A Regulated Crisis
The financial crisis that began in 2007 had its origins precisely in over-complex regulation. A serious history of the crisis would need to have at least five chapters on its perverse consequences:
First, the executives of large publicly owned banks were strongly incentivized to ‘maximize shareholder value’ since their own wealth and income came to consist in large measure of shares and share options in their own institutions. The easiest way they could do this was to maximize the size of their banks’ activities relative to their capital. All over the Western world, balance sheets grew to dizzying sizes relative to bank equity. How was this possible? The answer is that it was expressly permitted by regulation. To be precise, the Basel Committee on Banking Supervision’s 1988 Accord allowed very large quantities of assets to be held by banks relative to their capital, provided these assets were classified as low risk – for example, government bonds.
Secondly, from 1996 the Basel rules were modified to allow firms effectively to set their own capital requirements on the basis of their internal risk estimates. In practice, risk weightings came to be based on the ratings given to securities – and, later, to structured financial products – by the private rating agencies.
Thirdly, central banks – led by the Federal Reserve – evolved a peculiarly lopsided doctrine of monetary policy, which taught that they should intervene by cutting interest rates if asset prices abruptly fell, but should not intervene if they rose rapidly, so long as the rise did not affect public expectations of something called ‘core’ inflation (which excludes changes in the prices of food and energy and wholly failed to capture the bubble in house prices). The colloquial term for this approach is the ‘Greenspan (later Bernanke) put’, which implied that the Fed would intervene to prop up the US equity market, but would not intervene to deflate an asset bubble. The Fed was supposed to care only about consumer-price inflation, and for some obscure reason not about house-price inflation.
Fourthly, the US Congress passed legislation designed to increase the percentage of lower-income families – especially minority families – that owned their own homes. The mortgage market was highly distorted by the ‘government-sponsored entities’ Fannie Mae and Freddie Mac. Both parties viewed this as desirable for social and political reasons. Neither considered that, from a financial viewpoint, they were encouraging low-income households to place large, leveraged, unhedged and unidirectional bets on the US housing market.
A final layer of market distortion was provided by the Chinese government, which spent literally trillions of dollars’ worth of its own currency to prevent it from appreciating relative to the dollar. The primary objective of this policy was to keep Chinese manufacturing exports ultra-competitive in Western markets. Nor were the Chinese the only ones who chose to plough their current account surpluses into dollars. The secondary and unintended consequence was to provide the United States with a vast credit line. Because much of what the surplus countries bought was US government or government agency debt, the yields on these securities were artificially held low. Because mortgage rates are closely linked to Treasury yields, ‘Chimerica’ – as I christened this strange economic partnership between China and America – thus helped further to inflate an already bubbling property market.
The only chapter in this history that really fits the ‘blame deregulation’ thesis is the non-regulation of the market in derivatives such as credit default swaps. The insurance giant AIG came to grief because its London office sold vast quantities of mispriced insurance against outcomes that properly belonged in the realm of uninsurable uncertainty. However, I do not believe this can be seen as a primary cause of the crisis. Banks were the key to the crisis, and banks were regulated.*
The issue of derivatives is important because figures as respected as Paul Volcker and Adair Turner have cast doubt on the economic and social utility of most, if not all, recent theoretical and technical advances in finance, including the advent of the derivatives market.12 I am rather less hostile than they are to financial innovation. I agree that modern techniques of risk management were in many ways defective – especially when misused by people who forgot (or never knew) the simplifying assumptions underlying measures like Value at Risk. But modern finance cannot somehow be wished away, any more than Amazon and Google can be abolished to protect the livelihoods of booksellers and librarians.
The issue is whether or not additional regulation of the sort that is currently being devised and implemented can improve matters by reducing the frequency or magnitude of future financial crises. I think it is highly unlikely. Indeed, I would go further. I think the new regulations may have precisely the opposite effect.
The problem we are dealing with here is not inherent in financial innovation. It is inherent in financial regulation. Private sector models of risk management were undoubtedly imperfect, as the financial crisis made clear. But public sector models of risk management were next to non-existent. Because legislators and regulators acted with an almost complete disregard for the law of unintended consequences, they inadvertently helped to inflate a real estate bubble in countries all over the developed world.13
The question for me is not ‘Should financial markets be regulated?’ There is in fact no such thing as an unregulated financial market, as any student of ancient Mesopotamia knows. The Scotland of Adam Smith had a lively debate about the kind of regulation appropriate to a paper-money system. Indeed, the founder of free-market economics himself proposed a number of quite strict bank regulations in the wake of the 1772 Ayr Banking Crisis.14 Without rules to enforce the payment of debts and punish fraud, there can be no finance. Without restraint on the management of banks, some are very likely to fail in a downturn because of the mismatch between the durations of assets and liabilities that has been inherent in nearly all banking since the advent of the fractional reserve system. So the right question to ask is: ‘What kind of financial regulation works best?’
Today, it seems to me, the balance of opinion favours complexity over simplicity; rules over discretion; codes of compliance over individual and corporate responsibility. I believe this approach is based on a flawed understanding of how financial markets work. It puts me in mind of the great Viennese satirist Karl Kraus’s famous quip about psychoanalysis: that it was the disease of which it pretended to be the cure. I believe excessively complex regulation is the disease of which it pretends to be the cure.
Who Regulates the Regulators?
‘We cannot control ourselves. You have to step in and control [Wall] Street.’15 Those were the words of John Mack, former chief executive of the investment bank Morgan Stanley, speaking in New York in November 2009 (to audible gasps). Congress obliged Mr Mack by producing the Wall Street Reform and Consumer Protection Act of July 2010 (henceforth the Dodd–Frank Act, after the names of its two principal sponsors in the Senate and House, respectively).
The rule of law has many enemies. One of them is bad law. Formally intended to ‘promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail” [institutions], to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes’, Dodd–Frank is a near-perfect example of excessive complexity in regulation. The Act requires that regulators create 243 rules, conduct 67 studies and issue 22 periodic reports. It eliminates one regulator and creates two new ones. It sets out detailed provisions for the ‘orderly liquidation’ of a Systemically Important Financial Institution (SIFI). It implements a soft version of the so-called Volcker rule, which bans SIFIs from engaging in ‘proprietary trading’, or sponsoring or owning interests in private equity funds and hedge funds. But that is not all.
Section 232 stipulates that each regulatory agency must establish ‘an Office of Minority and Women Inclusion’ to ensure, among other things, ‘increased participatio
n of minority-owned and women-owned businesses in the programs and contracts of the agency’. Unless you believe, with the head of the International Monetary Fund, Christine Lagarde, that there would have been no crisis if the best-known bank to fail had been called ‘Lehman Sisters’ rather than Lehman Brothers, you may well wonder what exactly this particular section of Dodd–Frank will do to ‘promote the financial stability of the United States’. The same goes for Section 750, which creates a new Interagency Working Group, to ‘conduct a study on the oversight of existing and prospective carbon markets to ensure an efficient, secure, and transparent carbon market’, and Section 1502, which stipulates that products can be labelled as ‘DRC conflict free’ if they do not contain ‘conflict minerals that directly or indirectly finance or benefit armed groups in the Democratic Republic of the Congo or an adjoining country’. Conflict diamonds are bad, of course, as are race and sex discrimination, not forgetting climate change. But was this really the appropriate place to deal with such things?
Title II of Dodd–Frank spends nearly eighty pages setting out in minute detail how a SIFI could be wound up with less disruption than the bankruptcy of Lehman Brothers caused. But in the final analysis what this legislation does is to transfer ultimate responsibility to the Treasury Secretary, the Federal Deposit Insurance Corporation, the District of Columbia district court and the DC court of appeals. If the Treasury Secretary and the Federal Deposit Insurance Corporation agree that a financial firm’s failure could cause general instability, they can seize control of it. If the firm objects, the courts in Washington have one day to decide if the decision was correct. It is a criminal offence to disclose that such a case is being heard. How this extraordinary procedure is an improvement on a regular bankruptcy is beyond me.16 Perhaps, on reflection, SIFI should be pronounced ‘sci-fi’.
As I have suggested, it was the most-regulated institutions in the financial system that were in fact the most disaster-prone: big banks on both sides of the Atlantic, not hedge funds. It is more than a little convenient for America’s political class to have the crisis blamed on deregulation and the resulting excesses of bankers. Not only does that neatly pass the buck it also creates a justification for more regulation. But the old Latin question is apposite here: quis custodiet ipsos custodes? Who regulates the regulators?
Now consider another set of regulations. Under the Basel III Framework for bank capital standards, which is due to come into force between 2013 and the end of 2018, the world’s twenty-nine largest global banks will need to raise an additional $566 billion in new capital or shed around $5.5 trillion in assets. According to the rating agency Fitch, this implies a 23 per cent increase relative to the capital the banks had at the end of 2011.17 It is quite true that big banks became under-capitalized – or excessively leveraged, if you prefer that term – after 1980. But it is far from clear how forcing banks to hold more capital or make fewer loans can be compatible with the goal of sustained economic recovery, without which financial stability is very unlikely to return to the US, much less in Europe.
Lurking inside every such regulation is the universal law of unintended consequences. What if the net effect of all this regulation is to make the SIFIs more rather than less systemically risky? One of many new features of Basel III is a requirement for banks to build up capital in good times, so as to have a buffer in bad times. This innovation was widely hailed some years ago when it was introduced by Spanish bank regulators. Enough said.
Unintelligent Design
In the preceding chapter, I tried to show the value of Mandeville’s Fable of the Bees as an allegory of the way good political institutions work. Now let me introduce a different biological metaphor. In his autobiography, Charles Darwin himself explicitly acknowledged his debt to the economists of his day, notably Thomas Malthus, whose Essay on the Principle of Population he read ‘for amusement’ in 1838. ‘Being well prepared’, Darwin recalled, ‘to appreciate the struggle for existence which everywhere goes on[,] from long-continued observation of the habits of animals and plants, it at once struck me that under these circumstances favourable variations would tend to be preserved, and unfavourable ones to be destroyed. Here, then, I had at last got a theory by which to work.’18 The editor of the Economist Walter Bagehot was only one of many Victorian contemporaries who drew the parallel back from Darwin’s theory of evolution to the economy. As he once observed: ‘The rough and vulgar structure of English commerce is the secret of its life; for it contains the “propensity to variation”, which, in the social as in the animal kingdom, is the principle of progress.’19 We shall hear more from Bagehot below.
There are indeed more than merely superficial resemblances between a financial market and the natural world as Darwin came to understand it. Like the wild animals of the Serengeti, individuals and firms are in a constant struggle for existence, a contest over finite resources. Natural selection operates, in that any innovation (or mutation, in nature’s terms) will flourish or will die depending on how well it suits its environment. What are the common features shared by the financial world and a true evolutionary system? As I have argued elsewhere,20 there are at least six:
‘genes’, in the sense that certain features of corporate culture perform the same role as genes in biology, allowing information to be stored in the ‘organizational memory’ and passed on from individual to individual or from firm to firm when a new firm is created;
the potential for spontaneous ‘mutation’, usually referred to in the economic world as innovation and primarily, though by no means always, technological;
competition between individuals within a species for resources, with the outcomes in terms of longevity and proliferation determining which business practices persist;
a mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of under-performance – that is, ‘differential survival’;
scope for speciation, sustaining biodiversity through the creation of wholly new ‘species’ of financial institutions;
scope for extinction, with certain species dying out altogether.
Sometimes, as in the natural world, the financial evolutionary process has been subject to big disruptions in the form of geopolitical shocks and financial crises. The difference is, of course, that whereas giant asteroids come from outer space, financial crises originate within the system. The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity, with ‘mass extinctions’ such as the bank panics of the 1930s and the Savings and Loans failures of the 1980s. A comparably large disruption has clearly happened in our time. But where are the mass extinctions? The dinosaurs still roam the financial world.
The answer is that, whereas evolution in biology takes place in a pitiless natural environment, evolution in finance occurs within a regulatory framework where – to adapt a phrase from anti-Darwinian creationists – ‘intelligent design’ plays a part. But just how intelligent is this design? The answer is: not intelligent enough to second-guess the evolutionary process. In fact, stupid enough to make a fragile system even more fragile.
Think of it this way. The regulatory frameworks of the post-1980 period encouraged many banks to increase their balance sheets relative to their capital. This happened in all kinds of different countries, in Germany and Spain as much as in the United States. (We really cannot blame Ronald Reagan for what happened in Berlin and Madrid.) When property-backed assets fell in price, banks were threatened with insolvency. When short-term funding dried up, they were threatened with illiquidity. The authorities found that they had to choose between a Great Depression scenario of massive bank failures or bailing the banks out. They bailed them out. Chastened by ungrateful voters (who still do not appreciate how much worse things could have got if the ‘too big’ had actually failed), the legislators now draw up statutes designed to avoid future bail-outs.
Dodd–Frank states clearly that taxpayers will not pay a penny the next time a SIFI goes bust. It is rather less clear about who will pay. Section 214 is (mercifully) unambiguous: ‘All funds expended in the liquidation of a financial company under this title shall be recovered from the disposition of assets of such financial company, or shall be the responsibility of the financial sector, through assessments.’ So what about secured creditors, the bank bondholders whom so much was done to protect from loss in 2008–9? Prudently, Dodd–Frank commissions a study on that one. After all, if the net effect of the legislation really is to rule out any public funding for a seriously bankrupt SIFI, it is hard to see how those bondholders can avoid a sizeable loss. But if that is the case, then the cost of capital for big banks must rise, even as their return on equity is going down. You wanted to reduce instability, but all you did was increase fragility.
The Great Degeneration: How Institutions Decay and Economies Die Page 5
