On Crises – Mechanics and Resolution
Why the financial sector must at last be tamed and simplified
Financial crises have their origins in human behaviour. They are not natural disasters like hurricanes or earthquakes – events that we cannot avoid and must simply learn to manage. Economic policies can increase or reduce their frequency and size, and have.
The 19th century displayed a recurrent pattern of boom and bust, but in the early part of the 20th century, the amplitude of crises increased, culminating in the Wall Street crash and Great Depression. The period that followed, however, was one of historically unprecedented stability. That lasted until the 1970s and was followed by a steady rise in volatility, with debt crises first in Latin America and then in Asia, the ‘new economy’ bubble, and finally the global financial crisis of 2008.
Although there were many signs of future instability for those who cared to look, it is hard to overstate the complacency that characterized the period from the bursting of the Internet bubble to the global financial crisis. The Nobel Prize-winning economist Robert Lucas told the annual meeting of the American Economic Association that the “central problem of depression prevention has been solved.” Another academic economist, Ben Bernanke, who had recently been appointed to the Board of Directors of the Federal Reserve System, popularized the phrase ‘the Great Moderation’ to describe a supposed new era of economic stability. The critical development during this period was the growth in trade in asset-backed securities – especially mortgage-backed securities. A false belief in the security provided by such packaging stimulated demand for these assets and subsequently collateralized debt obligations between financial institutions. Far from understanding that the complexity of these instruments and the resulting interactions between financial institutions added to the fragility of financial structures, policy-makers congratulated themselves on the sophistication of modern risk management and the diversification of vastly enlarged balance sheets.
The crisis began in the US, but immediately crossed the Atlantic – in large part because European banks were large purchasers of doubtful paper originating in America. But the next crisis was made in Europe. The Eurozone – an ambitious scheme to link the currencies of France with Germany and the countries closely bound into the German economy – had grown into a political project that included Spain, Italy, Portugal, and even Greece.
The adoption of a common currency in 1999 by these countries (Greece followed in 2001) led to the convergence of interest rates across the continent. Traders no longer discriminated between the euro liabilities of different Eurozone governments, believing that not only currency risks but the credit risks that had once distinguished well-managed European economies from those with unstable public finances had been eliminated. Banks in Germany and France borrowed euros in the north of the continent to lend to southern Europe. By 2007, yields on Greek government bonds were barely higher than those on equivalent German bonds. Several states, including Greece, took advantage of what appeared inexhaustible supplies of credit at low rates.
As European banks struggled with the global financial crisis, the quality of their assets was viewed more skeptically. Credit risks were appraised much more carefully, and interest rate differentials across the Eurozone widened again. Greek bonds appeared relatively less attractive as interest rates rose and the refinancing of Greek credit became more difficult. The country effectively defaulted on its debts in 2011.
But Greece was not the Eurozone’s only problem. Ireland’s entire banking system had collapsed in 2008. A property bubble of extreme magnitude had burst in Spain. Other Eurozone members – Portugal, Italy and Cyprus – faced their own distinctive economic and political difficulties. All experienced spiralling debt service costs. With each mini-crisis, the scale and scope of European Central Bank intervention increased. In 2012, the new Governor of the European Central Bank, Mario Draghi, promised to do “whatever it takes” to preserve the Eurozone. Given the potential resources available to an institution empowered to print Europe’s money, that commitment stabilized the Eurozone crisis – for the time being.
The proximate causes of these successive crises are very different – emerging market debt problems, the new-economy bubble, defaults on asset-backed securities, political strains within the Eurozone. Yet the basic mechanism of all these crises is the same. They originate in some genuine change in the economic environment – the success of emerging economies, the development of the Internet, the adoption of a common currency across Europe. Early spotters of these trends make profits. A herd mentality among traders attracts more and more people and money into the asset class concerned. Asset mispricing becomes acute, but prices are going up and traders are mostly making money.
But reality cannot be deferred forever. The mispricing is corrected, leaving investors and institutions with large losses. Central banks and governments intervene to protect the financial sector and to minimize the damage done to the non-financial economy. That cash and liquidity then provide the fuel for the next crisis in some different area of activity. Successive crises have tended to be of increasing severity.
The booms are generally triggered by events external to the financial system. The busts may also appear to have extraneous causes – Russian default, a setback to US house prices, the collapse of Lehman Brothers. But these are triggers rather than explanations. The mechanisms of crisis are an intrinsic part of the modern financial system. It is not just that the modern financial system is prone to instability. Without the mechanics that produce recurrent crises, the financial system would not exist in the form in which it does today.
The primary objective of policy-makers since the global financial crisis has been to secure the stability of the financial system. This objective has in turn been interpreted as assuring the stability of existing financial institutions. It has been argued that the means of achieving this is to require institutions to have greater reserves of both capital and liquidity. Regulators have identified ‘systemically important’ financial institutions that are to be the subject of special supervision and (implicit or explicit) government support.
With crass hypocrisy, political leaders have set their public face against future bank rescues while reassuring markets that they do not mean what they say. President Obama could assert that the passage of Dodd-Frank meant “no more taxpayer-funded bailouts – period[,]” while his Treasury Secretary not only upheld the ‘Geithner doctrine’ – no significant financial institution would be allowed to fail – but also provided an extended defence of the doctrine in his memoirs. The European position is essentially the same – both in its substance and in its humbug. The bailout of the Portuguese bank Espirito Santo followed hard upon the announcement that the era of bailouts was at an end.
Assuring the stability of existing institutions was exactly the right short-term response to the global financial crisis, and exactly the wrong long-term response. For the origins of the global financial crisis lay in the structure of the industry. To stabilize – indeed, to ossify – that structure, therefore, is not a means of avoiding future crises, but a way of making them inevitable.
Systemic instability in the financial system is the result of the interdependencies inherent in an industry that deals mainly with itself. The growth in the scale of resources devoted to financial intermediation is not to any large degree – or, in most cases, at all – the result of any change in the needs of users of intermediary services. The growth of financial activity has come from a massive expansion in the packaging, repackaging and trading of existing assets.
The scale of this activity, which contributes little to the non-financial economy, requires much more capital – not the small additional amounts required by the regulatory demands contained in Basel 3. But equity investors will not provide financial conglomerates with fresh capital on the scale necessary. Investors no longer trust the financial statements of banks or the people who run these banks. They have little confidence in the long-term profitability of these institutions, and fear that if banks do make profits both regulators and senior executives will have priorities other than distributions to shareholders.
The solution that has instead been adopted is that central banks lend very large amounts of money to financial conglomerates at low rates in the hope that they will make sufficient profit from trading to rebuild their balance sheets. But the taxpayer cannot reasonably be asked to subsidize banks in this way – especially when a high proportion of these profits is creamed off to reward the traders concerned and the managers who ostensibly supervise them, allowing them to achieve levels of remuneration beyond the dreams of ordinary people. At the same time, bankers and their lobbyists claim that the provision of adequate equity capital for banks would drive down reported returns on equity capital to unattractive levels and inhibit the proper function of banks in lending to the real economy.
If activities cannot raise sufficient equity to ensure that they are adequately capitalized, or earn satisfactory rates of return on that equity if they do, the lesson of market economics is clear: such activities should not take place, or at least the scale at which they do take place should be substantially reduced. And that is how we should view the existing banking system.
Inevitably, financial services regulation and regulators have been heavily criticized since the 2008 crisis. Regulators were ‘asleep at the wheel.’ The revisionist account of the events of that period asserts that the failures and frauds in the industry were not, as the public was mistakenly led to believe, the result of managerial incompetence and individual chicanery. Business failures were the consequence of a series of errors by governments: unwise encouragement of home ownership, loose monetary policies, and weak regulation.
This description is essentially ridiculous, as each financial institution that failed did so because of identifiable and avoidable executive decisions and inadequate internal control and supervision. Nevertheless, there is an element of truth in it: there were serious policy errors. The exclusion of derivatives from the ambit of US regulation in 1999 is now almost universally recognized to have been a mistake. Moreover, the changed structure of the finance industry from partnerships to limited liability corporations effectively transferred a degree of responsibility for risk management from firms themselves to regulators.
The Basel calculations of capital adequacy became, in large part, a substitute for the prudential management of risk by banks themselves. Indeed, in the revisionist account of the crisis, banks blame regulators for their failure to impose more demanding requirements on them. And they have a point: bank executives were under pressure from their traders and shareholders to expand their balance sheets to the limits permissible by regulation. It is perhaps an exaggeration to say that the minimum standards of capital and behaviour prescribed by regulation were interpreted as maxima – but not a very great exaggeration.
Still, to see policy errors as the source of the problem is to fail to understand either the economics or the politics. Perhaps it was an error to eschew regulation of credit default swaps – but what is it imagined a regulator would have done if such an exemption had not been implemented? After all, the banks that were brought down by these instruments were themselves regulated institutions. These failures of regulation were observed in almost all advanced countries. It is implausible that so many regulators had, simultaneously and independently, fallen ‘asleep at the wheel’: the catalepsy had a more systematic underlying cause. Among policy-makers in the UK and the US, there has been little political appetite for restraint on the financial services industry, and often considerable political opposition. Even if regulators had been inclined toward pre-emptive actions, and had known which measures to implement, they would not have enjoyed political support. They therefore had little or no incentive or inclination to act. If the ship’s owners will not allow the captain to move the wheel much, it hardly matters whether he is asleep at the wheel or awake on the bridge. He might as well retire to his cabin.
Pre-emptive action by any regulator faces the dilemma that the costs and consequences of preventive action are real and measurable. However, if preventive action is successful, the costs of the damaging events that have been avoided, and indeed the very nature of these events themselves, will remain hypothetical. The public does not applaud the cautious captain who avoids the storm, but rather the heroic seaman who steers through the storm.
Politicians and the public get the regulation they deserve. Some regulators were essentially placemen – put there by the industry and its political cronies to represent the interests of the businesses over which they exerted nominal oversight. But others were honest and committed: those regulators who were genuinely public servants attempting to do an honest job were, however, constantly aware that industry leaders had political connections as strong as theirs, and often stronger. ‘Light touch regulation’ was not the product of idle regulators, but of the demands of the industry transmitted through the political masters of the regulators.
The finance sector of modern Western economies is too large. It absorbs a disproportionate share of the ablest graduates of our colleges and universities. Volumes of trading in financial markets have reached absurd levels – levels that have impeded rather than enhanced the quality of financial intermediation, and increased rather than diversified the risks to which the global economy is exposed. The capital resources needed to reconcile these trading volumes with economic stability have not been available; nor will they be. The scale of activities undertaken by traders within a modern investment bank is not viable without the implicit and explicit support provided by retail deposits and the taxpayer. The outcome is a structure characterized by tight coupling and interactive complexity, and the resulting instability has had damaging effects on the non-financial economy.
We need a finance sector to manage our payments, finance our housing stock, restore our infrastructure, fund our retirement, and support new business. But very little of the expertise that exists in the finance industry today relates to the facilitation of payments, the provision of housing, the management of large construction projects, the needs of the elderly, or the nurturing of small enterprise. The process of financial intermediation has become an end in itself.
The expertise that is valued is the understanding of the activities of other financial intermediaries. That expertise is devoted not to the creation of new assets, but to the rearrangement of those that already exist. High salaries and bonuses are awarded not for fine appreciation of the needs of users of financial services, but for outwitting competing market participants. In the most extreme manifestation of a sector that has lost sight of its purposes, some of the finest mathematical and scientific minds on the planet are employed to devise algorithms for computerized trading in securities that exploit the weaknesses of other algorithms for computerized trading in securities.
But finance is not a mathematical puzzle. It exists to serve households and businesses. Individuals and companies engaged in finance should have specific knowledge of at least some of the needs of these users of the financial system. We need focussed financial businesses with a clear productive purpose and a management system, governance regime and capital structure that are appropriate for that purpose. We should aim to restore and nourish the rich variety of institutions and organizational forms that existed in the finance sector before the 1980s.
The most common criticism of this suggestion is that it would involve ‘turning the clock back.’ In one obvious sense, we cannot turn the clock back. Many of the unwise property loans made to indigent householders, to overleveraged developers, and on inflated values and imaginary earnings, can never be repaid. The losses made by borrowing euros in the north of the continent to lend, directly and indirectly, to governments in the south are largely irrecoverable. It suits both financial institutions and governments to pretend otherwise. But only a realistic clean-up of both public and private sector balance sheets can clear the way for future action.
That action should target the structure of the industry. You should turn the clock back if it is telling you the wrong time – and in this case it is. There was wisdom in an older structure of industry and regulatory process that had evolved over decades, but was abandoned in a mixture of the ideological fervour of politicians and the personal ambition of financiers and deal-makers.
John Kay is Supernumerary Fellow in Economics at St. John’s College, Oxford. His latest book is Other People’s Money – Master of the Universe or Servants of the People?