Journal of Financial Stability 4 (2008) 364–367

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Journal of Financial Stability

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Panel comments�

Howard Davies ∗

The London School of Economics, Houghton St., London WC2A 2AE, United Kingdom

a r t i c l e i n f o

Article history:Received 7 April 2008Received in revised form 25 July 2008Accepted 1 September 2008Available online 25 September 2008

JEL classification:G10G28G38

Keywords:Incentive structuresOriginate and distribute modelMemoranda of understanding amongstregulators

a b s t r a c t

We need to beware of over-reaction, for example not to revise theUK tripartite MOU to indicate excessive future support for banks,nor to rush to rearrange regulatory structures. On pay and incentivestructures, shareholders should play a greater role. On securitisa-tion, in the short run market discipline will suffice; in the longerterm, all the players, risk managers, regulators, accountants, etc.,will just have to be tougher and more savvy.

© 2008 Published by Elsevier B.V.

I shall begin with two personal observations on the UK regulatory system, prompted by CharlesGoodhart’s paper.

1. The Tripartite MOU

I was one of the original authors of the tripartite memorandum of understanding between the Bankof England and Financial Services Authority in 1997. This used to be a source of pride to me, though Iam now less sure and may remove it from my list of authored publications.

Charles Goodhart rightly points out that the MOU was conceived against the background of concernabout too much forbearance. That is certainly true. From my experience working in the Treasury, the

� Presented at LSE Financial Markets Group and Deutsche Bank, London, 3 March 2008: The structure of regulation: Lessonsfrom the crisis of 2007.

∗ Tel.: +44 207 955 7006.E-mail address: h.davies@lse.ac.uk.

1572-3089/$ – see front matter © 2008 Published by Elsevier B.V.doi:10.1016/j.jfs.2008.09.004

H. Davies / Journal of Financial Stability 4 (2008) 364–367 365

Bank of England and the FSA, a unique treble I believe, I am aware that the Treasury believed stronglythat the Bank of England should have not rescued Johnson Matthey Bank. One common Treasuryprejudice is that in the past the Bank of England was too kind to its friends in the city (in the dayswhen it had some). So the initial draft of the MOU provided that the Treasury could reject a proposalfrom the Bank of England that it should provide assistance to a bank in difficulty, but was silent onwhether the Treasury could, by contrast, require the Bank to provide such support if it did not believeit was appropriate so to do.

We used to praise this regime as one which created an appropriate degree of uncertainty in financialmarkets about the circumstances in which lender of last resort support might become available.

In the light of the Northern Rock affair it may now be appropriate to redraw this MOU somewhat.But the original version showed the danger of being a prisoner of the past and we should avoid goingtoo far in the opposite direction, creating a greater presumption of support in the future. We mightthen generate more moral hazard.

My second point is also related to the MOU. During my six years as Chairman of the FinancialServices Authority the Tripartite Standing Committee never met at principal level. I often saw theGovernor, and indeed the Treasury, separately. And the Committee certainly met frequently at deputylevel. Those deputies frequently addressed the risk of crisis and explored appropriate responses. Butthe conventional doctrine related to business continuity and crisis management would advise, for goodreasons, that those who would in the end be involved in making decisions in a crisis should on occasiongame play that experience to give them a better understanding of the likely reactions of others. Thatdid not happen in my day, and I am not sure that it has happened since. There is a lesson there, I think.

More generally, though, I very much agree with Charles Goodhart that in this country we are oftentoo ready to jump to conclusions about structures. It may well be that the structures of supervisionhere do not need fundamental change, but that there were judgment calls which, with the benefitof hindsight, may not have been the best. We should be aware, even now, of reaching conclusions,however. We have not yet heard the full story. The Treasury Select Committee has given some usefulbackground but we still await the FSA’s own internal audit report which will look at the supervision ofthe bank in the period up to June or July of 2007, and it may well be that there are further independentenquires thereafter, which may cover the later period.

Turning to the financial market implications of the crisis, much of the debate has been well coveredalready. There are clearly big lessons for firms, for rating agencies, for bond insurers, and indeed foraccounting standards, particularly in allowing off balance sheet vehicles in which banks or investmentbanks parked risk. I will simply touch on two aspects: incentives and pay, and the future viability ofthe “originate to distribute” model.

2. Pay and incentives

An interesting debate has begun to develop on incentive structures in bank and investment banks,and the effect that they may have had on the development of the securitisation market, and on the cre-ation of the bubbles and imbalances which have caused so much damage. Raghuram Rajan at Chicagoand Martin Wolf in the Financial Times believe that pay incentives were a key element, and that reg-ulators should take an interest. Randy Kroszner at the FRB has placed the responsibility for reviewingpay firmly on financial institutions, but has argued that they “should understand the consequences ofproviding too many short term and one sided incentives”. He has also recommended that they should“try to match the tenor of compensation with the tenor of the risk profile”. In Congress the HouseOversight Committee is already holding hearings on CEO pay and the mortgage crisis. We can expecta lively political debate to come. But should regulators get into this territory at all? Charles Good-hart argues that they should, and says that he has been surprised that they have not done so in thepast.

In fact that is not quite true. Early editions of the Bank of England’s Financial Stability Report, whenthe Bank was still a banking supervisor, included some discussion of pay incentives, and the impacton risk. The fundamental point made then, which I believe still applies today, is that there can be amismatch between the declared risk appetite of the firm, and the behaviours which are promoted byits compensation scheme. That, I think, creates a legitimate entry point for regulators. They are not

366 H. Davies / Journal of Financial Stability 4 (2008) 364–367

simply practicing the politics of envy, they are looking at risk factors which may affect the viability ofthe firm.

But if regulators do take an interest, what should they do? The answers are not entirely straight-forward. Martin Wolf and others argue that firms should have pay structures which tie compensationto longer term returns. In fact many firms do that already and give much of their compensation in theform of shares which cannot be sold for a lengthy period. Lock-ins are already common, lasting up tofive years in many cases. One problem is that share prices may not well reflect the impact of losses byindividual departments, in diversified firms. Another problem is that there is not much modeling ofwhat the rational behavior of traders is when faced with different compensation structures and whatthat rational behavior, if pushed to extremes, could mean for the balance sheet and the firm’s riskprofile. At least I have not seen such analysis so far.

That should be done, and also shareholders should take more of an interest. The disclosure regimesbite on Board members. In the US that is rather an uninteresting disclosure as, usually, there is onlyone executive on the Board whose pay may therefore be scrutinised. US shareholders seem not to beinterested in the kinds of disclosure which have become common now in the UK, where the Remu-neration Committee must publish a report, on which shareholders are entitled to vote each year. Thatmay not solve all the problems, but it is a useful step forward.

3. Originate to distribute

The most difficult area, and one which could have far reaching consequences for financial markets,is whether the originate to distribute model is now finished, in the light of the crisis brought on by thesub-prime explosion. We must be careful what we mean here. Charles Goodhart in his paper calls itthe “originate and to pretend to distribute” model, as in many cases banks did hold on to much of therisk themselves. Martin Wolf is a more fundamental critic. He notes that the underlying justificationof securitisation and risk transfer is that risk may be moved around the system so that it is held bythose best able and willing to hold it. But in fact the aftermath of the crisis has shown that it has beenspread, instead, to those least able to understand it. Alan Greenspan, who is generally unrepentantabout the development of the sub-prime market, nonetheless acknowledges that there is a danger infinancial markets when the links between the originators of credit and the end investors in them areso remote and tenuous. Normal lending disciplines do not then operate.

What should we do to remedy these deficiencies? Here there is a clear danger of a descent intoplatitude. Some of the old banking saws seem entirely relevant. Do not invest in what you do notunderstand. Profits you cannot explain are more dangerous than losses you can, etc., etc. All of theseobservations are sadly appropriate, but do not take us very far. So what can be done?

Some of the suggested remedies seem to me to be unlikely to succeed. It has been argued thatinvestment banks should be required to hold a portion of the securitisation assets they have created.In fact some of the manufacturers of these toxic products held onto quite a lot of them, or at least tothe economic interest in them, one way or another, which sometimes came as a surprise to them. Sothat solution does not seem likely to be enough.

In the short term, of course, we might argue that there is not really a problem and that marketself-discipline is operating quite nicely. There are not too many new sub-prime bond securitisationsbeing developed these days. But in the medium term the old adage “once bitten, twice bitten” willbegin to apply again. And there will be a revival. I do not think that calls for a return to good oldfashioned banking will work. The consequences for credit availability and the profitability of bankswould be immense if they were required to re-intermediate all the risk onto their balance sheet. Sosecuritisation will continue, and new instruments will be developed. When that happens we have tohope that:

• Risk managers have come better to understand the nature of the risks their firms are taking on. Bigchanges are underway in reporting lines, staffing and skill levels, etc, and we have to hope that theywill be effective.

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• Audit and Risk Committees need better to understand the risk profiles of the institutions they oversee.Again, there are many reviews underway in that area.

• Regulators need to be tougher in assessing risk management systems and in requiring stress testingto be undertaken, and reported back to them.

• Accountants need to be tougher on consolidation and on understanding where economic risks lie,and

• The international early warning providers such as the IMF and others need to be tougher and morerobust where they identify bubbles being inflated.

This is a messy set of solutions, but then it is a messy problem, and if there were a simple one shotsolution it would have been found by now.