Conversation with Sir Paul Tucker, former deputy governor, Bank of England, discusses soundness of the banking system, focus of central banks, and impact of financial markets.
Here is the transcript of the video.
Integration of the financial economy and real economy
Emmanuel Daniel (ED): I’d like to capture your thoughts on what you see now that you’re outside of the Bank of England, and perhaps more time to reflect on what’s going on globally. Since the time you’ve left the Bank of England, have you had that chance to take a more global perspective?
Paul Tucker (PT): I hope so, which is one of the reasons that I’m here in Singapore today, this week. In some sense what’s driving the macro-prudential project is the rediscovery of something quite obvious: it is not enough to have regulatory policy very microscopic over here and managerial policy very macro over there. We live in economies where the financial economy and the real economy interact, and the financial system is a system. It’s not a series of atoms.
It’s not enough to ensure that each individual bank is sound; you have to ensure the system as a whole is sound. What’s interesting is what countries, particularly in Asia and Latin America, have just done in terms of macro-prudential policy. They’ve been faced with very strong capital inflows; pushing up their exchange rates, pushing up asset prices, fuelling local credit booms. After the experience of the Asian crisis in the 1990s there are concerns that this will lead to difficulty.
They’ve responded in various different ways, but they’ve been trying to ensure that their banking systems or economies are more resilient when the money flows out, as it has already started to do. There is no one model across the world. This is a cliché, but it’s a voyage of discovery. Different countries are doing different things. Everybody’s watching each other. People are going to be copying what works and discarding what doesn’t work.
ED: Can I add one dimension to this whole evolution of macro-prudential regulation, which is the balance sheet of the central bank itself. Which wasn’t on the table before, and which wasn’t of the size that it is today. How would you add that to the dialogue of how macro-prudential policies should be managed?
PT: Well, I think it’s a temporary phenomenon.
I’d be surprised if central bank balance sheets were let’s say in 15 years anything like the size they are now. I’m choosing 15 years because I don’t want to make a prediction about how quickly they will run off. It’s a very important factor in the time being. QE is designed to stimulate the economy, and as that happens it pushes up asset prices. It has the effect, I think, of encouraging capital flows. But that is an expedient in the face of a massive global crisis. When we get through the crisis, I think there will still be macro-prudential policy trying to lean against and prevent future crisis.
ED: Do you think that the organizations that take on the Central Bank function operate with their hands tied behind their back, in terms of the mandates given to them? Because in a lot of situations it’s really just two tools that they have, which is inflation and very often it’s employment, basically.
PT: Yes.
ED: Then now we have the unintended too, which is the balance sheet. Do you think that it should be broadened, it should be managed?
PT: They always have one other thing, which is the way that central banks conduct monetary policy is they conduct over market operations. They’re always managing collateral. I used to say we do two things. We set interests rates and we manage collateral. That’s always been true, perhaps neglected for a while, but affects the banking system in quite subtle and profound ways, and perhaps there’s a rediscovery of that I would agree. But there’s now another set of tools. For many years, for two or three decades, people took the view that we’ll set a capital requirement for banks, or liquidity requirements, and that’s it – we’ve written a rule.
Now I think people have realized that static rules don’t work all the time. You write them in good faith about how you think the world works, and then time passes and you discover that the world is risky. Perhaps in a phase of exuberance where actually you need your banking system to be a bit more resilient than otherwise. Or, if you prefer to think of it this way: to maintain the same degree of resilience you need a bit more capital, a bit more liquidity. And I hope that macro-prudential authorities, not all of whom are central banks, but I hope the macro-prudential authorities generally will have the conviction and courage to raise capital requirements, raise liquidity requirements in the future when they need to.
ED: Well, there is the mandate itself, the legislative mediate, there is the rule, and then there’s the situation. To what extent do you think that the infrastructure – the appropriate reconstruction taking in to account what you just said, which is to be able to respond correctly to different situations, it’s a function of personalities involved. If I look back at how the evolution of regulation itself in the UK, it was about strong personalities. And I would even argue that if you looked at Northern Rock, it was about the definition of roles and maybe where the ball dropped in the crack. But without reference to any one seclusion, reflecting on your own experience –
PT: I think it’s more about the definition of roles and structures than it is about personalities. Of course personalities matter, but I think they matter less than the structure. In the UK, the central bank was focusing on a managerial policy, and didn’t really have any involvement in regulation at all. I think that was a mistake, and that’s being corrected. But if I take your two questions together, if I may so, I think you’re making a very important point. Is it enough for an organization, say a central bank, to be given a legal mandate, to be given independence, to pursue that mandate?
No. It may be a necessary condition, but actually society has to really want it. Academics have known for a very long time that you can make a central independent from managerial policy, but it makes no difference if actually culturally in that particular country it’s still dominated by the short term objectives and pressures of politicians. And so society has to really want a policy for the policy to work. Because if you think whether it’s interest rates or tightening capital requirements; it isn’t popular when you do it. Eventually there will be a great boom somewhere.
I hope that my successors and other macro-prudential authorities around the world will lean against that boom. And everyone will be upset. The public will be upset. The bankers will be upset. The politicians will be upset. That doesn’t matter as long as society really has given a clear mandate to that macro-prudential body. So they can say “no, this is what you asked us to do and we’re doing it”. It doesn’t work if society was half hearted in its request in the first place. So you need law, and you need culture. And in a way that is what defines institutional structures.
ED: We measure what we can measure. And there are things that I would need to be the invisible flaw, or the invisible hand in any economic situation. If you take for example, carry trade and that how effects economies. The unintended consequence of macro-economic policy. Once the policy is set, you have all the players trying to find the backdoor and you know whichever way.
PT: Yes.
Measuring capital flows
ED: It’s always a function of price and benefit. For a long time in Asia the Japanese yen was the carry trade for the rest of region. Today if you look at property investors in the UK, a lot of that is actually coming from people funded from outside the UK, from places as far as Singapore, Malaysia, and China, and so on. So how do regulators take into concentration the things that they don’t see, or the things they cannot see?
PT: So your question is how on earth do they know what’s going on? Well, it’s tough. I think to start with countries need very good data on what’s called the flow of funds. The funds that are flowing from the banking sector, to the insurance sector, to the mutual fund sector, to the household sector, the company sector, and that’s even before I reach the borders and across border as well. The United States has pretty good flow of funds data. I think pretty well everybody else that’s serious needs flow of funds data as well. I think we need rich data across to measure capital flows and the types of capital flows.
Our days from derivatives, and that’s being developed in these so called trade repositories, which will have information about derivative transactions. So, all of that’s a work in progress, and it’s a very important work in progress. But somehow, and this is the burden of your question, it will never be quite enough. There will always be something going on that isn’t captured by the data. And for that the authorities need to keep their ears and eyes open, and accept informal knowledge, as well as knowledge that they can get from a formal data set. That is tough, because how can they validate policy decisions unless they’ve got the grounding and the data?
So I think that they will have to conduct more special exercises to get data in a particular sector as they hear about things anecdotally. This is quite ambitious.
ED: The frontier of macro-prudential regulation is really the areas of capital flow, which is still unregulated.
PT: Yes.
ED: You’ve got FX, which is really a wild seed out there. And some of FX is actually right on currencies being traded outside of the market. So Singapore for example is a regional financial centre. And it’s in the position to effect lending and borrowing in any number of markets in the region, and in that regard, the UK as well. So in that regard, how restrictive should macro-economic policy be, or macro-prudential policy be, and how liberal? Where do you draw the line?
PT: I think liberal capital flows are a good thing. I think actually in a deep sense, I think they’re good for freedom, and help protect against tyranny. But also attempts to manage capital flows, and manage exchange rates, didn’t work well. It’s been tough at times here over the past few years, but floating exchange rates have helped most of the countries. It’s a bit more of shock absorber, rather than a fixed exchange rate is brittle. It works until it breaks, and then a calamity can occur.
ED: If you look at Indonesia, which has probably the closest to perfect floating exchange rate in the region as a result of the ’97 crisis. Without the domestic assets to absorb that, and the rules of trading and so on, it’s been very difficult for the country to manage –
PT: Oh, no absolutely. I’m not saying it’s easy. I’m just saying it’s better. Because fixed exchange rates are brittle, and that’s what we’ve seen time and time again. It’s very smooth until it breaks and then there is a complete calamity. I’m not saying that floating exchange rate regimes are a walk in the park. It can be a very bumpy ride. What this does need to be accompanied by, and I think countries are now doing this where they need to, is when a lot of short term capital flows in to the banking sector, or into the property sector, or some other sector, they can actually take local measures to not cut off the flow of capital, but keep it liquid when it arrives, so as to make their system more resilient.
ED: In being a champion of floating exchange rates, what would you say are the important supporting elements that need to go with them?
PT: Well, first of all I’m only advocating floating exchange rates when you have the free flow of capital as well. If one doesn’t want current capital convertibility, currency convertibility, then one can fix the exchange rate. Each country must decide in its own particular interests a coherent policy. It’s less about exchange rates than it is about capital flows. If you allow capital to flow in and out, then you do need to have what are now known as macro-prudential policy tools to ensure that this doesn’t blow up your banking system, or some other part of your financial system in the process.
So a classic case would be: a lot of capital flows into a country’s banking system, it’s very short term say. Well, then it would be sensible for that authority to say: well, those banks need to hold more liquid assets in the currency in which the money is flowing in. Then when the money flows out, they’ve got the wherewithal to meet the requirement. The worse is the money flows in, in one currency short term, and then it gets invested long term in domestic currency. That’s a recipe for disaster.
ED: What would your advice be to a country that wants to get from here to there?
I have in mind really China, which wants to have full capital convertibility and floating exchange rate at some point. But it’s a huge economy. How much of trade flows does a macro-prudential regulator to know of, to be aware of? If you look at how China’s dealing with its liquidity situation, domestic liquidity, it’s actually using the trade flow corridor, literally or otherwise. But that seems to be a short term platform for getting around the problem of capital convertibility.
PT: I don’t think China needs any advice for me. Any country should just be very clear about its own objectives. Study economic history carefully. Study the experiences of other similar countries.
It is useful to know the patent of capital flows as I’ve said. Is it flowing into the banking sector? Is it flowing into government bonds? Is it flowing into insurance sector, directly to companies? I think this a broad aversion of the flow of funds data.
I’m not an expert on countries that don’t have currency convertibility. They don’t need any advice from me. I can tell you what it’s sensible to do if you have open capital flows and a floating exchange rate.
In those circumstances, the flows that are related to physical trade, and services and goods, will typically be small relative to the gross capital flows. The lesson of the last 20, 30 years is it’s not just the trade flows that matter. The trade flows certainly matter a lot, but it is not just the trade flows. What people call gross capital flows matter a great deal. People need to study those and compile what I and others call a national balance sheet. So are our external liabilities short term or long term? Are they in debt or are they in equity? Are they denominated in our own currency or in a foreign currency?
Those are the kinds of things which countries probably of all kinds need to know, and I think the IMF can help them with that.
Economic stability
ED: When we look at the impact of the banking system on the real economy, and I think that macro-prudential regulators are increasingly concerned about the impact of financial markets on the most of economy. The US Bureau statistics quite recently has been moving towards redefining that data such as the impact of financial services as a percentage of total GDP. As they move that, they’re actually redefining to what extent the markets play in the real economy.
What are the rule of thumb numbers that you have in the back of your mind when you look at how much of an economy is stable because its real economy is thriving, and how much of that is belief?
PT: There are two things. Finance has two roles in this respect. And it can make a contribution to GDP, but even if the contribution to GDP, to value added is small, it still plays an immensely important role in terms of allocating resources, shifting resources from savers to investors insuring against risk. These measurement questions are partly about the role of financial intermediation, those three functions. And they’re partly about the contribution to GDP, to value added output.
It’s not easy to measure the contribution of finance to value added to output. And what America has been doing, as I understand it, is reviewing that. I suspect that a number of countries need to do that. But there’s no magic benchmark here, or set of numbers, it’s simply that countries need to take it seriously.
ED: But it’s a working number, if you look at the assets under management.
PT: Yes.
ED: If you take a country like Singapore and Switzerland, the total financial assets under management is much larger than the economy itself.
PT: That’s true in Britain as well, but is a separate question from the contribution to GPD. That could be true even if the contribution to GDP was low. In terms of stability what matters, as all this capital flows in and out, and around the economy, is the financial system safe and sound, and is it honest? If you have a big financial centre, as is the case in Singapore, or Hong Kong, New York, London, Paris, Frankfurt, and Europe, you need to make sure that it is safe and sound, and it is honest. Doing that is vital for economic health and matters more than whether the contribution to GDP is four percent or eight percent.
ED: I would love to see a number. I would love to see regulators in different countries stating a number without upset of which they wouldn’t move because that creates the instability that they –
PT: I doubt whether you’ll get such a number. Maybe we’ll live to see it. I doubt it because it depends very much on the form of finance. If a country has, or its financial system has borrowed very short term in foreign currencies in large amounts, and has employed that in the domestic economy long term in its domestic currency. You don’t need very big numbers for that to be disastrous. You could have much bigger numbers in terms of pure entrepot intermediation, foreign currency inflows in, foreign currency outflows out with a spread in between I suppose, that might be safe.
So there isn’t going to be one number. It depends upon the nature of the liabilities, the nature of the assets to the financial system, and whether there’s a mismatch, or how big a mismatch there is between them.
ED: The final question is your own career. And actually I suspect that there’s something to be learned from someone who’s spend as much time as you have building macro-prudential infrastructure. In that, especially out in the UK where there was a time when regulation in the UK was about a handshake, about a phone call. It was very principles-based, perhaps. Today moving into more and more infrastructure, more and more rules, and very prescribed roles, is regulation in itself an evolution that we need to think about? Are there milestones in evolution that we need to come to?
PT: It’s partly evolution, but it’s also an oscillation between rules and principles. I think that is for a set of fairly deep reasons that are troubling. So if you’re at the principles end of the spectrum that has the disadvantage of it’s wooly. Do firms and society know what’s really to be expected? Can the goal posts be moved in an arbitrary way? Does that mean that the regulator has too much power? Or alternatively, does it mean that it’s all completely fuzzy, and there are no requirements, and it’s all far too informal. That’s the positive principles.
At the other end of the spectrum that has all the rules, is that perhaps more in finance than anywhere else, the industry is a shape shifter. If you write down a detailed set of rules, finance will find its way around those rules. You can build a bank out of insurance contracts. You can build an insurance company out of derivative contracts. You can do almost anything anywhere given cross border capital flow. So if one relies entirely on rules, I will write down the perfect static rule book and it’s going to go wrong. In some ways I think that part of macro-prudential policy is trying to find a way through these two poles, these two extremes.
Because it’s saying: we’ll write down a static rule book for capital requirements or liquidity, and that’s what you have – those are the minimum requirements. But things will happen where we have to increase them slightly, and Basel has embraced that. But there’s a lot of learning to be done because neither of the pole positions works very well.
ED: Here’s the question: you know to position the leadership role that the UK has in terms of the evolution of regulation in itself? The UK historically over the last 400 years was where this club ruled. It was a fundamental pillar of the entire infrastructure of finance, you know the Lloyds Club and so on. We’re moving away from that, and to some extent the change has been forced on the UK by players in the US and regulators outside the UK. Yet this whole concept of the markets being a self-regulating mechanism of its own; is it still a desirable goal?
PT: It has its strengths. It doesn’t completely work. Markets aren’t perfect. They have phases of exuberance and then they blow up. I can’t speak for the UK but I don’t think it’s just a question of importing new techniques from America, for two reasons. Although that is certainly an element of it, I think there are two other things going on around the world. One is the mythical nostalgic world that you described, was a world where for a while the city of London was quite homogenous, whether it was insurance or banking.
But the decades over which people are sometimes nostalgic, were the decades after the Second World War in which there was not financial liberalization. As soon as liberalization began, the markets became much more diverse with firms from all over the world. And you can’t operate anything like a club then, you have to have some clear standards. And then one gets back to this oscillation I was describing, the problems of principles and the problems of rules. I think they – in the macro-prudential area, I think what they’re now trying to do is write a rule book for normal times that they can adapt during more exciting times.
The authorities will probably try that for a while, and I think it will be an improvement on what went before. Then eventually someone will look back at it and say: actually there can be a big improvement to that.
ED: Should we globally, when we think about the Financial Stability Board (FSB) for example, what should their self-imposed architecture or mandate be? In that to allow each of the respective jurisdictions to decide on the kind of models that best suit them, because there’s the political image as well that is very specific. What should the FSB –
PT: I think you need common standards as far as possible. Now you can add to those locally, but I think there has to be – if we’re going to have global capital markets. One of the most significant things after the crisis was that, the G20 heads of government said in 2009 that they were not going to go down the protectionist route. They wanted to keep globalization in both the real economy and the finance economy. Then, particularly in finance, you have to have common standards. If you don’t, all the activity will go to the lower standard centre in the world. You have to have common standards.
That involves compromise as the agreements are reached. And actually on the whole the countries are pretty good at cooperating in that endeavor. Everybody has suffered from this crisis. Everybody knows that all parts of the world – everybody knows that they’re all in it together. And so I found when I was in office that the spirit of cooperation was pretty good. They’ll have to sustain that in the many years ahead.
