PrefBlog

Mr Paul Tucker, Deputy Governor of the Bank of England, made a speech at the Clare Distinguished Lecture in Economics, Cambridge, 18 February 2011 titled Discussion of Lord Turner’s lecture, “Reforming finance – are we being radical enough?”:

But none of what I have said makes a case for placing all of our eggs in the resolution basket. Switching metaphors, we need belt and braces. Which is why the G20 agreed that the so-called Global Systemically Important Financial Institutions (G-SIFIs) should carry greater loss absorbing capacity (or GLAC) than implied by Basel III.

First best would be equity. Indeed, Adair has argued this evening that ideally Basel 3 would have set a higher equity requirement. But that did not happen. In practice, we are going to have to be open-minded, but also principled, about quasi-equity instruments contributing to GLAC for SIFIs (sorry about the acronyms!). Currently, the leading candidate is so-called Contingent Capital bonds (CoCos), which convert from debt into equity in certain states of the world. It seems to me that to serve the purpose of GLAC for large and complex firms, such instruments would need to convert when a firm was still fundamentally sound, which is to say that they should have high capital triggers. For a large and complex firm, a low capital trigger would be dangerous, as funders and counterparties would be likely to flee before reaching the point at which the firm would be recapitalised through the CoCos’ conversion.

Moreover, high-trigger CoCos would presumably get converted not infrequently which, in terms of reducing myopia in capital markets, would have the merit of reminding holders and issuers about risks in banking.

Lord Turner’s speech discusses a particular hobby-horse of mine:

It is therefore crucial that our answers to the SIFI problem cover also the more difficult but more likely scenario of multiple bank systemic stress. And in such conditions, bail-inable bonds will only enable us to avoid the dilemma of Autumn 2008, if the following vital conditions are met:

• • If regulators could be confident that those bonds are held outside the banking system; and
• • in addition, confident that the bonds are held by investors who have so arranged their assets and liabilities that they could face the imposed losses without that in turn inducing systemic effects.

And it may be very difficult to be confident that those conditions we met.

There are two ways to gain that confidence – the first relies on empirical observation, the second on an assumption of fully informed investor rationality. Neither route may be entirely robust.

• • The first way to seek such confidence, would be for regulators to understand, or to regulate, which investors hold bank medium-term debt. Our information on this today is imperfect. We believe a significant proportion is initially held by other banks, and a larger proportion still by a broadly defined group of ‘fund managers’. (Slide 7). But ownership after secondary market trading could be significantly different. And some of these ‘fund managers’ may be in turn financed by banks (e.g. hedge funds by prime brokers), or linked to the banking system by complex repo and derivative relationship so that losses suffered by one bank, could indirectly impose losses or confidence shocks on others. And our ability to track these complex inter-connections, and as a result to predict the knock-on consequences of initial losses in conditions of systemic fragility is imperfect today and likely to remain so. We need to improve our understanding of the complex interconnections of our financial system: but it is unclear that understanding will ever be good enough for us confidently to impose large losses simultaneously on the senior debt of multiple large banks (or indeed multiple small banks), in conditions of macro-systemic stress.
• • The other route to confidence, would be based on faith in market and investor rationality, assuming axiomatically that investors who buy bail-inable bonds will only do so on the basis of rational assessments of their ability to absorb risks in all possible future states of the world, including those of macroeconomic stress. As Section 3 will discuss, this axiomatic assumption was at the core of the pre-crisis conventional wisdom, the reason why public authorities thought they could sleep easy in the face of an explosive growth in financial scale, complexity and interconnectedness. But it relies on an assumption of fully informed rationality, which may be simply untrue, and indeed impossible. For as Andrei Shleifer et al (2010) have argued in an extremely perceptive recent paper, it may be inherent to human nature that in the good times investors systematically fail to take rational account of the tail of low probability adverse events.

A bail-inable bond will have a highly skewed probability distribution of pay-outs. (Slide 8 ) Over a long period of time, only the zero-loss segment of the distribution will be observed. A low probability of significant loss continues to exist, but Gennaioli, Shleifer and Vishay argue that that low probability will be wholly discounted through a behavioural process which they label ‘local thinking’ – the reality, deeply rooted in human nature, that not all contingencies are represented in decision makers’ thought processes. After a period of good times, investors will assume that senior bank debt is effectively risk-free: as indeed they did, in the years before the crisis (Slide 9). Regulators cannot therefore rely on free-market discipline to ensure that the debt is only held by investors who can suffer loss without that causing knock-on systemic disruption.

If therefore we can neither perfectly and continuously monitor or regulate who owns bail-inable debt, nor rely on free-market discipline to ensure that it is always appropriately held, contractually bail-inable debt and technical resolvability will be valuable but still imperfect solutions to the ‘too big to fail’ problem. We can only be sure that losses can be smoothly absorbed if we are sure that the investors who provide funds do not suffer from ‘local thinking’ but remain perpetually aware of the full distribution of possible results. Subordinated debt which can convert to equity well before potential failure (‘early trigger CoCos’) may approach what is required since the price will presumably vary with probabilistic expectations of future conversion. But only with pure equity can we be fully confident that the dangers of ‘local thinking’ will not creep in over time, and that investors, facing day-by-day price movements up and down will remain continually aware that they hold a potentially loss absorbing instrument. The implication of Shleifer’s ‘local thinking’ theory is that if investors are to remain continuously aware of the full frequency distribution of objectively possible results the observed frequency distribution of returns needs to include negatives and well as positives. This is achieved by equity returns but not by low risk debt.

OSFI, in its infinite wisdom, is going in entirely the opposite direction: the lowest possible conversion triggers for CoCos, and seeking to include CoCos in the regular bond indices so that investors will be fooled into buying them.

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