It’s an honor to be in such distinguished company and to address such an impressive audience.
The issues before us could not be greater. The developed world looks to be facing a prolonged period of slow growth and high unemployment. The emerging markets could see slower growth. And, the markets, again, are struggling.
The volatility of the last two months reminds us again of the fragility of systemic safety and the overriding goal to protect the overall soundness of the financial system. This goal is vital to us all as direct or indirect beneficiaries of that system. Literally, we all have a stake.
Many things have changed since 2008. The financial system—particularly the banking sector—has been reformed in significant ways. But more steps are needed to achieve our common goals. Today I will discuss measures to enhance the governing framework across the entire financial system.
As everyone here is well aware, the financial system is far larger than just the banks. And while that system is mostly made up of private firms and individuals acting to further private interests, it also serves and promotes many public interests. The system provides and raises capital for essential projects large and small. It delivers services to businesses of every size and people at every income level. Its reach, diversity and sophistication—indeed, its very existence—all work in concert to efficiently move capital to where it can be most productively employed, creating jobs, wealth and opportunities for billions of people. Our multifaceted and complex global economy could not function without an equally multifaceted and complex financial system. Our GDP—as individual countries or as a global whole—would not grow, or grow as fast, without the system.
The necessity of a safe and sound financial system is, therefore, not hard to understand. But as we also know, there is a downside to the quasi-public nature of the system. We’ve all heard the phrase “tragedy of the commons.” Sometimes private and public interests collide. The threat to the system from excessive risk can be overlooked by individual participants because the near-term benefits can appear enormous. But if—or when—that private risk brings down the system, everybody loses. That cost, though predictable, probably never enters into the initial calculus.
Globalization makes the problem more complicated. Capital markets have been steadily dis-intermediating for at least the past century. Essentially the financial system has been transformed from a hub-and-spokes model into a networked model. In the old environment, the hubs were the financial capitals, such as New York, and the big banks based there. Today, capital flows directly from point to point, often bypassing the old hubs altogether. More links mean greater efficiency but also disparate regulation and more avenues for problems to spread rapidly from one corner of the system to another and beyond.
As more and more non-bank participants become integrated into this networked system, national and international regulators have struggled to keep up with the expanding scope and complexity of the global financial architecture. Many participants in that system fall outside traditional regulatory mechanisms.
It’s clear from the after-effects of the financial crisis that the regulatory environment can be enhanced to better address our networked world. Looking at the hubs is vital but not enough. Banks and non-bank financial institutions alike are all susceptible to the same shocks, whether they originate in a regulated or unregulated corner of the industry. Drop a large stone in a pond, the ripples will eventually cover the entire surface.
What we should seek to do, rather, is to include in any regulatory architecture all participants in the system, not just formal banks, to create a level playing field.
But how can we do that? The current model tries to manage risk at the institutional level. That is, regulators devise ways to gauge the risk exposure of firms on a bank-by-bank basis and set capital and liquidity requirements to protect those institutions—and by extension the whole system—in the event of some catastrophic event.
There are some limitations to this approach.
First, the current system applies only to the formal banking sector. The rest of the field is left open for the non-bank financial system to serve other customers out from under this regulatory umbrella. I am reminded of towns in India in which every house, on the inside, is as clean and orderly as you can imagine while just beyond the door chaos and disorder reign. But the people inside are not immune to what happens outside.
Second, it’s a blunt instrument. Systemic safety cannot be guaranteed solely or even mostly through high capital requirements on banks. Paradoxically, the higher we set capital requirements for banks, the more money flows into unregulated or less-regulated sectors of the system, thereby increasing systemic risk.
Third, it’s expensive. High capital requirements as a substitute for broader controls on systemic risk lead to misallocation that constrains lending and therefore economic activity.
Fourth, this approach presumes a level of clairvoyance that no regulator possesses or could possibly possess. If there’s one lesson we should have learned from the last crisis, it’s that even the best-informed observers of the markets—and even the markets themselves—cannot always predict what will happen next.
Fifth, it focuses on the institutional side and pays insufficient attention to the consumer side. Institutional regulation is necessary but, given the extent to which excessive consumer leverage fueled the last crisis, more attention needs to be paid to consumer product regulation.
There is a better way. Five specific proposals, grouped under three core themes, can help us look past the hubs and toward the whole:
First, we should implement stronger product regulation—for all participants in the financial system—to help consumers make better decisions.
Second, disclosure requirements should be simplified for consumers and strengthened for institutions.
Third, market structures should be reformed to create more transparency and invite more market discipline.
All of these ideas are united by a common principle: the more information that we can make available to a larger number of participants in the system, the more safely and efficiently the financial markets will operate. Think of these ideas collectively as a version of the “wisdom of crowds” thesis applied to the financial system.
The first idea is to bring a corporate-finance approach to consumer lending. This may sound too hard to implement, but other countries have already done so to great effect. We in the U.S. have historically relied on credit scores—an imperfect and backward-looking measurement that focuses on past borrowing. But many Asian countries have gone to a forward-looking approach. Credit bureaus and regulators have jointly created databases and regulations that foster information sharing on both sides of borrowers’ balance sheets and their income statements. Lenders then scrutinize this data to make informed assessments of creditworthiness and the affordability of debt.
This obviously is not an inexpensive or simple fix. Yet the potential savings from increased safety should far outweigh the costs. The fact that other countries already have or are moving to adopt such a system should stop and make us think.
Country-by-country implementation of such a standard is better than nothing. But all countries should follow suit. In today’s financial system, there is no such thing as a purely local market any more. Excessive leverage and lax credit in any corner of the system can threaten the entire architecture—often with little warning.
Second, I believe that all financial institutions should be required to disclose, in plain language, the essential facts about their products, especially credit offerings. The disclosures currently required by law theoretically tell the customer all he needs to know—provided, of course, that he can get through the fine print. But the information can be complex, confusing and hard to access.
For instance, consumers tend to assume that a credit card with the lowest annual percentage rate is best, but that’s not always true. At Citi we offer a product called the Simplicity Card. Customers are not charged annual fees or late fees and are not assessed penalty rate hikes. The interest rate is higher than the rate for many other cards. But for a customer used to being charged those fees, the actual cost of using the card is lower.
Yet we can’t make that crystal clear because other card issuers are not required to disclose the total potential cost of credit for their products. Hence consumers can’t make direct comparisons. They should be able to—which means that issuers should be required to disclose the full cost of credit for their products, which includes late fees and interest increases, in one clear sum.
Third, we need stronger product regulation to protect consumers against behavioral arbitrage. This is one instance where market mechanisms are inadequate to protect consumers’ interests.
What happens is often similar to the card example I just cited. When buying a car, for instance, a consumer is likely to choose the financing plan with the lowest up-front cost. Yet once every other cost and fee is factored in, the car with the lower monthly payment is often more expensive than the one parked next to it with the higher monthly payment. Think of the pre-crisis explosion of ARMs, Option ARMs, no-down payment loans and the like—they looked cheap but turned out to be very expensive.
Other countries have addressed this problem by setting loan-to-value ratios for mortgages. These countries have clearly decided that it’s not enough to leave things at caveat emptor. Some of the real-life patterns we see in consumer behavior lead to decisions that harm individuals’ balance sheets and threaten systemic safety. As we learned from the credit crisis and housing bubble, bad individual consumer decisions are not necessarily isolated events that hurt only the decision makers. In the aggregate, they can threaten the prosperity of the entire global economy. The point of rules against behavioral arbitrage is less to protect individuals from their own poor decisions than it is to protect the rest of us.
Let me turn now to the institutional side. The market for equities could not be more transparent. All of us have access to up-to-the minute information on equity pricing—and we all are seeing the exact same information, at exactly the same time. Opportunities for arbitrage are rare.
Derivatives, on the other hand, remain too opaque. Brokers often don’t know the volumes of transactions, the prices or the amounts outstanding. Lack of transparency inhibits market discipline, obscures risk and leaves nasty surprises buried in the system.
The over-the-counter system prevalent now cannot be the system of the future. Clearinghouses are better. Instituting initial and maintenance margin requirements across the board for derivatives would be better still. But best of all would be to create an exchange network for a good majority of derivatives.
I will not win any popularity contests for supporting these changes, but they would introduce much needed transparency and discipline and enhance systemic safety significantly. The cost of implementing such a system would not be low, but it wasn’t cheap to create equities exchanges either, and the world economy has benefited enormously.
My fifth proposal also addresses institutional safety. Given all the ink spilled about Basel III, the Volker Rule, resolution authority and so on, you might wonder whether it’s possible that I could have anything new to say on this subject.
The missing element in Basel, I believe, is transparency. Under the current rules, it’s hard to tell whether two banks with a declared 10 percent Tier 1 ratio are equally risky. You don’t know how they calibrate risk because you don’t know enough about what those underlying assets actually are or how that risk is measured. Basel III and “Stress tests,” in which so many put so much faith, are hampered by a similar problem. Hence it’s hard to say that capital requirements are really standardized.
For reasons ranging from complexity to competitiveness, financial institutions are not prepared to disclose their entire balance sheets to the world. Thankfully, it’s unnecessary.
It makes more sense for regulators to create a “benchmark” portfolio and require all financial institutions—not just banks—to measure risk against that. Institutions would be required to produce, on a quarterly basis for that benchmark portfolio, a hypothetical loan-loss reserve level, value-at-risk, stress-test results and risk-weighted assets. The benchmark portfolio would not actually exist on the balance sheet of any actual institution. Rather, it would be a collection of assets representative of the kinds of assets that most financial institutions actually hold at the time. What’s more, the contents would be 100 percent public.
Right now, loan-loss reserves, value-at-risk, stress-test results and risk-weighted assets are run only against an institution’s actual portfolio, whose composition is known only to insiders and select regulators. The results of the tests, therefore, have no common frame of reference. That could be changed simply by requiring financial institutions to run the exact same risk measures against the benchmark portfolio in addition to its own portfolio—and disclose the results of both tests publicly.
Knowing how a given company’s risk measurements perform against the benchmark portfolio tells the world how its management thinks about risk, and therefore just how conservative or risky its own portfolio probably is. An institution that cheerfully reports minimal expected losses from the benchmark portfolio in the event of a one-in-a-thousand market decline might well be understating the risk in its own portfolio. By contrast, one that predicts significant losses from the benchmark portfolio even from a routine decline is very conservative about risk. The benchmark portfolio allows for the kind of “apples to apples” comparison that the current approach does not provide.
The market will be able to reward institutions that take a conservative approach to risk. It will also be able to discount the claims of those whose predictions appear too optimistic. Investors will finally have some basis for judging whether that claimed 10 percent Tier One ratio really is 10 percent—or rather is closer to 8 percent or less.
Even better, the resulting market discipline would strongly encourage financial institutions to take a more conservative approach to risk. Just reporting a capital ratio would no longer be enough. The market would now have a firm basis for evaluating the reality behind the number. And it would reward institutions whose approach to risk and capital holdings seem to be sound and to punish those who appear to get it wrong. In this case, as in so many others, the crowd can be wiser than any individual experts.
The goal of reform—creating more systemic safety—is admirable and necessary. The means for achieving it proposed so far can help. But they don’t address all the issues. We need to open up new avenues for information to flow where it is needed.
Because the financial system serves the public, more information about it needs to be made public. Armed with more information, the public will be enabled to make better decisions that, in the aggregate, will foster systemic safety—and serve the public interest.