Paul Tucker

According to Paul Tucker, executive director, markets, at the Bank of England (BoE), when discussing the risks in today’s capital markets, “there are three things that are impossible to know”.

Aside from the initial surprise that there are only three, it is easy to feel that Mr Tucker might just know such things. In addition to being a member of the monetary policy committee (MPC), his role as head of markets gives him executive responsibility for the BoE’s implementation of monetary policy via open market operations, its foreign exchange market operations (including management of the UK’s foreign currency reserves) and related risk management. He is also responsible for gathering market intelligence and analysis to support the bank’s core purposes to maintain low inflation and financial stability.

In pursuit of ‘intelligence’, Mr Tucker and his team of 25 talks to other central banks, regulators, banking institutions, funds and real economy companies from around the globe; as many people as possible, in fact, to give a rounded view.

Intelligence gathering

Although the division of labour between the MPC, management of operations and market intelligence varies (Mr Tucker says: “The MPC obviously takes priority over everything else”), intelligence gathering can take up up to a third of his time. He sees it as a critical part of his role, and the bank’s. “It is not our job to try to predict the future, but we do try to flag up issues that risk managers and others should be thinking about. Equally, we have to do our utmost to keep up with how capital markets develop and how they fit together.

“It is crucial that we, as a central bank, are not lost naively in the world of 10 or five years ago. That would not serve either of our roles of maintaining low inflation, and working with the Financial Service Authority (FSA) and the Treasury to preserve financial stability.”

In the wake of the May-June volatility, Mr Tucker’s list of ‘impossible things to know’, if brief, is apposite. It centres on the pricing (or mis-pricing) of risk, the path market-adjustments may take, and the subsequent ramifications for the banking system. Topical though they may be, the issues are not new, he stresses. “For several years, we have been discussing the gap between the way my world talks about these kinds of risks and uncertainties, and the way the market prices them; these are issues that persist.”

Risk premia compression

His first imponderable concerns the compression of risk premia against the backdrop of a benign market environment. It is entirely sensible, he argues, that structural change in monetary policy regimes, product and labour markets, and banking and financial markets may have reduced risk, while financial institutions have found better ways to unbundle and distribute risk. “[But] it’s impossible to know how much the compression in risk premia is about fundamental improvements in the environment and how much is about a myopic search for yield pushing them down artificially,” says Mr Tucker.

“If the story is one of structural change, then the compression of risk premia and the associated rise in asset prices is a one-off adjustment. If, on the other hand, market participants have extrapolated forward the high returns earned in recent years, they will have had to start taking extra risk in order to generate those same headline returns.”

Quality of adjustment

Secondly, he says: “If we assume, for the sake of argument, that there is some under-pricing of risk, then it is impossible to know whether an adjustment will be smooth or abrupt.”

Mr Tucker is reluctant to equate the relative containment and brevity of the second quarter’s volatility with a smooth adjustment, although he acknowledges, with some caveats, that it was, ultimately, “fairly orderly” and that stronger national balance sheets and floating exchange rates make a rerun of the 1990s less likely. But it is hazardous to make too close a comparison with the emerging market meltdowns of the 1990s. First, the problems of the 1990s gathered slowly over many years, he emphasises; and second, emerging market bond spreads, despite the recent adjustment, remain similarly compressed as they were then. The lesson, Mr Tucker implies, is not to speak too soon, not to be completely confident that something more traumatic will not happen.

“The striking thing about the spring was that those markets that were shaken out were those that had risen very rapidly in the first quarter: equities, commodities and emerging markets. It illustrates that, for a period in the spring, people were extrapolating forward past returns,” says Mr Tucker.

Risk flow backlash

The third unknowable thing on Mr Tucker’s list strikes to the heart of the BoE’s core purpose. If the adjustment in risk premia – and therefore of asset prices – is abrupt, will the risk flow back to the banking sector in nasty ways, and perhaps cause banks to begin to restrict liquidity? Liquidity management, therefore, is no longer the poor relation in risk management discussions.

“In the past five or so years, liquidity management has begun to be given as much attention as capital adequacy,” says Mr Tucker. “And not just in the banking sector. Hedge funds, too, are looking for longer lock-up periods, which is all about liquidity, so that they are not blown out by mark-to-market fluctuations on what might be a long-term or a medium-term judgment.”

The growth in structured finance products, such as credit default obligations, plays into both spread compression and liquidity concerns, says Mr Tucker. There is one argument that suggests that as credit spreads on such products have fallen, returns become increasingly unattractive unless leveraged up, he explains. The leverage offered by new financial technologies has attracted new sources of capital (including hedge funds) into the credit markets, leading to greater demand and downward pressure on the price of credit risk (through lower spreads and less stringent covenants) in the underlying loan markets. This dynamic has helped to drive the leveraged buy-out market.

At the same time, many banks have shifted their business models to capitalise on the markets’ thirst for structured products, becoming originators and distributors of credit assets rather than holders. But risk does not go away: it has to be warehoused before it can be securitised and banks keep hold of certain tranches, often the unrated, illiquid portion. So if today’s benign environment of low default rates were to be replaced by a period of greater market stress, how, for example, would the illiquid tranches of credit derivatives perform; or what would happen to the collateral held by prime brokers against leveraged holdings?

Bank exposure

“It’s a bit like writing deeply-out-of-the-money options; it exposes the banking system to tail risk,” says Mr Tucker. “In really severe circumstances, [banks’] collateral could be significantly eroded. Liquidity management for such circumstances is therefore critical. But it is difficult for markets to price for the risk that exists in the whole financial system.”

Talk of risk is inherent to Mr Tucker’s job, but he is not particularly negative about exotic new products or the explosion of different market participants. New products, he says, can offer excellent opportunities to manage and reduce risk, while hedge funds and leveraged players can play a very useful role.

Hedge fund role

“There is no doubt that hedge funds and leveraged players can offer a positive dynamic. In difficult market conditions, for example, it means that there are now many more pools of capital prepared to take risk; [funds] are nimble and, in many cases, sophisticated. They are able to reallocate their risk from one asset class to another, and from one geography to another, without having to change their mandate to do so.

“So, to the extent that asset prices get out of step with fundamentals, they are able to be more nimble in responding to that. The fact that they are leveraged can enhance that flexibility, but it also means that they can flip from being liquidity providers to liquidity demanders and even forced sellers across markets,” he says.

What such funds do, however, is move the challenge, he adds. “You just have to be clear where the challenge [has moved to]. This puts a premium on prudent controls among the banks providing the leverage – something that the FSA has also emphasised. They need to be able to manage risk both for ordinary and extraordinary circumstances; and extraordinary circumstances are very difficult to model.”

But Mr Tucker is not losing sleep over fears that the credit markets are over-extended. “Some people say that at some point, those chickens must come home to roost in the form of defaults. That may well be true but there are now many more distressed funds out there to help absorb the situation. Similarly, look at the credit correlation wobble in 2005. Market contacts told us that some funds provided risk capital when correlations got out of wack, which helped to cushion the adjustment. The truth is, it is impossible to predict. Global capital markets have changed a lot in the past 10 years.”

CAREER HISTORY
2002:  executive director, markets, monetary policy committee (MPC), Bank of England
1999:  deputy director, financial stability, BoE; member of BoE management committee
1997:  head of monetary assessment and strategy division; member of the secretariat, BoE MPC
1994:  head of gilt-edged and money markets division, BoE
1993:  domestic markets operations, BoE
1990:  principal private secretary to BoE governor
1989:  risk review in the UK’s wholesale payments systems, BoE
1987:  seconded to the Hong Kong government, until 1988, to help develop reforms of securities markets and regulatory system, BoE
1985:  seconded to merchant bank as a corporate financier, BoE
1980:  joined BoE as a banking supervisor
1980:  graduated from Trinity College, Cambridge, with a degree in Mathematics (Parts I and II) and Philosophy (Part II)