Second, as recently laid out by Governor Tarullo,2 a problem in one firm can spread via the domino effect created by chains of counterparty credit exposures; forced asset sales; or contagion due to the reality or perception of common problems. 2  2  Daniel K Tarullo, “Regulating Systemic Risk”, March 2011. BIS central bankers’ speeches  And, to be clear, this is not just a vulnerability of firms. Markets too can suffer a self-fulfilling evaporation of liquidity. A central element of the recent crisis was, indeed, the drying up of liquidity in the ABS markets and the money markets. As liquidity premia soared, many asset values collapsed, and the net worth of many traders and banks was eroded. This was a vicious circle, because the liquidity of many financial markets depends on short-term traders being ready and able to trade, since end-buyers and sellers will not always want to transact at the same time. Those traders often depend, in turn, on maintaining access to financing from banks. Everyone has been reminded, therefore, that the liquidity of markets and the well-being of leveraged, maturity-mismatched firms are inextricably intertwined. Our capital markets and much of the “plumbing” of the financial system – notably the payments system – rely on confidence in the integrity of the assets being traded, in the robustness of counterparties, in the reliability of infrastructure. Crises nearly always involve that confidence sliding away. So, although financial systems look solid most of the time, they can in fact prove brittle.
The Objective of the FPC The UK government has proposed that the FPC’s main responsibility should be taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system (my emphasis). “Systemic risk” is defined to embrace both faultlines in the structure of the financial system, ie the way its components are joined up; and cyclical threats from unsustainable levels of leverage, debt or credit growth. Two glosses on that are warranted. First, the government’s plan does not entail the FPC being held accountable for fine tuning the credit cycle, but rather for ensuring stability by maintaining the resilience of the financial system. An example might help. Say that in the face of a credit boom, the FPC raised banks’ capital requirements. That might help to slow the boom, and it would be helpful if it did so. But even if the boom continued, by virtue of having higher capital ratios the banking system should be more resilient when the bubble burst. If those FPC actions prevented the banks going bust, the downswing in the credit cycle, and so in the business cycle, would be less severe because the flow of credit services could be sustained. That would be a success. Perhaps not always a glorious success, but a whole lot better than where we are right now.