The Bank of England was in the news twice last week, as some of its most senior officials spoke in their different ways on Threadneedle Street’s thinking on future economic and financial crises.
On Tuesday, the Bank gave evidence to the Treasury Committee on the latest Inflation Report that the Bank has just issued. As usual the Bank team was led by the Governor, Mark Carney, but it was the comments of Monetary Policy Committee member Dr Gertjan Vlieghe that caught the eye most. In discussing the Bank’s ability to forecast the shape of the economy he was disarmingly honest, admitting that “our models are just not that good”, and that expectations that the Bank could predict what was going to happen in the UK economy over the next five years or so were “unrealistic”.
Vlieghe’s comments follow those of Andy Haldane, the Bank’s Chief Economist, who last month admitted that the Bank’s failure to foresee the 2008 global financial crisis was a “Michael Fish moment”, a reference to the BBC weather forecaster who failed to predict the UK’s 1987 hurricane 30 years ago. They appear to be part of a sustained campaign by the Bank – still smarting from the failure of their warnings of an immediate and sharp recession should the country vote to leave the EU to come true – to reset expectations about how much economics can and cannot predict. As Niels Bohr, the famous Danish physicist, remarked, “Prediction is very difficult, especially if it concerns the future” – and as the Bank would probably add “and doubly so if it concerns the UK economy”.
This humbleness about the quality of the Bank’s economic crystal balls is however in stark contrast to its need to project a more confident air when it comes to the outlook for financial stability. And this was the subject of the other major public statement last week by a senior Bank official, as Deputy Governor Sir Jon Cunliffe spoke to a City audience on regulatory and financial stability issues.
Sir Jon spoke on the state of what he termed the “financial infrastructure” of markets – the clearing and settlement systems that underpin the world’s financial markets and ensure that transactions can be completed safely and securely – and presented a robust assessment of their readiness to withstand any shocks that could occur. These systems are often called the plumbing of the world’s markets, and with good reason, because while they are essential, they are often overlooked and operate out of sight behind the scenes – until that is, something goes wrong with them, when the resulting mess cannot be ignored.
The main thrust of regulators’ work since the financial crisis has been to make this plumbing more resilient, and the chosen solution goes by the name of Central Counterparties (CCPs), institutions that stand between market participants and take one side of every deal. By doing so, they turn the standard “cat’s cradle” of a market, in which everyone deals with everyone, into a “hub and spoke” system in which everyone deals with the centre. This is seen as the solution to the problem of a financial system whose linkages had become too complex and interwoven, and where as a result no-one had a full oversight of all the risks in the system and failures in one company had unpredictable consequences for others.
To go with the creation of CCPs, regulators have added the model of centralised regulation and risk buffers. Each market will have one central clearer under one regulator, with one set of risk controls and creating one common defence against financial instability. This, Sir Jon claimed, makes the system proof against almost all conceivable risks and defaults by participants – thus achieving one of the regulatory holy grails, a system which is strong enough to survive the default of individual constituent companies.
While accepting that financial infrastructure is a utility service that lends itself naturally to monopolistic providers, critics of this approach have focused on the considerable centralisation of risk that it implies.
Indeed, there are actually two centralisations inherent in the chosen structure of CCPs: the concentration of risk in the CCP itself, and the concentration of the regulatory response. Any given function of the market infrastructure has just one central clearing agent and one set of regulations. As long as the CCP stays operative, this is both effective and efficient, but for many in the market it recalls the phrase “all eggs in one basket”. And the response to this – in effect “Yes, but it is an extremely strong basket” – raises the issue of how regulators can be sure of this when faced with the unknown, and indeed unknowable, crises that will certainly occur in the future.
Beyond this, and potentially more seriously, there is the nagging fear that making CCPs ever stronger may not in the end be the most important thing the global financial system needs to worry about. For there is a growing concern among regulators and market participants alike that the next crisis may appear in a completely different part of the financial eco‑system, that of the asset management community.
For most people involved in asset management – and full disclosure, I worked for a large asset manager for 13 years – this statement will seem unreasonable. Asset managers are merely agents, they claim, managing their investors’ money; they do not put their own money at risk and cannot therefore be the cause of market turbulence.
This is disingenuous. It is true that asset managers do not put their capital into play, as banks do. Banks offer their clients two basic transformations: they transform credit (by offering their depositors a greater security than their borrowers give them) and they transform maturity (by offering their depositors instant access even when they cannot demand instant repayment from their borrowers). Both of these require banks sometimes to dip into their own money to make good on their promises, and it is for this reason that banks have to hold capital and are closely regulated to make sure they do. In short, their capital acts as a shock absorber between the market and their clients.
But while asset managers do not have capital buffers, they do in their own way offer clients a shock absorber through their intellect and trading ability. Asset managers traditionally manage client assets on a discretionary basis; that is, they know what their client is trying to achieve and have discretion on how best, given the state of the market, to achieve it. This discretion was in the past every bit as valuable a shock absorber as a bank’s capital – if an asset manager thought a particular market was fragile or unable to execute a trade, he would find a different way to meet the client’s needs.
The challenge for the asset management industry is that increasingly today, this discretion is being removed. The rise of passive investing (where, as the name implies, the asset manager has no choice over what they invest in but passively “buys the market”) and especially of vehicles like Exchange Traded Funds (ETFs) leaves the decision-making ever more firmly with the investor, both on what to buy and, more importantly, when – if an investor redeems a holding in an ETF, the ETF manager has no discretion at all, and has almost instantaneously to sell the underlying assets. Whatever the state of the market at the time.
It is this that worries many in the regulatory space. Asset managers who have no discretion about when they trade their clients’ funds can no longer provide the shock absorber of intelligent discretionary trading and sensitive market timing, and may make fragile and volatile markets worse.
To be fair to regulators, they have not been inactive. They have been urgently creating a new rulebook for asset managers, replete with acronyms (FMIR, MIFID, RADAR) and theoretical controls aplenty. But it remains controversial – asset managers are still resisting parts of the framework – and largely untried in the heat of battle.
So, two forward-looking statements by the Bank last week. On the regulatory and financial stability side, Sir Jon Cunliffe exuded confidence that the financial infrastructure of markets can withstand anything the next crisis could throw at it. For the economists though, Gertjan Vlieghe seemed keener to lower expectations that the Bank can predict either when that crisis will hit or what it will entail. We will all have to hope that when Vlieghe’s “unknown unknowns” occur, Sir Jon’s confidence is shown to be well-placed, and not just, like the Maginot line, defences against the battles of the last crisis while the next one blows up elsewhere.