Old papers never die, they just get recycled. The Den Uyl lecture I gave in Amsterdam on 15 December 2008 has been under continuous redevelopment since then. Its latest outing was as background paper for a lecture I gave at the 25th anniversary Workshop ” The Global Financial Crisis: Lessons and Outlook”, of the Advanced Studies Program of the IFW, Kiel, Germany, on May 8/9, 2009. The whole current enchilada can be found here. For those with lives, I reproduce below the Introduction, Section 1, the Conclusion and the 16 recommendations in between.
“Never waste a crisis. It can be turned to joyful transformation”. This statement is attributed to Rahm Emanuel, US President Barack Obama’s White House Chief of Staff. Other versions are in circulation also, including “Never waste a good crisis”, attributed to US Secretary of State Hilary Clinton. The statement actually goes back at least to that fount of cynical wisdom, fifteenth century Florentine writer and statesman Niccolo Machiavelli “Never waste the opportunities offered by a good crisis.” Crises offer unrivalled opportunities for accelerated learning.
I believe that the current crisis teaches us two key lessons. The first concerns the role of the state in the financial intermediation process and in the maintenance of financial stability. The second concerns the role of private and public sector incentives in the design of regulation. Unless these lessons are learnt, not only will the current crisis last longer than necessary, but the next big crisis, following the current spectacular example of market failure, will be a crisis of state ‘overreach’ and of government failure. Central planning failed and collapsed spectacularly in Central and Eastern Europe and the former Soviet Union. The next socio-economic system to fail, after the Thatcher-Reagan model of self-regulating market capitalism with finance in the driver’s seat – finance as the master of the real economy rather than its servant – may well be a stultifying form of state capitalism, with initiative-numbing over-regulation and overambitious social engineering.
The essence of the current crisis
This lecture focuses on the lessons for financial regulators and supervisors of the financial crisis that started around the middle of 2007 and the global contraction in economic activity that resulted from it. It does not address the macroeconomic imbalances and anomalies that were important contributors to both financial crisis and economic slump. The five most important of these will be referenced briefly.
1. The ex-ante global saving glut that resulted from the emergence of the BRICs and the redistribution of global wealth and income towards the Gulf states caused by the rise in oil and gas prices. This depressed long-term global real interest rates to unprecedentedly low levels (see Bernanke (2005)).
2. The extraordinary preference among the nouveaux-riches countries (BRICs and GCC countries) for building up huge foreign exchange reserves (overwhelmingly in US dollars) and for allocating their financial portfolios overwhelmingly towards the safest financial securities, especially US Treasury bonds. This increase in the demand for high-grade, safe financial assets was not met by a matching increase in the supply of safe financial assets. This further depressed long-term risk-free interest rates (see Caballero (2006)). Western banks and investors of all kinds who had target or hurdle rates of return that were no longer achievable by investing in conventional safe instruments, began to scout around for alternative, higher-yielding financial investment opportunities – the search for yield or for ‘pure alpha’, which, as everyone knows, is doomed to failure in the aggregate.
3. Following the entry of China, India, Vietnam and other labour-rich but capital-scarce countries into the global economy, the return to physical capital formation everywhere was lifted significantly. The share of profits rose almost everywhere (see Broadbent and Daly (2009)).
4. Following the collapse of the tech bubble in late 2000 – early 2001, monetary policy in the US and, to a lesser extent also in the Euro Area, was too expansionary for too long starting around 2003, flooding the world with excess liquidity. For reasons not yet well understood, this excess liquidity went primarily into credit growth and asset price booms and bubbles, rather than into consumer price inflation.
5. The unsustainable current account deficit of the US was made to appear sustainable through the willingness of China and many other emerging markets to accumulate large stocks of US dollars, both as official foreign exchange reserves – it helps to be the issuer of the dominant global reserve currency – and for portfolio investment purposes. A fair number of countries that continued to peg to the US dollar (or to shadow the US dollar) experienced excessive domestic liquidity and credit creation, contributing to asset booms and bubbles. China and the GCC countries are notable examples of this dysfunctional new ‘Bretton Woods’ (see Dooley, Folkerts-Landau and Garber (2004)).
These five developments, plus the many regulatory and supervisory failures outlined below, created the Great Moderation, Great Stability or Mervyn King’s ‘Nice Decade’: high and reasonably stable growth, low and reasonably stable inflation, high profits, steadily rising prices of ‘outside’ assets and extraordinarily low risk spreads of all kinds (see Buiter (2007, 2009), King (2004), Bernanke (2004), Lomax (2007)). This Great Stability carried the seeds of its own destruction: as analysed and predicted by Hyman Minsky, stability bred complacency, excessive risk taking and, ultimately, instability (Minsky (1986, 2008)).
The current financial crisis and the economic slump it caused arrived on the European continent about a year after it hit the US and half a year after it impacted the UK. It is the once-in-a-lifetime event that even the younger members of the audience will be boring their grandchildren with in the future. “You may think the financial turmoil and recession of 2034 is bad, but I can assure you that it is nothing like what we went through in the final years of the first decade of this century: the Great De-financialisation Crisis or the Great Deleveraging.” It started as a crisis in the financial system, became a crisis of the financial system and has now reached the point at which most of the western crossborder financial system of the past 30 years has effectively been destroyed and the remnants socialised or put in a state of subsidized limbo.
It is correct but unhelpful to characterise the crisis as the result of greed and excess or as a crisis of capitalism. Greed has always been with us and always will be. Greed can be constrained and need not lead to excess. Excess is just another word for greed combined with wrong incentives and defective regulation and supervision.
The current crisis is not a crisis of ‘capitalism’, defined as an economic system characterised by private ownership of most of the means of production, distribution and exchange, reliance on the profit motive and self-enrichment (i.e. greed) as the main incentive in economic decisions, and reliance on markets as the main co-ordination mechanism. Capitalism has not always been with us, but is infinitely adaptable and will be with us for a long time to come.
The crisis is a crisis of a specific manifestation of financial capitalism – a largely self-regulating version of the transactions-oriented model of financial intermediation (TOM) over the relationships-oriented model of financial intermediation (ROM). Every real-world financial system is a convex combination of the TOM and the ROM. In the north-Atlantic region, and especially in the USA and the UK, the TOM model became too dominant. This error will be corrected and the world will move towards a greater emphasis on ROM. But financial capitalism will be with us in a new phenotype, for a long time yet.
Require the originator of any securitised assets or cash flows to retain a sizeable fraction of the equity tranche or first-loss tranche of the securitised instrument.
Take the rating agencies out of the regulatory process by eliminating the role of external ratings in the Basel II capital risk-weightings.
Restrict firms providing ratings to engage in no other commercial activities.
Establish a global regulator (or a uniform standard for national regulators) for eligible rating agencies. Require that parties requiring ratings for their securities pay the regulator. The regulator then assigns the rating decision to one of the eligible rating agencies, using a competitive process.
Pay rating agencies at least in part in the securities they are rating. Require these securities to be retained for some minimal period (say 5 years) and do not allow the exposure to be hedged.
Establish a positive list of Gold-Standard ABS that are acceptable as collateral at the discount window of the central bank and in repos.
Taking out insurance through contingent claims trading should be encouraged; gambling or placing bets through contingent claims trading should be discouraged. At least one of the parties in a contingent claims trade should have an insurable interest in the contingency that is being contracted against.
All parties writing insurance-equivalent contracts should be properly capitalised and regulated.
Contingent claims trading should be moved wherever possible to organised exchanges, trading in standardised products through a central counterparty.
The introduction and marketing of new financial products and instruments should be regulated and be subject to testing in ways similar to those used for the regulation and testing of new medical and pharmacological drugs.
Any incorporated entity above a certain threshold size (de minimis non curat lex) and with narrow leverage in excess of X (15, say) will be subject to the same capital requirements regime, liquidity requirements regime, reporting regime and governance regime.
- Establish a single EU-wide regulator for crossborder banks.
- Establish a single EU-wide regulator for other systemically important crossborder financial activities or institutions.
Where a multinational College of regulators/supervisors is necessary, the host country regulator/supervisor should have the final say.
- A supranational EU fiscal authority is required to provide proper fiscal backup for the ECB/Eurosystem and for recapitalising systemically important crossborder financial institutions.
- Failing that, an EU fund from which the ECB/Eurosystem and systemically important crossborder financial institutions can be recapitalised should be created.
- Failing that, an ex-ante binding agreement on fiscal burden sharing for the cost of recapitalising the ECB/Eurosystem and systemically important crossborder financial institutions should be agreed.
All new board members should take a written test, set by the regulator and marked by independent experts, on the products, services and instruments traded and managed by their financial institutions. Existing board members should be tested every other year. Unless a passing grade is achieved, the would-be board member cannot serve. The graded test will be in the public domain.
Shareholders should have annual binding and separate votes on each of the individual total compensation packages of the five top managers of the company and of the five top earners. When a remuneration package is rejected by the shareholders, the default remuneration package cannot exceed that of the head of government.
Stick to (or return to) strict fair value accounting, including mark-to-market whenever possible. Do not permit reclassification of assets between liquidity categories. Use regulatory forbearance as regards capital ratios, leverage ratios or liquidity ratios to address the undesirable pro-cyclical side effects of mark-to-market through poorly designed regulatory requirements.
- Mitigate the pro-cyclical effect of external credit ratings in Basel II by eliminating the role of the rating agencies in Basel II.
- Mitigate the pro-cyclical effect of internal risk models in Basel II by precluding the use of information based on internal bank models or on any other private information when calculating regulatory capital requirements.
- Mitigate the pro-cyclical effect in Basel II of constant regulatory capital ratios by having counter-cyclical regulatory capital requirements.
- Legally and institutionally, unbundle narrow banking and investment banking (Glass Steagall-on-steroids).
- Legally and institutionally prevent both narrow banks and investment banks from engaging in activities that present manifest potential conflicts of interest. This means no more universal banks and similar financial supermarkets.
- Limit the size of all banks by making regulatory capital ratios an increasing function of bank size.
- Enforce competition policy aggressively in the banking sector.
- Require any remaining systemically important banks to produce a detailed annual bankruptcy contingency plan.
Create a Special Resolution Regime with Structured Early Intervention and Prompt Corrective Action for all systemically important financial institutions.
Don’t regulate on the basis of information that is private to the regulated entity. Only use independently verifiable information.
Reaction follows action in politics as in physics. The inevitable result of the financial collapse and deep contraction we are going through now will be at least a decade of over-regulation in the financial sector. Popular outrage at the excesses that were permitted to range unchecked during the era of self-regulation and light-touch regulation will have to be assuaged. The ‘pound of flesh’ demanded by the body politic is likely to involve a fair amount of ‘if if moves, stop it’ type regulation. That is regrettable but politically unavoidable.
The public no longer trust the captains of finance and the politicians and appointed officials who either actively contributed to the excesses (like Larry Summers and Timothy Geithner during the Clinton administration or Gordon Brown in the UK) or failed to warn or protest sufficiently vigorously when these excesses begin to materialise on their watch (Ben Bernanke (in public service since September 2002), Mervyn King (at the Bank of England since March 1991) and most other leading central bankers). Neither the public nor the new vintage of politicians that will take over is likely to listen to those who either actively contributed to the disaster or failed to foresee it or warn against it.
Over-regulation will harm the dynamism of the economy. How serious the damage will be is not clear. What is clear is that a lot more regulation, and regulation different from what we have had in the past, will be required to reduce the likelihood of future systemic failures and to better align private and public interests. The sixteen recommendations made in this lecture would represent a useful first step for financial sector re-regulation. As long as measures not too far from these recommendations are implemented, I am not too worried about whatever over-regulation may be imposed on top of them in the short term.
The damage caused by financial sector excesses is way out of proportion to whatever gains from financial innovation may have accrued to the wider economy in the last couple of decades. The political economy of successful reform dictates that radical, sweeping reform be introduced as soon as possible, before the defenders of the financial status quo are able to collect themselves and launch a massive PR campaign to close the door on radical reform.
Under normal circumstances (financial calm and boom), the financial sector has ‘owned’ the policy makers and the regulators in the US, the UK and much of continental Europe during the past twenty years. Its current weakened state, the result of the biggest financial bust ever, prevents the financial sector from mounting the kind of massive lobbying effort it has been capable of in the past. We should seize the moment. If over-regulation, indeed destructive over-regulation is the immediate result, then so be it. It is easier to negotiate sensible modifications to a framework characterised by over-regulation than it is to add sensible regulation from a framework characterised by under-regulation.
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