1. Comments on “Three Glass Tragedy Beginning to Rethink (US) Financial Policy” David A Westbrook Andy Haldane Bank of England

2. The Westbrook Thesis It has been a tragedy – but not a uniquely US one “Portfolio” approach to financial management: –May reduce risk –But increases uncertainty Risk is idiosyncratic; uncertainty is systematic Systematic risk has gone up Uncertainty manifests as: –“Indeterminate” asset prices –“Downward biases” in asset prices

3. Different regulatory structures, same outcomes

4. Systematic risk rises…

5. …and implied losses exaggerated

6. Roots of Uncertainty Among the primary causes of uncertainty are: –Contract design (eg CDO n ) –Industrial organisation of finance (eg securitisation) –Myopia (eg VAR) –Network topology (eg CDS market)

7. ABCP Equity SIV HY bonds Mezzanine Leveraged loans Mezzanine tranche Senior AAA Senior ABS/CDO tranches (and bank debt/ capital) CDO mezzanine tranches Senior Mezzanine Equity Capital Notes CDO HY bonds Mezz/second lien debt Corporate assets Leveraged loans Equity LBO’d company CDO 2 Mezzanine (often BBB-) Sub-prime mortgages/ Commercia l mortgages Senior Equity HEL ABS/CMBS Mezzanine BBB- rated HEL ABS/ CMBS or synthetic Senior Equity CDO of ABS CDO equity tranches Principal protected notes CPPI on CDO equity FINANCIAL ECONOMY REAL ECONOMY Financial contract design – ‘Russian Dolls’ MTNs Current episode borne of leveraging developments over the previous few years.

8. Sub-prime securitisation chain

9. Pre-crisis VaR

10. Post-crisis VaR

11. Post crisis CoVAR

12. So Where Next? Roll back innovation/liberalisation? –1945-1971 versus 1971-2007 Address the identified market failure? –Recognising uncertainty: Network information - “Leontief matrices” for financial claims –Rethinking financial contracts Creative destruction of the CDOs and SIVs –Rethinking financial networks OTC versus centrally traded/cleared Partitioning the public good activities of the financial system –Regulation targeted at systematic risk Countercylical regulation (“common shock”) Systemic regulation (“network shocks”)

13. Financial Crises – Past and Present