Buttonwood
The inevitability of instability
A welcome burst of new thinking on financial regulation
Jan 25th 2014
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THE frequency and severity of financial crises suggest that they are an inevitable part of capitalism. That does not mean policymakers should give up trying to limit the damage they cause. But it should make regulators careful when they try to stabilise the system.
That is the shared conclusion of two thoughtful analyses: a paper* by Marcelo Prates of the Brazilian central bank and a speech** in New Delhi by Adair Turner, a former head of Britain’s Financial Services Authority.
A fundamental instability results from the mismatch between the assets banks hold (long-term loans) and their liabilities, in the form of short-term deposits. As Mr Prates comments, “No regulation will ever be able to change this reality, unless a law is passed, for instance, setting the reserve requirements at 100% and prohibiting leverage.”
Regulators try to limit the problem with requirements for capital and curbs on leverage, but their rules are constantly overtaken by financial innovation. Such innovation is very hard to assess: unlike new medicines, financial products cannot be tested in advance. If regulators opt not for a rules-based system but for one based on general principles, the result is a lot of uncertainty over what is permitted and what is not.
In their response to the crisis, the American authorities opted for a highly complex regulatory regime, in the form of Dodd-Frank. But Mr Prates points out that each new rule creates a burden for the regulators as well as for the industry; supervisors cannot hope to keep track of all infractions. Each time the rules are evaded, the credibility of the system is reduced.
Mr Prates also quotes the economist J.K. Galbraith: “All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.” Lord Turner makes the same argument. Debt is useful, in theory, if it allows business to accumulate capital or consumers to smooth their consumption over their lives. In practice, however, debt is used to finance the purchase of existing assets, leading to bubbles. He cites an estimate that only 15% of British bank lending is used for capital investment.
Individuals may use credit as a means of financing consumption in excess of their income, as was the case with American homeowners in the past decade. This process is self-reinforcing: easier credit drives up asset prices, which makes banks confident and leads them to lend more.
These credit cycles lead to greater volumes in the financial markets, as assets are traded back and forth. Banks end up with an awful lot of claims on each other, a development which added to the panic in 2008. It is hard to see how this extra trading benefits the economy; it certainly does not ensure that asset prices stay in line with economic fundamentals.
In a world of (mostly) floating exchange rates, cross-border capital flows add to the problem. Countries are no longer constrained by their trade deficits, at least in the short term; a current-account deficit can be financed with capital flows which help to inflate an asset bubble (the Irish and Spanish housing booms, for example).
The two commentators disagree over how regulators ought best to respond. Lord Turner believes that the issue is “the wrong sort of capital flow” and that this needs to be handled at the national level, with the authorities stepping in to limit excessive credit creation. One approach could be to insist that foreign banks operating in a country do so via separately capitalised subsidiaries. Although this might lead to the “balkanisation” of financial markets, it would at least help to crimp flows of hot money.
Mr Prates, by contrast, thinks that the regulators should focus on minimising the consequences of the next crisis by strengthening the safety net, through deposit insurance (financed by a levy on all relevant institutions, not just deposit-takers), resolution plans for failed institutions and personal liability for the executives of failed banks. A proportion of bonus payments at each bank should be kept in a pool that can be raided if it gets into trouble.
Yet there is no reason why regulators could not follow both of these approaches. It might be more productive than creating ever more complicated regulations for financiers to evade.
* “Why Prudential Regulation Will Fail to Prevent Financial Crises: A Legal Approach”, by Marcelo Madureira Prates, November 2013
** “Too Much of the Wrong Sort of Capital Flow”, address at the Centre for Advanced Financial Research and Learning, January 2014
THE frequency and severity of financial crises suggest that they are an inevitable part of capitalism. That does not mean policymakers should give up trying to limit the damage they cause. But it should make regulators careful when they try to stabilise the system.
That is the shared conclusion of two thoughtful analyses: a paper* by Marcelo Prates of the Brazilian central bank and a speech** in New Delhi by Adair Turner, a former head of Britain’s Financial Services Authority.
A fundamental instability results from the mismatch between the assets banks hold (long-term loans) and their liabilities, in the form of short-term deposits. As Mr Prates comments, “No regulation will ever be able to change this reality, unless a law is passed, for instance, setting the reserve requirements at 100% and prohibiting leverage.”
Regulators try to limit the problem with requirements for capital and curbs on leverage, but their rules are constantly overtaken by financial innovation. Such innovation is very hard to assess: unlike new medicines, financial products cannot be tested in advance. If regulators opt not for a rules-based system but for one based on general principles, the result is a lot of uncertainty over what is permitted and what is not.
In their response to the crisis, the American authorities opted for a highly complex regulatory regime, in the form of Dodd-Frank. But Mr Prates points out that each new rule creates a burden for the regulators as well as for the industry; supervisors cannot hope to keep track of all infractions. Each time the rules are evaded, the credibility of the system is reduced.
Mr Prates also quotes the economist J.K. Galbraith: “All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.” Lord Turner makes the same argument. Debt is useful, in theory, if it allows business to accumulate capital or consumers to smooth their consumption over their lives. In practice, however, debt is used to finance the purchase of existing assets, leading to bubbles. He cites an estimate that only 15% of British bank lending is used for capital investment.
Individuals may use credit as a means of financing consumption in excess of their income, as was the case with American homeowners in the past decade. This process is self-reinforcing: easier credit drives up asset prices, which makes banks confident and leads them to lend more.
These credit cycles lead to greater volumes in the financial markets, as assets are traded back and forth. Banks end up with an awful lot of claims on each other, a development which added to the panic in 2008. It is hard to see how this extra trading benefits the economy; it certainly does not ensure that asset prices stay in line with economic fundamentals.
In a world of (mostly) floating exchange rates, cross-border capital flows add to the problem. Countries are no longer constrained by their trade deficits, at least in the short term; a current-account deficit can be financed with capital flows which help to inflate an asset bubble (the Irish and Spanish housing booms, for example).
The two commentators disagree over how regulators ought best to respond. Lord Turner believes that the issue is “the wrong sort of capital flow” and that this needs to be handled at the national level, with the authorities stepping in to limit excessive credit creation. One approach could be to insist that foreign banks operating in a country do so via separately capitalised subsidiaries. Although this might lead to the “balkanisation” of financial markets, it would at least help to crimp flows of hot money.
Mr Prates, by contrast, thinks that the regulators should focus on minimising the consequences of the next crisis by strengthening the safety net, through deposit insurance (financed by a levy on all relevant institutions, not just deposit-takers), resolution plans for failed institutions and personal liability for the executives of failed banks. A proportion of bonus payments at each bank should be kept in a pool that can be raided if it gets into trouble.
Yet there is no reason why regulators could not follow both of these approaches. It might be more productive than creating ever more complicated regulations for financiers to evade.
* “Why Prudential Regulation Will Fail to Prevent Financial Crises: A Legal Approach”, by Marcelo Madureira Prates, November 2013
** “Too Much of the Wrong Sort of Capital Flow”, address at the Centre for Advanced Financial Research and Learning, January 2014
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