Till Time's Last Sand

by David Kynaston

  The governor would continue to put forward these and similar arguments to the Treasury Committee on future occasions, while to The Times in 2012 he wondered aloud whether anyway the Bank pre-crisis would have been able to use interventionist, risk-reducing powers even if it had possessed them: ‘My guess is that that would have produced a chorus of complaints from banks, politicians and, dare I say, even the media about trying to restrain the extent to which our most successful industry wanted to expand.’ After leaving the Bank, he still reflected on the pre-crisis period. ‘Did anyone try to link what was happening in CDO [collateralised debt obligations] land to the macroeconomy? With hindsight, the answer is not enough,’ King observed to Gillian Tett for her 2015 book The Silo Effect. ‘But the question is what follows from that? It was not because people were not studying CDOs … [But] there were too many people focused on detail and there was so much paper produced that it was impossible to see the woods for the trees.’ And he went on: ‘Most public sector institutions suffer from the problem of an excess of bright young people and too few experienced people with the ability and perspective to see what detail matters and what does not. Our biggest problem with analysis was the difficulty in persuading young people to see the big picture and their managers to draw out the big picture.’

  The other main internal defence-cum-explanation came from a rising younger colleague, Andrew (Andy) Haldane, by 2010 executive director for financial stability. Speaking that year to Central Banking’s Robert Pringle, he claimed that the Bank’s pre-crisis reports (first in the Financial Stability Review, then in the Financial Stability Report) ‘did a reasonable job of identifying the key financial fault lines’, and he continued:

  At the Bank we even tried to quantify the impact of those fault lines using, at the time, a relatively untested approach – aggregate, system-wide stress tests. The estimated losses were large enough to chew up a chunk of the banking system’s capital. But, individually, those fault lines did not appear to be life-threatening for the global financial system.

  So what went wrong?

  Two things. First, the authorities perhaps discounted too easily the possibility of these fault lines being exposed if not simultaneously then at least sequentially. In the financial system, everything and everyone is connected. Those holding subprime securities also had exposures to various financial vehicles: structured investment vehicles, collateralised debt obligations, monolines and various other nasties. This interconnection across assets, institutions and countries is one reason Lehman’s failure [in 2008] brought the entire globe down to earth with a bump at precisely the same time.

  Given this interconnectivity, the probability of simultaneous financial earthquakes is many times greater than if you simply multiplied their individual probabilities together. Cumulative pre-crisis losses of many of these financial earthquakes would have been life-threatening for the world’s banking system. For UK banks at the end of 2006, the Bank’s Financial Stability Report stress test estimated total losses in the region of £100 billion. We had the analysis, and even the numbers, roughly right. But pre-crisis, they were viewed through too rose-tinted a lens.

  Second, even if we had had the right lens, this would probably not have altered the course of the crisis. The Bank, and others, spoke with increasing forcefulness about potential stresses in the system from 2003 onwards. We were dogs barking at the passing traffic. As the cars drove past at increasing speed, these barks grew louder. The drivers of some of the cars took notice, but they did not slow down. Why? Because they knew the dog’s bark was worse than its bite.

  What was needed in this situation was someone to slow the traffic, all of the traffic, for the game being played was a collective mania. These manias are founded on a desire to keep one step ahead of the opposition. This results in a race to the bottom which, although individually rational, is collectively calamitous.

  His insightful analysis might also have mentioned the sheer scale of derivative instruments in the system, seemingly impossible for the authorities to do anything about and making it very difficult to assess a bank’s true financial state. In any case, what, he asked rhetorically, was ‘the solution’? The answer to Haldane was clear: ‘A watchdog with teeth.’10

  Prior to summer 2007, the Bank’s three loudest barking dogs were Andrew Large, his successor Sir John Gieve (coming, like Rachel Lomax before him, from Whitehall) and Paul Tucker. Speaking at the LSE in January 2004, Large warned about the financial system’s increasingly dangerous ‘opacity’ – the consequence ‘of the sheer complexity, speed of movement of risks, and in some cases obfuscation through Special Purpose Vehicles, or other off-balance sheet devices’. He went on: ‘The existence of new concentrations of risk might not matter if their new holders are fully aware of the risk. But new holders of such risk may not have the same understandings of what the risks consist of, as those who generate them. And accordingly they may behave in unexpected ways when shocks arise.’ Similar speeches and warnings followed over the next two years before Large left the Bank early, in January 2006. Shortly before doing so, he not only rang the Daily Mail’s Alex Brummer to (in Brummer’s words) ‘express concern that banks, given the volume of transactions in which they were now involved as well as the complexity of the transactions, did not hold enough liquidity in the event of a swing in mood in the credit markets or an unexpected calamity’; but he also wrote a piece for Central Banking about his growing anxiety that, behind the ‘benign exterior’ of the current ‘financial and economic environment’, there were ‘vulnerabilities mounting’ that might ‘one day crystallise when a bigger shock arrives that the market simply cannot absorb’, not least because of the increasing concentration of banking firms – and therefore risks – in the global financial system. Gieve’s main warning came at a July 2006 roundtable at the Centre for the Study of Financial Innovation. Vulnerabilities that he identified, potentially amounting to systemic risk, included new products like structured credit derivatives (‘we simply do not have experience of how they behave in the full range of market conditions’), rising competition between financial firms to establish positions in new and fast-growing markets (‘the business risk not just of losing profits this year but of being left behind in the longer term by competitors looms large at the moment’), ill-conceived bonus structures (‘rewards from generating “excess returns” far outstrip the penalties for poor performance’), and the way in which ‘the more aggressively management pursues short-term shareholder value in the form of rates of return on equity, the greater the motivation to build leverage to meet its targets’.

  As for Tucker, the part of his December 2006 lecture at the Honourable Artillery Company where he focused on broad money growth included the revelation that almost half that recent growth ‘is accounted for by the money holdings of so-called Other Financial Corporations’; while four months later, addressing a Merrill Lynch conference, he sought to unpick what ‘Other Financial Corporations’ really meant:

  The key intermediaries [in finance] are no longer just banks, securities dealers, insurance companies, mutual funds and pension funds. They include hedge funds of course, but also Collateralised Debt Obligations, specialist Monoline Financial Guarantors, Credit Derivative Product Companies, Structured Investment Vehicles, Commercial Paper conduits, Leverage Buyout Funds – and on and on … SIVs may hold monoline-wrapped AAA-tranches of CDOs, which may hold tranches of other CDOs … and hold LBO debt of all types as well as asset-backed securities bundling together household loans …

  All these other-worldly terms and acronyms would soon become all too familiar; but in April 2007 this was pretty much terra incognita to the great majority of journalists and economists, not to mention central bankers. And as Tett would reflect in 2015, the reports of Tucker’s speech – which also dealt with such relatively straightforward matters as the housing market, inflation trends and interest rates – almost entirely missed that crucial dimension.11

  What about King himself? The gover
nor’s annual set-piece speech had long been at the lord mayor’s dinner for the merchants and bankers of the City of London, traditionally held in the autumn but from 1993 in June; and at the last one (as it turned out) before the crisis, on 20 June 2007, he gave – unlike in previous Mansion House speeches – full-frontal treatment to the stability or otherwise of the financial system. After he had explained how securitisation had been ‘a positive development’ because it had ‘reduced the market failure associated with traditional banking’, in other words ‘the mismatch between illiquid assets and liquid liabilities’, his central passage – giving rise at the time to some audible disapproval from parts of the audience – would become over the years much quoted:

  But the historical model is only a partial description of banking today. New and ever more complex financial instruments create different risks. Exotic instruments are now issued for which the distribution of returns is considerably more complicated than that on the basic loans underlying them. A standard collateralised debt obligation divides the risk and return of a portfolio of bonds, or credit default swaps, into tranches. But what is known as a CDO-squared instrument invests in tranches of CDOs. It has a distribution of returns which is highly sensitive to small changes in the correlations of underlying returns which we do not understand with any great precision. The risk of the entire return being wiped out can be much greater than on simpler instruments. Higher returns come at the expense of higher risk.

  Whether in banking, reinsurance or portfolio management, risk assessment is a matter of judgement as much as quantitative analysis. Ever more complex instruments are designed almost every day. Some of the important risks that could affect all instruments – from terrorist attacks, invasion of computer systems, or even the consequences of a flu pandemic – are almost impossible to quantify, and past experience offers little guide.

  Be cautious about how much you borrow is not a bad maxim for each and every one of us here tonight …

  The development of complex financial instruments and the spate of loan arrangements without traditional covenants suggest another maxim: be cautious about how much you lend, especially when you know rather little about the activities of the borrower. It may say champagne – AAA – on the label of an increasing number of structured credit instruments. But by the time investors get to what’s left in the bottle, it could taste rather flat. Assessing the effective degree of leverage in an ever-changing financial system is far from straightforward, and the liquidity of the markets in complex instruments, especially in conditions when many players would be trying to reduce the leverage of their portfolios at the same time, is unpredictable.

  ‘Excessive leverage is the common theme of many financial crises of the past,’ concluded King. ‘Are we really so much cleverer than the financiers of the past?’

  Yet, whether from the governor or his colleagues, the barking was sometimes muffled, sometimes absent. Take half a dozen moments from the year or so before the crisis broke. In July 2006 the Bank’s Financial Stability Report (FSR) noted that ‘the UK financial system as a whole has been remarkably resilient over recent years’; and it added that ‘several structural developments have helped improve that over time, including high profits and capital, continued improvements in risk management and more sophisticated ways of distributing risk’. Two months later, in the course of an interview with the Banker in which he mentioned that the gathering of market intelligence absorbed up to a third of his time (‘the MPC obviously takes priority over everything else’), Tucker made positive noises about the risk-reducing potential of new products and the arrival of new market participants – ‘there is no doubt that hedge funds and leveraged players can offer a positive dynamic’ – before emphasising that he was not losing sleep over fears that the credit markets were over-extended: ‘Some people say that, at some point, those chickens must come home to roost in the form of defaults. That may well be true but there are now many more distressed funds out there to help absorb the situation … The truth is, it is impossible to predict. Global capital markets have changed a lot in the past 10 years.’ The following spring, the April 2007 FSR began with the most reassuring of statements – ‘the UK financial system remains highly resilient’ – and although it observed that since 2000 the balance sheets of large financial institutions had more than doubled, it failed to go on to urge that banks should significantly reduce those balance sheets and thereby their vulnerability to shocks, not least if the inter-bank market (for wholesale lending and borrowing) suddenly dried up. That same month, Tucker in his speech at the Merrill Lynch conference did indeed try to chart the murky world of what he called ‘vehicular finance’, in which risk was transferred beyond banks; but he confessed himself ‘not so sure’ as to whether ‘the variety of vehicles and their use of risk transfer instruments’ was necessarily ‘a bad thing’, leaving his listeners with the cautious prediction that ‘in ten years’ time … we may be better informed on whether the changes in the structure of our financial markets help or hinder the preservation of stability’.

  The penultimate moment came on 11 July, when Haldane introduced to the Court’s committee of non-executive directors (NedCo) a paper on the Bank’s ‘restructured approach to its financial stability work’ – ‘aimed at providing a more analytical and rigorous approach to risk assessment’ and involving a set of carefully targeted modelling techniques. ‘In relation to the collaborative modelling work with commercial banks,’ recorded the minutes, ‘it was asked if the approach had revealed different insights about risks in the financial system. In response, it was highlighted that the work was at an early stage and there was considerable diversity in existing practices. It had not identified any looming gaps.’ Finally, there was the Inflation Report press conference of 8 August. A few minutes after replying to Jennifer Ryan about credit-related concerns, King took a question from the BBC’s Stephanie Flanders. ‘Is the greater complexity and international nature of financial instruments and the ways that risk is now being passed across the system,’ she asked, ‘making it harder for you to assess financial conditions here, liquidity conditions and indeed any systemic risk that might arise?’ ‘Yes and no,’ answered the governor:

  Yes, because I think as I said in the Mansion House speech, a common theme in many financial crises in the past was excessive leverage. And it’s not entirely easy to work out precisely how much leverage there is in the financial system when the instruments have become so complicated. And the fragility of institutions becomes much more difficult to judge.

  But I think against that it is very important to set a very, very key point here, which is that our banking system is much more resilient than in the past. Precisely because many of these risks are no longer on their balance sheets but have been sold off to people willing and probably more able to bear it.

  Now some have always had a preference for a banking system in which all the risks are concentrated there. But I think then you create extraordinarily risky institutions with highly illiquid assets in the form of loans to households and medium-sized business, matched by highly illiquid liabilities. And that’s a very risky system …

  We don’t have a system that is as fragile as that now. The growth of securitisation has reduced that fragility significantly. So that’s a very big plus to set aside the difficulty that we face in trying to assess the degree of leverage both because of the complexity of instruments and the wider ownership of those instruments, but also because as you say it’s become much more international.

  And I think it’s quite difficult to imagine a major financial crisis now that would be relevant to us in a systemic sense that wouldn’t have a major international dimension. And that’s why both in international meetings but also in collaboration with our colleagues elsewhere we have tried to work together to think about how such a problem would be managed in exactly the same way that the Tripartite Standing Committee [Treasury, FSA and Bank] here has regularly carried out exercises to make sure that we are well equippe
d to co-operate and work together to manage any problems that might arise domestically.

  These press conferences were not a forum for debate or even follow-up questions, and no one pressed him further.12

  Irresistibly, one comes back to assumptions and mental parameters. Much would be said and written about the pre-crisis period – not all of it mindful that in history real-life people act and take decisions in real time – but one retrospective assessment had perhaps a particular resonance. It came from John Gieve, speaking four years after he had left the Bank in 2009, following a little over three years in charge of financial stability: ‘The big macro variables which we concentrated on, particularly inflation, were not sending signals of danger, and the truth is that we thought we had cracked it.’ And he added: ‘We were expecting a shower, not a hurricane.’ Few if any believed with more certainty that they had cracked it than the Bank’s new priesthood: the economists. ‘With focus comes clarity,’ an MPC external, Adam Posen, told Central Banking in the early summer of 2007 for a tenth-anniversary feature on independence. ‘Both internally and externally, the concentration of the Bank on its core role has given it greater authority to carry out its monetary policy mandate.’ Indeed, he went on to claim, the Bank’s ‘virtuous self-restraint’ in areas outside of monetary policy had ‘caused the rest of the government to raise its game’.13 No one is immune from wishful thinking; but events would soon prove that this was wishful thinking, almost certainly shared by his fellow-economists, on a heroic scale.