Mervyn King on the Financial Crisis

On Monday 25^th of October the Governor of the Bank of England gave a forthright speech on the banking industry. He pulled no punches and it makes fascinating reading, from a man at the epicentre of the present financial crisis.

Why did the Crisis Occur?

King notes that despite the severe equity market falls in 1987 and 2000-2003 we did not see a comparable effect to the economy as we have with the banking crisis. He goes on to enquire

Unfortunately, such crises are occurring more frequently and on an ever

larger scale. Why?

I think we have to note that not only are they increasing, but they are becoming more globally correlated. Furthermore, the primary solution-lower interest rates-seems to be needing lower and lower rates to deal with the problem.

One of the reasons given by King for the increases in crises is the explosion of banks –in particular big banks-balance sheets, primarily as a result of an increase in leverage.

in the US, the top ten banks amount to over 60% of GDP, six times larger than the top ten fifty years ago. Bank of America today accounts for the same proportion of the US banking system as all of the top 10 banks put together in 1960.

Furthermore, banks have resulted to using more short term wholesale funding. At this point it is worth noting that it was this increasing reliance on short term funding that characterised HBOS in the credit crunch. HBOS moved away from relying on customer deposits (the traditional building society model) in favour of using short term wholesale market funding. This is relevant because HBOS difficulties were emanating from its commercial banking rather than from investment banking. In other words, the distinction between commercial and investment banking is not entirely clear here. This creates difficulties for those (such as Paul Volcker) who want these activities to be separated in order to avoid the danger of ‘too big to fail’ investment banks blowing up.

Indeed, King questions how this separation would work in practice, but I suspect that the development of these 'shadow' banking arrangements would not have occurred, had there been separation.


 

How Markets are Becoming Increasingly Correlated

King points out that this encourages greater interconnectedness in the system, and this caused knock on effects to sentiment.

Damningly, he goes on to point out

Moreover, a financial sector that takes on risk with the implicit support of the tax-payer can generate measured value added that reflects not genuine risk-bearing but the upside profits from the implicit subsidy.

 

and

But part of the value added of the financial sector prior to the crisis reflected temporary profits from taking risk and it was only after September 2008 that much of that so-called economic activity resulted in enormous reported losses by banks.

 

 Too Big to Fail

King goes on

Institutions supplying such services are quite simply too important to fail. Everyone knows it. So, highly risky banking institutions enjoy implicit public sector support. In turn, implied public support the banks an incentive to take on yet more risk, knowing that, if things go well, they will reap the rewards while the public sector will foot the bill if things go wrong. Greater risk begets greater size, most probably greater importance to the functioning of the economy, higher implicit public subsidies, and hence yet larger incentives to take risk

 

The rest of the speech goes on to discuss the various mechanisms by which solutions can be found. These include things like formally separating banking activities; increasing capital-asset ratio requirements; taxing the ‘polluter’ and, limited purpose banking so that the maturity mismatch is reduced or even eradicated. 

It is a fascinating speech.and I would encourage all, to read it in full.

Some Thoughts

I would like to focus on the incentive effect and also on how many aspects of the crises can be seen to be endemic in society.  It would be wrong to think of the crisis as being hermetically sealed to the banking industry. The tone of the speech seems to be echoing Taleb’s maxim that the bankers took all the rewards for risk but passed on all the costs to the taxpayer. It’s worse than that though. It appears that HBOS , Lloyds TSb et al were being incentivised to become ‘too big to fail’ so that they could ensure they would get bailed out.

Worryingly, the increase in ‘value added’ by the banks before 2008 was a chimera, according to King.  However, the illusion did not extend to scale of the salaries that the banking sector paid itself.  Those massive increases were real. Very real. Furthermore, they largely contributed to the increase in the high end if the London property market, or at least, that is what a strategist from Saviles told me at an AGM when we discussed it. Of course, as the high end goes up, so the rest follows. The sub-prime punters merely wanted a piece of the action too.

Therefore, the asset class –property- at the epicentre of the losses on the balance sheets of the banks in the UK, was actually being pushed higher by the people reaping the rewards of putting the economy in jeopardy. They were incentivised to do so by ‘gaming’ the system, in order to ensure that the taxpayers would bail them out.

The idea that the losses on sub prime in the States or UK could be mitigated towards that segment (relatively small) of the banking industry, unfortunately, proved fallacious for many of the reasons that King outlines.

Globalisation Increasing Correlation?

Similarly, this interconnectedness ensured that the financial system was in fact set up in one direction and, in my opinion, it is this increase in directionality-rather than the leverage per se- that caused the problem. For example, a lot of spilt ink was used in 2008 arguing over whether institutions should have to ‘mark-to-market’ some of the illiquid assets (CDOs etc) on their balance sheets. Banking apologists are keen to blame regulators for forcing them to ‘weaken’ their balance sheets unnecessarily in this way.  However, if all the financial institutions hadn’t been in the same direction then some of them would have been in shape to buy these ‘undervalued’ assets. Something only has a value for what somebody else is willing to pay for it.

The problem lies in the increase in the increasing correlation and directionality of markets. This is made worse by the fact that, if everyone is positioned in the same direction, the winner will be the one that takes on the most risk. A scenario which results in money and power being allocated towards the people who have the least understanding of risk. With increasing globalisation, these aspects are likely to increase until action is taken to strike at the nexus.

Source:

http://www.bankofengland.co.uk/publications/speeches/2010/speech455.pdf