Beware the Next Financial Blindspot
During the crazy credit boom of 2006 and 2007, Paul Tucker, now deputy governor of the Bank of England, tried to sound an alarm about shadow banks.
In a couple of prescient speeches he warned that "Russian doll finance" or "vehicular finance" — as he dubbed the shadowy network of non-bank finance entities in London — could pose systemic risks.
In the event, his comments had little impact; few listeners had a clue what "Russian doll finance" meant. But this week Mr Tucker finally got his wish: the Financial Stability Board issued a report that called for more oversight of the shadow banking world and its $67tn assets.
In some senses this is encouraging. But as the FSB finally — belatedly — flexes its muscles, it is worth asking why it has taken six years for regulators to act.
For behind that "Russian doll" tale there is a powerful principle that sheds light on past policy mistakes and highlights remaining challenges.
The problem is one of tunnel vision, or what might be described as "silos" in policy making.
Several decades ago, when people such as Mr Tucker started their careers, institutions such as the BoE had a generalist creed: employees moved between departments, graduates were hired from a range of disciplines and senior BoE officials were expected to watch for trouble by using instinct and peripheral vision as much as models.
But when the BoE gained independence in 1997, PhD-wielding economists became more dominant and specialist macroeconomic and monetary policy analysis turned into mental silos, separated from the grubby weeds of finance or markets.
That was partly because the Financial Services Authority assumed responsibility for bank supervision. But another factor was that economists such as Sir Mervyn King, current BoE governor, had little desire to peer into the entrails of finance.
Collateralized debt obligations or structured investment vehicles did not seem connected to the "real" economy or even monetary policy; at least not in the eyes of high-status economists.
Some regulators on both sides of the Atlantic tried to bridge that mental gulf. When Mr Tucker, for example, became head of markets at the BoE a decade ago, he realized the operations of CDOs and SIVs were affecting the flow of credit. He even suggested an analysis of "vehicular finance" should be incorporated into discussions of monetary aggregates, such as M4.
But he faced at least two big obstacles in raising interest.
First, it was unclear who was responsible for analyzing, let alone policing, this non-bank world. For while the FSA was watching the micro-level operations of banks, and the BoE was monitoring macro financial stability, CDOs and SIVs fell between the cracks.
Second — and more subtly — the silo mentality was so entrenched that Mr Tucker did not even have the words to communicate his fears. He knew the phrase "non-bank finance" sounded boring, so he tried to come up with alternatives. But they failed to grab attention.
Indeed, it was not until Paul McCulley, a senior Pimco official, coined the phrase "shadow banking" at a Jackson Hole economics conference in August 2007 that a term caught on — and policy makers finally had a way to discuss vehicles such as CDOs and SIVs. Providing a catchy label, in other words, helped shift the policy debate.
Ironically, many financiers now grumble that the phrase "shadow banks" has become too catchy. Some policy makers agree: in some languages the term sounds excessively negative and it has come to be used in an unhelpfully broad sense. As a result, a drive is afoot to find new labels.
But, if nothing else, this twist in the debate shows that some officials have grasped the point: words (or a lack of them) can set policy priorities. Other lessons have been learnt, too.
These days, for example, the BoE's new Financial Policy Committee is trying to take a holistic view of the financial system. Senior officials such as Andy Haldane are doing pioneering, silo-busting research that blends economic and financial analysis with other fields, such as zoology.
And Mr Tucker himself recently gave a thoughtful speech to economists in Oxford, calling for more silo-busting measures.
But while this is laudable, the sad fact remains that the problem of silos — and mental blind spots — has not gone away; on the contrary, it is intrinsic to any large, complex system.
So the question investors should now address is what other issues continue to fall through the cracks. What about cyber security, pensions or financial infrastructure?
Or is there something else we are ignoring because it is outside our mental map? Ideas would be gratefully received or, better still, sent to the FPC (or its US and euro zone counterparts), preferably with a catchy label that is as powerful as "shadow banks".