It’s been nearly six years since the world’s financial system nearly collapsed, and according to Paul Tucker, few realize just how weak the global capital regime aimed at mitigating risk was in the years leading up to the crisis. As a result, said Tucker, a former deputy governor of the Bank of England, many observers on both sides of the Atlantic continue to oversimplify causes of the financial crisis, something that could make it more difficult to prevent the next economic cataclysm.
“When people describe the crisis here, the say we had a liquidity crisis,” he said. “In London, they say we had a solvency crisis. Both propositions are true.”
Tucker, who oversaw financial stability at the Bank of England and is now a senior fellow at the Missavar-Rahmani Center for Business and Government at Harvard Kennedy School and Harvard Business School, was the keynote speaker at the inaugural conference for the Yale Program on Financial Stability. At the conference, global regulators and academics presented scholarship about the topic “bank capital,” with an eye to addressing practical questions facing regulators post-crisis. The gathering was the culmination of the two-week Systematic Risk Institute, a boot camp for a dozen rising regulators who may be in positions of influence if another crisis hits. Among those at the Institute were representatives from the United States, England, Germany, the European Union, and Japan. The participants spent long hours discussing detailed Yale raw cases examining previous crisis and how regulators responded to them.
Tucker said that a ripe area for research is the period, beginning in 1998, when the Basel Committee on Banking Supervision began updating the capital regime for global banking, considering, specifically, the amount of capital that banks should hold in reserve. One little-remarked-upon fact about the requirements that they settled on was that only half of the required 4% of assets held in reserve had to be common equity. The result, he said, is that the international community was endorsing leverage ratios of 50 to 100, which meant extremely dangerous levels of debt. “Even if the market required a bit on top, not much has to go wrong for banks to be bust,” he said.
The stress tests allow the Fed to say to powerful financial institutions, ‘You’re not as good as you think you are,’ That's a positive thing.
In the years since the crisis, a consensus has developed around a reserve rate of 10% for financial institutions. Whether that’s the right amount ultimately depends on how much risk in the financial industry society is comfortable with, Tucker said. Even with a 10% rate, the financial system can get into trouble. Raising the rate higher would lower the risk, but at a cost. “You can crush it to zero if you have no financial activity, but we don’t want that.”
Tucker said he’s skeptical that more regulations would have the intended effect, calling finance “a shape shifter” for its ability to circumvent even the tightest rules. One change since the crisis that he believes has been effective is the annual stress tests run by the Federal Reserve. The main benefit of the tests, he said, is to provide regulators a view into the health of individual banks and the system as a whole. “The stress tests allow the Fed to say to powerful financial institutions, ‘You’re not as good as you think you are,’” he said. “That’s a positive thing.”
An added benefit, he said, is that by providing a glimpse into the inner workings of banks, the tests provide a basis for open debate over how strong or weak the capital regime needs to be. “The stress tests don’t replace the capital regime,” he said. “They’re a way to have a debate with society over how to calibrate it.”