by Graham Reid & JR Max Wheel
09 March 2015
The latest Public Affairs Select Committee (PASC) report is, as usual, wide-ranging in its attempt to assess Whitehall’s capacity to address and respond to future challenges. In this article, we limit ourselves to comment on the financial aspects of the report. Having read its findings, and whilst presuming there are many omissions are on supposed grounds of confidentiality, we are alarmed to see in its second paragraph a rather glaring hole:
“The most surprising and urgent gap we found was in HM Treasury…..Market-wide exercises have been conducted to test resilience, but not on a comprehensive basis to address the risk of systemic financial collapse triggered by an unexpected event.”
Perhaps, the underlying cause for this potentially dangerous position can be found in the (incredible) response from the Treasury:
“It is unfortunate that the public administration select committee’s report takes no account of the relevant facts,” it said. “By focusing on Whitehall procedures they have entirely missed the point: the lessons of the financial crisis have been learned and acted upon by putting in place a reformed regulatory system, ring-fencing the banks, ending the ‘too big to fail’ problem, and dealing with the risks posed to the economy by an unsustainable deficit.” [So that’s all right then or do we hear echoes of “ending Boom & Bust”.]
Clearly, as regards the UK’s financial industry little or no attempt has been made to address the flaws and gaps in the risk assessment and evaluation methodology, not to mention the outright malpractice that consigned the UK, amongst many other countries, to the horrendous effect of the 2008 crisis, one for which we are still paying a very heavy price. We are astonished at the lack of interest into what has been possible for several years to anticipate and reduce massive risks particularly those that are systemic. None of this is questioned in the report so we must assume that there is ignorance on the part of both questioners and responders. So sad!
The report reminds us that the Treasury’s 2012 review of its response to the global financial crisis identified the lack of a legislative basis to resolve failing banks and records that “Remedying this was not deemed to be a priority by the Treasury in the context of the benign financial climate (sic). War games were played for the scenario of an individual institution failure but not for a system-wide crisis, which was judged to be highly improbable.” Strangely, most of us seem to recall in detail this highly improbable crisis!
Reliance on politically-inspired legislation to anticipate the effects of varying risk scenarios is naïve at best since both foreseeable and unforeseen risk situations do occur. However, modern modelling techniques can both identify potential damage and can produce warning signals in advance. Recall following Enron’s sudden collapse, the lights in the US did not go out, even if the company’s did!. The energy sector had highly sophisticated risk modelling systems in place, of the sort that could have helped mitigate the worst of the 2008 financial crisis. Systemic risk can be valued and contained but only if there is an acceptance of and the will to pool knowledge in the best interests of all but that is the subject of other articles.
We now make specific comments on some of the points raised in the report as follows:
“Market-wide exercises have been conducted to test resilience, but not on a comprehensive basis to address the risk of systemic financial collapse triggered by an unexpected event.” This is an urgent exercise and there needs to be one body coordinating it, even if the prudential supervision activity is carried out by another.
“A group of constitutional experts and economists wrote a letter to The Queen in November 2009 which contended that “the failure to foresee the timing, extent and severity of the crisis and to head it off … was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.” This is nonsense! releasing the brakes on the financial system happened in several stages and with increasing levels of potential risk. We recall in no particular order-.Big Bang deregulation, repeal of the Glass-Steagel Act, massive overseas expansion by banks, widespread growth and misuse of derivatives, weak or ill-focused regulation including by the BIS, via its Basel capital adequacy arrangements, which offered tempting targets for banks to navigate and game. Absence of proper supervision by the FSA, abusive accounting techniques, tax mitigation games, wrapping and bundling of assets as investible “securities”, the sucking in of the insurance industry to create“financial products”, an abuse of Chinese walls, growth of shadow or perhaps shadowy banking, Central Banks’ loss of control over money creation and the growth of quantitative modelling as a substitute for good judgement and management rather than a useful mathematical tool.
It is pretty basic but surely the onus should fall on banks, not to use capital just as another source of lendable funds, but as a proper buffer against liquidity, cyclical, credit and country risks. Leverage ratios amongst major banks are still too high. As the Central Banks Club, the BIS should insist on agreed wind-up procedures for all banks including shadow banks and funds management companies.
Black Swans (Low probability high impact events) need particular care since contrary to popular imagination in an interconnected world they are far more common than realized.
No problem though, we can relax because apparently “The Civil Service usually responds brilliantly to fast onset, short duration crises, with clear responsibility taken by a lead government department.” Really? How about Foot & Mouth, BSE, Floods, and stockpiles of Tamiflu vaccine to name a few then? Either no plans were in place and/or a joined-up response was sadly lacking.
The Committee really gets into its stride here: “We commend the development of the National Risk Register. It is a vital tool to enable and encourage thinking about better management of short and long-term risks. The challenge is to ensure that this information is used in advice to ministers, and not ignored.” This surely should be a base point from against which Government policies are costed, tested and implemented. Those that fail the risk “sniff” test should be challenged or dropped by Parliament.
“Professor Ian Goldin, Director of the Oxford Martin School, has described systemic risk as a process to be managed, not a problem to be solved.” This is a very academic view, which may be theoretically correct but absolves everyone from exercising any foresight or care. Systemic risk surely needs, where possible, to be identified and avoided, not fatalistically managed: it’s the constituent parts that need to be managed, precisely what was not done.
It gets better “Sir Nicholas Macpherson told us that: They are very good at forecasting in the good times, or indeed the bad times, if there is a steady trend. […] What forecasters are generally very bad at is forecasting inflexion points.” What forecasters are bad at doing is…ahem forecasting and understanding the difference between predictions and projections! Anyone can extrapolate from a trend.
“To reassure us that he was not complacent, Sir Nicholas Macpherson cited a standard, well understood risk–the failure of a bank: We did a lot of analysis and contingency planning around the impact of a banking collapse on Britain. When one of the Cypriot banks got into difficulties, we basically put into practice that contingency plan. There are a lot of Cypriots living in this country and it worked pretty well.” We totally disagree; Cyprus is a rotten example of a small economy most recently dominated by laundered Greek, Russian and Mafia money, whose disproportionately sized banking system unsurprisingly imploded. Maybe is this mandarin-speak i.e. another case of selective examples chosen to prove a point. Trust us, we are the Treasury.
“Mark Carney, Governor of the Bank of England, intends that firms are able to fail without threatening the stability of the system as a whole: “firms should face the discipline of the market and consequences of their actions. We do not operate a zero failure regime.” This is very easy to say, but our guess is in the event of a future large bank crisis the Government will be forced to do the same again- bail them out, why? Because despite having increased capital, regulators have not taken action to force recognition of impaired assets, control leverage ratios and demand that assets are accurately marked to market. Better still why not also ensure that a Risk Director with appropriate experience is mandatorily appointed to Bank Boards with direct access to CEO/Chairman and the BoE as regulator.
Risk is a complicated concept and is unlikely to ever be totally eliminated but surely we should try to put proven systems in place to protect us without relying on politicians to protect us from their own mistakes.
Why not Be better Prepared by having a Select Committee for Strategic Planning?