Abstract
In this chapter, the focus is on the areas where my work offers the greatest departure from current practice and thinking. I will show that a reinvention of financial regulation can deliver a financial system that is less prone to crash and can do this without ossifying finance. It will achieve these goals because it is better at managing financial risk across the financial system.
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Notes
- 1.
In 1996, as the dot-com euphoria was getting going, the US Congress passed legislation to remove some restrictions on retail access to hedge funds. In retrospect, this would have been the time to tighten them.
- 2.
Financial repression includes such policies as maximum loan rates or minimum deposit rates. These policies are designed to protect vulnerable consumers from usury. However, since they stop the market for loans or funds clearing at whatever price they clear at, they do reduce the total possibilities available to all borrowers and savers.
- 3.
In the United States, the 1929 Great Crash and subsequent Great Depression of the 1930s gave birth to the Banking Act of 1933 (more commonly known as the Glass-Steagall Act). The bill was designed “to provide for the safer and more effective use of the assets of banks . . . to prevent the undue diversion of funds into speculative operations and for other purposes.” It separated commercial and investment banking. The crisis also brought into fruition the Securities Act of 1933 and the Federal Deposit Insurance Corporation.
- 4.
See in general, Eric Helleiner, Forgotten Foundations of Bretton Woods: International Development and the Making of the Postwar Order (Ithaca, NY: Cornell University Press, 2014).
- 5.
Mr. Carr is not without his critics, most notably, Sir Geoffrey Elton who responded with The Practice of History (New York: Cromwell, 1968). See Edward Hallett Carr, What Is History? (Cambridge, UK: Cambridge University Press, 1961).
- 6.
Arthur C. Pigou, The Veil of Money (London: Macmillan, 1949).
- 7.
Besides the introduction of the long-term stable funding ratios, which are being delayed anyway, much of Revised Basel II (more popularly known as Basel III) could be characterized in this way.
- 8.
The “Tequila Crisis” of 1994–95 centered on Mexico and the pressure on the exchange rate band—relating to a prior borrowing binge—that “broke” at the end of 1994. The cumulative 55 percent devaluation of the Mexican peso had adverse consequences for its Latin trading partners and competitors.
- 9.
See Stephany Griffith-Jones, Ricardo Gottschalk, and Jacques Cailloux, eds., International Capital Flows in Calm and Turbulent Times: The Need for New International Architecture (Ann Arbor: University of Michigan Press, 2003).
- 10.
This is how the IMF acquired its moniker, “It’s Mostly Fiscal,” and why one cannot underestimate the degree of resentment many in developing countries feel toward the organization.
- 11.
This international payment cycle was dubbed “Bretton Woods II” by Michael Dooley, David Folkerts-Landau, and Peter Garber in “An Essay on the Revived Bretton Woods System” (Working Paper 9971, Cambridge, MA: National Bureau of Economic Research, September 2003).
- 12.
See Claudio Borio and William White, Whither Monetary and Financial Stability: The Implications of Evolving Policy Regimes (Jackson Hole, MI: Federal Reserve Bank of Kansas City, 2003).
- 13.
See Claudio Borio and Piti Disyalat, Global Imbalances and The Financial Crisis: Link or No Link? (Working Paper 346, Basel: Bank for International Settlements, May 2011).
- 14.
See Stephany Griffith-Jones, Jose-Antonio Ocampo, and Joseph Stiglitz, eds., Time for a Visible Hand: Lessons from the 2008 World Financial Crisis (Oxford, UK: Oxford University Press, 2010).
- 15.
It doesn’t always look that way, as financial booms and the greed they unleash increase the number of swindlers, the size of the swindles, and the propensity of the ordinary public to be swindled.
- 16.
In a story that has been distorted by time and moment, Joe Kennedy, father of President Kennedy, claims to have sold his stocks in the winter of 1928, less than a year before the Great Crash, after his shoe-shine boy told him to buy Hindenburg shares—makers of the Zeppelin. “You know it’s time to sell when shoeshine boys give you stock tips. This bull market is over,” Quoted in Ronald Kessler’s “The Sins of the Father: Joseph P Kennedy and the Dynasty He Founded”, (Warner Books, March 1997).
- 17.
See Table 1, in Fabio Panetta’s remarks to the De Nederlandsche Bank special conference, titled “On the Special Role of Macroprudential Policy in the Euro Area,” www.bancaditalia.it/interventi/intaltri_mdir/en_panetta_10062014.pdf, June 10, 2014.
- 18.
Simply put, banks are required to put aside capital—approximately 8 percent of risk-weighted assets. If reported risks fall, the amount of capital required falls. Invariably what happens in a boom is that reported risks fall at the same time as assets grow, so that the dollar amount of capital may well rise to record levels. What we observe precrisis is a rising leverage ratio (total assets to bank equity) and postcrisis, when risk is reestimated, is that capital has fallen to dangerous levels.
- 19.
This is what former CEO of Citibank Chuck Prince was getting at in his ill-fated, but prescient remarks to the Financial Times on July 6, 2007 that “When the music is playing you have to get up and dance.” The imperative was reinforced by stock-related compensation for bank managers. Unfortunately for Mr. Prince the music had stopped but he was still dancing.
- 20.
See Charles Goodhart, “Procyclicality and Financial Regulation,” Establidad Financiera 16 (Banco de España, 2012).
- 21.
An increasing number of people claim to have correctly predicted the crisis. But predicting that something in the economy and society is amiss and predicting the inevitability of a banking crisis are different. Contrary to public opinion, there were a number of people who identified the direct causal link between the increasing market sensitivity of banking regulation and a future banking crisis. The problem was that few wanted to hear it. See: (1) Jón Danielsson, Paul Embrechts, Charles Goodhart, Con Keating, Felix Muennich, Olivier Renault, and Hyun Song Shin, Financial Markets Group, LSE, “An Academic Response to Basel II” (Special Paper 130, Financial Markets Group, May 2001); and (2) Avinash Persaud, “Sending the Herd off the Cliff Edge,” World Economics 1, no. 4 (2000), pp. 15–26.
- 22.
See Avinash Persaud, “The Inappropriateness of Financial Regulation,” Research-Based Policy Analysis and Commentary from Leading Experts, www.voxeu.org/article/inappropriateness-financial-regulation, May 1, 2008.
- 23.
“By 1890 just 300 trusts [in the United States] controlled 5,000 companies. Financial practices aided insiders while relevant information to investors and other outsiders remained problematic and usually hidden.” Gary Giroux, Business Scandals, Corruption and Reform (Santa Barbara, CA: Greenwood Press, 2013).
- 24.
There are examples of where greater transparency, especially in the greater frequency of reporting, can lead to greater market instability. See Benu Schneider, ed., The Road to International Financial Stability: Are Key Financial Standards the Answer? (New York: Palgrave Macmillan, 2003). Similarly, disclosures can bring harm to private asset holders—making them out as targets for physical harm for example—and so a public interest test should be brought to bear on the form and extent of disclosures. I once started receiving hate mail at my home address from an anti-vivisection group, that had caused serious harm to some of their other targets, because I was sometime previously a director of a division of State Street Bank and another division of the bank was at the time of the letters acting as a custodian for an asset manger who held shares in a company that had tested its products on animals. The custodian’s name was down as the owner of the shares.
- 25.
Webvan.com is a particularly egregious example. It was valued at $1.2 billion in 1998 and just $2.5 million by 2001.
- 26.
Or the number of visits to online shops.
- 27.
Arguably, some of the ventures during the South Sea Bubble of 1720 in England were equally intangible. The allure of the discovery of South America for Western Europeans drove that bubble higher. One prospectus during the South Sea Bubble read: “A company for carrying on an undertaking of great advantage, but nobody to know what it is.” See Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds (Lexington, KY: Maestro Reprints, 1841/2014).
- 28.
Hans Christian Andersen’s story, The Emperor’s New Clothes, comes to mind.
- 29.
Less often stated by the boom’s cheerleaders, but equally important, is how much easier it is to borrow money to invest in housing, with the attendant tax advantages, than for almost any other investment. Lord Adair Turner, former Chairman of the UK’s Financial Services Authority, among others, has frequently emphasized this driver of property and financial booms. See Jerin Matthew, “Lord Turner: Britain’s Property Frenzy Will Lead to Another Financial Crisis,” International Business Times, March 27, 2014, www.ibtimes.co.uk/lord-turner-britains-property-frenzy-will-lead-another-financial-crisis-1442030.
- 30.
A sophisticated version of this defense of Basel II can be found in the response to my general arguments by Jesus Saurina, the highly intelligent, conscientious director of the Stability Department of Banco de España, in the IMF’s Finance and Development (June 2008), pp. 29–33.
- 31.
Market discipline was the essential component of the third of Basel II’s three pillars.
- 32.
See Basel Committee on Banking Supervision, A Brief History of the Basel Committee (Bank of International Settlements, 2013), www.bis.org/bcbs/history.pdf.
- 33.
The supervisory-approved methodologies were based around “value at risk” models that estimated the potential loss a bank may face from recent volatility and correlation of market prices. These models are procyclical, with short-term volatility and correlations being low during quiet times, encouraging the buildup of risk but spiking sharply higher during periods of crisis, dictating a sell-off of risky assets and causing further increases in volatility, correlations, and so on. See Avinash Persaud, “The Folly of Value-at-Risk: How Modern Risk Management Systems Are Creating Risk” (lecture, Gresham College, London, December 2, 2002).
- 34.
On December 16, 2010, the European Systemic Risk Board (ESRB) was established and given responsibility for the macroprudential oversight of the EU’s financial system and the prevention or mitigation of systemic risk to the financial system. On April 1, 2013, the UK established an independent Financial Policy Committee (FPC) at the Bank of England charged with a primary objective of identifying, monitoring, and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system.
- 35.
Federal Reserve Chairman, William McChesney Martin, famously said in a speech given on October 19, 1955: “The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”
- 36.
Charles Goodhart and Avinash Persaud, “How to Avoid the Next Crash,” Comment Page, Financial Times (January 30, 2008). This is a proposal for time-varying capital adequacy requirements based on the acceleration in credit growth. An alternative approach focused on bank profitability is favored by the Swiss National Bank among others.
- 37.
This could be measured by estimating the covariance of the risks the bank is running. See Tobias Adrian and Marcus Brunnermeier “CoVaR” (unpublished mimeo, Princeton, NJ, 2011).
- 38.
For a discussion of the endogeneity of liquidity, see: (1) Anastasia Nesvetailova, “Liquidity Illusions In The Global Financial Architecture,” (Cheltenham, UK: Edward Elgar, 2012); and (2) Marco Lagana, Martin Penina, Isabel von Koppen-Mertes, and Avinash Persaud, “Implications for Liquidity from Innovation and Transparency in the European Corporate Bond Market,” (ECB Occasional Papers 50, August 2006).
- 39.
See Charles Goodhart, “Is a Less Pro-Cyclical Financial System an Achievable Goal?” National Institute Economic Review 211, no. 1 (2010), pp. 81–90.
- 40.
Persaud, “Sending the Herd off the Cliff Edge.”
- 41.
In The Fall and Rise of Keynesian Economics (Oxford University Press, 2011, p. 51), John Eatwell and Murray Millgate flatteringly refer to this as the “Persaud Paradox.” There are now a number of references to the Persaud Paradox, including Pablo Triana’s fascinating study on value-at-risk, The Number That Killed Us: A Story of Modern Banking; Flawed Mathematics and a Big Financial Crisis (Hoboken, NJ: Wiley, 2011).
- 42.
This approach is well described in Anat Admati and Martin Hellwig’s, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It (Princeton, NJ: Princeton University Press, 2014).
- 43.
Funding liquidity has receded from the center of attention today. However, when the GFC first emerged in 2007 it did so as a crisis in funding liquidity. The institutions most in trouble, like Northern Rock, HBOS and Bradford and Bingley in the UK, were those that had relied most on the short-term money market funding— which dried up—of long-term mortgages.
- 44.
Scaling up or down these error prone risk assessments by countercyclical mechanisms is unlikely to solve the underlying problem that banks are most harmed by previously considered safe assets becoming risky rather than risky assets being risky.
- 45.
I am particularly worried about this being the unintended outcome of the move to the European Banking Union. See Avinash Persaud, “Vive la difference,” Guest Article, Economist (January 26, 2013).
- 46.
There is some research that questions the intuition that more capital means less lending. See Thomas Hoenig, “Safe Banks Need Not Mean Slow Economic Growth,” Financial Times (August 19, 2013).
- 47.
To be fair, bankers are not only referring to capital adequacy requirements when they say this, arguing moreover that anti-money laundering and anti-terrorism finance rules also make them reluctant to do any new business.
- 48.
This effect of time can be seen in the differential pricing between long and short-dated credit default swaps on the same credits.
- 49.
For an excellent survey of long-run returns in different markets and instruments, see Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002).
- 50.
Depositors suffer tough penalties for breaking the deposit before 12 months.
- 51.
The words of Winston Smith in George Orwell’s 1984.
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Persaud, A.D. (2015). How Should We Regulate the Financial System?. In: Reinventing Financial Regulation. Apress, Berkeley, CA. https://doi.org/10.1007/978-1-4302-4558-2_5
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