«Association for Financial Markets in Europe Annual dinner, London Thursday 3 November 2016 1 All speeches are available online at ...»
And as my colleague Minouche Shafik has recently pointed out, while misconduct in financial markets is older than the South Sea bubble, the scale of the misconduct which has emerged since the financial crisis is 7 unprecedented. The magnitude of the fines is indicative of the scale of the problem – since 2008 wholesale market participants have paid $170 billion in misconduct fines and the story is not yet over. Perhaps most worrying is that while some of this relates to misconduct before the financial crisis, a good part of it is more recent.
A year ago, the Bank used its convening power to bring together a wide range of stakeholders and market participants in an Open Forum on Fair and Effective markets. A message that emerged with great clarity and force from the non-financial sector participants was that there remains a major lack of trust in financial markets and financial institutions because of misconduct. Participants saw cultural and ethical changes as an essential component of restoring the social license for financial markets.
The Bank of England is not responsible for market conduct and integrity in the UK. That task rests with the FCA under the very able leadership of my erstwhile colleague Andrew Bailey. But our overall responsibility for the financial stability of the UK, our prudential responsibility for the major wholesale financial firms and the Bank’s close and historic interaction with London as an international financial centre means we have a very active interest in the integrity and fairness of the wholesale financial ecosystem which is located here.
That is why the Bank, alongside colleagues from the FCA and HMT, led the fair and effective markets review which reported last year and why we have made significant progress in ensuring that its recommendations 8 are implemented.
All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 7 It is why alongside the necessary development of ‘hard law’ to enforce minimum standards of conduct and accountability, such as the Senior Managers Regime, the Bank is using its influence to bring together market participants to solve collective action problems, for example, through the FICC Market Standards Board, to set expectations on behalf of broader society about expected behaviours and to encourage adherence to voluntary market standards.
Addressing ethical drift – and persuading broader society that it has been addressed and that markets work for the benefit of society – is a huge challenge for financial markets and the financial centres in which they are concentrated.
I do not want to go into detail tonight – though I would encourage you to read Minouche’s excellent speech on the subject. I would just want to emphasise one crucial point – industry leadership is and will remain vital if this challenge is to be met.
Resilience and regulation Restoring public support also requires authorities and the financial sector to demonstrate that the risks that are posed by large, very complex and highly interconnected financial markets can be effectively managed.
I am not sure whether my namesake in 1914 would have recognised the term ‘financial stability’ let alone ‘macroprudential’ policy. There certainly was no Deputy Governor for financial stability in those days. But I suspect he would have recognised well the way in which financial markets and the institutions that support them can generate and amplify stress in the financial system and how they can be subject to runs, fire-sales and contagion.
This is a lesson we had to relearn, very painfully, eight years ago. The result has been a major programme of reform of the regulation of wholesale financial market firms and of some aspects of markets themselves.
We are still in the process of implementing that reform programme. Again, I do not want to go into detail tonight. But, looking forward, two particular points are worth stressing.
First, as far as the Bank is concerned, there will be no going back to the future. The great financial crisis reminded us that the failure of the financial system, though rare, is possible. Contrary to the received wisdom pre-crisis, we learned that greater scale, complexity and sophistication of financial markets can make the system more not less vulnerable. And it also taught us again the cost of systemic failure.
8 All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 8 Or to put it in banking terms, we were reminded brutally not only of the probability of default but also of the social and economic loss given default.
For those charged with protecting financial stability, this lesson shifted our tolerance for risk. We are now much more aware of risks further into the tail of the distribution. And much more concerned to manage them. Given the size and scale of the concentration of financial market activity in the UK, that is particularly true for the Bank of England.
The events of eight years ago are receding into time. But I very much doubt that the generation of regulators that lived through the great financial crisis will revert to their pre-crisis tolerance and ignorance of systemic risk. And I very much hope that our successors do not forget those lessons either.
The regulatory reforms now being implemented will not in practice prove perfect in every specific. There will be places where reforms aimed at one part of the financial sector will cut across changes made elsewhere.
And where reforms have both an unintended and an undesirable effect greater than their benefits.
The Bank has made very clear that we will look carefully at hard and clear evidence of such effects. Where justified we are prepared to adapt the reforms.
In this respect, I would point to the changes we and the ECB have championed to the EU regulations on securitisations. And to the change the Financial Policy Committee recently announced to exclude reserves held by banks at the Bank of England from the application of the UK leverage ratio capital requirement. We will offset this elsewhere to ensure that the overall stringency of the capital requirement is not weakened.
But while I can envisage that there might be specific and targeted change based on clear evidence, I do not envisage wholesale changes to the reforms. And I for one will continue to treat with caution generalised claims of ‘unintended consequences’, comparisons of conditions with the pre-crisis years and dire threats that regulation is preventing the financial sector from doing its job of providing credit and liquidity.
My second point about regulation is that the past is not a perfect guide to the future. Financial centres innovate and change at speed. New products and ways of working can become significant very quickly.
And sectors that have not generated risk in the past can change their profile quickly.
In this respect I would mention the explosive growth since the crisis in the size and importance of asset managers and in the funds they manage, especially open-ended investment funds.
Market-based finance has grown very strongly in recent years. Since the crisis it has accounted for virtually all of the growth in net lending to businesses in Europe and the US.
9 All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 9 The assets under management of the top 500 asset managers grew by nearly $30 trillion over the last 10 years or so. It now stands at $77 trillion, broadly equal to annual global GDP. Over half of this is accounted for by open-ended funds, most of which promise daily liquidity to their investors.
Such funds have generally been stable in times of stress – during the crisis they experienced relatively modest outflows. Unlike the banking sector they are not in the main highly leveraged. But they have grown markedly since 2008 and, with the search for yield, have become active in more illiquid and volatile markets while still in the majority of cases promising daily liquidity to their investors.
We do therefore have to ask not just whether individual funds are properly managed and can cope with redemption pressures. We also have to ask whether this increasingly important element of market-based finance, as a whole or in large part, would under stress transmit pressure to the rest of the system, for example, through fire sales of assets. And whether there needs to be a stronger link between a fund’s promise of liquidity to its investors and the nature of the assets in which it is invested.
The Financial Stability Board and IOSCO are now taking forward important work to address these broader potentially systemic risks. This issue illustrates more generally that as markets innovate and market-based finance develops we need to remain very alert to possible systemic implications and keep our eye on the management of risk.
The UK exit from the European Union I have discussed the fundamental challenges around ethics and risk that are crucial to building societal trust in and support for modern, international financial markets.
I am however conscious that I am the guest tonight of the Association for Financial Markets in Europe and the clue is in the entire name. I therefore should perhaps say a few words on the challenges for Europe’s financial markets that may be posed by the exit of the UK from the European Union.
We do not yet know what arrangements will govern the trade of financial services and the integration of financial markets between the UK and the EU once the UK has completed its exit. That will be one of many issues to be determined by governments in negotiations over the coming years.
Nor do we know how the financial sector in the UK and elsewhere in Europe will respond to the process and outcome of those negotiations. There are many possible answers to both questions.
What I think is clearer is that this is not a zero sum game.
10 All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 10 It is certainly possible – indeed some would say likely – that some wholesale financial market activities currently carried out in London and elsewhere in the UK are in future carried out elsewhere in Europe.
But as I have discussed earlier this evening, the re-emergence of London as the world’s leading financial centre over the past 50 years, despite the decline in importance of the UK in the world economy, is the product of many factors.
It may in part be due to London’s role as Europe’s financial centre. But the scale and scope of broader international activity here suggests that clustering effects such as labour market externalities, specialised inputs and knowledge transfer have become even more powerful in a world of financial globalisation.
It is conceivable that given time these effects and the benefits they bring in terms of more efficient allocation of capital and risk could be replicated elsewhere in Europe. It is in my view more likely that if they are lost in London they would be lost to Europe – for the foreseeable future at the least. Fragmentation of wholesale financial markets activity in Europe, to the extent it occurs, is likely to have a general cost to European economies, including the UK.
And to the extent that the transition to whatever new arrangements will apply is not orderly and smooth, the costs and risks will be greater.
This is of course a technocrat’s view and these issues, rightly, will not be settled by technocrats. The impact of Brexit on European financial markets is only a part of a much broader set of considerations. As an ex EU negotiator, I have some inkling of how many other factors can come into play. Whatever the outcome, and the twists and turns on the way, the Bank will continue to focus on its role in protecting financial stability.
Financial markets have come a long way since Cunliffe Bros became a founding member of the Accepting Houses Committee at the end of the first wave of financial globalisation. After a long hiatus, the second wave has led to an even greater development of large, interconnected and complex financial centres. But the markets here and the ecosystem that supports them, the challenges they face and the risks they pose, remain as central to the Bank’s objectives and responsibilities as they have ever done.
11 All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 11 Chart 1 UK current account (% of GDP) Source: Bank of England.
All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 12