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82/09

18 September 2009

Speech by Paul Myners, Financial Services Secretary, Developing a new financial architecture: lessons learned from the crisis, at the Financial Times Global Finance Forum

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A year ago this week the world’s financial system faced its most dangerous moment in at least 70 years.  The collapse of Lehman Brothers made even the world’s oldest, most storied firms appear vulnerable. 

After watching Lehman collapse, the US Government was forced to prop up insurance giant AIG as it became clear the firm could not realistically honour its billions of dollars in obligations. 

Right across the globe, a spike in interbank lending rates and credit default swap prices arrested the flow of credit, further weakening already struggling banks.

Having stared into this abyss just a year ago, we should be pleased to be in attendance at an event that can reflect on the future of the financial system – 12 months ago it was not entirely clear it had much of a future at all.

But thinking about the future we are.  And as we do so it is remarkable to think about how far we have come since the dark days of last autumn. 

Our financial system – whether judged by the share prices of major banks or the flow of credit between institutions – is on a much stronger footing than many of us would have imagined, though far from where we need it to be.

In my comments today, I want to focus on how we have arrived at this point of relative calm and tentative stability, and what we have learned along the way.  The core of my message is that this crisis exposed a fundamental imbalance between the power of the financial system and its accountability for its actions. 

As banks fought for survival, we learned that their impact on the real economy – on workers, businesses, and households – was greater than most people had imagined.

But we also learned that that power of the financial system was not matched by responsibility for its actions, creating an accountability gap that has had to be filled by taxpayers across the globe.

A strong, independent, and commercial banking system must be our goal for the future. But as we rebuild the architecture of our global financial system, the task of rebalancing the power and accountability of the sector must define our efforts. 

To understand this task, we first need to renew our understanding of the basic function of finance in society and the economy.  The financial sector must profit by enabling the ambitions of the economy, not by dictating its direction.

Second, we need to reflect on the failures of both regulation and market discipline in keeping the financial system safe and focused on its long-term health. 

The Government’s commitment to regulatory reform is real and no one should be in doubt that change is coming.  But nor should anyone in the sector think that government alone will be able to drive the change we need – the time for owners, governors, and managers of firms to show leadership has well and truly arrived. 

We need to reaffirm our understanding of the role of finance in society and in our economy.

We know that a strong finance system is critical for growth. But it is too simplistic to talk about ‘providers of capital’ and ‘the financial services industry’ as if these were discrete entities that can be tidily analysed.  These days financial services companies do so much more than simply provide capital. 

In reality, the ‘providers of capital’ captures every member of society with a savings account or a pension. These individuals are connected, through a chain of relationships between financial services specialists, with businesses that receive capital for investments and growth.

It is the efficiency of this network that will determine whether or not recent events recur in the future. If the interests of those at the bottom of the chain don’t factor in the decisions made by those at the top, the system is inherently weakened. 

If we are to align the interests of users and participants in the sector, we need to go right back to basics and reiterate the industry’s fundamental role.

The financial services industry performs a function critical to the social and economic wellbeing of the nation; it provides businesses and households with the finance they need to make investments in their future. In return for this service, providers of capital expect a return on their investment.

At the heart of the function lies the management of risk: providers of capital must expertly assess investment opportunities to balance likely returns with the risks of an adverse outcome.

The fundamental role of any country’s financial sector is, therefore, to manage the allocation of two scarce economic resources; capital and entrepreneurship – that is, the ability to assess, take and manage risk.

Risks have become increasingly complex, opaque and inter-linked; and it is now clear that the assessment and management of risk by financial institutions failed.

The results have been seen throughout the world. Without government action, the impact would have been far worse.

The recapitalisation of the banks, the creation of UKFI, the launch of the credit guarantee and asset protection schemes, the offering of additional liquidity support, assertive monetary policy and the creation of a lending panel were all crucial steps in shoring up the UK finance industry, and protecting the wider economy from the shocks of the global financial crisis.

But the impact of the financial sector crisis remain; we can see the effects not only on the financial services industry, but on closely allied industries – on professional services, on shipping and construction.

We can see the impact on workers, consumers and homeowners. We can see that what happens in the financial services sectors is inexorably linked to the real economy, and whilst the rescue of the banking sector was necessary to prevent systemic collapse, it has come at a cost to the public.

We have learned hard lessons from the crisis.

Firstly, we have learned that there were systematic flaws in the operation and regulation of our financial services markets.

We have learned that within the financial service system, neither regulation nor market discipline managed to keep pace with developments in the global finance industry.

Major changes are now needed to the way firms manage risks, to the quantity and quality of capital they hold, and to the way regulators monitor firms, so that we can return to the fair, efficient and stable financial markets which play their part in supporting economic growth and prosperity.

Secondly, we have learned that there has been a mismatch of risks and rewards, benefits and losses. The taxpayer is bearing the risks created by private industry, created through complex casino trading and a pursuit of short-term gain. 

Thirdly, we have learned that the challenges we face are much broader than just making sure we get things right in the UK.

The lead-up to the crisis, and the dramatic events of last year, demonstrated the extent to which risks in one segment of the global financial system can quickly spread to other countries, with monetary and fiscal consequences for authorities and citizens beyond the jurisdiction where the problem originated.

We have seen what happens when risks become too great and trust disappears. As Government, as industry and as regulators we need to work together to restore that trust and rebuild the financial services sector.

As a first step in this process, the industry itself must acknowledge that the values and ethics which drive its business must be built on the values and ethics of wider society. 

Behaviour that would be judged as reckless and self-serving on the High Street must not be rationalised as acceptable on the trading floors of the City. 

Corporate leaders in the global financial sector have begun to talk about addressing moral failures and that is to be welcomed. 

But it’s time to move beyond sound bites and to start hearing how they intend to drive moral reform within their institutions. 

The banks need to understand that they have lost the trust of the public, and need to change their behaviours and values in order to earn forgiveness.

The second step in restoring trust will be taking every reasonable step we can to assure the public that they will not again be asked to finance a sweeping rescue of the sector. 

It had been argued that financial institutions have effectively been subsidised by an implied guarantee from the Government for a long time.  This moral hazard in the banking sector is a risk to our economy.

Banks must not in the future be allowed to overextend themselves in the knowledge that their risks will be borne by the state.

Without action to strengthen systematically significant banks, we will find ourselves with yet more ‘too big to fail’ problems.

If we are to rebuild trust in our institutions and rebuild stability of the financial system, we need to reform the rules and regulations governing markets, and need to be on the front-foot in identifying and dealing with issues.

The Government’s recent paper “Reforming financial markets” sets out the measures that we believe are necessary to monitor and manage risk prudentially, to provide greater protection for consumers and taxpayers if and when institutions to fail. 

These are complex issues, but there should be no doubt that the regulation of financial institutions will be tougher in future. 

The Government’s resolve here should not be questioned – focused legislation later this year will be just one part of our efforts.

As well as taking a more intrusive approach to regulating individual firms, our regulators need to take a system-wide approach, recognising that institutions operate in a complex, inter-linked environment.

Lord Turner is right about the need to “shift from focusing primarily on the regulation of individual institutions, to combining this with a strong focus on the overall system and on the management of systemic risks across the economic cycle”.

We will introduce an explicit financial stability objective for the FSA; and give the FSA an explicit duty to have regard to systemic stability and the need to work internationally.

Alongside this, the new Council for Financial Stability (CFS) will provide the UK Authorities with a better mechanism to analyse emerging risks to the financial stability of the UK’s economy, and coordinate the appropriate response. The public will be able to draw confidence from the publication of the minutes of these meetings.

The 2009 Banking Act gives us a more effective system for unwinding banks in the event of their failure.

But I am clear that we need to do more and we must act now. Firms that are systemic, and that will cost more to resolve in times of failure, should be supervised and regulated more intensively.

This will mean higher capital requirements, and tougher standards of liquidity than for smaller firms.

The Chancellor has talked this week about planned legislation that will require banks to draw up “living wills”, resolution plans to facilitate wind-down without exposing the tax-payer to yet more risk.

In fact, these are less ‘living wills’ than examples of ‘prestructured euthanasia’.  Every large institution will have to have an in-house ‘undertaker’ taking custody of the process, keeping it current, fully advised of any proposed action which needs to conform.

This will change the structure of some banking groups; slim-lining structures and reducing complexity.

Much work remains to be done.  But our emerging view is that living wills will become key elements of the FSA risk assessment framework and prudential supervisory processes. 

What will these living wills look like? Again, these are complex issues that will require detailed work.  But let me outline some of our thinking.

At the core is a plan that will allow the authorities to resolve a bank quickly in the case of it getting in to difficulty – essentially a blueprint for resolution.
 
But there are also elements either side of the actual resolution.  Banks will have to produce clear plans as part of their living wills of how to reorganise or de-risk, should the institution get in to difficulty – essentially preparing for resolution.

Finally, there is the question of what happens after resolution – a living will would also contain a plan for orderly wind-down of the residual elements of a bank once the deposit book has been resolved. 

This, in outline, is what a living will will look like.  And we will be taking action, including legal powers where necessary, to ensure the FSA is equipped to insist on the implementation of these living wills.

The UK is leading this debate and we are working internationally, through the FSB and other fora, to ensure that other jurisdictions introduce similar plans from their banking sectors. But we do not need to await the action of others.

Critics have already started attacking these plans, complaining that the changes living wills will bring will be expensive and time consuming.

Let me assure these critics that this Government does not support regulation for regulation’s sake, but also remind you that the costs you will face in implementing resolution plans will pale in comparison to the costs faced by the taxpayer in rescuing the sector. 

As the Chancellor has said, banks must be structured for their safety and their long-term success, not for tax, regulatory arbitrage or any other short-term purposes.

The Government has rightly intervened in the recent past to save failing banks and support the banking system.

But we will not implement a regime in this country which wholly eradicates the risk of institutions failing, and the measures described will help to ensure that fewer systemically important institutions can fail, and that when they do, they can be wound up with minimal cost to the taxpayer and damage to the economy.

The Government is taking tough action to restore the integrity of our markets, improve transparency and reduce the burden on the taxpayer.

But our efforts alone will not be enough. Every part of financial services ecology needs to take seriously their responsibilities to create and promote long-term, sustainable value. 

Regulation alone will never be enough – good companies with credible strategies and effective boards do not fail as a result of regulatory shortcomings. 

It is critical that we have effective corporate governance – failures of corporate governance were after all a material contributor to the financial crisis.

Company directors must make decisions based on long-term performance considerations; investment managers must engage with the companies in which they invest and hold them to account when they fail to think long-term; shareholders, for instance pension fund trustees, must ensure that their managers are appropriately incentivised to engage and held to account when they don’t. 

Shareholders must take front-line responsibility for the companies in whose equity they have invested their client funds.

Shareholders have previously spoken of their concerns that there were structural impediments to effective engagement.

Therefore I welcome the recent announcements by the FSA and the Takeover Panel that their rules do not constitute an impediment to effective collaborative engagement by like-minded shareholders.

There is no structural or regulatory obstacle to the pursuit and delivery of effective stewardship. But does the will exist for shareholders and trustees to take seriously their fiduciary and legal responsibilities? Sir David Walker will have more to say on this.

Firms too need to show leadership if they are to regain the public’s trust. This applies to everyone in the governance chain, including banks and their boards.

It is time for banks to explain to the public what contributions justify the ever-growing rewards of derivatives traders, speculators and other inhabitants of the so-called casino end of the industry. 

Where those justifications cannot be easily made, tough questions need to be asked by boards and shareholders.

Also, directors and senior management need to take full and explicit responsibility for Risk. Walker is proposing a Board Risk Committee. Good. The challenge to put to the banks is they should not approve new products or engage in complex strategies without the fullest possible understanding of Risk and economic purpose. The government and the regulator cannot do that for them. Clearly that challenge was not always properly applied prior to the crisis.

For obvious reasons, the issue of remuneration is a sensitive one. For some the only answer is to ban bonuses outright, for others, a bank in a free market should be able to pay as it pleases. 

There is an irony in the labour market not working effectively at the heart of financial markets; the citadel of market efficiency.

Supply is not responding to pricing signals. If some activities like proprietary trading are so profitable, banks clearly have an economic incentive to participate, provided risks are properly controlled and regulation complied with. But why do banks appear to be allowing a disproportionate share of surplus to pass to employees?

Do these employees really have unique talents, or are they largely reliant on the banks' capital and franchise and the banks' knowledge, from order flow? Logically, the banks would 'institutionalise knowledge', and nurture pools of talent to reduce dependence on individual talent; writing it down and building bench strength.

And yet they do not appear to have done this. Derivative traders are not footballers with unique talents, and should not be paid as though they are. Bank owners, our pensions and savings, are possibly being short-changed by ineffective governance and stewardship.

And why do M&A bankers get so hugely rewarded? What skill do the members of this small elite community have which cannot be replicated by others? I suspect a great deal has to do with the authority of the investment bank’s brand – which begs the question why individual bankers frequently pocket 50 per cent or so of the fee charged by the bank to clients.

Some get bonuses in excess of £10million per annum (and not always for advising on transactions which deliver all they promise, as we have seen in banking sector transactions in recent years). Why hasn't the market mechanism adjusted pricing? What is frustrating a logical market response? If the market was working rationally, these rewards should have led to a sharp increase in supply and downwards pressure on margins.

These are not the only areas where market discipline doesn't appear to function at the heart of markets. Another example is equity underwriting or agency brokerage.

Let me be clear: the primary responsibility for achieving rational outcomes lies with directors and shareholders. They need to explain why they are not pressing much harder, for instance, on fees at M&A or the costs of underwriting.

For the Government, our focus in this area is on ensuring that bank remuneration is structured so that it rewards long-term value creation in an environment of rigorous risk control and regulatory compliance; not short-term and unsustainable illusory profit streams. 

It is clear is that the prevailing bonus culture failed to take a long-term approach to risk allocation and capital protection.

The public is rightly angered by what we have seen with bonuses and remuneration, and change is coming. 

Higher capital requirements (higher in the case of some activities by multiples rather than percentages) will serve to limit bonus pools for risky activities, reducing the profitability of many activities and dealing strategies, and the G20 has agreed to implement tough rules to ensure clawback and deferral of bonuses in addition to significantly enhanced disclosure of remuneration culture and structures. 

There is another very important issue around remuneration: perceived fairness. Organisations with extreme distributions of income are inherently prone to greater instability. It is harder to foster shared values and common culture. It can be a source of risk.

The national minimum wage is £5.73 per hour. That means that someone working for forty hours a week for forty-eight weeks a year earns £11,001.60 per annum.

According to the Office for National Statistics' Annual Survey of Hours and Earnings (ASHE), "mean" gross annual earnings across all employee jobs in 2008 came to £26,020 and "median" gross annual earnings was £20,801, across all employee jobs.

I sometimes think that Remuneration Committees and senior investment banking executives need to be reminded of this reality before they disgorge huge bonuses. And they have to ask themselves whether they have fully explored all options to protect organisational and shareholder interests before going down the route of making payments which many in society find unacceptable in terms of reward for skill and contribution.

We need to get the balance right between the individual and the firm, and the individual and society. Communitarianism emphasises the need to balance individual rights and interests with that of the community as a whole, and the fact that individual people are shaped by the cultures and values of their communities.

Lord Levene said last night that the City is one of the strongest sectors of the economy and it is nonsensical to say that it is too big. The balance was not right. We are not knocking the City, we are not being unpatriotic by acknowledging the need for change.

You should be in no doubt that the Government is taking the action needed to restore trust and accountability in our financial system.

But we can not do this alone and we will fail if we try to.

We are working with our European colleagues – you’ll know that I am a strong advocate of the need to work hand-in-glove with Europe to deliver proportionate reforms to benefit our domestic industry and protect our economy.

We are also leading the world through the G20 to ensure that actions here are mirrored across the globe, creating a transparent, stable system in which agents and consumers can operate with confidence.
 
As I conclude, I want to reiterate that we have come a long way since this time last year.

The UK has led the intellectual debate on the reform of financial markets, with Lord Turner’s report and the Government providing thought leading contributions to the reform of financial markets.

The Government will continue to seek agreements on a regulatory regime within the EU and globally that is appropriate to the importance of financial services, and that enables us to have a financial services sector that  serves the needs of the UK economy.

At the very core of these reforms will be the accountability of individuals and firms for their own investments, business decisions and choices.

All necessary measures should be taken to ensure that we do not have a repeat of the recent crisis, and if people act with the knowledge that they will share in the losses – as well as the profits – of their choices, then the financial markets will again earn the trust of their users and participants.

Thank you.

ENDS

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