London Takes the Lead

Remember the spectacular opening ceremonies of the London Olympics two summers ago?  James Bond, played by Daniel Craig, with Queen Elizabeth parachuting into the stadium and all that?  I especially liked the moment when a house surrounded by teenagers doing social media pulled away to disclose Sir Tim Berners-Lee, inventor of the World Wide Web, tweeting “this is for everyone” from his computer keyboard. The skit made a double-edged point. It reminded the world that British ingenuity was alive and well in the twenty-first century. And it bespoke the British government’s willingness, or at least that of the British Olympic Committee, to take a risk (in this case, on the television spectacular itself).

Americans got another glimpse of Cool Britannia last week when The New York Times front-paged the news that Britain would replace its cotton-paper £5 and £10 bills with wipe-clean polymer banknotes, starting in 2016 (featuring Winston Churchill and Jane Austen, respectively). The United Kingdom thus will join 25 other countries already using plastic bills. Australia was the first, in 1988. The assumption is widespread that the US will follow suit. The new notes won’t soil as easily as paper ones. They’ll be slightly more slippery to handle, will fold but not rumple, and be harder to fake.

Bank of England Governor Mark Carney, who made the announcement in London, introduced plastic notes to Canada when he was governor of its central bank. In 2007-08 Carney led Canada’s banking system through a resourceful and relatively smooth response to the financial crisis. Now that he heads the 319-year-old British central bank, Carney has ambitious plans to rebuild Britain’s financial sector. Presumably these initiatives will have an impact well beyond the borders of the UK.

In a speech in October marking the 125th anniversary of the founding of the Financial Times, Carney described a series of “core elements” of the Bank of England’s Financial Stability program. Among them, two key efforts to reorganize the system stood out:  rebuilding securitization and encouraging better collateral management.

Since these two little-understood aspects of modern banking were at the heart of the crisis, Carney’s remarks deserve some attention beyond the ranks of Federal Reserve bankers who sat up sharply at the news of his speech.

To this point, securitization has been mostly a dirty word. The practice of assembling individual loans and other receivables into large packages, converting the packages into complex securities, and enhancing their credit status with ratings and/or insurance before their sale to third-party investors has often been blamed for the financial crisis. An especially good account of the originate-to-distribute version of the crisis is All the Devils Are Here: The Hidden History of the Financial Crisis, by Bethany McLean, of Vanity Fair, and Joe Nocera, of The New York Times.

Yet the bankers who pioneered securitization, starting in the mid-1970s, insist that it is one of the most important and abiding innovations to emerge in financial markets since the 1930s.  Originally developed to augment mortgage lending to baby boomers by cash-strapped thrift institutions and banks in the United States, the cost advantages of tapping global money and capital markets directly proved so great that today the vast majority of, not just home mortgages, but auto loans and credit card receivables are assembled, sliced, diced, packaged and sold to giant institutional investors like pension funds and asset managers seeking safe and predictable investments.  Securitization is clearly here to stay; the trick is to make it more transparent and so safer. Carney, in his speech, promised details in months to come.

Similarly, the failure of collateral management is perhaps the least well-understood aspect of the crisis. Big institutional investors long ago lost the convenience of government insurance for money they wanted to lend at interest – you can’t, after all, split a few billion dollars – much less a few hundred billion dollars – into $250,000 increments to be tucked away in CDs in government-insured banks.

So institutional lenders instead evolved the system of sales and repurchase agreements known as “repo”– the custom of accepting a pledged package of securities as collateral in return for short-term cash, the big-league equivalent of a demand deposit. And, as retail bankers keep only as much money in the till as they need to meet ordinary withdrawals, otherwise lending out depositors’ money many times over, so repo dealers have learned to use the collateral they are pledged to finance their own borrowing, an institutional equivalent of fractional banking known as rehypothecation.

Such repo agreements are routinely rolled over, often day after day. But in parlous times, the demand for the amount of collateral in exchange for a loan – the haircut – rises, irregularly and sometimes dramatically. And in a panic the whole system can shut down – in essence, when everyone tries to take their money out of the bank.

A run on repo, in the wholesale banking system, was at the center of the 2008 crisis – all but invisible to the outside world.  In his speech, Carney noted the several steps that international regulators had taken to standardize collateral management – numerical floors on haircuts, central clearing houses for standardized derivative contracts, new capital and margin requirements for bilateral trades – and concluded that institutions will both need more collateral and need to learn how to manage it better.  “Fortunately, financial markets know how to innovate…,” he said. “Central banks need to keep up.”

As for emergency lending, Carney pledged to catch up with the US Federal Reserve Board and its powers as enhanced by the Dodd-Frank Act. Longer lags in the disclosure of emergency lending to banks through the central bank’s discount window, and auctions designed to prevent stigma were among the measures mentioned; so was the greater clarity about lending in a pinch embodied in the new Sterling Monetary Framework, its standard operating procedure for the next crisis. Included too are plans to take over in the next crisis some of the lending in dollars to foreign banks performed by the Fed in the last.

“Five simple words describe our approach,” Carney said.  “We are open for business.”

Those who remember Iceland’s role in the 2008 crisis will feel a little shiver.  Not every high-income island in the North Atlantic needs a huge financial sector.  Financial services revenues today account for a tenth of UK GDP and for more than a million jobs, two-thirds of them outside London.  Bank lending is something like four times GDP today.  If UK banks’ share of global lending remained the same, and capital deepening in foreign economies proceeded at historic rates, then by 2050 UK bank loans could be nine times GDP – Britain once again would be banker to the world.

Not everyone is persuaded.  Wise (if not old) FT columnist Martin Wolf wrote, “The governor has opted for boldness at a time when caution might be a safer course…. The idea that a huge expansion even of a reformed financial system would bring great global benefits is doubtful.  Not too much zeal, Mr. Carney,” he advised.

Yet as a practitioner of finance, as opposed to an expert in monetary policy, Carney brings a different angle of vision, and a different set of skills, to the small, cohesive world of global central banking. As an innovator, he might lead the way to reforms that would spread through competition to New York and Washington (and Frankfurt, Hong Kong, Shanghai and Beijing). These might make the global system both safer and more efficient – at least until the next bout of overconfidence threatens once again.

Carney is an exceptionally interesting figure. He is one of four children, his father a high school principal in Canada’s Northwest Territories (and later a professor of education at the University of Alberta); his mother was an elementary school teacher. He graduated from Harvard College in 1988, joined Goldman Sachs thereafter, earned an MPhil in economics from St. Peter’s College, Oxford (where he played goalie for the Oxford hockey team), and a DPhil from Nuffield College, two years later.

After a total of thirteen years in international banking at Goldman, Carney was appointed deputy governor of the Bank of Canada in 2003, and quickly was seconded to the Canadian Department of Finance as its G7 deputy, until he became governor of the central bank in February 2008. In 2011 he was named chairman of the Financial Stability Board, the global regulator in Basel that the G20 nations established in 2009, and continues today in that role. The Bank of England chose him to be governor last summer.

One senior London banking figure described Carney (in an FT story by reporters Sam Fleming, Chris Giles and George Parker) as a practical man “whom people can do business with,” in contrast to “the more rarified academic ambiance of Lord [Mervyn] King,” his professor predecessor who led the bank for a decade.  The reporters wrote, “In some ways, this shift represents a shift back towards an old-style Bank of England, in which the Governor has a sun-king like status in the Square Mile, using subtle diplomacy and arm twisting rather than bludgeoning the sector.”

In that case, Carney’s resemblance to James Bond, the ultimate guardian, is entirely coincidental. Then again, perhaps it is not. For a video of a ten-minute conversation with FT  editor Lionel Barber, click here.

And for all of this, from all of us, thank you, Tim Berners-Lee.

2 responses to “London Takes the Lead”

  1. “Fortunately, financial markets know how to innovate…,” he said…..

    Yeah, leveraging 40 to 1 on ‘investements’ that you don’t understand. Duh!!!

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