Independent Commission on Banking

Lord May of Oxford Excerpts

Thursday 15th September 2011 Lords Chamber

[Lord May of Oxford]

My Lords, I join others in my thanks to the noble Lord, Lord Myners, for giving us this debate. I also express my gratitude for the privilege of hearing the incisive analysis of the report of the noble Lord, Lord Lawson. Perhaps I should also explain why a theoretical physicist who had a mid-career transmogrification into an ecologist and epidemiologist is having the cheek to speak in a debate about banking.

In 2006, in a very prescient way, the US National Academy of Sciences and the Federal Reserve Bank of New York put together a study on the premise that in the increasingly elaborate things happening within financial systems with the aim of maximising profit for minimum risk for individual institutions—allegedly— nobody was thinking about the system as a whole. The NAS and the Fed put together a study that was going to focus on systemic risk. In doing so, they drew in people from cognate disciplines where there might be some read-across—ecology, epidemiology and the electricity grid. It turns out that the electricity grid is not so interesting because we really understand how it works and how switches can control it.

As a result, when the crisis manifested itself a couple of years later, I spoke with friends at the Bank of England. I have been working with Andrew Haldane, the executive director of systemic risk at the Bank of England and some of his very able younger people, following through those ideas about what might be called systemic risk in banking ecosystems. The first conclusion, which I cannot emphasise too strongly, is that there is a huge gulf of difference between natural ecosystems and complex banking systems—not least in that ecosystems, for all their complexity, are simpler. If you think of them as networks, nodes in the network—to be technical for a minute—are species and the connections are that they eat something or something eats them, and the like. In a banking network, the nodes are banks, which have all sorts of things coming in from outside and inside the system, and all sorts of things getting out from inside and outside the system—networks of networks.

I wrote a turgid paragraph in the paper which Andrew and I published emphasising that difference. Andy captured it rather better by saying:

“In financial ecosystems, evolutionary forces have often been survival of the fattest rather than the fittest”.

That caveat having been issued and emphasised, the simple fact is that the recommendations which emerged from the work of the National Academy of Sciences/Federal Reserve Bank are strongly in support of the major recommendations in John Vickers’s independent banking commission report. Specifically, if very telegraphically, first, perhaps I may read from an op-ed that Andy Haldane and I wrote in the FT:

“Are big banks less prone to failure? The traditional economics of diversification suggest so. By scaling up balance sheets across different classes of asset, risks to portfolios will tend, on average, to cancel each other out”.

In general, that seems like a good idea. It is a good idea for individual banks, one by one, reinforced by Basel I and II.

If you look at complex systems in the round in nature, you find that they tell a different tale. Very often, scaling up risks in that way causes them to cascade rather than to cancel out. The conclusion from that is that the present situation in banking is, in many respects, perverse. All banks becoming diversified—spreading risks—means that they become more homogenous, whereas if they were all different and one failed that would be it. The homogeneity and the linkage refer to the system as a whole, and there is genuine tension between the interest of the individual and the interest of the whole, between diversification of individual banks and diversity of the system.

Some of the morals of that translate into the simple fact that, over the past decade or more, if you look at systems of that kind, if you think of the spread of infectious disease within networks, we have learnt to focus our attention on the superspreaders—HIV among people with many partners. The analogue here is the big banks. By virtue of their size, the big banks have argued that they may hold relatively smaller capital reserves and that has been the habit. All the messages of a general kind suggest that in a system like that, the superspreaders, the big banks, should hold relatively larger capital reserves and liquidity, and that is one of the firm recommendations of the Vickers report.

More interestingly, going back to ecosystems, there used to be a naïve notion that there was a balance in nature and that complex systems would be stable by virtue of their complexity, which turns out to be rubbish in ecology. Redefine the research agenda to ask what are the specific structures that real ecosystems have: as observed, that reconcile the complexity that we see with persistence and stability? One of the most important of those is modular organisation. So there are chunks that loosely connect them and there is a clear echo of that in the Glass-Steagall Act and in the desire to produce greater, if not complete, separation between retail and investment banking.

I will not inflict any more of this seminar on the House but I want to conclude by touching on two other topics which have already been broached with more authority and more force, I suspect, by previous speakers. All of what I have been talking about, much of what the analysis has been about, and much of what the banking commission report is about, is systemic risk. If I were a supreme dictator and could do one thing, I would try to forbid the trading in instruments that are so complicated that they cannot be reliably priced. It does not require much sophistication to recognise that if you have a bunch of triple B house mortgages, even though you conceal the assumption in a lot of jargon, and you are going to assume all fluctuations in individual houses are totally uncorrelated, you will have a sort of quadruple B—they will certainly not be triple A. There are more sophisticated examples of that and I would like to see us taking more steps against the inherent problem in credit rating agencies going out of business if they are too diligent.

Finally, I turn to a point raised by the other Friedman, Benjamin Friedman, distinguished professor at Harvard, who, in the spring issue of the American Academy of Arts and Sciences, asked: what is the essential purpose of the financial markets? He said that it is to allocate capital efficiently in that best of systems, free markets, but that the time had come for a serious evaluation of the costs and benefits. He offers the following remarkable statistics: 30 years ago, the cost of running the financial system in the United States was 10 per cent of all profits earned in the United States; 15 years ago, the figure had grown to 20 to 25 per cent; and just before the crash the estimate was one third.

The time is more than right to go beyond the Independent Banking Commission, sound though I believe its recommendations are, to a more fundamental examination of the effective running of the financial system.