Speech The Platypus Moment: Rents, Risks and the Right Responses
Head of Financial Stability Department
Paul Woolley Centre for Capital Market Dysfunctionality Annual Conference
I would like to thank the Paul Woolley Centre for the invitation to speak to you today. Dysfunction in the financial system can have a profound effect on a country's citizens, as we have seen all too starkly around the world in recent years. This is something the Reserve Bank is charged with avoiding, so the work of the Centre could provide insights into policy questions of substantial interest to us.
As you might know, we released the September issue of the Financial Stability Review a few weeks ago. As always, this publication goes into great detail on our analysis of the current state of the financial system, the forces acting on it and the possible risks and issues it faces. I don't propose to repeat that material today. Instead I would like to discuss the broader issue of how we can go about our task of detecting the warning signs of possible future distress.
The World Isn't Simple
One important theme of the last couple of Reviews has been the idea that we have passed the end of a credit boom. For nearly 20 years, banks and borrowers were adjusting to the new reality of lower inflation and liberalised finance. Lower inflation means lower nominal interest rates. Households can then service larger mortgages with the same repayment. So of course the sustainable ratio of household debt to income has risen. Housing prices followed suit, having previously been constrained in the 1970s and 1980s by the same strictures – high nominal rates and regulation. Businesses can also service larger loans out of the same stream of gross profits.
It takes a while to adjust to all this, to reach the new higher ratios of prices and balance sheet quantities to income. Credit growth should be expected to have exceeded income growth for a period, to generate that adjustment. But we now think that this transition is complete. Credit growth, and asset price growth, can diverge from income growth for a period while the system is adjusting. And there might well be some remaining trend: as incomes rise, balance sheets become deeper. But they cannot do so without bound or forever. Indeed, credit booms are very often part of the story in the lead-up to a period of financial instability.
We published that assessment in the March and September Reviews. In the wake of that, we have sometimes been asked: how fast is too fast? Do we have a target for credit growth? Or for the ratio of credit to GDP? Or, perhaps, for housing and other asset prices?
I can tell you quite plainly that we do not have numerical targets for any of these things. A target for credit growth, or any of these other variables, is not analogous to the RBA's inflation target. It is more like the monetary targets that were tried – with mixed results – in Australia and elsewhere in the 1970s and 1980s, and that subsequently had to be abandoned.
The distinction is simply that price stability is about inflation. So it can be defined as keeping inflation at an acceptably low rate. Financial stability is harder to define, but in essence it is about avoiding episodes when the financial system significantly harms the real economy. Recent events in the United States and several other countries show just how damaging financial instability can be to employment and human welfare.
To judge whether a mandate for financial stability is being fulfilled, we must assess the costs being borne by the real economy. They could be costs borne now or those likely in future. So we need to assess the risk that financial stability might be degraded in future. Specific asset prices or balance sheet quantities might well be useful indicators for that assessment. But like the money supply, they are not the ultimate policy goal.
Some observers nonetheless try to force thinking about financial stability policy into that targeting mould. They want a numerical target. They want a policy rule – even though monetary policy isn't conducted as a rule either. The messiness of other ways of thinking about policy bothers them. Without a numerical target for policy, you can't graph it. You can't put it into a model. You can't turn it into a simple equation. And so you can't evaluate decisions using some welfare measure or score.
I would encourage those observers to let go of their desire for the simplicity of a target-and-rule framework when considering financial stability policy. No realm of public policy is really that simple, that free of ambiguity – not health policy, nor education, transport, policing or defence. Only monetary policy is depicted that way. And even that is an oversimplified abstraction.
So if we aren't targeting some single quantity or metric, how do we assess the risks to financial stability? How do we decide if something should be done?
At the risk of disappointing those who prefer those simpler answers, the truth is that the necessary data and analysis aren't simple. There is no single indicator or smoking gun that tells you that financial stability is at risk. Nor can you find an easy rule of thumb to know if there is a boom that might not be speculative now, but could become so later.
In the end, there is no substitute for careful analysis from a range of perspectives, focused on distributions and risks, not just macro-level data and simple ratios. There is also no substitute for policymakers who can use that analysis judiciously, neither dismissing every boom as based on fundamentals, nor seeing bubbles in every wobble of a price index.
At the Reserve Bank, and at most of our counterparts overseas, financial stability analysis includes looking at those macro ratios, but we don't stop there. We look at the structure of balance sheets, both of financial institutions and the non-financial sectors that are their customers. Distributions matter a great deal as well. It is rarely the median borrower that causes the trouble. So we also analyse detailed micro data.
Undesirable Behaviour and Unpredictable Fauna
Today I would like to emphasise sources of information that are too often neglected in financial stability analysis: the attitudes and behaviour of key actors in the financial system. The behaviours we watch for most carefully are the seeking of rents and the taking of risk. I will talk about them in some detail. And from there, I would like to emphasise the role of judgement in determining the right responses.
Some people think that looking for risks to financial stability is about hunting out the ‘black swans’ that could blindside you. This is, of course, the concept popularised by Nassim Nicholas Taleb in his book of the same name: that there are things that can't be forecast on the basis of past experience. It's an important point about the limits of models, and about the need to make systems robust to unexpected events. But I don't think that, taken literally, it's a constructive way to conduct financial stability policy. The whole point about black swans is that you can't look for them. You can't imagine scenarios that are by definition unimaginable.
Anyway, the careful historical comparisons by Charles Kindleberger, and more recently by Carmen Reinhart and Kenneth Rogoff, show that there is actually not much new under the sun when it comes to financial crises (Kindleberger and Aliber 2000; Reinhart and Rogoff 2009). The precise assets involved might differ, as might the sectors harmed – maybe that's the black swan element. But it boils down to the same narrative. First, there is a genuine fundamental shift that leads to real, sustainable changes. But it also engenders a wave of optimism. The optimism motivates more borrowing and lending, higher prices for some assets and higher turnover in markets for those assets. Credit expands faster than normal. Ultimately the boom goes too far and collapses under the weight of debt and of unrealistic expectations. Crises might not be predictable, but they are all too imaginable.
So instead of looking for the unimaginable black swan, I would advocate observing those attitudes and behaviours, as well as the data. And the test I would apply is inspired by another member of Australia's weird and wonderful fauna – the platypus. You see, when Europeans first saw a black swan, it would have been a surprise, but I doubt it rocked their world. There are plenty of other cases where the same species of animal is a different colour in different regions. But the platypus is strange. It is a mammal, but it has a duck's bill; it is the only mammal with venomous spurs; it lays eggs; and it is a monotreme. When European scientists first saw the stuffed body of a platypus, they found it so bizarre that they thought it was a fake.
It's that sense of disbelief, of incredulity, that something is too ridiculous to be true, and yet it is true: that feeling is telling you something. When you have that feeling, you are having what I have come to describe as a Platypus Moment. And it is that moment, that feeling, we should be alert to. It is not just a reaction to a statement or claim you find unbelievable. The reaction is to a practice or behaviour you concede is truly occurring, but find bizarre or foolish. The motivations underlying the behaviour are not coherent. The behaviour spurred by the motivations is not internally consistent, at least not from the perspective of the system.
This is not just about making decisions on the basis of personal incredulity. After all, the idea that the Earth orbited the Sun was once thought incredible and against the natural order. You could say that to be effective in financial stability analysis, you need to have a sense of the ridiculous of just the right kind. It should be one built on an internally consistent analytical framework, one that starts from a vantage point of the whole system, not just the financial sector or some part of it.
To give a personal example, some years ago I experienced a Platypus Moment when I first read about vendor-financed down payment assistance charities in the United States. They became quite common during the housing boom there. Home-building companies would donate money to charities that in turn gave money to first-home buyers to fund their deposits. Usually these charities were quite local, so the builder that funded them often got the money back by inflating the sale price of the house. Unsurprisingly, US government housing agencies have found that borrowers who had received this kind of assistance were three times more likely to default on their mortgage as those who had not (Montgomery 2008).
‘How’, I asked myself, ‘is this even legal?’
Rent-seeking and Governance
As well as being a good example of something that induces Platypus Moments, the down payment assistance charity industry is a good example of rent-seeking. The textbooks define rent-seeking, roughly speaking, as manipulating the economic and social environment to benefit yourself without adding any real economic value to the world. In fact, because the act of rent-seeking absorbs time, energy and resources, it actually reduces human welfare. Often, but not always, rent-seekers try to persuade the government to bestow some favour on them. In other cases, the rent-seeker takes advantage of private information. The borrower knew that their down payment wasn't their own savings, and the builder knew the house price was over-inflated. But the lender didn't know either fact. Is it any wonder that outright fraud became such a problem on both sides of the US mortgage market?
Rent-seekers thrive in complex, opaque markets. A perfect example was the structured credit boom in the years before the crisis. In all the controversy about mark-to-model and the difficulties of pricing these securities, it is often forgotten that it matters whose model the security is being modelled with. Those kinds of informational advantages can be quite lucrative, for a while, at least.
Much rent-seeking is enabled by governance problems. We can see it in the rogue trader who games the risk-management system to get a bonus. We can see it in loan officers who approve a dubious loan to make their sales target. We can see it in decisions of CEOs to grow their firms even when it doesn't make sense, except to meet a bonus hurdle. Employee compensation systems set up plenty of inappropriate incentives during the boom. It is no surprise that this was one of the areas that the international regulatory community targeted first in the post-crisis reform process.
Inappropriate incentives for staff can take forms other than money. Some of the earliest events in the crisis, back in 2007, were losses and liquidity problems at hedge funds sponsored by some large global banks. Often these funds were set up specifically to reward or motivate a few star employees. That is, the financial group's business structure was changed, and hundreds of millions of dollars in client funds were reallocated, all to keep somebody happy.
The rent-seeking doesn't happen only in financial firms, though. The market for corporate control can also be fertile grounds for this behaviour. Recall that the pre-crisis credit boom wasn't just in US mortgages. Takeover activity was also booming. Much of it was driven by highly leveraged private equity firms and at least in some cases, the deal would never have happened without easy access to credit. Some of these takeovers involved subsequent rounds of borrowing, just to pay dividends to the owners. If the deal left the acquired firm worse off, but the acquirer managed to extract equity in this way, it is fair to call the transaction an exercise in rent-seeking. In these cases, the acquirers are taking advantage of their access to credit, beyond what the target firms themselves could have borrowed. It is a pity that the lenders did not experience their own Platypus Moments, and question why they should lend money for that purpose.
Risk-taking and the Price of Risk
The second key behaviour we watch for is risk-taking. In fact, the goal of financial stability policy is sometimes defined as reducing systemic risk: the risk of a disruptive financial crisis. I should emphasise that the objective here is not to eliminate all risk. Most social and economic progress comes from somebody being willing to take a risk – on a new idea, a new product, a new way of doing things. Since central bankers and prudential supervisors tend to be risk-averse in temperament, it is not for us to second-guess every aspect of the decisions by the people taking those risks. We should, however, pay attention, and perhaps take action, depending on the answers to two important questions.
- One, do those involved correctly perceive the risks?
- Two, who is taking risk on behalf of whom?
Thinking back to the credit boom before the crisis, it is clear that this first question on risk perception is very important. We knew that risk spreads were low, perhaps too low. We knew that market players were treating many products and exposures as safer than they had been historically, and that they were assuming that new, untested products were safe. They weren't taking those risks while saying to themselves, ‘Don't worry, if it blows up, the government will bail us out’. Rather, it simply didn't occur to them that the trades would blow up. Or they thought it too unlikely to worry about, let alone price it in.
The problem in structured credit markets was not so much ‘Too-Big-To-Fail’ as ‘Too-Smart-To-Fail’. Or at least, the people involved thought so.
Incorrect risk perceptions can lead to bad assets being created unwittingly, just as we saw in the US housing boom. Households did not factor in the possibility that housing prices might fall. RMBS investors did not understand how far mortgage lending standards had deteriorated. And some sub-prime lenders did not factor in that some of these mortgages would default so quickly that the lenders would have to buy them back.
Inappropriately relaxed perceptions about risk therefore led to inappropriately lax lending standards. Lenders didn't worry if the borrower could afford the loan, or if that undocumented income really existed. Housing prices were rising rapidly. So lenders assumed that a borrower in trouble could always sell, or refinance with another lender.
Why were US mortgage lenders so willing to ease their standards, far beyond those in other countries? That brings us to the second question – who is taking risk on behalf of whom? The regulatory system was part of the story. But the answer also lies partly with the fact that lenders were taking those risks with other people's money. They were not putting their own balance sheets at risk: often they didn't have balance sheets. Even if they experienced a Platypus Moment when extending an enormous loan to a retired person on a fixed income that didn't even cover the repayment, they had no incentive to do anything about it.
The other-people's-money issue goes far beyond the mortgage lenders, though. Think back to the internal hedge funds I mentioned earlier. Banks and fund managers invest on behalf of their customers. A raft of regulation and codes of conduct has been designed to ensure that these agents are acting in their customers' best interests. But as with any principal-agent problem, no set of rules will solve that completely.
The Right Response
We should bear in mind that no regulatory regime is perfect. Even so, in the face of rent-seeking, risk-taking and other challenges to financial stability, we need to be able to respond in the right way. The right response is certainly not ‘shovel the risk somewhere else and hope for the best’. That was the rationale behind the ‘originate-to-distribute’ model in securitisation markets in the United States. Having rid themselves of some risk, US mortgage lenders felt free to create more. So there was not a fixed amount of risk that could be spread ever thinner over a wider population of investors. The total amount of risk taken depended on the incentives to do so. That is why a system-wide view is essential. Likewise, we must be alert to incentives to take risk, especially when some parties think they have ‘managed’ that risk away entirely. A risk hedged is better than one not hedged, but it is not the same as a risk not taken at all. Hedges can and do break down. In the crisis, some broke down in spectacular fashion.
The right response, in fact, has several preconditions and from there can take several forms. The first precondition is the background of the macro policy framework. Avoidance of damaging credit cycles starts with management of the business cycle. Of course it will never be possible to eliminate the business cycle completely. But the quickest way to create a damaging credit boom is to run your economy too hot. I should therefore mention the positive role of a floating exchange rate here. If the exchange rate floats, the authorities can set macroeconomic policy according to domestic circumstances, rather than having to defend a particular exchange rate.
The second precondition is the regulatory and institutional framework. Regulators must have the powers, the mandate, the resources and – importantly – the culture to make them able and willing to respond appropriately to a threat to financial stability. Even more important, they must be able and willing to intervene early. Not every regulator in the world would do so. When they do, you might never hear about it. Regulatory culture is hard to capture in an assessment of compliance with international standards, so its importance has perhaps been underappreciated.
Given these preconditions, regulators have a variety of tools at their disposal already, which they can use to respond to problematic behaviours or emerging risks. Most of these tools are regulatory or prudential. A good Australian example comes from the 2004–2005 period. A system-wide stress test revealed that mortgage insurers needed more capital to be resilient to a major downturn in the housing market, should one occur. So APRA raised these firms' capital requirements. The stress test and the fallout from the early 2000s housing boom also revealed that some newer mortgage loan products were riskier than others. So APRA raised risk weights on those loans. It has retained that tougher treatment even after adopting the Basel II standard.
A more recent example relates to so-called ‘synthetic’ exchange-traded funds. Some of these funds overseas involve conflicts of interest that make rent-seeking perhaps too easy. The Financial Stability Board has expressed concerns about this publicly. Although this type of fund is not yet that important in Australia, ASIC has already moved to head off such problems here. Following consultations with the Bank, ASIC and the ASX are working on refinements to the exchange's listing rules that, once introduced, should deal with most of the FSB's concerns.
These examples show the value of having flexible, principles-based regulatory frameworks, not a legalistic set of rules that encourage a box-ticking frame of mind. If the regulators are focused only on compliance with existing rules, they will always be playing catch-up to a fast-moving industry. I am glad to say that narrow, box-ticking cultures are not what we see in the Australian regulators.
Another important response we can use is communication. This is where a central bank is most likely to be involved if, like the RBA, it is not a prudential supervisor. Sometimes that communication occurs in concert with actions from the other regulators. Given that many participants in the system might prefer not to be restrained by regulation, it is helpful to follow up those actions with support from other public agencies.
Perhaps more challenging to communicate are the earlier interventions, warning that something might become a problem one day, but it isn't now, and maybe won't ever be. Those exercises in communication are designed to mould risk perceptions. We are frequently trying to strike a balance between sounding too alarmist and sounding too complacent. For between everything being rosy and an existential threat, there are many shades of grey.
It is important to remember that we will mention, and sometimes explicitly warn about, things that do not pose a risk of sparking an imminent crash. Drawing attention to concerns early can influence expectations and beliefs and, we hope, the behaviours that could otherwise lead to future distress. Focusing on risks and behaviours is the key to that communication, not numerical targets or forecasts. For if we succeed in preventing crises, whether through communication or some other response, then any prediction of a crisis will not occur. It would be a self-negating prophecy, one that would make it harder to repeat the success later on.
Sometimes it will be better, and more effective, just to point out that the platypus is strange. Like black swans, they turn up more often than you expect.
Gerardi et al (2008) showed that analysts pricing RMBS during the US housing boom had a reasonable understanding of what would happen to mortgage arrears rates if housing prices fell, but attributed very low probabilities to such a scenario actually happening. 
See Financial Stability Board (2011), ‘Potential Financial Stability Issues Arising from Recent Trends in Exchange-traded Funds (ETFs)’, April. Available at <http://www.financialstabilityboard.org/publications/r_110412b.pdf>. 
Gerardi K, A Lehnert, S Sherlund and P Willen (2008), ‘Making Sense of the Subprime Crisis’, in Brookings Papers on Economic Activity, Vol 2 (Fall), Brookings Institution Press, Washington, pp 69–145.
Kindleberger CP and RZ Aliber (2000), Manias, Panics and Crashes: A History of Financial Crises, 5th Edition, Palgrave Macmillan, Basingstoke.
Montgomery B (2008), ‘Prepared Remarks at the National Press Club’, 9 June.
Reinhart CM and K Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, Princeton.