Lessons from Northern Rock: Banking and shadow banking

Willem Buiter, 4 March 2008

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Two highly readable reports on the lessons learnt from the Northern Rock debacle have been published recently. The first is the Treasury Committee Report The Run on the Rock published on January 26. The second is Financial stability and depositor protection: strengthening the framework, published jointly by HM Treasury, the Financial Services Authority (FSA) and the Bank of England (BoE) on January 30. The publication of the latter document launches a consultation on the proposals contained in it for domestic and international action to enhance financial stability. The Treasury Report covers five areas: (1) Strengthening the financial system through domestic and international actions; (2) Reducing the likelihood of banks failing; (3) Reducing the impact of failing banks; (4) Deposit insurance: and (5) Strengthening the Bank of England and improving the operation of the Tripartite Arrangement. This column analyses the first two parts.

Strengthening the financial system

There is nothing substantive regarding unilateral or coordinated international action to strengthen the financial system, just some pious platitudes about the need to strengthen risk management by banks and to improve the functioning of securitisation markets by beefing up valuation methods and the performance of credit rating agencies. This is a missed opportunity, as the current financial crisis has reminded us that when finance is global and regulation is national, accidents are much more likely to happen. Regulatory arbitrage and competitive deregulation to gain or retain footloose financial businesses within national jurisdictions have been important contributors to the excesses committed by financial institutions and to the mis-pricing and misallocation of risk by credit markets and other financial markets since (at least) 2003. The proliferation of opaque complex financial instruments traded by opaque off-balance sheet financial vehicles calls for global action. Coordination between multiple institutions, especially in a crisis, is always problematic: panic moves at the speed of light and even well-intentioned, cooperatively minded parties will find it hard to engage in synchronised swimming while piranhas and sharks lurch at their tender extremities.

The UK’s ‘light -touch’ regulatory approach has been found wanting and exposed as little more than soft-touch regulation. No doubt it has been successful in attracting financial sector activity to London – that is, it has been an effective competitor in the socially negative-sum global deregulation game. It has made a material contribution to the regulatory race to the bottom, which has left much of the shadow banking sector outside the regulatory net altogether, and has reduced both the information available to the regulator and the power of the regulator to prescribe or proscribe behaviour in those market segments that remain regulated.1

At the European level, the need for the creation of a single EU regulator for any given market segment, responsible for all financial institutions engaged in significant cross-border activity (including foreign subsidiaries and branches) is now paramount. At the global level, a greater sense of urgency as regards the activities of the Financial Stability Forum is key. The IMF is waved around briefly in the Treasury Report, but what role it would play in the prevention of crises (‘enhanced multilateral surveillance’ anyone?) or in their mitigation is not developed.

It is also clear that Basel II has to go back to the drawing board. While some of the excesses of the recent past would not have been possible had Basel II been in effect (especially the ability of banks to make economic exposure disappear for reporting purposes through the creation of off-balance-sheet vehicles), Pillars I and 2 of Basel II have three flaws which are, I believe, collectively fatal. One is the procyclicality of the capital requirements directive. The second is the reliance on internal models of banks to mark-to-model (i.e. mark-to-myth and mark-to-the-short-term-requirements-of-the-banks’-profit-centres) illiquid and often complex financial instruments and structures. The third is the reliance of the risk-weightings on the ratings provided by discredited rating agencies.

The Report also mentions the need to improve the functioning of securitisation markets, including improvements in valuation and credit rating agencies, but it offers very little beef in these areas. It is clear that the credit rating agencies will have to be ‘unbundled’ and that the same legal entity should not be able to sell both ratings and advice on how to structure instruments to get a good rating. The conflict of interest is just too naked. Rating agencies will have to become single-product firms, selling just ratings.

The only two proposals for improving the operation of the securitisation markets I have seen are not discussed in the Report. The first is for the originator of the assets (home loans, say) underlying the securitisation process to be required to retain the equity or first loss tranche of the securities issued against the underlying assets. This strengthens the incentives for delegated monitoring and reduces the severity of the principal-agent problem in the securitisation process. The second prescribes a ‘gold standard’ for simple and transparent securitisation, as proposed recently by the UK Treasury, but – unlike the Treasury proposal – one with teeth. In a revised collateral framework, the Bank of England would only accept as collateral at the standard lending facility (discount window) or in open market operations through repos, asset-backed-securities conforming to the ‘gold standard’.

One of the key drivers of the excesses of the most recent (and earlier) financial booms has been the myopic and asymmetric reward structure in many financial institutions, including banks and commercial banks. Clearly not all is well when the CEO of Citigroup, after marching his institution to the edge of the abyss, is let go with a golden handshake worth in excess of $130 million. If that is the punishment for failure, what could be the reward for success? And this is just an extreme example of poorly structured reward systems that encourage excessive risk-taking and the pursuit of short-term profits. Where action to prevent such outrages in the future should be focused is not clear. It is fundamentally a problem of general corporate governance, not restricted to the financial sector: where were the shareholders of Citigroup? But there clearly is an urgent need for intelligent design here.

Reducing the likelihood of banks failing

As regards proposals for reducing the likelihood of banks failing, there are some sensible proposals for enhancing the ability of the FSA to demand information at short notice.

Provision and disclosure of liquidity assistance

This part of the Report is hamstrung by a failure to distinguish clearly between funding liquidity and market liquidity. Funding liquidity, which refers to the cost and availability of external finance (including the speed with which it can be accessed) is a property of economic agents and institutions. Market liquidity, which refers to the speed and ease with which an asset can be sold at a price close to its fair value and with low transaction costs, is a property of assets or financial instruments and of the markets in which they are traded. Funding liquidity and market liquidity are not independent; the funding liquidity of a market maker or trader will influence the liquidity of the market he makes; the funding liquidity of a trader will depend on the market liquidity of the assets he holds or the liquidity of the markets in which he intends to borrow, secured or unsecured. There are private and public sources of both funding and market liquidity. When push comes to shove, only the public sector can provide instruments with unquestioned liquidity. Funding liquidity is provided by the authorities at the discount window (on demand against suitable collateral) and, in extreme circumstances, through lender of last resort (LoLR) facilities. Market liquidity is provided by the authorities through open market operations (OMOs), both repos/reverse repos and outright purchases/sales, and, when markets become illiquid, by the authorities acting as market maker of last resort (MMLR), buying normally liquid but temporarily illiquid instruments at punitive prices and discounts.

Funding liquidity and market liquidity need not be provided by the same agency of the government, both in normal times and in extraordinary times. Only the central bank can realistically provide market liquidity, but the central bank need not be the active party deciding on the provision of funding liquidity, even if it is likely to be the (passive) source of such liquidity.

Covert operations: James Bond at the Central Bank

Quite a lot is made of proposals to allow the authorities (specifically the Bank of England), to provide covert liquidity assistance or other ‘good offices’. There are three sets of conditions under which covert assistance may be desirable.

First, there may be a use for secrecy surrounding assistance provided by the authorities during short-term windows of extreme vulnerability, say, just after a major fraud has been discovered. Of course, with the sophisticated control systems in place since, at least, Nick Leeson’s destruction of Barings, a major-institution-threatening fraud is surely a thing of the past…

Second, there may be a use for secrecy surrounding the authorities’ involvement in attempts to find a ‘private sector solution’ for troubled/failing bank. Under the current UK Take-over code, such covert assistance is problematic.

Third, there could be a need for secret lender of last resort assistance. Although the Bank of England’s belief that covert LoLR assistance would fall foul of the UK’s transposition of the EU Market Abuse Directive, this turns out to have been a chimera. In any case, with effective deposit insurance and an effective ‘special resolution regime’ for troubled or failing banks, the need for both the second and the third kind of covert operation would vanish.

When safeguards fail

My recommended policies would likely strengthen the banking and financial sectors, reducing the risk of failure. But such a likelihood is impossible to eliminate. In my next column, I will address how the UK government could best prepare for a non-trivial bank failure.

Footnotes

1 The shadow banking sector consists of the many highly leveraged non-deposit-taking institutions that lend long and illiquid and borrow short in markets that are liquid during normal or orderly times but can become illiquid when markets become disorderly. They are functionally very similar to banks but are barely supervised or regulated. They hold very little capital, are not subject to any meaningful prudential requirements as regards liquidity, leverage or any other feature of their assets and liabilities. They also have very few reporting obligations and have to meet few governance standards, as many are privately or closely held. Examples are hedge funds, private equity funds, money market funds, monolines, conduits, SIVs and other special-purpose, off-balance-sheet vehicles.

Topics: Financial markets
Tags: bank failure, financial stability, liquidity, Northern Rock, securitization

Comments

Role of Basle 2

Agree with your article but I suspect that one of the main drivers to the crisis was allowing 'hedges' to largely drop-out of a bank's VaR calculations. Once Credit Default Swaps expanded to bank's loan books you have a generator of free reserves which will go towards chasing ever more marginal credit worthy borrowers. The off-balance sheet aspects of Basle 2 you mention will no doubt force a truer definition of exposure but if CDSs are allowed you will still have the temptation to ramp-up the loan book.

Willem Buiter
Chief Economist of Citigroup and CEPR Research Fellow