Robert Diamond: Financial Reform, Economic Growth and the International Dialogue
Barclays PLC President Robert Diamond addresses the Peterson Institute for International Economics.
The following speech, “Financial Reform, Economic Growth and the International Dialogue,” is by Robert E. Diamond, Jr., President of Barclays PLC, as he addressed the Peterson Institute for International Economics.
It’s a great honor to be here today at the Peterson Institute, an organization that’s built a fine reputation for being at the very center of the debate on the most important economic and political issues of the day.
I want to talk this afternoon about the importance of working together on financial reform in order to create a safe and sound financial system which fosters economic growth and job creation both here in the U.S. and internationally. This is a timely moment for this discussion.
We are at a critical stage with the Financial Reform bill and we at Barclays have been highly engaged with and supportive of the legislation. I want to compliment the Administration, the Treasury, and the Congress for the work they’ve done. There are still areas for improvement that the Conference Committee is working hard on to achieve strong, balanced, and effective reform.
We’re also at a critical stage in terms of economic recovery – a recovery that’s fragile and needs strengthening. This is the moment for business leaders, financial institutions, and financial regulators to work together with political leaders to drive economic growth and stability. It is also time for those on this side of the Atlantic to work with our counterparts on the other side of the Atlantic. We live in a connected world and we need to get financial reform right, globally.
As I said, the timing is critical. Over the last couple of years we’ve lived through a crisis in the financial markets followed by an economic crisis. Then in the months leading up to May this year we saw a recovery led by Asia – where business confidence in the first quarter was higher than in 2007 – followed by a return to growth in the UK, the US, and Europe. It is apparent that the enormous fiscal and monetary stimulus is working.
The financial services industry has unquestionably benefited from the actions of governments and central banks around the world to mitigate the crisis. All banks, even those like Barclays, who took no government money, are grateful for that stimulus. We recognize the benefits and we recognize the responsibilities that go with them – a responsibility first to help governments, regulators, and central banks build a safe and sound financial system. We have a responsibility also to support clients, whether they’re companies, institutional investors or governments, to drive economic growth and job creation both here in the US and globally.
And just as the economy has started to recover we seem to be facing another crisis; this time a fiscal crisis with government budget deficits of record proportions in the developed economies. We have all heard a lot about Europe recently and in particular Greece. If you look at 2009 government deficits as a percentage of GNP, they were: 14 percent for Greece; 11-12 percent for Spain, Ireland, and the UK; and 9 percent for Portugal. Ten years ago Ireland and the UK had a surplus and the others had deficits but they were in the range of 1 percent to 4 percent. Today’s deficits are a real concern given the high level of government debt. Debt as a percentage of GNP in both Greece and Italy was 115 percent last year, in the US it grew to 83 percent compared to 55 percent ten years ago, and its forecast to rise still further to 110 percent in five years time.
So both Europe and the United States face extraordinarily high government debt levels combined with demographics that make this very difficult to manage. I have just come back from Asia and the Middle East which have the highest levels of GNP growth in the world along with some of the youngest populations. Compare that with the major economies in Europe where almost 20 percent of the population is over 65. The US is not far behind at 13 percent. That is two to three times the proportion of over 65 year olds than in India and China.
Model for Economic Growth
So how do we tackle this issue of government debt and get economies growing? Government stimulus was critical during the crises but today’s problem can not be solved by increasing taxes alone; it must be managed by a reduction in public spending and by spurring private sector growth.
Over the last three years we have seen the private sector in the U.S. show tremendous resilience as it has adjusted to the environment by deleveraging, restructuring and increasing productivity. In that period, private sector employment fell 7 percent and productivity grew by as much as 6 percent year on year. In the same time frame, U.S. government debt grew 50 percent to almost $12 trillion and employment in the public sector rose with no improvement in productivity. We now need to unwind that position.
And the timing is critical, once again, because reduced public spending will not kick in until next year. In many countries that gives a window for a private-sector recovery to take a lead in driving economic growth. We have seen examples of public-sector deleveraging in advance of strong growth in the past. Finland faced a difficult situation and reduced government debt sharply in the early 1990s and their economy grew by 4-6 percent in subsequent years. It was similar in Canada, in the U.S. and in Sweden. We know this can be done.
Both the U.S. and UK are taking steps to tackle the issue. Chairman Bernanke has spoken consistently this year about the need to cut spending and deficits and the Administration has created the National Commission on Fiscal Responsibility tasked with how we can best achieve that. In the UK, the Chancellor of the Exchequer, George Osborne, has said that tackling the deficit is the greatest economic challenge the new government faces. He announced steps in his first budget yesterday to reduce public sector borrowing from £150 billion this year to £20 billion in about five years time. Other countries in Europe are taking similar measures.
So this is the moment when we need support from the private sector most of all. The private sector can drive economic growth as long as there are banks that can help companies access funding, that can help them manage risk, and that can help them carry out business across borders. Companies and banks must work together now in support of governments to stimulate the economic growth we need.
Funding and Managing Risk
Let me give you three areas where I think this is important. The first is doing everything we can to enable businesses to access funding and manage their risks. I will take one of our clients in the pharmaceutical sector as an illustration, though it could be a client from almost any sector. We provide loans to the company so they can invest and grow. They manufacture and sell in multiple locations around the world, they buy raw materials in multiple locations, they trade across borders, and they have to manage risks associated with borrowing with foreign exchange rates, raw materials, and commodity prices.
We also help them access funding through the capital markets. Since institutional investors cannot invest in a single company because the risk is far too concentrated, we also transform and structure that risk in order to diversify it for investors.
The only organization that can help this client do all these things is an integrated bank – an integrated global bank with both cash and derivatives working closely together as one business.
Financing in the Capital Markets
The second area where we need to work together is in attracting new finance through the capital markets. Sensata is a global producer of controls for manufacturers in the car, aircraft and air-conditioning industries. They raised over half a billion dollars in an IPO earlier this year – the largest IPO in the U.S. in 2010. In order to access the widest range of investors from them, we talked to clients not just in the U.S. but in eight other countries in Europe and Asia.
It is not much different with governments. Barclays today is the number one provider of liquidity to the governments in both the UK and the U.S. There is no solely domestic provider of liquidity and capital to either of these governments. All the top participants are global because you must have scale, breadth, and global reach for this.
When the U.S. government issues bonds, the buyers are not solely in the Unites States – they are in Asia, Europe, and the Middle East. We have to make markets to manage these auctions and, in doing so, we put our own capital at risk. We also have to ensure that those buyers can sell their investments when they want and that the market is liquid. And many buyers want their currency risk managed as well. If none of this happens, the result is an increased cost of borrowing and slower economic growth. Again the only organization that can help them do this is an integrated bank – an integrated global bank with both cash and derivatives working closely together as one business.
Cross Border Trade
The third area where we have to work together is in stimulating economic growth via cross border trade. Foreign direct investment from the private sector to the emerging economies is far larger than development aid from governments and charities. In 2007, the top ten emerging market recipients of foreign direct investment received over $300 billion while the top ten recipients of development aid received just 10 percent of that – $30 billion. Companies can only expand into emerging economies, create jobs, and provide core services if they are able to hedge their risks. This foreign trade is hugely important for the U.S. – this is not a one way street. We can not expect private sector growth at home without embracing global trade, so this is no time for protectionism. The U.S. economy depends on global trade.
An excellent example is the U.S. company Yum Brands, which owns restaurant chains including Pizza Hut, Taco Bell, and KFC. It operates in 110 countries around the world with about 40% of its restaurants and profits in China. It opened 500 new restaurants there last year at a time when it would have been hard to do that in the U.S. This is a real U.S. success story – it has become the world’s largest restaurant company through its ability to trade and invest globally.
Yum needs to purchase goods from 1,500 suppliers around the world in order to run 37,000 restaurants employing more than a million people. It needs international payment mechanisms and it needs the ability to hedge equity, commodity, currency, and interest rate risks. The only organization that can help them do all these things is an integrated bank, an integrated global bank, an integrated global bank with both cash and derivatives working closely together as one business. And by the way, Yum’s shareholders include pension funds who can only access growth in emerging markets through this kind of company – pension funds that people depend on for their retirement; pension funds that can only access this growth with the help of a global integrated bank.
We need global companies supported by global banks to foster economic growth both here in the U.S. and around the world, and we need to drive that growth now, at a point when governments have to deleverage and reduce spending.
Strong and Balanced Financial Reform
The other reason this is a critical moment is because legislators and regulators around the world are now making decisions about financial reform. Now let me be clear – it’s a myth that banks resist reform. We welcome it – strong banks want strong regulation. We certainly do not want to go through a similar crisis again. No tax payer money should ever be put at risk again so it is in everyone’s interests that we have a safe and sound financial system.
That is why banks have already made changes. Since the start of the crisis we have been operating with more capital, with less leverage, and with stronger liquidity buffers. Barclays, for example, has increased its Tier 1 Ratio from just below 8 percent to 13 percent, and its Equity Tier 1 from 5 percent to almost 10 percent. We have brought leverage ratios down from the high 30s to the low 20s, and we have more than tripled our liquidity position to over $200 billion. Barclays is not alone in taking these actions – actions that help create a safe and sound financial system. Banks understand that the world has changed. That is also why we have been working closely with government leaders in the U.S., the UK, and Europe to help achieve sound legislation.
Barclays supports the creation of an oversight authority to monitor systemic risk. We support strong consumer protection, strong corporate governance and strong remuneration policies. We support the clear resolution authority and controls on firms that pose a risk to the system. In other words, we support most of the Financial Reform Bill. But just like any other legislation, even in the final moments, there are areas that must be improved, areas that will help banks extend their lending, their underwriting, and their risk management services without reducing safety and soundness.
Coordinating Capital Requirements
The first area to focus on is capital. We all know we have to operate with more capital so we are working closely with regulators to assess the aggregate impact of new capital requirements on our ability to lend, our ability to raise debt and equity capital, our ability to hedge customers’ risks, and our ability to make markets liquid in the buying and selling of securities.
National and international regulators are adding capital charges on certain trading books and certain asset classes at the same time as redefining what counts as capital. There are also initiatives such as Basel III that more than double the capital charges on some trading books. We have to coordinate these regulations. We have to fully understand their cumulative impact. And we have to manage the timing of implementation carefully so that banks are not forced to reduce their lending and underwriting which could damage the economic recovery.
Determining the right level of capital that an institution needs calls for a real understanding of the potential consequences and that is why this should be a regulatory issue, not a statutory issue. Establishing the right capital framework must be left to regulators. We also have to ensure an even playing field on a global basis so that we avoid the systemic risk of capital arbitrage between countries. We must work across the G20 to ensure international coordination. That is why we must allow Secretary Geithner to do his work with our partners to define the solution. That is why we should allow Secretary Geithner to work with partners in the G20 towards an international agreement not be driven by national considerations.
Here in the US, for example, the Collins Amendment proposes that trust preferred securities no longer count as Tier 1 capital. If this is implemented in isolation it will disadvantage not just U.S. banks but US businesses and consumers as well. US banks have $150 billion of trust preferred that counts today as Tier 1 capital. Removing this could reduce credit extension by as much as $1.5 trillion.
And if U.S. banks are required to hold 5 percent of all the assets they securitize for clients, as the Senate Bill proposes, the securitization markets could virtually close, hurting those we want to help the most – consumers. To give you some idea of the impact this could have over the past 14 years, about $10 trillion of consumer loans have been made available by transferring loans from lenders to investors through securitization. This one measure alone would consume almost all the sector’s capital. A better solution could be for the originator of the loan to hold a proportion of it or to let loans season before securitization.
The danger if we get it wrong on capital is that we significantly increase the cost of credit and in doing so, damage the prospects for economic growth.
Strengthening Derivatives Markets
The second area where we can improve legislation concerns derivatives. We support full transparency and reporting in derivatives markets so that regulators can understand the kinds of instruments being used and know where there is excessive risk concentration.
Barclays was one of the first to promote electronic trading and clearing. We invested heavily in our platforms in this area. We encourage full transparency, and exchanges have a very important role to play in providing this. So we support clearing and trading of all standard derivatives.
At the same time we have to recognize that our clients, whether they are companies, pension funds or governments, continue to need customized derivative products which are fundamental to their everyday business. Take one of our utility clients for example – a company in a highly regulated sector, one of the first to expand into alternative energy, and today one of the largest developers of wind farms in the world. They were able to hedge out and monetize forward energy prices to fund their investment in wind farms thanks to structured over-the-counter derivatives. We must allow these transactions to take place to ensure growth, not just in the energy industry but across all industries. And this can be done through immediate reporting without compromising transparency or centralized clearing.
And we cannot separate out derivatives businesses from banks because funding and derivatives go hand in hand, this is a part of everyday business. Our cash and derivatives businesses operate as one in order to help clients manage their risks. Banks working with the government to finance the Government Sponsored Enterprises simultaneously provide interest rate swaps to manage asset/liability risk. Had we not been able to provide those derivatives, they would have had fixed-rate funding that was not hedged – meaning higher risk.
It is interesting that the Lincoln Amendment proposing the separation of banks and derivative dealers seems to find little support from the Treasury, the Federal Reserve, and leaders on Capitol Hill. The Treasury Secretary himself says we would not make the system more stable “by separating functions that are integral to banking and putting them somewhere else” and that is for a good reason – separating out derivatives businesses will both increase the cost of capital and add risk for all our clients.
Market Making and Principal
Similarly the Volcker Rule aims to separate out proprietary trading activity but banks need to use their own capital – their principal – for buying and selling securities, for raising capital on behalf of our clients, and for hedging clients’ risks as well as their own. So we need to define proprietary trading as trading activity with segregated capital and separate teams of people who have no interaction with client businesses. Otherwise regulation will have a negative impact on our clients and put the U.S. at a disadvantage in providing the most liquid, efficient, and low-cost markets in the world.
Global Universal Banking Model
The last area that is important concerns the model and size of banks. A notion of regulating the model of a bank – or of breaking up banks that are “too big to fail” – is overly simplistic. The world in which we operate is global. The model and size of banks reflects clients’ needs, and clients are larger, more international, and have more complex requirements than ever before.
There is no empirical evidence that narrow banking is safer. 140 small retail banks in the U.S. collapsed last year, for example, with 78 additional institutions confirmed this year. By contrast the global universal banking model, which integrates retail, commercial and investment banking, is well diversified by business and geography, well diversified by clients and products and should carry less risk by virtue of that diversification, if it is well run.
What’s more, large universal banks understand the risks they’re taking on better because they have broader deeper client relationships across a wider range of services. This gives them a better understanding of their clients and the issues they face.
But what is most important of all in this debate is what is required to stimulate economic growth. We need banks that can both lend and access the capital markets because that is what clients need. We need banks that can trade derivatives because that is what clients need. We need large global banks to support cross border trade because that is what clients need as they put capital to use to stimulate trade and global economic growth.
The Global Approach
In conclusion, we must work together now to achieve what is in everyone’s best interests. Banks made some very serious mistakes leading up to the financial crisis. There was no bank, and no banker, that did not make mistakes, and I include myself in that. But there were also mistakes in public policy, monetary policy, and in regulation. What is important now is that we move forward together to make sure we do the best for the future. We all have lessons to learn and we all have one chance to get this right because what happens in the U.S. is critical to what happens globally.
If we do not get it right here, it will be much tougher to harmonize regulations across markets and we need a global approach to avoid regulatory arbitrage. There is no other industry as interconnected globally as the banking and finance industry, and while the U.S., UK, and EU all have their own paths, processes, and timetables to follow, for the first time, the G20 offers the foundations on which to build a global regulatory framework. And the goal must be globally coordinated regulation.
So what does this mean for all of us here today? The reform being debated as we speak is a strong bill but the improvements I have talked about this afternoon are critical to getting this right. We have to work together to ensure a safe and sound financial system which firstly enables banks to lend and raise capital at an affordable price, secondly enables banks to deliver the services clients need to manage their risks, and thirdly enables banks to support clients on a global basis whether those clients are companies, financial institutions, or governments. These things are vital if we are to generate business and economic growth for the benefit of all.