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After giving brief (and staggering) estimates of the costs of the global financial crisis, Andrew Haldane identified the systemic risk which triggered the collapse as having two root causes: 1) the credit cycle and 2) institutions that had been allowed to become 'too-big-to-fail' (TBTF).

 

The first problem is conjunctural, the second structural. They combined in particularly devastating fashion to cause the crisis, with the latter problem amplifying the former. Ireland is as good a case study as can be found of the interaction of these two factors, but the UK, Iceland, the US and others in their own way exemplify the problem.

 

Historically, the credit cycle is just as regular as the business/output cycle, only higher in amplitude and over a longer timescale. Asset price cycles are bigger still. Throughout history, booms and busts in these credit and asset price cycles have foretold of impending (banking or exchange rate) crises.

 

Behaviourally, credit cycles are rooted in copy-cat competition among financial actors. Crucially, this competition, and consequently the credit cycle, has become increasingly international, generating a dangerously large collective mania.

 

Moving from the first to the second root cause, Mr Haldane demonstrated that credit growth in recent years has been driven by the biggest banks, and that much of the new lending occured only within the financial sector itself.

 

Flows of funds within the banking system and between national systems increased hugely from the mid-80s until the mid-00s. So did the average size of banks relative to their home economies, and the concentration of assets into a top tier of superbanks.

 

Meanwhile (and over a longer timescale), banks have become far more highly leveraged on one side of their balance sheet and their stock of assets far less liquid on the other.

 

A financial system that is big, concentrated, interconnected, debt-propelled, and increasingly illiquid will inevitably suffer crises. The consequence in this case was not just crisis, but a massive bailing out of banks by taxpayers.

 

***

 

Mr Haldane next considered how much of an implicit subsidy was being provided by governments to banks ahead of and during the crisis. As an example, the implicit subsidy to British banks in 2009 was £100 billion, roughly the same amount that is required to run the UK's national health service. Within that figure, the lion's share is reserved for the biggest banks, because they know that government will have to step in to help them if they get into serious trouble.

 

All of this adds up to what Haldane has called a 'doom loop' – an evolutionary equilibrium whereby size, leverage, illiquidity and concentration generates a crisis; government is forced to ride to the rescue and provide a safety net; thus giving rise to misaligned incentives and moral hazard; thereby encouraging the biggest banks to become even bigger, more debt-propelled, illiquid, and interconnected.

 

Next time, the moral hazard is amplified.

 

So the dangerous aspect of credit cycles becomes amplified rather than tempered by the structure of banking. But rather than learn from this crisis and adapt, the structure of banking has if anything gone in the wrong direction since. This is a gloomy prognosis, the severity of which should impel a robust policy response.

 

There are two key dimensions to an appropriate  response:

 

1) Micro-prudential

2) Macro-prudential

 

 

The micro-prudential response is familiar. Embodied in the Basel III agreement, the solution proffered is 'more of the same, but better'. So:

This is certainly progress, but is it sufficient? If we try to reconsider and evaluate the Basel basics, the benchmarks should be the complexity, robustness and timeliness of rules. By these measures the existing framework falls somewhat short. Basel is exceedingly complicated. Many of the best-capitalised banks failed. And it did not provide much by way of warning of impending doom.

 

If not this then what? It is worth considering the introduction of an instrument on banks' balance sheets that would be both simpler and offer more timely warning if the institution is heading for trouble. One such instrument is the 'CoCo' (Contingent Convertible) Security.

 

When a bank runs into the buffers, the CoCo as a debt instrument converts into equity, automatically recapitalising the firm. Crucially, the trigger for conversion is based not on regulatory ratios but on the market price of the CoCo. So corrective action is guaranteed and quasi-automatic.

 

An obvious question is: where would the demand for CoCos come from?

 

One answer is that a bank could create demand by distributing them to shareholders and staff instead of cash dividends or bonuses. This does two things: 1) it keeps money in the business, thus boosting capital ratios and making the bank more resilient. 2) It aligns incentives. The payoff profile of CoCos means that shareholders and staff would share in the downside as well as the upside risks of the business.

 

 

The macro-prudential dimension is relatively new. It aims to tackle the credit cycle and too-big-to-fail problems head on. A new institutional apparatus of macro-prudential surveillance is currently being installed (see for example: the FSOC in the US, the ESRB in the EU, and the FPC in the UK).

 

These bodies hope to lessen the fluctuations in the credit cycle by, for example, installing counter-cyclical capital ratios (Basel III), demanding counter-cyclical risk weights where there is evidence of 'sectoral exuberance', or applying loan-to-value rules, such as many Asian authorities are using, which limit the volume of loans to a certain multiple of the value of property market.

 

They hope to address the TBTF issue in a number of ways. These include: asking the biggest banks to hold more capital because of the higher systemic risk they pose; creating instruments that would 'bail-in' private investors in emergency situations rather than taxpayers; building resolution regimes ('living wills') that preserve performing parts of institutions while allowing other parts to be wound down; and fundamentally reviewing the structure and industrial organisation of the financial system itself.

 

***

 

In conclusion, Mr Haldane argued that the world simply cannot afford another crisis of the magnitude of what we have just witnessed. So fundamental and far-reaching reform is required. There has been – and continues to be – progress, but much more is required if we are to break the 'doom loop' once and for all.