good morning ladies and gentlemen my name is master mukhardi i work for the korea de la sierra in the united states and i in addition to the traditional audience of the festival today we also have a group of students from inet this new initiative of the festival that focuses on international economy in cooperation with this international institute um i don't think i need to introduce to you mr andy haldane is an economist and member of the central bank of england although he is quite young is very well known for his work he has been the person in charge of the um office on the stability of the british financial system but is also famous for his very sharp analysis and judgment of international financial situation and financial stability and the need to fend off the risk of going through uh experiences like those of 2008 that led uh to the present crisis so rather than describing uh mr haldane's career wish to focus on some of his recent comments that raised a lot of discussion we already spoke about the financial crisis which started in 2008 in the past editions of this festival and a few years ago there was even a kind of trial organized to try indeed the financial institutions and central governments and so on so it's a kind of fake trial but i think it can be useful to stress again what was the origin of this uh crisis and the role of the central banks and we may uh really ask ourselves whether a similar experience may happen again five years ago as probably you remember the crisis started in the united states and spread all over the world starting from the issue of the subprime money given to families in troubles uh the these companies began to go through a crisis initially it seemed that the crisis might have been limited but in march 2008 uh one of the major investment banks in wall street closed down or ahead and this happened in a night when jamie diamond the head of jp morgan chase was celebrating his anniversary in a greek restaurant in new york capra an excellent restaurant indeed and so during this celebration with his family he received a call from the federal reserve asking him to take action immediately to save ben spares and preserve the stability of the financial system he decided to do so although with some specific conditions and the bank the jp morgan chase was going to play later on a key role in the international financial system so for a few months the system went on but then you know lehman brothers came along and we all know what happened after that credit crunch and financial troubles for companies banks no longer trusted each other and this led to apprentices of the financial system there was even the risk of going back to the stone age in the world of finance then central banks and the american government came along there was a lot of discussion in the us uh whether the 900 billion dollars given by president obama to support the u.s economy and bring it back to a situation of growth unlike what happened in europe was the right choice certainly the federal reserve took a very courageous altitude it supported the banking system uh and saved many banks and gave them a wave a huge wave of money at virtually no cost and this of course brought about some very important distortions into the system but it also gave banks the opportunity to make profit again and continue to play the role and finance economy much more than is the case in europe now but this brought about some major imbalances many of these banks began to have some huge profits again but the main reason is that they were directly or indirectly supported by the federal reserve and by governments so that too is a matter of great discussion there's a lot of discussion on whether this new balance is sustainable or whether some new action is needed to fend off the risk of going back to a situation similar to the one of 2008 the financial market is still very complex creative finance in the great market of derivatives and fake financial products is still there and the figures are still rocketing so in an attempt to address all these problems in the united states some three years ago in july 2010 a reform was passed that was meant to prevent similar situations to happen and avoid that banks that were too big to fill would create a terrible imbalance into the system although other people feel that this uh reform is too complex or has not been applied sufficiently and so it is not very effective more recent data more recently two mps shell brown and bitter put forth a proposal in the united states which addresses this problem of be too big to fail in accordance with this proposal big banks don't have to break down but those that have uh over 500 million dollars asset to double the reserves that may be needed in times of crisis bringing them up to 15 that's of course a major effort they should set aside uh 1 200 billion dollars so these big banks are doing all they can to prevent this from happening claiming that this is discrimination against them but in fact it's an attempt to try to almost force them to break down into smaller units the market is aware that these banks are too big to fail and the result is that they uh receive funding at lower rates than small banks do so in a way it's safer to put your money in one of those banks because even in the situation of future crisis it's going to be saved by the government to protect the economy now let me go back to mr haldane one year ago andy haldane spoke at the seminar of central bankers uh held in august end of august he chair in a wyoming in a city that is a bit of a bit like a trento in the far west it's a mountain place in a wonderful place where people go skiing in the winter with ranches and buffaloes and it's a very suggestive place where bankers get some privacy they're not many journalists there and they discuss the international financial situation once a year and last year um andy haldane had a key role uh during that event they wanted to get some new and provocative idea from him which he duly did indeed and he explained that in his opinion the great complexity of the financial system has been opposed so far by the regulators through an equally complex set of rules in a very long report and i have a copy here but i i'm not going to read it of course and andy haldane is going to focus on some of the same topics today but he gave a very detailed uh description of this matter using algorithms and complex things and he gave his report a very technical uh titles the dog and the frisbee but the point he was making there is that getting a frisbee is very difficult you need to know it's trajectory which is influenced by the climate by the wind speed by the frisbee rotation speed and a man who has all this knowledge is less skillful than a man in in the end less skillful than a dog um all of this means that very often uh you don't need to try to find complex solutions to complex problems uh at the end of his presentation of his report there he said and i wish to make a small quotation he said the rules in modern finance are complex perhaps too complex and this is a major challenge for us you cannot put off a fire use if using fire you cannot fight against complexity with complexity complexity brings about uncertainty and not risk and it requires regulators to develop simple rules in his report he gave some important facts and figures the grass legal act for example that provided the solution to the great depression in 1929 was an act of 37 pages the ruler one again was very short and the case about two uh it was just a little bit more some 100 pages then val3 became a document of 800 pages the us dot frank act is an 800 000 documents and the implementation description will require some 30 000 pages in the opinion of andy haldane this tower is really like the babel tower the bell tower and the babel tower very close to each other so uh what i will do is i would ask how dane to illustrate these issues for us and whether we've done some progress with our attitude with the banks that are too big to fail or whether we're running the risk of going back to association comparable to that of 2008 the most terrible crisis in the past 80 years thank you thank you massimo can you all hear me um for that kind introduction i didn't actually understand most of it so i can only assume it was kind uh the only words i did pick up rather disconcertingly were were jamie diamond and frisbee um anyway it's a huge pleasure um to be here at the trento festival a celebration a real celebration of economics and it's particular pleasure to be giving one of the inet lectures because inet is committed to celebrating new economic thinking and there has never been a better time in the past century for some new economic thinking i had planned to talk about growth but when i thought about it i couldn't resist instead turning to the question of banking and to the question of the banking crisis given that i was speaking here in italy i'm going to stand up and actually probably involve one or two of the audience as well to make it easier on me hands up who's here from the inet young scholars good well identified yourself um so why do you think there's a natural link between banking and italy why is it appropriate that here in italy who is that it started here italy is the i can't hear what you're saying but i'm sure you're right i'm sure you're right um italy as you say the the the mother of banking bank modern banking was was born here um uh to the west of here actually in lombardy in the 13th century and then spread spread all over the place including to to london including to to where i work at the bank of england in fact the um uh the most famous street in the city of london in the financial center anyone have a guess i would ask actually where's perry perry if any man in the room knows the name of the most famous banking street in london it is perry merlin is lombard street lombard street um named of course after the lombardi region which was the birthplace of modern banking so next question um who or what this one's harder who or what is celebrating its 450th anniversary this year anyone anyone know what i have in my head but uh you might well be right um it's the four as i understand it the 450th anniversary of the last meeting of the council of trent the council of trent who i only knew this fact yesterday someone told me let me not um but the council of trent that provided that provided the intellectual foundations of the counter reformation so i thought what better place than this spectacular 16th century plazo jeremiah in trento the very heart of the counter-reformation in italy the very heart of banking what better place to talk about the counter reformation in banking that we need and today the counter reformation starts here in this room i will start it off uh and you i think will be left to finish it may take some years but if we start today it gives us it gives us a real a real opportunity and crises are a real opportunity so in mandarin as many of you probably know the word crisis breaks down into challenge and have been plenty of challenges over the last four or five years and and equally importantly opportunity opportunity and there are opportunities right now to rethink our models our economy our banking system from pretty much a clean sheet of paper and what better place to do it than here and this is why it matters this is why it matters this chart just looks at the path of output in three country blocks the uk the us and the middle block is the euro area the colored line is gdp in those countries the black line is the pre-crisis trend in gdp in those countries the key point for you to take away is to observe at just how costly in lost output this crisis has been already you know five years on most economies most western economies are operating with output 10 or more below where it would have been had we not had the crisis here in italy in europe output is still below where it was when the crisis first broke in 2008. if we added up the cumulative loss of output so far and looking forward this will end up costing us more than a year's annual output nothing compares in terms of economic events to financial crises and few financial crises compare with that which we've been living through over the past few years this is why it is so so important we do something to prevent a repetition if we can so what is it about banking that has gone most wrong what are the biggest problems it has encountered well they have been many and various but there's one in particular i want to focus on today and to bridge to that i want first have a little quiz um involving the audience again um this quiz is odd one out so there's three pictures and your job as the audience is to tell me which of those is the odd uh one out let's start just by naming them so we all know what we've got in front of us um and let's start here would anyone like to have a guess about who who that is it's king kong thank you i'm i was here sorry i missed you well marshall well done well done well done you're a fan of king carl you're a fan of king kong okay that one's easiest maybe the easiest this one this is the trickiest the middle one does anyone know what what this is god's very good very good who said that was that here are you you're a godzilla fan sir you look like a godzilla fan um no impressive uh so um so then moving along um this one this one anyone mario draghi was that robert no no well maybe murray i i doubt that is mario actually um uh this is father christmas very good well done well done um so these these are the three and um one one of these one of these is the odd one out would anyone um like to have a guess which is which is the odd one out here so it's an answer that's difficult to argue with um it's a good answer it's not the right answer um i'm sorry anyone else like to have a a stab which is the odd one sir he has clothes on that that is also difficult to argue with um and actually you have got the the answer right even though you've got the reason the reason wrong the odd one out and the reason father christmas is the odd one out is because um father christmas could exist he he doesn't exist and i'm i'm sorry if that's a surprise to anyone in the room um but he but he could exist he could he could exist um whereas uh king kong and godzilla they they couldn't exist they are physiologically impossible right so given their body mass if king kong or godzilla were to take one step forward the weight of their body would snap their thigh bone and they would collapse under uh their own weight so that the physiologically impossible um why is any of this relevant to banking is the question many of you are probably asking yourselves and it's because many of the world's biggest banks would also be physiologically impossible were it not for state support they too would have collapsed under their own weight if they'd taken one step forward had it not been there for governments to catch them this is the problem of too big to fail that when these godzillas and king kongs in 2008 risked collapsing under their own weight government was forced to ride to the rescue to stop them failing and this gave birth to what has become known as the two big to fail problem we fast forward from 2008 and we saw a new manifestation of this problem which is as governments rode to the rescue and as output collapsed we saw government balance sheets coming under pressure we moved from a situation of too big to fail to too big to bail too big to bail out which is why we found countries such as iceland or ireland or spain or greece or cyprus finding themselves in the acute problems they found themselves with oversized banks and oversized banking systems bearing down on the government finances and ultimately blowing them up and during the course of the last 12 months we have had a third manifestation of this problem we had too big to fail we then generated too big to bail we now have too big to jail with questions being asked about whether we can indeed bring to justice those that have run our big banks in many cases into the ground so whether it's too big to fail or bail or jail the key thing is that at present many of our global banks the banks that dominate our financial system are too big and what i'd like to do today is tell you a story about how it was we arrived at this position that's the first thing secondly what has been done so far to tackle this problem what have me and my colleagues in the regulatory community been doing to get our arms around these financial leviathans and thirdly what more might be needed to finish the job to crack this the hardest nut we have faced during the course of the financial crisis i want to conclude that more does need to be done more has to be done because quite literally quite literally we cannot afford to have a crisis on this same scale in the near future so that's the plan and let me start with how we got here how did we get here what this chart does is look at the ratio of total bank assets the total size of their balance sheet if you like in relation to annual gdp in a selection of 14 countries over a lengthy period of time over the last 140 years or so the orange swathe shows the cross-country variation but if i take the average with the blue line what has been happening well in the main this blue line has trended inexorably upwards so banks balance sheets in relation to incomes have gone up the banks collectively have got bigger particularly so you'll see after around 1970. so if you take the for about 100 years from 1870 to 1970 there was a financial deepening bank assets relative to gdp were increasing at around half a percentage point per year the ratio after 1970 big financial liberalizations and this ratio of assets to gdp started growing at more like three percentage points per year six times the rate in the preceding century now typically uh economists think that this sort of pattern ought to be a pretty positive one we use the word financial depth to describe this trend and typically we think of financial debt as being a good thing for growth it enables a greater number of households and companies to get access to credit which in the past they may not have had access to and up until a couple of years ago most of the evidence the empirical evidence looking across a large number of countries suggested that indeed that intuition was right that greater financial depth helped boost medium term growth but and the butt is very important over the last couple of years that orthodoxy that financial depth equals higher growth has begun to be questioned in particular a number of bits of empirical evidence have suggested there are limits there are thresholds beyond which this positive relationship between finance and growth begins to break down indeed not just break down but reverse sign that banking can become too big you can have too much of a good thing in a way that acts to growth not promote it so here's a a picture of um if i press the right button of one of these empirical studies the relationship they have plotted between um this is private sector credit your bank assets to gdp running horizontally and then running vertically is a measure of productivity in the economy sort of outputs per unit of inputs so a higher number is higher productivity which is good and a lower or negative number is bad one of the key points here well you see this relationship based upon evidence from a whole set of countries and across a long period of time suggests it's actually pretty uh u-shaped reverse u-shaped pattern this hump pattern so indeed financial depth can be productivity enhancing within limits but you can indeed have too much of a good thing and if you have if banking gets too big you might even find productivity being certainly slowing down and possibly even being negatively affected why might that be well because if banking gets too big it drains resources prospectively away from other sectors of the economy it could drain labor away from the non-financial economy it could drain financial capital away from the non-financial economy and could indeed be bad for growth so banking too big question mark what is certainly true is that banking has become more concentrated so this rising tide of banking assets is being held by an increasingly concentrated set of big banks so this picture looks at the share of total banking assets accounted for by the three largest institutions in the countries concerned so in the uk in germany and switzerland the three biggest banks account for anywhere between two-thirds and three-quarters of all assets a very concentrated system and even in the u.s where which is the blue line here where concentration is somewhat less it has increased very dramatically over the last 20 years or so in 1990 the three biggest u.s banks accounted for only 10 to 15 of total assets today that number is around 40 or more so the total size of the banking pie has got a whole lot bigger but the share accounted for by the largest banks has at the same time also grown and if you're saying well size isn't everything that is indeed true but it's not just size it's also concentration and complexity this takes some of the biggest banks in the world and looks at the number of distinct subsidiaries they have number of legal entities that they contain the number of countries they operate in and the size of their balance sheets these big global banks are fiendishly fiendishly complex they have often thousands of distinct legal entities they operate in dozens sometimes hundreds of countries they have a balance sheet which is larger than the annual output of italy these really are mammoth entities and they're therein lies the problem when they get into trouble because whether it's too big or too complex or too concentrated events of the last few years have illustrated that it's very difficult for a government to stand aside and let these large entities fail and just think through what that means what does that mean imagine everyone recognizes that the government will ride to the rescue what will results well that will mean that investors in those banks feel pretty happy they can get all of the upside and none of the downside because i know if the bank fails the government will be there to catch them their investment is less risky a less risky asset will be provided more cheaply so the funding costs of the largest banks will fall lower funding costs for banks mean bigger profits for banks it's the biggest banks the ones with the strongest expectations of state support will have lower funding costs larger profits and that will of course encourage them to get larger still we find ourselves on an evolutionary trajectory in which the big become progressively bigger because of that too big to fail problem because of the expectation of state support and these expectations this implicit guarantee of the biggest bank of the biggest banks can be very sizable here is one measure of it so the rating agencies which typically no one likes do at least do one useful thing maybe more than one but certainly at least one they provide for the banks two measures of their credit worthiness okay they provide one measure one rating assuming that the bank would be allowed to fail the standalone rating but they also brought a second rating which is the one that matters which is the rating that embeds an assumption about whether this bank will be bailed out by the government and that's called the support rating so the difference between these two ratings the standalone rating and the support rating provides the rating agencies the financial markets best guess of whether this bank will be bailed out and that's what the blue line here shows looks the difference between these two ratings how much of a ratings uplift how much lower are the funding costs for the biggest banks in the world because of this expectation of state support so what we see here is up until around 2007 the crisis broke this expectation of state support this implicit guarantee was worth just over one notch in ratings and then after the crisis as that implicit support became explicit banks were bailed out the rating agencies revised up their expectation of the likelihood of banks being bailed out and therefore this additional rating support from being too big to fail went from around one and a bit notches to around three notches so what that doesn't sound much uh on the face of it but let's now translate those differences those implicit subsidies if you like to the biggest banks from the government into some concrete numbers some real numbers that we might recognize this is for the the 29 biggest banks in the world and this is then a measure of the implicit financial subsidy extended to these banks over this period so again let's break it down prior to the crisis that too big to fail guarantee was worth for the big banks on average around 50 billion dollars every year every year so to put that in context that's almost half of the profits earned by those banks in the pre-crisis period could be accounted for by these implicit government subsidies and of course after the crisis when those implicit subsidies became explicit we find the corresponding subsidy shoots up very dramatically and interestingly has remained at those higher levels so today that implicit support that implicit guarantee to the world's biggest banks is worth to them several hundreds of billions of u.s dollars which is actually well in excess of the profits that they earn on an annual basis and if you don't buy very precisely the numbers you'll see the orders of magnitude are such that this is a very big deal a big deal for governments and a big deal for the banks that are the recipient of these subsidies what it does is to lock governments and banks in this deadly embrace where government feels duty-bound to ride to the rescue even if it means endangering their own balance sheet as we found in iceland and ireland and spain and greece and cyprus and whoever is to come next we get locked into what elsewhere i have called a doom loop in this feedback and interaction between an oversized banking system on the one hand and a potentially bankrupt government on the other just look at the way in which the government debt to gdp ratio in the major economies has shot up over the last few years one of the tangible costs of this doom loop between banking and sovereign states so that's the evolutionary trajectory that is the problem that is the key structural fault line in the global financial system how are we to tackle it i want to discuss three sets of initiative that have been put in place over the course of the last five years to try and crack this nut i want to talk about additional capital being put in to the world's biggest banks i want to talk about resolution regimes means of liquidating the biggest banks in an orderly fashion i want to talk about so-called structural measures measures to price apart the balance sheet of banks to make them safer because those are the three strands where there's been most policy progress over the last five years starting with what i'm going to call systemic surcharges so what does this mean so you often hear economists talking about these things called externalities and simply put they are just bad outcomes created within society which those contributing to those bad outcomes don't take fully into account so the classic example pollution okay so i'm a factory i am polluting the atmosphere that leads to a collectively worse outcome for everyone but i don't fully take into account the effects of my own polluting actions on broader society so pollution is a classic externality and so too is risk across the system that too is an externality those biggest banks aren't fully taking into account the damage their failure would do to society if they were government wouldn't need to ride to the rescue so systemic risk is an externality and for several hundred years economists have had a ready-made solution to this externality problem and it's to tax it it's to impose what economists called a pigouvian tax after the classical economist pagoo to tax it to such an extent that there are no longer incentives to pollute to create systemic risk and somewhat remarkably the microeconomic theory has found its way into regulatory practice over the last two or three years the world's regulators have taken this message too hard and said yes what we need is a tax a systemic risk tax a systemic surcharge imposed on the world's biggest banks and the way the form this tax will take is by requiring them to hold a bigger cushion of rainy day reserves what regulators call capital will require a surcharge of extra capital to reduce the chances of them going bust and us as governments finding ourselves on the hook and that's exactly what's happened rather remarkably that economic theory has found its way onto the statute books very quickly and we're now going to acquire from the world's biggest banks extra cushions of capital up to two and a half percent of their balance sheet so directionally this is right extra capital means lower risk means less chance of government being on the hook the problem is the size of this tax two and a half percent of capital isn't really all that much i mean bear in mind that we're talking about institutions that are financed with around 98 debt on average the 98 debt financed right so requiring that they go from 98 to perhaps 96 or 97 isn't such a big leap and doesn't have such a big impact on the chances of them failing this is a slightly complicated chart which i won't labor but it's a simulation for the economist in the room it's a simulation of the probability of those big 29 banks going bust drawn from a little contingent claims framework and it asks how much are expected losses across the system reduced by systemic surcharges measured horizontally being of varying sizes should take the yellow the yellow line for a second what that messy tells us is that you know a surcharge up to two and a half percent the dotted line does help lower those expected losses quite a bit but there's still a whole chunk indeed 300 billion dollars worth of a chunk left untouched with capital surcharges set at those levels is this progress yes is this sufficient to rid us of the problem of too big to fail absolutely not why was it regulators didn't choose a number bigger than two and a half percent uh i've got some good stories as to why that is but uh i'll tell you them privately um the second attempt we have made to to do a better job of handling these big banks is to try and put in place arrangements so that when they do fail when they do stumble when they do fall instead of writing a check and bailing them out we instead put them into a special form of bankruptcy we treat them in the same way as we would any other non-financial firm we let them go bust but we do that in an orderly fashion in a way that doesn't bring the ceiling down in a way that doesn't lead to gdp falling off that cliff that i showed you in the slide at the beginning and this too has seen some real regulatory progress over the last few years the first mover here was in the u.s and the dodd-frank act massimo mentioned what does that do well it um identifies those firms that are the greatest source of risk it says whether those firms are banks or non-banks they will be subject to these special bankruptcy arrangements it says we will legally prohibit ourselves from bailing these guys out in future and it says that to make good the losses these big banks face we won't bail out we will instead bail in the creditors of these firms we'll impose losses on the investors in banks rather than on us taxpayers and the essential logic the principles underlying that that general approach have now been agreed um globally by this thing called the financial stability board and here within europe here within europe where in the process over the next few months of putting in place a regulatory directive which will enshrine this statutorily within europe as well as in the us and elsewhere so so far so good is this the answer to our prayers is this as some have suggested the solution to the two big to fail problem no no or not yet at least for two reasons how is it that we deal with a big bank let's take a a huge bank let's take uh massimo mentioned jeffy mr jp morgan the world's biggest bank it is failing there are two ways of dealing with a failure of someone as big as jp morgan one would be to take its assets and its deposits and sell them on to someone else okay to sack the management strip the assets and the liabilities and to sell them to someone else and indeed that was the way a number of the larger banks were dealt with during the course of the crisis so when bear stearns failed it was sold to jp morgan and when merrill lynch stumbled they were sold to bank of america when washington mutual failed they were handed on to city bank on the face of it this sounds okay but just think about what that does to the evolutionary trajectory of the financial system the only bank capable of buying of digesting a big bank is another big bank which means that the biggest banks become larger still and the too big to fail problem becomes ever more acute over time and interestingly during the course of this crisis we've seen the degree of concentration in the financial system become greater not lesser the too big to fail problem has worsened so there are natural limits to i think how far we can go in this splitting up and selling approach to dealing with the big banks it works like a dream for the small banks for the big banks it won't work it can't work if we're serious about reducing not increasing concentration so if not selling what else could be done well the other solution the one i mentioned is to not bail out but instead to bail in there's lots of talk globally now about this being the solution to all of our prayers when push comes to shove when problems strike all we do is hand the bill to the creditors of the bank in question and we say things like um it's very important that we uh we protect taxpayers and make investors pay this all sounds terrific this sounds fantastic on paper but the fact is crises are not fought on paper so put yourselves in the shoes of the finance mystery or the treasury secretary of the day and a big bank comes knocking at your door and it says bad news bad news i'm bust i'm bust uh you have finance minister treasury secretary you have two options two options um you could bail in all our creditors you know uh you could bail them in if you wanted to by the way um they're all pension funds and insurance companies i imagine they make him knocking on your door when you tell them that their pension is worth half the amount it was previously or their insurance claim is worth half the amount it was previously by the way when you bailed in lehman brothers how well that went and you always brought the world to an end that's one option finance minister and the second one is that you write the check and faced with that dilemma based on that time consistency problem it strikes me as very likely indeed almost inevitable that whoever it is they will blink and take the second option if i were them that's what i would do and that's not conjecture that's because that is what hap that is what has happened on every occasion pretty much every occasion on history where a treasury secretary or finance minister has been faced with that dilemma and in some ways part of me thinks there's some logic to it because what you do in writing the check is to smooth out the pain you spread it across a wide range of taxpayers rather than a narrow range and you spread it between today and tomorrow you smooth it out if i'm a politician or a finance minister or treasury secretary or new central bank governor i might quite like to smooth the pain out and that being the case there's a decent chance that i will do the right thing which is to reach for the checkbook and to bail out rather than to bail in history tells us that is what has happened and the rating agencies tell us that's still what they expect to happen so i mentioned this dodd-frank act which in principle takes the checkbook the government checkbook and tears it up says never again i will never again bail out a big bank in america instead i will bail in creditors so let's ask the question has the passage of the dodd-frank act the dotted line there made any material difference to the likelihood of a bailout happening well not really in fact the expectations of a bailout today even in a post dodd-frank are higher underlined higher than they were before the crisis struck rating agencies market participants central bankers recognize the importance of incentives whatever however you write the legal rules exante what matters our incentives our behaviors ex post we need if we are to solve this problem to solve that incentives problem if too big to fail had a legal solution we'd have solved it a long time ago it's all about incentives which takes me to the third strand of reform which is meant to speak to this incentives problem it says well if we can't wind a bank down in an orderly fashion and if we haven't done enough to prevent them failing why don't we act directly on the structure of banking put in place so-called structural reforms there have been many versions of these i've listed some of those down here there's a volcker rule that some of you mentioned in the us we have proposals in the uk called the vickers plan there are proposals across europe put forward by this guy called herkie likenan which would also affect the structure of banking within europe lots of progress on this front over the last few years i won't go through the detail but these three proposals differ in their detail they're all about separating out or ring fencing the risky bits that we often call investment banking from the less risky bits which we sometimes called retail banking but they achieved that separation in slightly different ways and they put the ring fence in slightly different locations but in essence all three of those proposals are doing something broadly similar why to make it somewhat simpler somewhat easier to keep the good bits of banking the retail bits of banking safe and sound and to allow the risky bits of banking the less good bits to be wound down safely without fear of cross-contamination between the sheep and the wolves these are proposals for separating out ring fencing the wolves in the investment banking world from the sheep in the commercial banking world the good bits from the bad to put it very crudely and you you might just see what why is it we might want to do that well these are quite different beasts wolves and sheep are quite different animals and have paid themselves rather different amounts of bonuses over time this chart speaks to that looks at the the in wages selection of sectors so the green line is this good retail banking commercial banking the orange line looks at wages in the insurance sector and this blue line captures effectively investment banking it's quite a striking picture so um back in 1980 your average professional person with equivalent qualifications would be be paid the same in investment banking as they were in commercial banking as they were in insurance as they would be in law or medicine all professions paid roughly the same multiple which is why this is around one this number is around one for all the sectors over the following 30 years or so however something pretty extraordinary happened i mean the bankers started paying themselves a bit more uh than their professional equivalents in law and medicine as did the insurance company people but the investment bankers made out like bandits 30 years on they were being paid four times the amount of their equivalently skilled professionals in other industries a pretty dramatic cultural shift which generated pretty dramatic differences in risk culture in risk taking culture so the notion behind these ring fencing proposals is to try and achieve a separation of balance sheet as well as separation of culture given how differently they pay themselves will these structural proposals work we do not know those of you familiar with the us debate will know that they are facing real difficulties in implementing this thing called the volcker rule here in europe will europe enact any type of structural reform to its banking system will these leaking proposals find fruit that remains a big question but many people within europe are skeptical that for example france or germany would turn its back on its universal banking model there's a high a healthy degree of skepticism that structural reform proposals of these types will solve the too big to fail problem i come back to this chart which is what the market thinks today about whether we have solved too big to fail it is concluding pretty decisively this problem is if anything if anything worse than when the crisis commenced and why is that because banks are even bigger they're even more concentrated they are ever more complex the implicit subsidies that generate this doom loop are even larger these beasts speak king kong or godzilla but not father christmas remember have not as yet been tamed and that's why the debate about too big to fail has taken a new turn there has been a growing recognition over the last six to nine months starting in the us and gradually percolating outwards that this problem has not been solved and that's meant that several proposals more radical proposals have been put forward for tackling and taming those beasts i've mentioned one or two of them here so there's a a very active debate actually within uh the us right now about whether we should require the biggest banks on the planet to hold not just a little bit more of this thing called capital but a lot more so the most radical of those proposals are by these two u.s senators sherrod brown and david vitter who have proposed a leverage ratio i won't bore you with the detail of that a leveraged version of 15 which is basically five times larger than is currently required by international regulation in other words a lot a lot more capital for the world's biggest banks those with balance sheets in excess of 500 billion dollars in assets others have said um well capital is one thing but why don't we just play some caps on these guys let's just say you can't be bigger than x impose some explicit size limits and this isn't just the crazies in academia saying this it's been an idea that's been muted within parts of the official sector the federal reserve system in the u.s too there are those that say we ought to turn back the clock and reimpose something that achieves proper separation not just ring fencing but proper separation between say retail and investment banking a return to what some of you have come across as the glass-steagall act provisions of 1933. all three of these radical proposals for tackling too big to fail are back firmly on the table but but the big question each of them poses is what are the costs from this more radical course what are we losing if we for example impose size limits on banks and the most natural thing was natural argument that's often used about what we might lose is that we then remove the possibility of so-called economies of scale or economies of scope in other words you are bigger banks do a better job of spreading the costs out and therefore can be maybe more productive than smaller banks or that by diversifying across activities that leads to lower risk among the bigger banks so these are the economies of scale or scope the biggest banks have argued would be lost if we were to pursue some of these more radical proposals so what do we make of those arguments are those compelling reasons not to pursue these more radical options what is the evidence on these economies of scale or scope in banking well this summarizes it there's surprisingly little evidence actually on whether there are economies of scale or scope in banking but i've summarized roughly where it comes out here in the 1980s there were a set of papers that argue that it's pretty tough to make a case for economies of scale for banks that had more than a hundred million dollars in assets in other words very small in the 1990s there were a set of papers that pushed that threshold up they said yes those economies of scale were there but appear to cease at an asset size of around 10 billion dollars neither none of these studies at this stage were music to the ears of the big banks because these thresholds were much much less than their scale even then fortunately there's been some papers over the last two or three years that have pointed to a more optimistic conclusion for the biggest banks they have found economies of scale for banks with balance sheets well in excess of 100 billion dollars indeed some have found economies of scale for banks with balance sheets as large as the largest bank in the world in other words economies of scale even when assets are one and a half two trillion dollars in size and this is that evidence so i've taken their studies and replicated them across the horizontal axis this shows the the total assets size of a variety of banks so um is the banks with assets less than 100 billion these are banks with assets of more than two trillion dollars in assets and the ones in between so bank asset size is increasing coming up here what are these blobs showing where they're showing a measure of whether there are indeed economies of scale in banks of different sizes so along the if these if these blobs lie above the dotted line what it's saying is that there are economies of scale there are increasing returns to scale in banking by doubling the inputs into banking we can more than double the outputs and because these green blobs lie above the line rather than below the line we conclude there are increasing returns to scale there are economies of scale in banking which if anything increase with size so taken at face value this would suggest that we might well be throwing away something rather important if we were to size cap the biggest global banks but and there is a very important but what these studies fail to take proper account of indeed any account of is the fact that these self-same institutions all benefit from that government guarantee i mentioned at the beginning remember that remember the doom loop remember the implicit support from the implicit subsidies so what do they do so implicit subsidies make big banks less risky because of the guarantee that lowers their funding costs that boost their profits and therefore would show up as greater value added for the bigger banks than is in fact the case it would distort upwards any measures of economies of scale from studies such as these so we shouldn't really take these studies too seriously unless they take proper account of that government guarantee when you do that what happens that's what happens so you flip that round you do your you do your econometrics properly you take proper account of these government guarantees these subsidies what do we find well we now find that these now purple dots are not above the line increasing returns to scale but are instead below the line that is to say decreasing returns to scale and what's more size if anything tends to make those decreasing returns more acute rather than less acute we don't have an efficiency loss we prospectively have an efficiency gain from capping size why might that be well because because alongside too big to fail or too big to bail or too big to jail we also have the problem of too big to manage and it's that incapacity to manage a balance sheet bigger than the annual gdp of italy with 2 000 subsidiaries operating in dozens or hundreds of countries that might generate just those dis economies so where are we we've seen an evolutionary path for banking over more than a century which is generated not just bigger banking but bigger banks more concentrated banks more complex banks and the government finding itself progressively on the hook for supporting those godzillas those king kongs when they fail and therefore generating incentives for the largest banks to become larger still the last four or five years have seen a dramatic set of interventions by regulators like me to try and solve that problem we have tried but on the base of the evidence so far our job remains unfinished this counter reformation in banking that i said we should start today is unfinished business it will not be people like me old and tired and wizard who will complete the job completing the job will fall to you and i wish you all well in that thank you but you andy it's uh 12 20 25. i think we have a a short time for i would like to open the floor to a q and a with a preference for questions in english i'm sorry i spoke in italian i was requested to speak in italian i didn't realize that you didn't get the the italian translation so i have a request for myself but it's better to start with the floor one here thank you isn't it obvious that the solution is to remove banking from the market uh to make banking into a national service that's provided perhaps by the state should i collect some or should i yeah one well um that will be one even more radical reform proposal um i think there are proposals short of that which could provide a greater degree of assurance that the banking system should serve the essential social functions that we believe it should serve so i think um personally you know we do have experience of running banking explicitly within the state sector in the past it hasn't always worked so well one reason is it's very difficult if you place banks within the public sector in state hands for them to be very innovative and we do want our banking system to be innovative as well as safe actually banking has got a pretty bad record on both you know on some measures the productivity of the banking sector in the u.s has been little changed for the past century last century imagine that and for me it's something of a conundrum a puzzle that the i.t revolution that has swept through every industry on the planet has not done more to revolutionize banking why do i say that i say that because finance is an information business that's all it is and the i in i.t stands for information so in principle the sector that should have benefited most from the i.t revolution is banking and yet and yet the payments technology that we face today is little different than what it was 30 or 40 years ago to the extent that innovation is happening it's coming not from within banking but from the encroachment of the big it companies paypal google wallets so um one reason i'd be hesitant about going too far down your path is that it might actually snuff out that embryonic financial innovation including from non-banks that i think we all longer term benefit from foreign um okay thank you for your lecture i wrote a small paper on um how to it's a bit difficult now to to to put the question well what i want to say is that um until um let's say 1950 you had a national interest in national banking and there was at least in germany in the past there was a nobility who accompanied the evolution of growth and what we then have seen is that big banking overtook probably also the government now we face a problem that the um the asian countries are growing they have a national control of the economy somehow and we don't get back to our investment path just because we have a banking sector is out of control and i mean that's not not that's something which we realize but um how do we get back to control given these incentive structures how do we get back to i mean before the glorious revolution that government ban government debt was private debt by the king and if things got too difficult it just repudiated its debt and he cancelled it after 30 years war after you know i mean you know the history probably better than me um it's just kind of um how do we get it back to because it's a political problem i mean we are risking our future because we give too much of our of our future to the banks that's a problem what what do you see as points to really reform because i mean we know these we can think back to glass-steagall and but how do we implement that in practice that's a problem so um as you say we've gone through a really interesting cycle here because you know taking us back to the origin of banking in this country 13 14 15 16th century the boot was on the other foot so the typical practice then was that it was governments borrowing from the banks the government's going bust and then causing problems to balance sheet the banks and the last 200 years it's been the other way around it's been the banks stumbling and drawing upon the balance sheet of the government and imperiling both whichever way around it is we need to price these two things apart the government or sovereign balance sheet on the one hand the banking balance sheet on the other a less large banking sector in relation to gdp is part of the answer to that because that means the collateral damage in both directions is less when it happens and i think given the regulatory initiatives in train that will happen over the course of the next 20 30 40 years i think in addition to that we need to think about the incentives embedded within the current system what was it that kept banking boring for most of its 800 year history and one of those things to pick out just one was was unlimited liability it was that you faced the losses of the risks you took as well as the gains the losses weren't capped below at zero and unlimited on the upside you start to lose everything if your bet went sour now it's unrealistic i think for us to turn the clock right back to one of unlimited liability but i think we could importantly reshape incentives for example in the design and structure of pay contracts to try and better replicate that unlimited liability world leave one concrete example of how that might happen why not require that any bonus paid to a banker is deferred for a much much longer period arguably up until the point when they retire that wouldn't fully replicate the old unlimited liability world but it would better replicate it than the current structure which enables people to take their bonus either immediately or within a year or two of having our own dates so i don't have a magic one solution to your problem but there are elements that could take us back to the future i think there's one here as i see that we have still several questions and we are really five minutes remaining they would put together all the questions my husband is english but my english is very poor alas i'll try to be very quick and to the point do you think that uh if we really want to avoid this uh terrible things that uh we are talking about we can think that uh each single state even in europe not to mention of course the united states um that basically do what they want don't you think that in an attempt to avoid or prevent these economic downturns states could pass very strict legislation than they have done in the past both to prevent this excessive growth of banks and to limit their exaggerated growth in income in profit and do you think that the uh if one or more banks go bankrupt or have gone bankrupt this may have been partly at least due to the fact that they did not require sufficient guarantees to their creditors in an attempt to increase their profit the technology scholars say that the banking system stopped in the phase of of process innovation and didn't move enough to the product innovation which is something similar to what you said but then there is the good and the better product innovation for example in spring 2008 the gillian that is the anthropologist and journalist of nation times was interviewing some people from from the big um financial banks american financial banks they were saying one of them i don't remember which one of the big financial the three big finances would say yes we invented the compass derivatives we are the inventor we were the first one to be but we were meant to put their good things in the package not not bad things so they imitate also put in the compass derivative the the the bed the bad things and compacted the bed with the good ones so there was innovation which was good but the imitation was bad in that single case foreign you said during your presentation that over the next 20 or 30 years the strength of banks will have to be played down to some extent do you think that this will have a direct impact on real economy on jobs and in which sector in particular got one more question i think it has to be the last because we are really quite late intellectual clarity and inspiring uh presentation it's good to start the counter reformation here in trento it's good on banking with inet and with the young scholars uh the bad news is that the council of trent actually lasted for 23 years so it might take two generations of economists i mean to reverse that but the question i would have i mean is basically you've seen the the financial world metamorphosis metamorphising or i mean evolving in through these very difficult times so i was wondering i mean what your advice would be to young scholars in terms of the obstacles to new economic thinking and how to move from thinking to acting newly thanks a lot hey that's maybe i can take them in uh turn if i can remember remind me if not um um so to your question i was listing an app i pressed the wrong button and it i thought it was the sound it was actually the um the channel so i got half of your question italian i'm afraid so i may not have fully got it um is is more needed is more needed absolutely personally i am i'm i'm skeptical massimo mentioned this at the beginning that the solution is to layer extra regulation on top of extra regulation we've been trying that for the last 40 years and it tends not to work so well for the very simple reason that the banks can find ways around the system quicker than we can redesign it so charles goodhart who's a british economist often used the the metaphor this relationship between banks and regulators was the the bloodhounds in pursuit of the greyhounds we could basically never keep up they're running much faster than us i think there's something to that so if i were to do something of a statutory nature it would be something to the underlying corporate structure of banking in ways that didn't chase risk around the system but instead reshaped risk-taking incentives within banks it could be pay it could be company law banks are i was discussing this with rob just last night they are social institutions actually most firms are social institutions because they touch the lives of all of us so taking seriously those social responsibilities is key if that requires a change in corporate form or company law for me that would be the right way to go i very much like the color of your dress which is the same as the trento festival color by the way i thought i just mentioned that in passing um flash innovation you're right there's been plenty it was the wrong type of innovation the quants the scientists the mathematicians the physicists they were sucked out of doing what they should have been doing which was mathematics and science and physics and inventions were too busy creating rubbish and that was deeply unfortunate could they be redirected onto the path of righteousness yes i think they could and yes i think they should there has been far too little we need to be mindful of the wrong type of innovation but i think with the right culture with the right risk taking culture we'd find the right sort of innovation uh happening i've forgotten your question which is terrible just remind me very quickly what your question was sorry look at behind you system good can you hear me have costs for the wider economy it need not do so and the reason is because we don't need banks to do banking we certainly don't need banks to do lending the natural holders of long-duration loans the type of which we might want to be provided to our companies to our households to build our schools to build our infrastructures are actually not the banks they are institutional investors such as pension funds and insurance companies right now one of the factors one of the structural obstacles to growth in europe has been that it has lacked a non-bank engine for financing the economy this is an engine a second cylinder that the us has and has been an important contributor to the us recovering more quickly than has europe europe in future needs to place less reliance on banks and more reliance on non-banks when financing businesses and households if it does that there is no reason why this regulatory squeeze on banking ought to have any negative effects on the economy in fact if anything this more diverse financial ecosystem ought to be supportive will be supportive of growth in europe as it has been in the u.s and finally to the last question um which is um 23 years is a short space of time um if we do it in 23 years you know i would be over the moon um what direction of travel the inate young scholars young scholars everywhere and i say this to all the graduates that join the bank of england and i mean it with an absolute passion that they have no idea how lucky they are to be landing at this point in history to be facing this set of challenges not just in banking but more broadly there is a real opportunity for that cohort for this cohort to make a real difference go out and make a real difference make a name for yourself we know events like this do spawn new thinking do spawn new policies and do make for better outcomes that will not come from me it will come from you thank you okay thank you very much indeed for your attention it's not so common to see the audience so widely involved on such a difficult topic for such a long time so thank you again you