The failures of the western financial models
The worst outcome of the current financial crisis would be a return to the status quo ante that produced the pathologies, anomalies and contradictions that are its root causes.
I believe that the Western model of financial capitalism – a convex combination of relationships-based financial capitalism and transactions-based financial capitalism – has, in its most recent manifestations (those developed since the great liberalisations of the 1980s), managed to enhance the worst features of these two ideal-types and to suppress the best. This period has been characterised by a steady increase in the relative dominance of the transactions-based financial capitalism model in the overall financial arrangements of the world, most spectacularly in the US, the UK, and such smaller countries like New Zealand and Iceland, somewhat less in most of continental Europe and elsewhere.
The key policy issues created by the recent excesses of the financial sector, once the immediate financial crisis has been euthanised, are those of governance and regulation. Governance issues include prominently the question of remuneration for top managers and superstars. I will not address this issue here. Regulation (and public ownership) inevitably become issues in all industries where widespread, systemically significant externalities, free rider problems and public goods features ensure that decentralised, competitive outcomes are inefficient. They are especially acute in the area of financial intermediation, because leverage permits the scaling up of financial activity to astronomical levels in no time at all. The damage that can be done by a rogue individual, a rogue firm or a rogue instrument is unparalleled among legal business activities.
Financial intermediation is playing with fire; there is no escape from this. Any economic activity undertaken for profit or power which has trust and information as its two key inputs is bound to be vulnerable to abuses, distortions, excesses and deception.
Effective financial intermediation is also a key and necessary feature of any economic system capable of delivering sustained increases in material well-being. If every economic agent were required to be financially self-sufficient, we’d all still be living in trees.
Getting ex-ante financial surpluses from economic agents whose planned saving exceeds their planned capital formation matched efficiently with the ex-ante financial deficits of economic agents whose planned capital formation exceeds their planned saving can, given time, increase the productive efficiency of an economy by orders of magnitude.
Transactions-based financial capitalism emphasizes arms-length relationships mediated through markets (preferably competitive ones), is strong on flexibility, encourages risk-trading, entry, exit and innovation. It is lousy at endogenous commitment: reputation and trust are not a natural by-product of arms-length relationships. Commitment requires external, third-party enforcement.
Relationships-based financial capitalism emphasizes long-term relationships and commitment. It has, however, compensating weaknesses. Investing time and other resources in building up relationships with customers creates an insider-outsider divide that is very difficult to overcome for new entrants. It also encourages, through the interlocking directorates of the CEOs and Chairmen (seldom women) of financial and non-financial corporations, a cosy coterie of old boys for whom competitive behaviour soon no longer comes naturally. At its worst, it becomes cronyism of the kind that was one of the key ingredients in the Asian crisis of 1997.
The financial system that during the first decade of this century ruled the roost in the US, the UK, increasingly in continental Europe and in its outposts in Australia, New Zealand, Iceland etc., combined many of the weaknesses of the transactions-based system (opportunism, myopia, lack of commitment), with the worst features of the transactions-based system – a dreadful clubbiness and homogeneity of outlook and perspective, and a ruthless closing of ranks when the sector as a whole was threatened with legislation or regulation. Let me just remind you of some of of the issues that prompted vigorous lobbying: the taxation of non-doms; taper relief under the UK capital gains tax for private equity magnates; tax havens; proposals for reporting obligations, transparency and audited accounts for highly leveraged financial entities above a certain size, regardless of their legal nature and regardless of what they call them selves; anti-cyclical capital adequacy requirements and liquidity requirements for highly leveraged entities.
It’s time to learn from these lessons and to act on what has been learnt. Acting now would not mean rushing into hasty if-it-moves-stop-it forms of regulation. We have had 20 years to think about this. It is clear where the problems are. In the past 20 yearns, the financial sector has, starting as a useful provider of intermediation services, grown like topsy to become an uncontrolled, and at times out-of-control, effectively unregulated, hydra-headed owner of licenses to print money for a small number of beneficiaries. The sources of much of these profits turned out to be either a succession of bubbles or Ponzi schemes, or the pricing of assets based on the belief that risk disappeared by trading it. This belief that there is a black hole in the middle of the financial universe that will attract, absorb and annihilate risk if the risk it packaged sufficiently attractive and sold a sufficient number of times is closely related to the firm conviction of every trader I have ever met, that he or she can systematically beat the market. The fact that all traders together are the market did not constrain these beliefs. General equilibrium and adding-up constraints are not the markets’ forte.
So is tighter regulation of the financial sector, and especially of highly leveraged entities above a certain size the answer? It would be part of the solution if we could find and keep the right regulators and design and implement the right regulations. Here, however, I hit a blind wall.
Quis custodiet ipsos custodes?
Who polices the police or, more to the point, who regulates the regulators? No doubt they are formally accountable to some departmental minister or even to Parliament/Congress. But does that fill me with confidence their their actions will promote efficiency and fairness? No, it does not. If regulation is to be effective, it may have to be hands-on and quite intrusive, if only for the regulator to acquire the information (s)he requires to make an informed judgement.
Effective supervision runs into some rather impenetrable obstacles.
First, a $5 million dollar a year trader will run rings around a $150,000 a year regulator.
Second, regulators involved in intrusive and hands-on regulation are virtually guaranteed to be captured by the industry they are meant to be regulating and supervising. This regulatory capture need not take the form of unethical, corrupt or venal behaviour by the regulators or members of the private financial sector. It could instead be an example of what I have called cognitive regulatory capture, where the regulator absorbs the culture, norms, hopes, fears and world-view of those whom he regulates. We cannot just appoint ethical Vestal Virgins to be regulators, regulators who start out pure and stay pure despite their daily associations with people who don’t instinctively play by the rules of the House of the Vestals
Third, even if (1) and (2) don’t apply, regulators will serve their own parochial, personal and sectional interests as much as or even instead of the public good they are meant to serve. No bank regulator wants a bank to fail on his or her watch. As a result, either excessively conservative behaviour will be imposed by the regulator on the regulated bank or other financial intermediary (ofi), that is, we will have if-it-moves-stop-it-regulation, or the regulator will mount an unjustified bail out when, despite the regulator’s best efforts at preventing any kind of risk from being taken on by the regulated entity, insolvency threatens.
I don’t know the solution to this conundrum. To minimise the risk of the first two problems emasculating regulation, any regulation will have to be as much arms-length and impersonal as possible, rather than invasive, intrusive and hands-on. A further key requirement is that institutions that are deemed too big and too systemically important to fail should be de-coupled from their owners and their top management if a publicly organised and/or funded rescue effort is mounted.
So any institution-specific support operation should require that the entire board and top management resign and leave without even a bronze handshake, the minute an agreement is reached. A special resolution regime (along the lines the FDIC runs for insured deposit-taking banks) with Prompt Corrective Action and a special form of regulatory insolvency that can be invoked by the regulator before the financial entity at risk is balance sheet insolvent or cash-flow insolvent. The shareholders should get nothing up front, but would have to take their place at the end of the line of claimants to whatever value can be realised under the special resolution regime.
The regulator as deus ex machina, doing his philosopher king bit in the disinterested pursuit of the public good is a dangerous fiction. Attributing competence and disinterested benevolence to regulators is as sensible as relying on self-regulation by the financial sector. So there will have to be a messy compromise. Clearly, things got badly out of hand in the private financial sector this past couple of decades, and the sector’s capacity to take on excessive risk will have to be restricted severely if we are to avoid another credit orgy of the kind we saw during the years 2003-2006. But am I confident that regulators will do more that bolt the door after the horse has bolted – never to return? I am not. But I am ready to be pleasantly surprised.