Why financial regulation is both difficult and essential
MARTIN WOLF Add to myFT
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Martin Wolf
APRIL 15, 2008
Nice try; no cigar. That was my reaction to the attempt of the banking community to forestall additional regulation, by recommending “a suite of best practices to be embraced voluntarily”. It was also the reaction of the policymakers meeting in Washington over the weekend. More regulation is on its way. After frightening politicians and policymakers so badly, even the most optimistic banker must realise this. The question is whether the additional regulation will do any good.
In an interim report on “market best practices”, the Institute for International Finance, an association of bankers, offers devastating self-criticism.* Here then are some of the weaknesses it identifies: “deteriorating lending standards by certain originators of credit”; a “decline of underwriting standards”; an “excessive reliance on poorly understood, poorly performing and less than adequate ratings of structured products”; and “difficulties in identifying where exposures reside”. Would you buy a voluntary code from people who describe their own mistakes in this brutal manner? I thought not. There are two powerful additional reasons for not doing so.
First, in such a fiercely competitive business, a voluntary code is almost certainly not worth the paper it is written on. When they can get away with behaving irresponsibly, some will do so. This puts strong pressure on others. That is what Chuck Prince, former chief executive officer of Citigroup, meant when he told the FT that “as long as the music is playing, you’ve got to get up and dance”. So, as Willem Buiter of the London School of Economics remarks: “Self-regulation stands in relation to regulation the way self-importance stands in relation to importance.”
Second, the industry has form. The IIF itself was founded in 1983 in response to the developing country debt crisis. At that time, big parts of the west’s banking system were in effect bankrupt. Now, many upsets later, we have reached the “subprime crisis”. The IIF was created not only to represent the industry, but to improve its performance. It is clear that this has not worked.
Do not just take my word for it. Last month, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard published an extraordinary paper on the long history of financial crises.** The chart shows that the incidence of banking crises (measured by the proportion of countries affected) has been as high since 1980 as in any period since 1800; that the incidence of crises is correlated with liberalisation of capital flows; and that there was, until 2007, a decline in the incidence of crises in the 2000s.
Yet why, I ask, should this industry have apparently failed to improve its standards of performance over the past century? After all, almost every other industry has done so. Consider how confident we are that the food we buy will not poison us. Yet adulterated food was once a threat.
Consider, by those standards, the failures of the banking industry, as admitted by the IIF itself. Its purely operational performance is now impressive. But competition does not work well in finance. The “product” of the financial industry is promises for an uncertain future, marketed as dreams that can readily become nightmares. Customers are readily swept away by exaggerated promises, irrational beliefs, misplaced trust and sheer skulduggery. So, too, are practitioners: basing risk management on limited data and inadequate models is a good example. Emotions count wherever uncertainties loom.
Boeing would not survive if the aircraft it built fell out of the sky. Yet in the financial industry, huge blunders are also almost always made in common. If everybody is in the dance nobody is to blame and, in any case, governments, horrified by the consequences of a collapsing financial system, will come to the rescue.
Until last August, I comforted myself with the thought that many of the crises of the past quarter-century occurred in relatively backward financial systems, even if institutions of the first world played a part in “seducing minors”. So things might, I hoped, be getting better.
That is no longer a plausible view. Once the US itself ran a large current account deficit the concomitant accumulations of internal debt generated huge losses, as the excellent new Global Financial Stability Report from the International Monetary Fund points out. The one good thing is that estimated losses of close to $1,000bn are widely distributed (see charts). That makes today’s situation less transparent, sadly. But it also means that the pain is more widely, and so much more safely, shared.
What then is to be done now? Interestingly, there is substantial convergence on the substance between the IIF and the authorities, as shown in a devastatingly critical recent report from the Financial Stability Forum on “enhancing market and institutional resilience”.*** Both agree, for example, that structures of compensation matter, as both I and others have argued. Both agree, too, that risk management was appalling.
The agenda laid out in the official report is lengthy. It includes: strengthening prudential oversight of capital, liquidity and risk management; enhancing transparency; changing the role and uses of credit ratings; strengthening the authorities’ responsiveness to risk; and improving arrangements for dealing with stress. But, it should go without saying, policymakers also believe regulation must be tougher. Given the damage done and the extent of the safety net provided, no alternative exists.
Yet I am not that optimistic about regulation either. Regulators are doomed to close the stable doors behind financial institutions that always find new and more exciting ways of losing money. It is, for this reason, crucial that the institutions, and unsecured creditors, feel some pain: the burned child fears the fire; singeing is less effective. Yet the fire must never burn too far, since that might destroy the entire economy.
If regulation is to be effective, it must cover all relevant institutions and the entire balance sheet, in all significant countries; it must focus on capital, liquidity and transparency; and, not least, it must make finance less pro-cyclical. Will it ever work perfectly? Certainly not. It is impossible and probably even undesirable to create a crisis-free financial system. Crises will always be with us. But we can surely do far better than we have been doing. In any case, we are doomed to try.
*
www.iif.com;
** ‘This time is different: a panoramic view of eight centuries of financial crises’, Working Paper 13882, March 2008,
http://www.nber.org
***
http://www.bis.org
That is a good quip. But equally he could be Hal Holbrook in Wall Street.
