Caging Finance

Why it is so hard to keep the financial sector caged
By Martin Wolf
Financial Times February 5 2008 20:06

When will the next financial crisis come? We do not know. Yet of one thing we can be sure: unless we learn from this crisis, another one will put the world economy back on to the rocks in the not too distant future.

The FT has published a number of contributions on the lessons: Charles Goodhart of the London School of Economics and Avinash Persaud of Intelligence Capital offered “a proposal for how to avoid the next crash” (January 31); Francisco González of BBVA discussed “What banks can learn from this credit crisis” (February 4); and Daniel Heller of the Swiss National Bank argued for three ways to reform bank bonuses (February 4). The substance of Mr Heller’s argument was similar to a contribution of my own (“Regulators should intervene in bankers’ pay”, January 15), but without the regulatory coercion.

The big question, indeed, is whether lessons must be embedded in regulation. Optimistic opponents of regulation argue that the banks have learnt their lesson and will behave more responsibly in future. Pessimistic opponents fear that legislators might create a Sarbanes- Oxley squared. The Act passed by the US Congress in 2002, after Enron and other scandals, was bad enough, they say. The banks might now suffer something worse.

“Dream on” is my reply to the optimists. To the pessimists, I respond: yes, the danger of over-regulation is real, but so is that of doing nothing at all.

Two points shine out about the financial system over the past three decades: its ability to generate crises, and the mismatch between public risk and private reward.

It is true, on the first point, that none of the financial crises of this period has gravely damaged the world economy, although some have devastated individual economies. But it is probably just a matter of time. What would be happening now if US inflation were out of control or foreign official support for the US dollar were withdrawn? A deep and prolonged US recession would be probable, with devastating economic and political consequences.

It also true, on the second point, that the banking sector is the recipient of massive explicit and implicit public subsidies: it is largely guaranteed against liquidity risk; many of its liabilities seem to be contingent claims on the state; and central banks create an upward- sloping yield curve whenever banks are decapitalised, thereby offering a direct transfer to any institution able to borrow at the low rate and lend at the higher one.

In addition, banking institutions suffer from massive agency problems – between clients and institutions, shareholders and management and management and other staff. All this is also exacerbated by the difficulty of monitoring the quality of transactions until long after the event.

Consider, for example, the process that brought subprime loans to investors in special investment vehicles (SIVs). In between the ultimate borrowers and the risk-takers were loan-originators, designers and packagers of securitised assets, ratings agencies, sales staff, managers of banks and SIVs and managers of pension – and other – funds. Given the number of agents and the wealth of information asymmetries, it is astounding how little went wrong.

Yet big risks have indeed been run. The US itself looks almost like a giant hedge fund. The profits of financial companies jumped from below 5 per cent of total corporate profits, after tax, in 1982 to 41 per cent in 2007, even though their share of corporate value added only rose from 8 to 16 per cent. Banking profit margins have been strong, until recently. Now, at long last, earnings per share and valuations have collapsed.

Yet can anything effective be done to contain the risk-taking this implies? To answer this, we must distinguish “micro-prudential” controls over institutions from “macro-prudential controls” over the entire system.

On the former, the consensus of regulators seems to be that we need tweaks to the existing system. This could include: greater attention to liquidity management, alongside the focus on capital requirements in Basel II; more stress-testing of “value at risk” models; greater transparency throughout the businesses; and greater independence of ratings agencies from issuers.

I would argue, however, that none of this will make a sufficient difference. Regulators must also pay attention to the incentives – particularly the structure of pay – within the businesses. I would argue, in addition, that regulators would have to take a tougher approach than most did in the past cycle.

The bigger point still, however, concerns macro-prudential regulation. As William White of the Bank for International Settlement has noted, banks almost always get into trouble together.* The most recent cycle of mad lending, followed by panic and revulsion, is a paradigmatic example.

One response would be to raise capital requirements counter-cyclically, in response to the growth of credit, as Profs Goodhart and Persaud suggested. They also suggest a variable maximum loan-to-value ratio for mortgages. Mr White adds the need for tighter monetary policy.

These are all reasonable ideas. Yet, as Mr White also notes, the strength of the pressures against taking “away the punchbowl just as the party gets going”, in former Fed governor William McChesney’s famous phrase, is formidable. In addition to bureaucratic inertia, such action is subject both to unavoidable uncertainty about the dangers of current trends and to resistance from private interests. Furthermore, regulators are in constant danger of losing sight of the systemic wood for the institutional trees. I would add to all this the simple fact that freedom of US monetary policy is constrained by the monetary and exchange-rate policies of others, notably of China.

In the end, we are left with a dilemma. On the one hand, we have a banking sector that has a demonstrated capacity to generate huge crises because of the incentives to take on under-appreciated risks. On the other hand, we lack the will and even the capacity to regulate it.

Yet we have no obvious alternative but to try to do so. A financial sector that generates vast rewards for insiders and repeated crises for hundreds of millions of innocent bystanders is, I would argue, politically unacceptable in the long run. Those who want market-led globalisation to prosper will recognise that this is its Achilles heel. Effective action must be taken now, before a still bigger global crisis arrives.

Sources for charts: Smithers and Co; Thomson Datastream