17 October 2012

BoE/Tucker: Competition, the pressure for returns, and stability

"The changes are profound”, says Tucker.  But in “overhauling the ‘rules of the game’ for global finance”, he emphasises that the goal of the international authorities is not to abolish risk or risk-taking. “We need to find broadly the right balance between, on the one hand, safety and, on the other hand, the contribution that sound and honest finance can make to economic prosperity.”

Tucker notes the way increasing leverage fed upon itself in the run-up to the current crisis, and says it poses “deep but pressing questions about the efficiency and effectiveness of capital markets in monitoring and pricing risk”.  And while ‘Too Big To Fail’ is “the biggest problem we have to crack”, he says moral hazard isn’t a complete explanation.  Rather, it was compounded by agency problems, myopia, complexity obscuring the risks in the system as a whole, and accommodative global monetary conditions.  Together, these factors combined, he says, to create “a heady mix ... which the prevailing regulatory regime was singularly ill equipped to address, and in some respects had done much to create through inadequate capital requirements and an absence of liquidity requirements.  In fact, a toxic mix.”

Tucker highlights six key aspects of the domestic and international reform programme pertinent to the banking industry:

• “First and foremost, we need holders of bank debt to be exposed to losses when banks fail.”  He stresses it is imperative to have deposit-takers that can be resolved in an orderly way, and the significance of the UK government’s ring-fencing plans in this context. 
• Second, the authorities need to consider whether to require management to be paid to a significant extent in subordinated debt, an idea recently endorsed by the Liikanen Committee.
• Third, he highlights measures to address industry structure and system resilience. These include the UK’s ring-fencing plans, which will he says make it somewhat easier to see what is going on, and help establish different cultures in different lines of business.
• Fourth, he notes changes in prudential regulation, in particular higher risk-based capital requirements and a cap on leverage. As well as providing a bigger buffer against loss, higher capital requirements will, he says, also affect behaviour, depressing the headline return on equity and likely prompting shareholders to “demand a larger share of the cake”.
• Fifth, he discusses the role of micro-prudential supervision under the UK’s new Twin Peaks structure. 
• Finally, he highlights the significance of macro-prudential policy: keeping the rules of the game up to date and leaning against exuberance.  This, he notes, is precisely the remit of the FPC.

In conclusion, Tucker states that “work by the international central banking and regulatory community to make the system safe and sound has made real progress in recent years, but it is not complete and absolutely must continue with energy … We may not be able to abolish the occasional waves of optimism that grip humanity and the tendency to excess they set off. But we can and must dampen their effects on the financial system and economy… Markets will, in time, forget about the risks, but the system will be safer if we succeed in building official institutions that do not forget. Parliament can underpin that by holding us to account in this endeavour, as it does on monetary policy – incentives matter in the official sector too. That will make for a safer and sounder financial system that can meet the abiding needs of the economy as a whole. And, to those of you here today, I would say that the Bank believes what it always believed: that sound and honest finance is not only essential for the economy, it will be good for the City too.”

Full speech

© Bank of England