I have had the misfortune or fortune of being up close and personal with seven major financial crises in my banking career, from the US savings and loans crisis of the late 1980s to today’s credit crunch. In each crisis, I have observed a “cycle” in the response to the crisis. In the middle of a crisis, when circumstances look dire and chunks of the financial system are falling off, proposals get radical. I recall in December 1992, with the UK and Italy having already been ejected from the European Exchange Rate Mechanism, and Spain and Portugal looking vulnerable, some European policymakers flirted with capital controls. But (soon) after each crisis is over, these radical plans are tidied away and we are left with three things. And they are always the same three things: better disclosure, prudential controls and risk management.
These measures are the regulatory version of apple pie and ice cream. Who would say no? The thing is — we have been investing heavily in these areas for the past 20 years and do not have much to show for it in terms of financial stability. Over the past 11 years, we have had the Asian financial crisis, Long Term Capital Management crisis, the “dotcom bezzle” and, now, the credit crunch. While more disclosure, controls and risk management are generally good things and necessary fraud-reducing measures, there are few crises I have known from the inside that would not have happened if only there was more disclosure. People knew that subprime was a poor risk; it is called subprime, after all.
The problem is more fundamental and, unless we address these fundamental issues, we will be condemned to repeat the cycle of boom and bust. Lying close to the heart of the problem in all of these recent crises is the inappropriateness of financial regulation.
My own view of banking regulation would be considered quaint next to today’s practice. I consider the primary objective of intervening in the banking market to be mitigating the substantial systemic consequences of market failure in banking. It is, therefore, puzzling to me that market prices are now placed at the heart of modern financial regulation, whether in the form of mark-to-market accounting or the market price of risk in risk models. It is not clear to me how we can rely on market prices to protect us from a failure of market prices. I have discussed this before many times, so I will focus on the secondary objective, which is to avoid the discouragement of good banking.
A good bank is one that lends to a borrower that other banks would not lend to, because of their superior knowledge of the borrower, or one that would not lend to a borrower to which everyone lends because of their superior knowledge of the borrower. Modern regulators believe this is too quaint and, to be fair, many banks were not any good at it. But instead of removing banking licences from these banks, regulators decided to do away with relationship banking altogether and promoted a switch away from bank finance to market finance where loans are securitized, given public ratings, sold to many investors, including other banks, and assessed using approved risk tools sensitive to publicly available prices. Now, bankers lend to borrowers that everyone else is lending to, the outcome of a process where the public price of risk is compared with its historic average and a control is applied based on public ratings.
This switch to market finance improved “search liquidity” in quiet times. Credit risk that was previously bundled with market and liquidity risk was separated, priced and traded. This has improved the transparency and tradability, but it comes at the expense of systemic liquidity in noisy times.
Almost every economic model will tell you that if all the players have the same tastes (reduce capital adequacy requirements) and have the same information (public ratings, approved risk models using market prices), the system will sooner or later send the herd off the cliff edge. And, no degree of greater sophistication in the modelling of the price of risk will get around this fact. In this world, where falling prices generate more sell-orders from price-sensitive risk models, markets will not be self-stabilizing but destabilizing and the only way to short-circuit the systemic collapse is for a non-market actor, such as some agent of the taxpayer, to come in and buy up assets to put a floor under their prices.
The alternative model rests on three pillars. The first recognizes that the biggest source of market and systemic failure is the economic cycle and so regulation cannot be blind and deaf to the cycle — it must put it close to the centre. Charles Goodhart and I have proposed contra-cyclical charges — capital charges that rise as the market price of risk falls as measured by financial market prices — and a good starting point is the Spanish system of dynamic provisioning.
The second pillar focuses regulation on systemically important distinctions, such as maturity mismatches and leverage, and not on outdated distinctions between banks and non-banks. Institutions without leverage or mismatch should be lightly regulated — if at all — and, in particular, would not be required to adhere to short-term rules such as mark-to-market accounting or market-price risk sensitivity that contribute to market dislocation. Bankers will argue against this, saying that it creates an unlevel playing field, but financial markets are based on diversity, not homogeneity. Incentivizing long-term investors to behave long term will mean that there will be more buyers when banks are forced to sell.
The third pillar is requiring banks to pay an insurance premium to taxpayers against the risk that the taxpayer will be required to bail them out. If such a market could be created, it would not only incentivize good banking and push the focus of regulation away from process to outcomes, but it would provide an incentive for banks to be less systemic. Today, banks have an incentive to be more systemic as a bailout is then guaranteed. The right response to Citibank’s routine failure to anticipate its credit risks is not for it to keep on getting bigger so that it can remain too big to fail, but for it to wither away under rising insurance premiums paid to taxpayers.
Avinash Persaud is chairman of Intelligence Capital. Edited excerpts published with permission from VoxEU.org. Comment at firstname.lastname@example.org