ƒ Ideal equity ratios higher than Basel III

ƒ TBTF: making banks ‘resolvable; necessary but not

sufficient

ƒ Markets as important as institutions; shadow banking as

important as banks

ƒ The fundamental issues

¾ Debt/equity balance
¾ How much maturity transformation

ƒ Four implications

1
 IMF estimates of public support costs in 2008-2009
financial crisis

% of GDP

Net direct
Pledged Utilised Recovery
cost

Advanced
economies 6.2 3.5 0.8 2.8

Emerging
economies 0.8 0.3 - 0.3

Source: IMF: A fair and substantial contribution by the financial sector, June 2010 2
Growth in lending and nominal income:
UK 2005 – 2010

14
Private debt stock (%YoY)
12
10
% change year-on-year

Leverage increased
8 through the boom
6
4 Nominal GDP (%YoY)
2
0
-2
-4
-6
Q1 2005

Q3 2005

Q1 2006

Q3 2006

Q1 2007

Q3 2007

Q1 2008

Q3 2008

Q1 2009

Q3 2009

Q1 2010

Q3 2010

Q1 2011

Q3 2011

Q1 2012
3
Credit and asset price cycles

Increased credit
extended

Increased
Increased lender Increased asset
borrower demand
supply of credit prices
for credit

Expectation of
future asset price
increases

Favourable
assessments of
credit risk
Low credit losses: high
bank profits
• Confidence reinforced
• Increased capital base
4
Minimum bank equity ratios: Basel II to Basel III

Basel II Basel III

Total assets

Risk Risk
weighted weighted
assets assets
Estimated
riskiness, e.g.
SME 100%
Mortgages 15%

Required
2%
2% equity 7%

5
Costs and benefits of higher bank equity capital

Key insights from:

David Miles et al: “Optimal Bank Capital”

Costs: Increased cost of
Martin Hellwig et al: “Fallacies, Irrelevant
credit intermediation
Facts and Myths in the Discussion of Capital
Regulation”

Vs
ƒ Distinguish social from private costs
ƒ Consider low probability extreme events
Benefits: Reduced likelihood
of financial crises ƒ Focus on total systems not specific
institutions

6
UK banks’ leverage and real GDP growth

5% 40
4% 35
3% 30
2%
Real GDP growth 25
(10 year m.a.) 1%
Leverage (rhs) 20
0%
15
-1%
-2% 10

-3% 5
1880 1900 1920 1940 1960 1980 2000

Source: David Miles, Jing Yang and Gilberto Marcheggiano, Optimal Bank Capital, External MPC Unit, Discussion
Paper No. 31 7
Mechanisms to increase loss absorption capacity
and market discipline
Capital surcharge
and/or sub debt Resolvability &
convertibility statutory bail-in

Insured
depositors

Resolution
Non-insured procedures which
depositors can rapidly
impose
Interbank & other losses/conversion
counterparties on all liabilities (to
extent required)
Senior debt
instruments

Subordinated Increase role of

debt & Preferred loss-absorbing
stock capital
Common
equity

8
 Mechanisms to increase loss absorption capacity
and market discipline
Capital
surcharge
and/or sub debt Bail-inable senior Resolvability &
convertibility debt statutory bail-in

Insured
depositors

Resolution
Non-insured procedures which
depositors can rapidly
impose
Interbank & other losses/conversion
counterparties Smooth resolution on all liabilities (to
without disruption extent required)
Senior debt
instruments OR
Increase role of ‘Reserve army’ of capital
Subordinated loss-absorbing to cover extreme events
debt & Preferred capital
stock

Common
equity

9
Current initial investor base for UK bank senior debt

Other banks
25%

12%
Insurance 50%
12% “Fund Manager”
Other

Source: Broad estimates from firm information

10
Frequency distribution of bank bond payouts

Observed in good times

100%

Not observed in
good times

0
100% of principal
and due interest
11
Financial firms’ CDS and share prices
Exhibit 1.27: Composite Time Series of Select Financial Firms' CDS and share prices
1.2% 2.50
Average CDS Spread in Percent

1.0%
2.00

MarketCap Index
0.8%
1.50

0.6%

1.00
0.4%

0.50
0.2%

0.0% -
Aug 03

Aug 04

Aug 05

Aug 06

Aug 07

Aug 08
Dec 02

Dec 03

Dec 04

Dec 05

Dec 06

Dec 07

Dec 08
Apr 03

Apr 04

Apr 05

Apr 06

Apr 07

Apr 08
CDS SHARE-PRICE-ADJUSTED

Firms included: Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway,

Bradford & Bingley, Citigroup, Deutsche Bank, Fortis, HBOS, Lehman Brothers, Merrill
Lynch, Morgan Stanley, National Australia Bank, Royal Bank of Scotland and UBS.
Source: Moody’s KMV, FSA Calculations CDS series peaks at 6.54% in September 2008. 12
Development of the crisis: 2007 – 2008

June 2007: Bear Stearns hedge funds

August 2007: Major losses by ‘market neutral’ hedge funds

February 2008: Carlyle Capital and Peloton Hedge Funds closed

Autumn 2007 to
Mid 2008: Liquidity and solvency problems at off-balance sheet SIVs

Summer 2008: Stresses at MMMFs: Reserve Primary Fund ‘breaks the buck’
August to
October 2008: Liquidity run in repo and other secured funding markets

Late autumn Hedge fund deleveraging and asset sales exacerbate

2008:
downward spiral of asset values
13
US financial sector assets

Banks MMMFs
GSE Agency and GSE- Mortgage Pools
Issuers of ABS Finance Companies
300% Security Broker-Dealer Funding Corporation

250%

200%

150%

100%

50%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
14
Traditional non-bank credit intermediation

•Leverage
•Maturity
transformation

Corporates Banks
Corporates

•Insurance
•Pensions Households
•Other

Households Direct Government

Non-intermediated

•Not leveraged
•Little maturity
transformation
15
Credit intermediation via the shadow banking system

Hedge
Funds
Investment
Banking /
Prime brokers

Corporates
Corporates

Securitisation Households
SIVs &
Conduits

MMMFs
Government
Households

Multi-stage
leverage and
maturity
transformation 16
 Credit intermediation via the shadow banking system

Extensively
interconnected via repo
market

Hedge
Investment Funds
banks
Corporates
Corporates
Banks

Households
Securitisation
SIVs &
MMMFs Conduits
Government
Households

17
 Source: Datastream
0
1000
2000
3000
4000
5000
6000

02/01/95

02/07/95

1995
NASDAQ: 1995 – 2002

02/01/96

02/07/96

1996
02/01/97

02/07/97
1997

02/01/98

02/07/98
1998

02/01/99

02/07/99
1999

02/01/00

02/07/00
2000

02/01/01
02/07/01
2001

02/01/02

02/07/02
2002

18
 Greek sovereign debt and cost of borrowing

Basis points % GDP

1000 150
Greek 10-year spread to bunds Forecast
Greek general government gross debt as % of GDP
140
800
130
600
120

400 110

100
200
90

0 80

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014
2005

2006

2007

2008

2009

2010

2011

Source:
Source: Datastream Source: IMF World Economic

19
Maturity transformation

Bank based Liabilities Assets

Liquid Assets

Deposits
Corporates & Corporates
short Loans
term
debt Deposits

Households Government
Equity/debt
capital

Market based

Corporates Corporates
Debt markets
Equity markets Deposits

Households Government 20
Household deposits and loans: 1964 – 2009

100%

90% Securitisations and loan transfers Deposits Loans

80%

70%

60%
% of GDP

50%

40%

30%

20%

10%

0%
1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Source: Bank of England, Tables A4.3, A4.1

21
 Holdings of US MMMF Shares by Sector
100%

90%

80%

70%
Other
60% Rest of the World
Insurance Companies
50% Pension Funds
Funding Corps
40% Non-Financial Business
H'Hold
30%

20%

10%

0%
1980 1985 1990 1995 2000 2005 2010
Source: US Flow of Funds
22
 Financial institutions, corporate bond and CP
issuance
Total issuances
$ billion 768 2823 6410 16281

>10 years 4% 4%
10% 7%
11% 10%
19%
6-10 years 26% 22% 24%

26%

1-5 years 28%

63% 61%
48%
36%
<1 year

1991-1994 1995-1999 2000-2004 2005-2010

Source: McKinsey Global Institute: Farewell to Cheap Capital? The Implications of long-term shifts in global investment and
saving“, December 2010 23
 A capital adequacy and liquidity trade-off?

Liabilities Assets Liabilities Assets

10 Liquid 5 Liquid
assets assets

Debt of Debt of
Loans average Loans of
average of average
maturity 6 95 90 maturity 80 95
average 1 month maturity
months maturity 1 year
1 year

Equity 20
Equity 5

Which is riskier?
24
Typical haircuts on term securities financing
% for prime counterparties

June 2007 June 2009

Prime MBS:
AAA rated 4 10
AA and A rated 8 ~ 100
Asset backed securities
10 25
Structured products 10 ~ 100
(AAA)
Investment Grade Bonds
AAA and AA rated 1 8
A and BBB rated 4 10

Source: CGFS Paper No. 36 The role of margin requirements and haircuts in pro-cyclicality, March 2010

25
Measures of increasing financial intensity

US debt as a % of GDP by Global issuance of asset-

300%
borrower type backed securities
250%
te
o ra
200% rp
Co ol
d
150% h
u se
100% Ho l
n cia
50% a
Fin
10%
1971
1965

1977

1983
1990
1996
1959

2002

2007
1929
1935

1941
1947

1953

450 1,100
1,000
FX Trading values & world GDP
400 Growth of interest rate
900 1977-2007
350 derivatives values, 1987-2009
300 800
700
250

$Trn
$Tr

600

$bn
200
500
150
400
100
300
50
200
0
100
1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

0 1977

1982

1987

1992

1997

2002

2007
OTC interest rate contracts, notional amount outstanding
Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn

26
 Share of the financial industry in US GDP

Source: Andrew Haldane, What is the contribution of the financial sector: Miracle or mirage?, Chapter 2, The Future of
Banking, LSE Report 2010 27
Historical ‘excess’ wage in the US financial sector

Source: Andrew Haldane, What is the contribution of the financial sector: Miracle or mirage?, Chapter 2, The Future of
Banking, LSE Report 2010
28