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Adair Turner


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20 Jul 2012

Speech by Lord Turner, FSA Chairman during the Financial Policy Committee regional visit to Manchester

It’s a pleasure to be here in Manchester and have the opportunity to talk with many businesses about the conditions they face.  I am here not as Chairman of the FSA, but as a member of the newly created Financial Policy Committee (FPC) of the Bank of England – the body charged with identifying the big picture risks facing our financial system.  That Committee will also – as the Chancellor announced last month – have a responsibility to support the government’s objective of nurturing growth and employment – to think not only about the stability of this financial system, but also its ability and in particular the ability of the British banking system, to provide sufficient credit to businesses and households to support a growing economy. 

The financial crisis of 2008 was a huge setback to economic growth. The fundamental cause of that crisis was that in several advanced economies there was a build up of excessive debt in the real economy, among households and some businesses, and that we allowed the banking system and some related shadow banking activities to become too highly leveraged.  And that was made possible because of three major policy failures – poor rules, poor theory, and poor institutional structure.

  • We had totally inadequate rules on bank capital and bank liquidity, which had been agreed by apparent experts from regulators and central banks across the world: rules which allowed banks to run with levels of capital which we now consider a fraction of that required to ensure a stable banking system.
  • We also had a flawed theory of economic stability – supported by many apparent experts in economics faculties throughout the world – which believed that achieving low and stable current inflation was sufficient to ensure economic and financial stability, and which failed to identify that credit and asset price cycles are key drivers of instability.
  • And in the UK certainly, but also in some other countries, we had an institutional structure of responsibilities which left an underlap between an inflation targeting central bank and a rule-driven regulator – with no-one clearly responsible for assessing the big picture risks and no-one equipped with the tools to address them.

When the economic history books are written, I suspect it is on these failures that they will concentrate, with the role of individual miscreants and poorly run institutions likely to seem less significant over the years.  Just as in the serious economic histories of the Great Depression of the 1930s, policy mistakes are to the fore, not the many examples of unscrupulous activity and bad individual business decisions.

Amid the undoubtedly important business of addressing poor past conduct, it is therefore essential that we address the fundamental roots of a financial crisis which has harmed the economic prosperity of so many businesses and households in this and many other countries.

And we have already taken many of the measures needed to create a sounder system, less likely in future to generate a crisis similar to 2007/8.  We have agreed at global level and are now implementing a radically changed regime for bank capital adequacy: and we have required banks to improve their liquidity positions – reducing their dangerous pre-crisis reliance on short term wholesale market funding.  And the government has established the Financial Policy Committee – initially in an interim shadow form ahead of the legislation now going through parliament.

The role and responsibilities of the FPC are designed to ensure that we never again suffer from the policy gap – the underlap – which existed pre-crisis.  It has a clear remit to focus on the big picture, to spot the development of system-wide financial risks which we failed to spot ahead of the last crisis: and a remit to apply policy levers which can slow down a credit and asset price boom before it produces disaster – to puncture irrational exuberance to, in the phrase of a past chairman of the US Federal Reserve, ‘Take away the punch bowl before the party gets out of hand’.

The interim Financial Policy Committee was asked to recommend to government what those policy levers should be – and in March this year, we made our initial recommendations.  We need to be able to impose countercyclical capital requirements – increasing the capital which banks hold in the boom times to slow things down, but then removing that constraint in recession to ensure that banks can keep lending to the economy.  And we need to be able to do that on a sector specific basis – for instance imposing higher capital requirements against lending to commercial real estate, while not increasing requirements against loans to other sectors of the economy.

Some critics have suggested that this amounts to a return to a 1960s style industrial policy.  It does not.  We have no intention of using this sector specific tool to try to pick winners.  Instead the need for a sectoral focus simply reflects the fact that behind almost all banking crises in the last 50 years, we find either bad lending against commercial real estate or bad lending against residential homes, and that if we are not equipped with a tool to constrain lending to those sectors specifically, we will have to use the blunt instrument of across the board capital increases – hitting lending to other sectors of the economy, such as manufacturing, not involved in the credit and asset price boom.

The dynamics of property lending are central to banking crises.  So it is reasonable to ask why the interim FPC did not recommend that we have the power to impose and vary over time direct constraints on residential or commercial mortgage borrowers, via for instance, Loan-to-Value (LTV) or Loan-to-Income (LTI) constraints.  After all, in several other countries which have done better at protecting their financial systems against the harmful effects of property lending and price booms – countries such as Canada or Hong Kong – constraints on mortgage lending have played a major role.  While, therefore, the Committee did not recommend that it should now be given powers to set and vary LTV or LTI ratios – it did call for a careful public debate on the merits of those tools.  And we certainly need to ensure that we are well equipped to lean against any future property lending and asset price cycle which could threaten the same harm as the pre-crisis boom. 

But dealing with a future potential boom is clearly not the most pressing problem today.  We do not need to take away the punch bowl.  The party is not out of hand – rather we are suffering a massive hangover.  And right now, a little bit more exuberance, a bit more risk taking, would be no bad thing.

So the challenge which the FPC now faces is to determine what role if any it can play, not in constraining some future potential out of control boom – but in helping to stimulate recovery from today’s long lingering recession.  And the answer is that it can play an important role – because the creation of the FPC makes it possible for us to integrate and consider together different levers of policy which were previously quite separate.

The economic challenge faced by all the advanced economies is severe – the danger that the excess credit created by the pre-crisis boom – and the process of deleveraging which inevitably follows, could result in a sustained period of deflation – with inflation more likely to fall below than stay above an optimal level, with sustained low real growth, and with national income in nominal terms therefore growing very slowly, which in turn makes it very difficult to reduce leverage from excessive levels.  Across all of the major advanced economies – the US, Japan, the Eurozone and the UK – we face an overhang of excessive debt, and economists and policy makers are becoming increasingly aware how difficult are the problems that creates, and how great the dangers that if we get policy wrong sustained deflation will result.1

In the UK, as the Monetary Policy Committee (MPC) noted on 20 June, GDP is 0.4% lower than 18 months ago, and as the one-off effects of sterling depreciation, VAT increases and commodity price increases recede, inflation is now falling rapidly.  In the US, the pace of recovery is slowing; in Japan, the nominal value of national income is static and still 7.7% below pre-crisis levels; the Eurozone is facing strong recessionary headwinds.  Across all four advanced economies, there is a danger that if policy is not appropriate, we could fall into the debt and deflation traps from which Japan has suffered since the mid 1990s.  As the Chief Economist of the International Monetary Fund (IMF) Olivier Blanchard, said last week, even more worrying than falling base case forecasts for global growth is the increase in downside risks.2

We therefore need to think through carefully and creatively the policy responses required to off-set that deflationary risk.  The problem is that any one policy lever applied alone may either bring with it offsetting disadvantages, or be less than fully effective.

  • In Japan, which faced a huge problem of excessive corporate debt after the bubble burst in the early 1990s, the process of corporate deleveraging has been offset by large fiscal deficits, and the economist Richard Koo has argued persuasively that without them Japan would have suffered a still more severe recession3  But the result of that policy is that, overall, Japanese indebtedness has not actually reduced but rather simply shifted from the corporate to the public sector – with Japanese government debt to GDP now at about 230% and rising relentlessly.4
  • Meanwhile in all four advanced economies, central bank interest rates have been dramatically reduced, but in all there is now either minimal or nil potential for further reduction.
  • In Japan, the UK and the US, central banks have in addition employed unconventional monetary policy – quantitative easing – buying government bonds and creating additional money in the form of bank reserves at the central bank.  And the best available analysis suggests that without that quantitative easing (QE), both real growth and inflation would have been appreciably lower.5  But there are some dangers that QE, if the only policy deployed, will suffer from diminishing returns, with the economy facing a liquidity trap in which replacing private sector holdings of bonds with private sector holdings of money has little impact on behaviour and thus on demand.

That danger was considered in the MPC’s June meeting, with members noting that while QE was creating additional bank reserves at the Bank of England, there was a possibility that other factors, such as banks’ increased holdings of liquid assets, might be ‘offsetting to some extent the impact on the economy’ of the Bank’s QE measures.6

The crucial issue is the effectiveness with which the banking system acts as a transmission mechanism of monetary stimulus.  And the danger is that in the wake of a financial crisis that effectiveness is impaired.  The questions the FPC has therefore had to consider are:

  • How far has an impaired banking system been a brake on recovery from recession
  • Why and in what specific ways has it been impaired
  • And what if anything can macro-prudential policy do to mitigate the consequences.

The question of whether the recovery is being held back by an inadequate supply of bank lending is addressed in the latest Financial Stability Report7which FPC published three weeks ago.  The answer we proposed distinguishes three time periods.

  • First, it seems clear that a credit supply crunch was a key driver of the economy’s switch from growth to recession between 2008/9 – cut backs in small and medium enterprise (SME) lending, trade finance and mortgage lending, all key drivers of falling demand, confidence and activity.
  • From 2009-11, however, the story is more nuanced – falling demand for loans probably playing a major role, as consumers became cautious about real income prospects and increased their savings rate, and as businesses cut back in the face of depressed consumer demand.
  • Over the last year, however, supply factors seem to have become more important again, with banks tending to tighten their credit criteria, and in some cases to reduce their market share objectives, and in many cases increasing loan pricing.

Why is that occurring?  Well the crucial point to note is that it is not because bank’s profit margins are increasing.  Indeed Net Interest Margin (NIM) – the difference between the banks’ cost of funds and what they lend at has, if anything, slightly declined over the last three years.  The problem is that their cost of funds has increased; banks are having to pay more for unsecured funding in wholesale markets, and having to pay up to gain term retail deposits.  So lending rates are far above Bank Rate and now rising slightly, because banks’ cost of funds are also above Bank Rate and rising.

And that may mean that the power of monetary policy to stimulate the economy via a lower Bank Rate has become muted – that the transmission mechanism of monetary policy is less effective.

The crucial issue for the FPC in our latest round of deliberations, was therefore whether macro-prudential policy could play a role in unblocking the link between loose monetary policy and the real economy.

The theory of what we are meant to do in future in those circumstances is clear – in a future downturn the FPC should remove the additional capital and liquidity requirements which it will have imposed in the upswing.  But we face a ‘don’t start from here’ problem – since we never imposed those buffers in the last upswing they are not there to be removed.

But given the severity of the current deflationary threat, ‘don’t start from here’ cannot be an excuse for doing nothing.  So the FPC considered the following options.

  • First, we considered whether we should relax capital requirements on banks – slowing the progress towards the higher capital levels which we believe are appropriate and which are expressed in the Basel III standards.  That might enable banks to lend more on an unchanged capital base.  But the problem is that one of the reasons banks have had to pay more for funds is precisely because markets are concerned that their capital remains insufficient to absorb the losses which might arise in current stressed conditions.  So relaxing bank capital requirements to stimulate lending could easily backfire – it could increase the cost of funds and thus the cost of lending.
  • The second option is to relax liquidity requirements.  Prior to the crisis, banks were allowed to take excessive liquidity risks.  FSA requirements for banks to hold liquid asset buffers – introduced in 2009 – have had a major benefit in increasing the resilience of British banks, and in making them less vulnerable to liquidity runs.  So again there is a danger that if we were now to relax those standards we would take risks with future resilience, and if the market perceived this, we would produce a negative rather than positive effect on lending supply.

But while we were therefore wary of simply suspending or relaxing liquidity requirements on their own, we were also very aware that banks do not just hold the liquid asset buffers we require them to hold, but buffers in excess of that, buffers on buffers.  And that at first sight seems odd, because an increasing share of those buffers are held in Bank of England reserves which yield only 0.5% interest, but which could be lent out for a much higher rate. 

Why therefore do banks hold those buffers on top of buffers?  Well probably as a form of self-insurance – insurance against future possible ratings downgrades, insurance against the emergence of sudden market stresses which might push them below the FSA’s guidance levels, or below the levels that the market considers essential.

But these are risks against which a central bank can also provide insurance.  So the greater the degree of liquidity insurance provided by the Bank of England – the less essential it is for banks to self-insure.  That therefore created the possibility of an integrated policy response – the Bank of England announcing that it would provide additional liquidity assurance through the Extended Collateral Term Repo (ECTRO) facility: and the FPC reaching the judgement that in those circumstances it would be safe and appropriate for the FSA to do two things:

  • First to signal clearly to banks that if there are stresses they should be willing to use their liquid asset buffers even if they fall for the duration of the stress below our ‘normal times’ guidance. 
  • And second to take into account the degree of central bank liquidity insurance provided by the ECTRO, and by the discount window facility (DWF), in the precise terms of our individual bank liquidity guidance.

Together these actions should have some beneficial effect in facilitating lending: and our ability to design these integrated policies depended crucially on the creation of the Financial Policy Committee.

But even these integrated responses might prove insufficient in themselves to make a major difference to bank lending supply and thus to economic activity.  They may do so, however, when combined with another key innovation of public policy – the Funding-for-Lending scheme.

  • Under the scheme, the Bank of England stands ready to lend money at a lower than market interest rate to banks, provided the money is on lent to the UK real economy.  And with a carefully designed set of incentives to encourage them to do so.
  • In doing so, it is playing a more direct role in stimulating credit supply than has been considered appropriate for many decades.  And it is taking on credit risk (albeit carefully managed via the haircuts applied) which under a different scheme design, for instance that of the National Loan Guarantee Scheme, would have been taken on by the fiscal authority.

The package of measures announced over the last four weeks, thus involves a combination of policies which neither a fiscal, a monetary, nor a prudential authority – i.e. the government, the Bank of England, or the FSA – could have implemented on its own. 

And that illustrates a vitally important feature of optimal policy in the face of deflationary forces.

In the upswing of the cycle, there are reasonable arguments that different aspects of policy – for instance, monetary and macro-prudential policy – can be considered somewhat separately:monetary policy using the interest rate instrument to achieve an inflation target, while macro-prudential policy works through levers such as countercyclical capital to slow down a credit and asset price boom.

But in the downswing there is a danger that the effectiveness of any one policy instrument employed alone is constrained – that fiscal, monetary and macro-prudential policies, if not integrated with other aspects of policy, are all in different ways ‘pushing on a string’.

The FPC’s ability to consider policy options in an integrated fashion, taking into account central bank liquidity insurance when designing prudential liquidity policy, is therefore peculiarly important in deflationary times. 

And in deflationary times too the government’s proposed amendment to the FPC mandate – requiring it to support the objective of employment and growth – becomes particularly important.  It would be possible to achieve a resilient financial system within a perpetually slow growth economy – but as the Chancellor put it that would be ‘the stability of the graveyard’. 8

Faced with the risk of continued deflation, we need to think creatively about the combination of policy measures which will both aid economic recovery and help create a more stable future system. 

The package of measures announced over the last three weeks reflects the integrated approach required: but it is possible that further creative policy combinations will be needed as we observe the impact of these measures and learn more about the challenges of the deleveraging process.  We do not know precisely the balance between supply and demand factors in explaining the lack of credit growth; but since supply is certainly part of the story, it makes sense to use integrated policy to ease any supply constraints.  But over time, as we observe usage of the Funding for Lending Scheme, we will learn more about the supply/demand balance, and about whether the present package of measures is sufficient.

We should therefore remain open to the need for further forms of integration between aspects of policy formally kept quite separate. 

And in the longer term, we should keep under review the appropriate tools and modes of application of macro-prudential policy.  I have already mentioned the need for a debate on whether direct borrower constraints, such as LTV limits, should be part of the macro-prudential armoury.  The other issue worthy of debate is the relationship between the role of the FPC and the Independent Banking Commission’s recommendations on ring fencing.

The FPC will, following the Chancellor’s announcement, have an ancillary objective of ‘supporting growth and employment in the UK’.  And the tools we have available to support those objectives work primarily via bank balance sheets – ensuring their resilience and their ability to lend to the real economy.   But if we apply our policy tools at a group balance sheet level, then for the more global of our banks the link between our policy tools and UK economic activity is a relatively loose one.  If, for instance, through appropriate use of countercyclical capital tools, we ensure that our biggest banks have increased their capacity to lend safely, they may be as likely to lend more in the US or Asia, as in the UK. 

That poses the question as to whether macro prudential tools should be applied at the level of the ring fenced UK retail and commercial banks, which will emerge from the implementation of the Vicker's Commission recommendations, rather than, or as well as, at group level.  But that in turn may have implications for the range of activities which should ideally be included within the Vicker’s ring fence.  If we wish to encourage a steady rather than volatile supply of credit to UK SMEs, the best way forward may be to ensure that all SME lending is included within the ring fence and to apply macro prudential policy levers at that level.

All of which takes us far away from the pre-crisis conventional wisdom which lauded complex financial innovation and globalisation as the key to prosperity, and which rejected the idea that public policy should pay attention to the pace of credit growth or to asset price developments.  But then so too – indeed in some senses even more so – does the Funding for Lending scheme.  And the fact that we are now considering policy options far from the pre-crisis consensus, appropriately reflects two considerations:

  • First, the severe faults of that consensus, which led us into financial and economic calamity.
  • Second, the specific and severe challenges created by deleveraging and deflation.

1. See Adair Turner, ’Debt and Deleveraging: Long Term and Short Term Challenges’, Presidential Lecture at Centre for Financial Studies, Frankfurt, 21 November 2011.

2. Press Conference on Updates of the IMF’s World Economic Outlook, 16 July 2012.

3. Richard Koo’s ‘The Holy Grail of Macroeconomics: lessons from Japan’s Great Recession’..

4.Japanese debt to GDP is 230% on a gross debt basis and 127% on a net basis (after deducting Japanese government assets).

5.Bank of England Quarterly Bulletin, Q3 2011.

6. Record of the Monetary Policy Committee, 6-7 June 2012.

7.Financial Stability Report, June 2012, page 28.

8.Chancellor’s speech to the Mansion House, June 14 2012.

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