Risk aversion is a basic human characteristic, and in response to it we seek to safeguard the world live in. We mandate airbags and safety belts for automobile driving, set standards for the handling and shipment of food, build levees and dams to control floods, and regulate financial transactions and institutions to avoid financial collapses. But Greg Ip in Foolproof shows that our best attempts at avoiding catastrophes can fail, and even bring about worse disasters than those that motivate our attempts to avoid them. Drivers who feel safer with antilock brakes drive more quickly and leave less space between cars, while government flood insurance encourages building houses on plains that are regularly flooded.
Is the financial sector different? The traditional measures implemented to avoid financial failures are based on attaining macroeconomic stability. Monetary policy was used to control inflation, and when necessary, respond to shocks that destabilized the economy. When a crisis did emerge, the primary responsibility of a central bank was to act as a lender of last resort, providing funds to institutions that were solvent but illiquid. There was a vigorous debate before the global crisis of 2008-09 over whether central banks should attempt to deflate asset bubbles, but most central bankers did not believe that this was an appropriate task.
Fiscal policy was seen as more limited in its ability to combat business downturns because of lags in its design, implementation and effect. A policy that established a balanced budget over the business cycle, thus limiting the buildup of public debt, was often considered the best that could be expected. Automatic stabilizers, therefore, were set up to respond to cyclical fluctuations.
In open economies, flexible exchange rates provided some insulation against foreign shocks, and avoided the dangers that a commitment to a fixed rate entailed. Countries that did fix, or at least manage, their exchange rates stockpiled foreign exchange reserves to forestall speculative attacks. IMF surveillance provided an external perspective on domestic policies, while IMF lending could supplement foreign exchange reserves.
The global financial crisis demonstrated that these measures were inadequate to provide financial stability. The Federal Reserve led the way in implementing new monetary policies—quantitative easing—to supplement lower policy rates that faced a zero lower bound. But policymakers also responded with a broad range of innovative financial regulations. A new type of regulation—macroprudential—was introduced to minimize systemic financial risk, i.e., the risk associated with the collapse of a financial system (as opposed to the microprudential risk of the failure of an individual institution). These measures seek to prevent speculative rises in asset prices and credit creation, and the establishment of risky balance sheet positions. They include limits on interest rate and foreign exchange mismatches on balance sheets, caps on bank loan to value ratios, and countercyclical capital requirements (see here for an overview of these measures).
In the international sector, the Basel Committee on Banking Supervision produced “Basel III,” a new set of regulations designed to strengthen the resilience of its members’ banking systems. Capital control measures, once viewed as hindrances to the efficient allocation of savings, are now seen as useful in limiting inflows of foreign funds that contribute to asset bubbles. Swap lines allow central banks to draw upon each other for foreign exchange to meet the demand from domestic institutions, while the IMF has sought to make borrowing more user-friendly. Meetings of the member governments of the newly-formed Group of 20 allow them to coordinate their policies, while the IMF’s surveillance purview has expanded to include regional and global developments.
Are these measures sufficient? The lack of another global crisis to date is too easy a criterion, given that the recovery is still underway. But there may be inherent problems in the behavior of financial market participants that could frustrate policies that seek to prevent or at least contain financial crises. Moral hazard is often blamed for shoddy decision-making by those who think they can dodge the consequences of their actions. Many who were involved in the creation and sale of collaterized securities may have thought that the government would step in if there were a danger of a breakdown in these markets. But many banks held onto these securities, indicating that they thought that the reward of owning the securities outweighed the risks. Bank officials who oversaw the expansion of mortgage lending generally lost their jobs (and reputations). It is difficult to believe after the crisis that anyone thought that they could manipulate the government into absorbing all the consequences of their actions.
But if moral hazard is not always at fault, there is ample evidence that asymmetric information and behavioral anomalies result in hazardous behavior. Will the regulatory provisions listed above minimize the incidence of risky financial practices? There is some evidence that the provisions of the Dodd-Frank Act are working. But the regulatory framework continues to be implemented, and bankers and other financial market participants will always seek to find loopholes that they can exploit.
Regulatory practices on the international level are also subject to manipulation. Roman Goldbach, a political economist at Deutsche Bundesbank, in his book Global Governance and Regulatory Failure: The Political Economy of Banking points out that the overlap of national and global standards in what he calls the “transnational regulatory regime” results in layering “gaps.” The resulting loopholes in the policymaking process allow private interest coalitions to have a disproportionate influence on policy formulation. Moreover, policy officials consider the competitiveness of domestic financial structures as a goal (at least) equal to financial stability in international negotiations over regulatory standards. While there have been substantial changes since the global crisis, including the formation of the Financial Stability Board, the incentives in the governance structure of global finance have not changed.
Even regulations that work as intended may have unintended and unwanted consequences due to externalities. Kristin Forbes of MIT and Marcel Fratzscher, Thomas Kostka and Roland Straub of the European Central Bank examined Brazil’s tax on capital inflows from 2006 to 2011. They found that the tax did cause investors to decrease their portfolio allocation to Brazilian securities, as planned. But other countries also felt the impact of the tax. Foreign investors increased their allocation to economies that had some similarities to Brazil, while cutting back on those countries that were likely to impose their own control measures. Capital control measures that are imposed unilaterally, therefore, may only divert risky funds elsewhere, and are not a tool for controlling global financial risk.
The flow of money looking for higher yields outside the U.S. may diminish in the wake of the rise in the Federal Funds rate in the U.S. But Lukasz Rachel and Thomas D. Smith of the Bank of England claim that long-term factors account for a decline in the global real interest rate that will not be soon reversed. This poses a challenge for policymakers, as measures implemented in one country to contain a domestic credit boom may be undermined by foreign inflows. Domestic actions, therefore, ideally would be matched by similar measures in other countries, which would require macroprudential policy coordination.
Barry Eichengreen of UC-Berkeley has studied the record of international policy coordination, and finds that it works best under four sets of circumstances: when the coordination is centered on technical issues, such as central bank swaps; when the process is institutionalized; when it is aimed at preserving an existing set of policies, i.e., regime preserving, rather than devising new procedures; and when there exists a sense of mutual interests on a broad set of issues among the participants. Are such conditions present today? At the time of the crisis, central bankers cooperated in setting up the currency swap agreements while discussing their monetary policies. The formation of the Group of 20 provided a new forum for regular consultation, and there was widespread agreement in preserving a regime that encouraged international trade while preventing competitive currency devaluations. But the passage of time has weakened many of the commitments made when the crisis threatened, and the uneven recovery has caused national interests to diverge.
Perhaps a more basic issue is whether it is possible to design a financial system free of volatility. A government that is willing to replace markets in directing financial flows and allocating financial returns can maintain stability, but at a price. Such a system is characterized as “financial repression,” and includes limits on interest rates received by savers, control of banks and their lending, and the use of regulations to prevent capital flows. These regulations penalize household savers, and allow the government and state-sponsored enterprises to receive credit at relatively low rates while blocking credit to firms that do not enjoy government backing.
China used these types of measures during the 1980s and 1990s to finance its investment- and export-led growth, and its self-imposed financial isolation allowed it to escape the effects of the Asian financial crisis. But more recently China has engaged in financial liberalization, removing controls on interest rates and bank activities while deregulating its capital account and allowing more exchange rate flexibility. The responses have included the emergence of a shadow banking system and a boom in private credit, which will require government actions to avoid a crisis.
Several years ago Romain Rancière of the Paris School of Economics, Aaron Tornell of the University of California-Los Angeles and Frank Westermann of Osnabrueck University coauthored a paper (here; working paper here) on the tradeoff between systemic financial crises and economic growth. They showed that financial liberalization leads to more growth and a higher incidence of crises. But their empirical estimates indicated that the direct effect on growth outweighed the negative impact of the crises. They contrasted the examples of Thailand, which had a history of lending booms and crises with that of India, which had a more controlled financial sector, and showed that Thailand had enjoyed higher growth in per capita GDP. In a subsequent paper (here; working paper here), they explored the relationship between crises that produced a negative skewness in the growth of real credit, which in turn had a negative link with growth.
If there is a tradeoff between the volatility associated with financial liberalization and economic growth, then each society must choose the optimal combination of the two. Financial innovations will change the terms of the tradeoff, and lead to movements back and forth as we learn more about the risks of new financial tools. The advantages of novel instruments at the time when they seem most productive must be weighed against the possible (but unknown) dangers they pose. Perhaps the greatest threat is that the decisions over how much control and regulation is needed will be made not by those public officials entrusted with preserving financial stability, but by those who will profit most from the changes.
Is the financial sector different, with regard to the fact that our best attempts at avoiding ca-tastrophes can fail, and even bring about worse disasters than those that motivate our at-tempts to avoid them? With regard to regulation before the financial crisis, in particular the rules of the international Basel II standards, the question is no – highly complex risk regulation has not improved the resilience of the financial system; to the contrary, it contributed to the build-up of the credit bubble, the burst of which initiated the crisis (see D. Tarullo Banking on Basel, 2008, Petersen Institute; R. Goldbach, Global Governance and Regulatory Failure. The Political Economy of Banking Palgrave Macmillan, 2015). So the pressing question is, whether the post crisis financial regulatory reforms since 2009 have changed this?
The frustrating answer is no. In this reply, I outline why that is the case and what would be better options to regulate financial institutions.
Politicians, regulators and supervisors have put tremendous, impressive efforts into the enhancement of the regulatory and supervisory framework. But my argument is that this has only reanimated a problematic regulatory approach and prolonged its existence. That approach is complex risk regulation, i.e. to quantify the risk of unwanted events taking place – in particular a bank becoming insolvent — based on historical data, and to calculate how much equity a bank needs to have in order to safeguard against these expected risks. The inherent belief is that this approach can safeguard against future crises.
Unfortunately, this doesn’t work. Economic processes are highly dynamic in a manner that is not predictable. Assuming that it is, and developing a model that stipulates how banks have to calculate their risks leads to two detrimental effects: herding behaviour. First, it demands a lot of the regulatory and industrial resources, which have to be pulled away from actually evaluating credits and banks. Second, complex risk regulation is so complex that it opens more loopholes in the detailed rules text than closing such opportunities for regulatory arbitrage. Third, in the belief that the calculations are accurate capitalisation of banks are becoming extremely thin. In sum, it is not surprising that this approach didn’t work.
The reforms in reaction to the crisis have failed in overcoming the paradigm of complex risk regulation. The new rules have attempted at optimising the approach. Yet, the problem that the regulatory regime creates loopholes which huge banks use to build-up excessive leverage remains under Basel III and the other reforms. This will fuel the next bubble – which is currently supported by expansionary monetary politics. And once this one bursts, politicians will again step in to rescue the banks (in the belief that it is most important to keep the econ-omy running); moreover, this will be even harsher on public spending as the level of public debt is already very high in several countries. Thus, the next crisis might be even worse than the latter, even though policy makers have put a lot of effort in painfully complex regulations. Which brings us to two crucial questions: Why does this happen again? And, do we have a better approach for financial regulation, and which?
Let’s begin with why does this happen again? The answer is twofold, but simple: because the mind-set of the decision makers has not changed (sufficiently), and because the institutional set-up of the regulation of international finance remains ill-designed as before the crisis.
Mind-set: Politicians and high-level bureaucrats continue to look for simple truths to guide their decisions in their busy life– such as: finance supports growth and high capital requirements undermine financial institutions’ capacity to provide this growth. This is plain wrong. It’s almost the opposite, where stable banks with sustainable capital ratios lend more and, most importantly select the good credits and do not engage in bad ones. (see among many others: Admati, A. R.; DeMarzo, P. M.; Hellwig, M. & Pfleiderer, P. Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why bank equity is not socially expensive; Adair Turner, Between Debt and the Devil; Buch, C. M. & Prieto, E. Do Better Capitalized Banks Lend Less? Long-Run Panel Evidence from Germany International Finance, 2014, 17, 1-23). As long as politicians – and unfortunately based on my experience in a supervisory institution even many high-ranking regulators/supervisors – believe this simple but wrong argument, regulatory standards will be watered down. It’s just too good to simply make securitisation cheaper and think that this will create jobs – makes a complicated day much simpler.
For decision makers, whose options for solution are limited by the above mind-set, the con-tinuation of complex risk regulation was/is the best way forward, because it offers them a convenient approach to pursue the finance-led growth strategy. The success of these ideas fuels regulatory capture, i.e. rules being written and interpreted to serve the private interests of the regulated entities (here: financial institutions) rather than the interests of the public.
This brings us to the second reason, the problematic institutional setup. And here it is relevant that most regulatory reforms are harmonised globally in transnational networks like the Basel Committee; later on these standards are implemented nationally. In my book, which Joseph Joyce cited in his post, I demonstrated that this set-up of global governance in financial regulation does undermine financial stability, rather than strengthening it (Global Governance and Regulatory Failure. The Political Economy of Banking Palgrave Macmillan, 2015; see also Asymmetric influence in global banking regulation, in: Review of International Political Economy, 2015, 22, 1087-1127). The logic, for which the book and the paper present clear empirical evidence, is that in order to achieve a globally harmonised agreement (which is another established idea among policy makers, because only globally harmonised rules, so the argument goes, would enable global financial markets, which are necessary for better development; both parts of this argument are faulty), a very high number of bargains are made. There is no majority mechanism in global harmonisation – every jurisdiction must agree. This is utilized by special interest in the jurisdictions, where banks push politicians (and regulators/supervisors) to integrate specific clauses that serve the special interest. Multiply this with around 10 to 20 jurisdictions and what you get is a perforated standard. Nobody outside the specialized circles recognizes this. Moreover, the global standard – remember the perforated one – is considered best practice, and departing from it by a national supervisor is almost impossible due to market and political pressure (see M. Thiemann’s article: In the Shadow of Basel: How Competitive Politics Bred the Crisis Review of International Political Economy, 2014, 21, 1203-1239.).
In sum then, the new standards around Basel III etc. are an improvement, without a doubt. Within the system of complex risk regulation many things have changed to the better. But the system still follows the same paradigms, which leads to the same kind of loopholes that caused the financial crisis, and is not suited to undermine the build-up of leverage. The fi-nancial system has too much room to serve itself rather than the economy – at the cost of the society, when the next crisis hits.
Which brings us to the question, do we have a better approach for financial regulation, and which? The answer is yes, but these aspects are at the moment outside the politically realistic. Three things are important here: two related to the institutional design of how we regulate and one to the content of the approach to regulate.
Let’s begin with the latter. Once the crisis hit, politicians searched for a quick solution to evade Great Recession like events. That led them to give a mandate for reforms to those who created the regulatory pre-crisis mess in the first place, transnational expert networks, most importantly the Basel Committee. Unsurprisingly, feeling the tremendous time pressure, they did not overcome the ideational paradigms that guided their work over the previous two decades. And so it came, that their approach of choice was to fix the existing system, to fix complex risk regulation. Since politicians and bureaucrats did not think outside the box of (a) finance-led growth, and (b) complex risk regulation, fundamentally different approaches nev-er had a chance.
Nevertheless, the belief in this almighty approach has been hit hard by real life events of the crisis, and some scholars and policy-makers have thought outside this box – see in particular Andrew Haldane’s ‘The dog and the Frisbee’ and the references there. Thus, blueprints for fundamentally different approaches are available, and would aim at redirecting public institu-tions’ resources from collecting data and measuring risk (which both do keep regulators and supervisors very busy) towards actually running and supervising institutions. For this we would need a simple supervisory approach with simpler rules but higher capital requirements – it would have advantages for banks and for supervisors: the banks could utilize their resources for evaluating the quality of credits, rather than hiring huge teams of mathematicians to design complex capital calculation models and lawyers to fulfil the compliance burden; the supervisors could use their staff to actually scrutinize what’s going on in banks, rather than following a box-ticking (covering your ass) approach.
With higher equity requirements – such as 20% percent or higher as convincingly argued by Admati, A. & Hellwig, M. The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It Princeton University Press, 2013 – errors in banks would be less dangerous to the system, and thus not every single position needs to be measured by supervisors. To be sure, the masters of quantitative regulation will argue this is not scientific, and their leaders will agree. Yet, calculations and theories that are ignorant to the many omitted variables that their models suffer of are at least as un-scientific.
Admittedly, this very basic idea would have to be thought through in detail. But, certainly, the regulatory approach would imply the better use of our public and private resources.
Let’s come to issues two and three, the institutional design issues.
What could improve the situation is an institutional veto player, to be implemented nationally, that has an independent mandate to scrutinize regulation and supervision with a view to the public good of financial stability. This institution could intervene in existing business or block new regulation, if the public good is disregarded (see for a related proposal: Barth, J. R.; Caprio, G. & Levine, D. S. Guardians of Finance. Making Regulators Work for us MIT Press, 2012). From my personal experience, within a regulatory/supervisory institution, it already helps to have a strong department with responsibility for financial stability that can affect the positioning of the entire institution.
The other institutional aspect to be improved is the mode of international cooperation, where another still existing paradigm has to be overcome, namely the imperative to regulate finance in a globally harmonised manner. Global harmonisation means that one set of regulatory standards are implemented in all relevant jurisdictions (currently the G20 plus a few financial centres in small jurisdictions). Most of us probably do cherish the idea of a global community with a global set of rules. But, scientific evidence (see my book and article cited above) and practical experience (in a supervisory institution) convinced me that this approach does not work (the reasons for which I outlined above). Since, national isolation on the other hand is also not preferable (for geopolitical reasons), we need to think harder outside the box of a global market with one set of global rules. Rather we need to carefully evaluate options that lie between the extremes of global harmonisation and national isolation. This could comprise different variations of information exchange, memoranda of understanding etc. There is no room here to discuss this in detail, but hopefully more research and thinking is done in this area. An easy way out could be to separate the regulatory regime between international, large banks and rather smaller, local/regional ones. Globally harmonised standards would be developed for those institutions that are active on global markets – for all other banks, we would have more national discretion, while global fora could develop guidelines, which can but most not be implemented nationally. Note that the Basel Committee (1) has an explicit focus on international banks, but in most jurisdictions (but not the US) the rules are, nevertheless, implemented for all banks, and (2) that the Committee already has followed the two-tiered strategy of standards for global banks and guidelines for rather national ones in the context of capital add-ons for (global/domestic) systemically important banks. For this two-tiered international system to develop, only one thing might be necessary: further important jurisdictions, like the EU and Japan, would have to follow the example of the US and imple-ment Basel standards only for the internationally active banks (in combination with diplomatic efforts that explain that it is not the intent to end global cooperation, but to the contrary to strengthen it, and in particular to strengthening the global cooperation for those institutions where global cooperation is beneficiary).
This is only one approach, others are imaginable, and might be better. The simple bottom line is: while global harmonisation in principle is a neat idea, it does not work in reality (at least in its current form). If we want better regulation, we must accept that fact and move on to better approaches.
To sum up, let’s return to the question of the original post: Is the financial sector different, with regard to the fact that our best attempts at avoiding catastrophes can fail, and even bring about worse disasters than those that motivate our attempts to avoid them? More specifically, have the post crisis financial regulatory reforms since 2009 changed this? The frustrating answer is no. We have done a lot to save a system that serves the fairy tale of finance-led growth. Complex risk regulation to keep capital requirements low so that banks can fuel economic growth remains the approach of choice to regulate financial institutions. I argued that the underlying reasons for this are (1) the unchanged mind-set of policy makers for whom the finance-led growth strategy is the most convenient idea to structure their political days, and (2) the institutional set-up in which rules are developed. What we need is more education by such great contributions like those from Admati et al and Adair Turner etc. Fur-thermore, institution-wise we need an institutionalised veto player with a strong mandate to protect the public good of financial stability as well as a more moderate approach to what in-ternational cooperation can achieve. Finally, we should think about fundamentally different approaches to financial regulation, and consider the complex risk regulation experiment dead. These are only very basic ideas that need a lot more careful thought and analysis. But hope-fully good ideas and facts are ready, when the next crisis opens a window for paradigm-changing reform.