Saturday, August 30, 2014
9

Ending the Financial Arms Race

CAMBRIDGE – People often ask if regulators and legislators have fixed the flaws in the financial system that took the world to the brink of a second Great Depression. The short answer is no.

Yes, the chances of an immediate repeat of the acute financial meltdown of 2008 are much reduced by the fact that most investors, regulators, consumers, and even politicians will remember their financial near-death experience for quite some time. As a result, it could take a while for recklessness to hit full throttle again.

But, otherwise, little has fundamentally changed. Legislation and regulation produced in the wake of the crisis have mostly served as a patch to preserve the status quo. Politicians and regulators have neither the political courage nor the intellectual conviction needed to return to a much clearer and more straightforward system.

In his recent speech to the annual, elite central-banking conference in Jackson Hole, Wyoming, the Bank of England’s Andy Haldane made a forceful plea for a return to simplicity in banking regulation. Haldane rightly complained that banking regulation has evolved from a small number of very specific guidelines to mind-numbingly complicated statistical algorithms for measuring risk and capital adequacy.

Legislative complexity is growing exponentially in parallel. In the United States, the Glass-Steagall Act of 1933 was just 37 pages and helped to produce financial stability for the greater part of seven decades. The recent Dodd-Frank Wall Street Reform and Consumer Protection Act is 848 pages, and requires regulatory agencies to produce several hundred additional documents giving even more detailed rules. Combined, the legislation appears on track to run 30,000 pages.

As Haldane notes, even the celebrated “Volcker rule,” intended to build a better wall between more mundane commercial banking and riskier proprietary bank trading, has been hugely watered down as it grinds through the legislative process. The former Federal Reserve chairman’s simple idea has been co-opted and diluted through hundreds of pages of legalese.

The problem, at least, is simple: As finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance to win.

Even back in the 1990’s, regulators would privately complain of the difficulty of retaining any staff capable of understanding the rapidly evolving derivatives market. Research assistants with one year of experience working on derivatives issues would get bid away by the private sector at salaries five times what the government could pay.

Around the same time, in the mid-1990’s, academics began to publish papers suggesting that the only effective way to regulate modern banks was a form of self-regulation. Let banks design their own risk management systems, audit them to the limited extent possible, and then severely punish them if they produce a loss outside agreed parameters.

Many economists argued that these clever models were flawed, because the punishment threat was not credible, particularly in the case of a systemic meltdown affecting a large part of the financial system. But the papers were published anyway, and the ideas were implemented. It is not necessary to recount the consequences.

The clearest and most effective way to simplify regulation has been advanced in a series of important papers by Anat Admati of Stanford (with co-authors including Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer). Their basic point is that financial firms should be forced to fund themselves in a more balanced fashion, and not to rely so heavily on debt finance.

Admati and her colleagues recommend requirements that force financial firms to generate equity funding either through retained earnings or, in the case of publicly traded firms, through stock issuance. The status quo allows banks instead to leverage taxpayer assistance by holding razor-thin equity margins, relying on debt to a far greater extent than typical large non-financial firms do. Some large firms, such as Apple, hold virtually no debt at all. Greater reliance on equity would give banks a much larger cushion to absorb losses.

The financial industry complains that efforts to force greater equity funding would curtail lending, but this is just nonsense in a general equilibrium setting. Nevertheless, governments have been very timid in advancing on this front, with the new Basel III rules taking only a baby step toward real change.

Of course, it is not easy to legislate financial reform in a stagnant global economy, for fear of impeding credit and turning a sluggish recovery into a full-blown recession. And, surely, academics are also to blame for the inertia, with many of them still defending elegant but deeply flawed models of perfect markets that create an illusion of safety for a system that is in fact highly risk-prone.

The fashionable idea of allowing banks to issue “contingent capital” (debt that becomes equity in a systemic crisis) is no more credible than the idea of committing to punish banks severely in the event of a crisis. A simpler and more transparent system would ultimately lead to more lending and greater stability, not less. It is high time to restore sanity to financial-market regulation.

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  1. Commentedniels kristian schmidt

    Complicated laws create a Kafkan society. There is an optimal degree of complexity in maintaining a balance between anarchy and dictatorship to achieve a Rechtsstaat instead of a Willkürstaat. Without law there is chaos, with complicated laws there is also chaos.

    Laws of more than 10 pages disenfranchises the people and the legislative body who's members cannot have time to read and understand more than most of us, the people, humans. It's uneconomic and undemocratic to have 1000 page laws. It's likely good business for civil servants and lawyers, but do we want a society where we are their servants and they are not ours?

    Judges need to judge, and not just relay what the law says (or hire a consultancy firm to do so) and people need to use judgement too, not just communicate through lawyers.

  2. Commentedd clark

    Everyone knows that complicatedness = unintelligibility, especially when money is the protagonist. For someone to write laws and regulations that are unintelligible to the common political representative means that the common American has no chance of understanding them either. With money a sine qua non of American life, Americans had better understand. For trust has vanished.

    There are plenty of counter-arguments against simple, understandable laws, of course. But they are easily out-weighed by the pedigree of those who make the laws—banking industry employees who “advise” bewildered political staff over lunch. In other words, those who must work under the laws make them. That's just great.

    The fact that any lawyer can show as reasonable that 1 + 1 = 3, means that complex financial regulations are a joke, if they are expected to be rationally constructed. And they are even more hilarious if one expects them to be followed and monitored. The more pages, the more gold-plated lawyerly exits. It is nice for sellers to customize a product to the consumer's wish, at the consumer's cost, but not nice to customize laws to the desires of the sellers, also at the consumer's cost. Especially when the fertile legal maziness suffers a Grecian crackup, allowing the banks to escape bankruptcy.

    Laws bulk up from 37 pages to 848 not because of print size. Some say that over the last eight decades, “Times have changed.” Have they? Financial consumers were wrecked eight decades ago, and again during the enduring present. Time to change.

  3. CommentedAndrey Shvets

    "Money - a convention, but the economic processes are assessed only in monetary terms. What does it lead to? Imagine that the cars go down the street and cast shadows on the wall. Imagine that passersby catch those shadows on the wall to stop the car. Have you imagined? Economists who use monetary measures to stop the crisis, are similar to those passersby."

    http://andreyshvets100.blogspot.com/2012/08/i-know-how-to-stop-global-crisis.html

  4. CommentedProcyon Mukherjee

    Some of the points are well taken like the gush of talent that the financial industry attracts by virtue of its power and the asymmetric payoffs that this industry commands to its trader-professionals where gains are always privatized, while losses are not. The regulators on the other hand cannot attract talent to find the optimum solutions to excessive financialization and we obviously find floor-crossing happening in one direction. In fact the whole structure of financial market and the rating agencies together with the regulators have one fundamental draw back that independence of the regulating agencies is sacrificed and replaced by inter-dependence which could hardly be the optimum solution; this perhaps creates ground for regulatory capture, which in some ways has been deepening in the last five years. The growth of finance from 4% of GDP to 8% of GDP, is a clear indication that products and processes designed to increase risk taking has replaced the products that actually create value to the common man, otherwise how could it be that the rest of the industries have shrunk as a percentage of the GDP.

    Rogoff raises another important pointer that very successful innovative companies like Apple or Microsoft are virtually debt free as they finance their business through equity, while there are host of companies who leverage to balance growth, like the finance companies themselves. It is interesting that finance companies that continue to increase their leverage find value in debt over equity, while innovative companies who have no problem to sell their concepts and products can heavily rely on their equity for all kinds of funding. This leaves a looming doubt that increasing the flow of credit itself cannot be the solution to business growth, it is fundamentally innovation through which value is created and cannot be replaced by lower cost of capital, something that monetary policies have to grapple with.

    Procyon Mukherjee

      Portrait of Gregor Schubert

      CommentedGregor Schubert

      Mukherjee claims the following about the financial industry:
      "The growth of finance from 4% of GDP to 8% of GDP, is a clear indication that products and processes designed to increase risk taking has replaced the products that actually create value to the common man, otherwise how could it be that the rest of the industries have shrunk as a percentage of the GDP"
      There are some fundamental issues with this statement:
      1. That other industries have shrunk as a percentage of GDP does not mean that finance's growth has come at their cost: relative shares can change even while all parts of the economy grow in absolute size.
      2. Risk taking usually goes hand in hand with higher returns - otherwise why take the risk? So those risk-taking finance types create higher returns and innovation for society on average at the risk of being the one of the unlucky few who lose it all - doesn't sound so bad, does it.
      3. As for why the relative share of finance might have increased: as risk-averse capital was flowing to the US over the last decade, the premium for bearing the risk portion of the investments financed by those flows increased. US financial institutions bore that risk and got the premium as its reward.

  5. CommentedMatthew Lee

    I agree with Rogoff in that regulation needs to be changed, perhaps even "simplified". However, in this article, several measures have been proposed about which measures to simplify, but the question of how to simplify financial regulation still remains unclear.

    If we understand the principle and fundamental workings of the financial industry, then I believe we will know how to regulate it. As long as that principle remains constant, then it will be clear what sort of regulation is necessary and to what extent (e.g. Glass-Steagall vs. Dodd-Frank).

    I think the nature of the finance industry lies in the speed and scope that technology has granted it. Before modern information technology, prospective investors would have to trade certificates by hand, which is a tedious process. As a result, people thought long and hard before they made an investment, and then waited a much longer time for returns issued by a company. Nowadays, it's possible to make many transactions in just seconds, and investing little slips of paper has become profitable in itself; it is no longer "investment", but "trading".

    The nature of the game has changed, and it is now up to people to decide whether and how regulation should be updated in order to remain applicable and effective. As discussed in the article, government regulation certainly cannot keep up with the pace of the financial industry. Therefore, the key is not in regulating every single new detail, but regulating the fundamental rules.

    If interested, there is more info on the "nature" of this new financial industry here:

    http://onefreelunch.blogspot.com/2012/08/income-inequality-in-united-states.html

  6. CommentedCher Calusa

    This article is an oversimplification of the current challenges in the world today. On the one hand, the author is admitting that flaws in legislating our end of the financial system brought the world to the brink of a second Great Depression, and on the other hand, the article suggests that balanced funding on the part of the USA will somehow remedy the situation. The author may have wanted to isolate his remarks and I appreciate that, but there are continuing problems related to the economy in general that have little to do with regulating money alone and more to do with using and protecting natural resources, understanding our role in the proliferation of disease, unrest and starvation as well as providing for the management of natural disasters, etc. From any of these areas a blow to the world system can be delivered and it will take money, people, resources to deal with it. When societies of the past over consumed, over planted, concentrated their populations into small areas, etc. these societies disappeared through natural consequence. What makes us believe we are immune today?

  7. CommentedZsolt Hermann

    We are not in a banking or financial crisis.
    We are in a system failure.
    Our whole life is based on an unnatural and unsustainable bubble, the present financial system only serves it, and as the bubbles started bursting we need the growing number of patches to try to keep the bubbles inflated, but now we are running out of patches thus the whole balloon is falling fast.
    We are still trying to correct the superficial aspects, treat the symptoms instead of the disease.
    It is the constant quantitative growth, expansive economic model that has crashed being unrealistic and unsustainable, until we accept this as fact and correct it we will just continue playing around with virtual money transfers, restrictions, regulations until we suck the whole system dry.

      CommentedMark Pitts

      As long as the 5 billion poor are allowed to work their way out of poverty, there will be quantitative growth and an expansive economic model.

  8. Commentedradek tanski

    I feel that complexity is the arrow of will towards power. Always domineering simplicity.
    Interestingly leftist perspectives perceive financial innovation as threating, just as financial innovators fear and avoid leftists.
    Perhaps they are locked in a struggle that is as old as time, rather than new. Except that the innovators are the honest ones?

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