In June 2009, PricewaterhouseCoopers brought together a panel of senior central bankers from around the world for the sixth annual Central Bank Financial Reporting Working Group, which was held over two days at the Reform Club in London. Discussions amongst the group are open and are held under the ‘Chatham House’ rule. The meeting was a timely opportunity to reflect on the lessons of the financial crisis and discuss the way ahead for monetary and market supervision.[1]
As the financial system plunged into crisis, central banks were at the forefront of an emergency response that was eventually able to avert the danger of absolute collapse.
However, working group participants acknowledged that by allowing financial stability to take a back seat to inflation control, some central banks may have been too slow to anticipate and respond to the growing risk of systemic breakdown.
One of the invited keynote speakers noted that less than a quarter of central banks had an explicit objective to promote financial stability in the lead up to the crisis. Even where this objective was formally in place, it was often qualified (i.e. ‘contribute to’) or secondary (i.e. ‘supporting tasks pursued by others’).[2] This underlines the importance of central banks having clear objectives which are closely linked to financial stability.
[1] ‘Surviving the credit crunch’, the sixth annual gathering of the Central Bank Financial Reporting Working Group, was held at London’s Reform Club in June 2009. The working group report is available for view and download by visiting http://www.pwc.com/gx/en/banking-capital-markets/central-bank-advisory-group/index.jhtml. | [2] Based on analysis carried out by the Bank of International Settlements into whether ‘financial stability’ or equivalent was specified in the objectives of 146 central banks. | [3] Daily Telegraph letters page – 11.05.09.
Although this hypothesis is clearly open to question, what is certain is that the recent turmoil has cast central banks into the spotlight and that governments will now not only use them to remedy such a crisis, but also may expect them to do more to avert similar events in the future.
Working group participants recognised the need for a renewed focus on the safety of the financial system, both through tighter market supervision and greater recognition of the links between monetary policy and credit market stability. However, a number of participants believe this may be easier said than done, arguing that financial stability is a far less clear-cut concept than fixed inflation targets and other such monetary goals. In particular, what different parties interpret as ‘financial stability’ may vary markedly. Clear ‘labelling’ of a central bank’s objectives and the tools at its disposal to make this possible would help to ensure that it does not create false expectations about what it can and cannot do.
Naturally, central banks also need appropriate authority to enforce their will, although, as several participants noted, many governments and central banks do not see eye to eye over how far this should go. This echoes concerns voiced by Mervyn King, Governor of the Bank of England (BoE), in his Mansion House Speech of June 2009, about what he sees as the lack of sufficient powers to support the BoE’s new statutory role as guardian of financial stability. ‘The Bank finds itself in a position rather like that of a church whose congregation attends weddings and burials but ignores the sermons in between,’ said Mr King. ‘Warnings are unlikely to be effective when people are being asked to change behaviour which seems to be highly profitable. We need instruments to prevent the size, leverage, fragility and risk of the financial system from becoming too big.’[4] Others fear that central banks could become too powerful; there are even moves in the US Congress to subject Federal Reserve Bank decisions to legislative audit as a result of such concerns.
[4] Mervyn King, Governor of the Bank of England, addressing the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House – 17.06.09.
However, others questioned whether already overstretched central banks could cope with additional responsibilities or whether key areas such as consumer protection would be submerged within a ‘super regulator’ and would therefore be better dealt with by a dedicated authority. Within many commercial banks, there are obvious misgivings about what they see as needless change and disruption at this already challenging time.
For example, in the UK, some commentators have questioned whether bringing the operations of the UK Financial Services Authority (FSA) under the umbrella of the Bank of England would simply result in the same personnel carrying out the same jobs but under a new ‘banner’.
A further impact of the financial crisis is the renewed primacy of national governments over supra-national regulators. This is highlighted by the fact that certain groups had to be broken up into their national constituent parts before being rescued. This underlines what a working group participant described as the ‘golden rule’ – those with the gold make the rules. As the treasure chests are in the keep of national governments, they will be the ultimate rule-making authority within the banking industry for some time to come.
[5] Reuters – 24.06.09
As the divergence of views expressed at the working group highlighted, there is still much to be decided on the future of banking supervision and many countries are moving in different directions. The future course of regulation is therefore likely to be as uncertain and turbulent as the market situation, and banks will need to anticipate the possible changes ahead, how these are likely to vary from country to country and how they will affect their business model. Just as the collapse of inter-bank lending has put paid to a number of wholesale funding-dependent models, some institutions may find that certain products and market strategies are no longer viable under a more rigorous and nationally controlled regulatory environment. The most successful institutions will be those best able to assess the impact of, and plan how to adapt to, a variety of possible scenarios.
Among the specific considerations discussed at the working group were higher capital charges (some of which may be designed to address pro-cyclicality), closer attention to the prudent pricing of risk, and curbs on any policies that could encourage financial recklessness, such as short-term volume-related bonuses. As part of the move from micro- to macro-supervision, many banks may also be required to comply with a market-wide capital ratio, reversing the trend towards the own risk assessment of capital requirements seen in previous years.
Some supervisors may insist that certain functions such as treasury management are decentralised to avoid funds being tied up in a single location. The UK FSA has set a further precedent by expecting all banks to hold an appropriate level of operating cash to cover short-term liabilities, which could tie up a huge level of funds if others follow suit. The working group discussions also raised the possibility that groups deemed ‘too big to fail’ should be broken up, though some participants countered that there is a growing risk that some banks have moved from being too big to fail to being too big to save. The collapse of a bank like Lehmans can be absorbed within a large market, it was argued, but would be calamitous if it were to have had a significant operation in a small country.
Supervisors and investors are also demanding greater transparency from commercial banks, though whether this openness should stretch to information relating to central bank intervention (‘market support activities’) was a source of considerable debate among working group participants. The glare of publicity may accelerate a potential run on a bank. It could also discourage banks from seeking help until it is possibly too late as they are scared of the stigma. Supporters of transparency countered that problems will soon become public one way or another, especially given the heightened level of scrutiny of banks’ health, and therefore the key issue is how to manage communication rather than avoid it.
A keynote speaker at the working group went further by arguing that directing stimulus funding towards banks may be largely futile. He believes that buying debt from banks, which was the focus of initial quantitative easing in many countries, repeated mistakes made during the Japanese slump of the 1990s, as its impact on lending is limited by the size of the maturing debt, and the fact that capital constraints may still discourage banks from lending. He argued that it is more effective to buy debt from non-banks, as this is unlimited in scope and injects liquidity directly into the productive economy.
Although working group participants agreed that public funds are still likely to be made available to commercial banks, institutions will face increasing pressure to justify the support by stepping up lending to small businesses and consumers. If they do not, the public money may dry up, or be withdrawn and diverted to other sources. Initial signs of a tougher line include a recent threat by the BoE to follow Sweden’s lead by reducing the interest paid on commercial bank funds held at the Bank. However, if commercial banks do expand lending, their credit risks will inevitably increase. They may also face political pressure to keep credit prices low to encourage economic activity, which will slow the pace of revenue growth. The underlying challenge will be balancing the need to restore profitability with the expectations of being a responsible corporate citizen.
Working group discussions centred on the difficult balancing act for central banks as they seek to control inflation and sustain the recovery. Their dilemmas could increase still further if governments succumb to the temptation to inflate their way out of debt.
The job of a good central banker has been described as ‘taking away the punch bowl before the party gets out of hand’. Working group participants discussed the notion put forward by some commentators that central banks and their colleagues in other supervisory bodies were too slow to call time on the financial party, with disastrous results. Averting a repeat of the crisis will require clearer objectives and greater co-operation between the various arms of government and regulation, though the corollary is likely to be increased political influence and greater media scrutiny of how banks are supervised and bankers remunerated.
For central banks, moving from the relative autonomy of setting monetary policy to the more collaborative field of financial stability is likely to require a re-think of governance and policy making. In turn, commercial banks will need to take account of the likely changes to the regulatory framework and be flexible in adapting their business model. There is already a trend towards more traditional forms of banking, eschewing the complex structured financial products for more straightforward business.
Key considerations include the impact on the cost of capital, capital management and capital efficiency; and the requirement to maintain a prudent level of liquid funding. They also need to look at how having ‘government in the tent’ (in various roles as shareholder, regulator or Board representative) will affect their ability to sustain growth and create wealth.
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