In his opening remarks to the Treasury Committee on May 20th, Governor Bailey made an interesting observation point about market values:
… had you done a stress test in the run-up the financial crisis on the market value, you would have been doing it on the market values that were trading well in excess of book values, so … that would of course have severely misled you. You would have concluded there was no problem and you would obviously have been badly wrong. (Our emphasis)
Mr. Bailey isn’t the first Bank spokesman to make this claim. The Bank’s head of financial stability Alex Brazier said as much in almost the same words back in January 2017:
… if you had [relied on market cap values] before the crisis, you would have been led completely astray … You would have been led to the conclusion that the British banking system was remarkably resilient, and, as forecasting errors go, that would have been quite a good one. 1
It’s an important point, but it is wrong. Flat out wrong.
It’s a shame that none of the MPs challenged it.
Still, we have to admire the chutzpah. The technique is to make sure that when you say something, you should say it in an authoritative tone of voice and give the impression that everyone already knows what you are saying or really ought to, so it would be silly to challenge it. With a bit of luck, the MPs will be too intimidated to have a go. And let’s face it, that technique has worked at least twice so far.
Now we can well believe that a BoE stress test would have missed the impending problems in the run up to the last crisis, but the fact is that the markets did not.
Let’s look at the evidence.
Exhibit 1 is the following chart, which shows how the PtB ratios of international banks fell the before crisis.
Price-to-Book Ratios of Banks Internationally
Source: IMF Financial Stability Report, October 2016, Figure 1.11, panel 1.
The PtB ratios for UK banks are similar. Market values and PtB ratios started falling sharply in April 2007, well before the GFC.
Exhibit 2 is the next chart, which comes from, er, the Bank of England and shows the ratios of market capitalisation to the book value of assets for two sets of international banks, the ‘crisis’ ones that failed, required assistance or were taken over in distressed conditions, and the ‘non-crisis’ ones that weathered the storm.
Market Capitalisation to Book-Value of Assets
“Capital discipline,” speech given at the American Economic Association, Denver January 9th 2011, Chart 8.
It is clear that markets were signalling problems with the banks and they correctly identified the weakest banks too. In the UK case, they also correctly identified in advance the two biggest UK problem banks, HBOS and RBS. 2
CDS premia were also signalling problems in advance. The following chart (also from the Bank of England or at least its chief economist) plots CDS premia for a sample of 33 large international banks over the period 2002 to 2011. The sample is again partitioned into ‘crisis’ and ‘no crisis’ banks:
CDS Premia for ‘Crisis’ and ‘No Crisis’ Banks
Source: A.G. Haldane, “Control rights (and wrongs),” Wincott Annual Memorial Lecture, Westminster, London October 24th 2011; Based on Thomson Reuters Datastream and Bank calculations.
From early 2007 on the spreads of the ‘crisis’ banks start to rise above those of the ‘no crisis’ banks and in the run-up to the Lehman crisis the former were sending much stronger signals than the latter.
As Jonathan Ford put it to us:
Look at the crisis. Market values started sliding in April 2007, 18 months before Lehman collapsed. If you relied on accounting values, many of the doomed banks were still solvent at the end of 2008!
Exhibit 4 is a quote from a careful analysis of this issue by the Bank’s chief economist:
… market-based measures of capital offered clear advance signals of impending distress. … Replacing the book value of capital with its market value lowers errors by a half, often much more. Market values provide both fewer false positives and more reliable advance warnings of future banking distress.
… market-based solvency metrics perform creditably against first principles: they appear to offer the potential for simple, timely and robust control of a complex financial web. 3
So market values did signal impending problems and that should be the end of the matter.
Mssrs. Bailey and Brazier also omit to mention that the Bank was relying on Basel regulatory balance sheet values that completely missed the impending meltdown and they do not offer any alternative that would have worked better. The same applies to the Bank’s crystal ball. Not only did the Bank itself have no inkling of the impending crisis before it hit, but in the early stages of the GFC and as late as January 2008, the Bank was still reassuring us that there was little to worry about and that the UK banking system was more than adequately capitalised. To quote Governor King at that time:
I do not believe that in a year’s time people will look and say that there was any lasting damage to the British banking system. It is very well capitalised, it is very strong … (s. 291)
As forecasting errors go, that is quite a good one too.