a group restructuring order where subject to various constraints,

510
00:52:57,160 --> 00:53:02,979
regulators and government could say to a bank that's been who's been eroding its fence,

511
00:53:02,980 --> 00:53:08,950
tunnelling under climbing or whatever you do and it can say, right, you are split totally into two.

512
00:53:09,250 --> 00:53:15,010
So it's a reserve power and it's meant to deter going near the fence.

513
00:53:15,010 --> 00:53:22,989
And I, I once in a rural cricket match, I was on the boundary and the ball whizzed past and I did not realise that the wire.

514
00:53:22,990 --> 00:53:27,010
Right. So this is very credible in my, in my mind.

515
00:53:29,530 --> 00:53:35,410
So we didn't go for a full split. I characterise it as structured universal banking, which is what they've got in the US for example.

516
00:53:35,920 --> 00:53:39,700
Second frequently asked question why not go for the Volcker Rule? Well, that has to pass.

517
00:53:40,000 --> 00:53:44,800
Why not do that instead of what we did? Well, it wouldn't have gone anywhere near far enough.

518
00:53:45,010 --> 00:53:48,400
And the Volcker Volcker rule is proving enormously difficult to implement.

519
00:53:48,790 --> 00:53:51,940
And don't forget, the UK has two separate affiliate business anyway.

520
00:53:52,470 --> 00:53:56,900
US. These are the US dollars. Thanks, Miles. Why not add it to ring fencing?

521
00:53:56,920 --> 00:54:03,579
Good question. Parliamentary commission looked at it, said important question, keep an eye on it, but on balance, not worth doing it,

522
00:54:03,580 --> 00:54:08,380
partly because the banks and you can now say they're not doing it and any vulcanised activity anyway.

523
00:54:09,380 --> 00:54:14,350
So we now have legislation. It's gone through the Commons.

524
00:54:16,960 --> 00:54:20,260
Part way through the Lords, I think next up is the Lords Committee stage.

525
00:54:20,560 --> 00:54:26,950
So it's most of the way through. There is a broad cross-party consensus which I think is really good.

526
00:54:27,640 --> 00:54:30,640
So this hasn't been party political or not very much.

527
00:54:31,210 --> 00:54:38,200
And what the bill does is those things it provides for ring fencing, depositor preference and a bunch of recent amendments the government laid down.

528
00:54:38,230 --> 00:54:39,490
A week or so ago.

529
00:54:39,820 --> 00:54:47,469
It does other things like providing for the regime, for the bail in debt business, so it doesn't specify capital levels and the rest.

530
00:54:47,470 --> 00:54:54,310
That's for not for primary legislation, but for other things. But it is know so far so good in the legislative process.

531
00:54:55,750 --> 00:55:03,309
To Europe, the Silicon in group, which was set up after we'd finished and somewhat to our surprise, they were asked, look at very similar questions,

532
00:55:03,310 --> 00:55:11,470
the structural questions they recommended separating trading from deposit banking, which in in my view is ring fencing by another name.

533
00:55:12,130 --> 00:55:17,320
Tells me that ring fencing is a phrase that doesn't work in any other European language and Finnish in particular.

534
00:55:17,320 --> 00:55:21,940
It doesn't work. So they call it separation. But that's a nominal, not real difference.

535
00:55:22,390 --> 00:55:25,690
It's not identical to us. They and it's odd,

536
00:55:25,690 --> 00:55:31,809
I think they would allow the the retail entity to do securities underwriting that seems to me and the

537
00:55:31,810 --> 00:55:37,389
Glass-Steagall legislation from the thirties in the US that's a classic investment banking activity in my mind.

538
00:55:37,390 --> 00:55:41,920
So that's different from us. But in many, many ways it's very similar.

539
00:55:42,190 --> 00:55:50,110
Where's that proposal got? Well, the Commission consulted, Brussels Commission consulted and I think is still mulling consultation responses.

540
00:55:52,450 --> 00:55:56,950
I don't want to dwell on this. This is a chart from the European Commission consultation.

541
00:55:57,280 --> 00:56:02,560
Thing I really like about this option h explicitly recognises the point I've been banging on about,

542
00:56:02,770 --> 00:56:08,079
which is the UK and the US bank holding company structure are in the same box and licking an option.

543
00:56:08,080 --> 00:56:14,410
E I think Ian's actually very, very close to each other, so this is exactly correct portrayal.

544
00:56:15,860 --> 00:56:19,849
Eurozone banking union, some say on a separate issue.

545
00:56:19,850 --> 00:56:25,309
I don't think that is true at all. I think eurozone banking union makes a lot of sense if it's between banks that

546
00:56:25,310 --> 00:56:29,330
are well capitalised and safely structured could be disastrous otherwise.

547
00:56:29,630 --> 00:56:33,290
So you want to do banking reform anyway, but all the more so if you're going to do this.

548
00:56:34,440 --> 00:56:42,310
And to end. The U.K., I think it's fair to say, is leading on structural reform,

549
00:56:42,730 --> 00:56:46,750
even though we're not going as radical as some like I think Lord Lawson would want to.

550
00:56:47,290 --> 00:56:49,629
UK was one of the leaders on loss absorbency,

551
00:56:49,630 --> 00:56:54,850
but the government unfortunately has not accepted our leverage backstop recommendation, at least not yet.

552
00:56:55,240 --> 00:56:58,750
So I wouldn't count the UK as in the vanguard on loss absorbency.

553
00:56:59,080 --> 00:57:02,290
I hope the UK will be on the loss absorbing debt issue.

554
00:57:02,320 --> 00:57:06,160
Maybe it will be and that would be good. EU Watch that space.

555
00:57:06,640 --> 00:57:15,640
US The Dodd-Frank legislation 2010 still being implemented, so still a lot to play for Basel process.

556
00:57:16,120 --> 00:57:22,630
I think it's unambitious what they agreed to on capital, but the bail in debt space is still to be filled.

557
00:57:22,930 --> 00:57:29,110
So there's still, in my view, lots more to do and as to whether the first five years of reform have been successful or not,

558
00:57:29,590 --> 00:57:32,260
if this is all we're going to get, then the answer is no.

559
00:57:32,620 --> 00:57:38,110
If it's a prelude to be built on in the next five, then then maybe we will get to a much better place.

560
00:57:39,310 --> 00:57:41,140
Thank you. Thank you very much, indeed.