By Martin Wolf
Published: April 20 2010 19:42
Can we afford our financial system? The answer is no. Understanding why this is so is a necessary condition for evaluating ideas for reform. The more aware of the risks one is, the more obvious it becomes that radicalism is the safer option.
People pay too much attention to the direct cost of bail-outs. As Andrew Haldane of the Bank of England, author of several brilliant papers on the crisis, has noted, these costs may be around 1 per cent of gross domestic product in the US and UK. The costs that matter, however, are those of the recession and the huge jump in public debt. If only a quarter of the world’s loss of output during the recession were to prove permanent, the present value of these losses could be as much as 90 cent of annual world product.
How did this happen? Quite simply, the financial sector has become bigger and riskier. The UK case is dramatic, with banking assets jumping from 50 per cent of GDP to more than 550 per cent over the past four decades. Capital ratios have fallen sharply, while returns on equity have become higher and more volatile. As Mr Haldane notes in another paper, leverage is the chief determinant of returns on equity and increased leverage also explains the level and volatility of banking returns. Finally, the banking sector has also become substantially more concentrated. (See charts.)
Mr Haldane bemoans “a progressive rise in banking risk and an accompanying widening and deepening of the state safety net”. This is a “Red Queen’s race”: the system is running to stand still with governments racing to make finance safer and bankers creating more risk. The route was via liquidity, deposit and capital insurance. Mr Haldane notes that rating agencies value government support for banks. Government support must surely provide a part of the explanation for the low yields on bonds issued by these massively leveraged businesses (see chart).
The combination of state insurance (which protects creditors) with limited liability (which protects shareholders) creates a financial doomsday machine. What happens is best thought of as “rational carelessness”. Its most dangerous effect comes via the extremes of the credit cycle. Most perilous of all is the compulsion upon the authorities to blow another set of credit bubbles, to forestall the devastating impact of the implosion of the last ones. In the end, what happens to finance is not what matters most but what finance does to the wider economy.
Does today’s engorged financial system produce gains that justify these costs? In a recent speech, Adair Turner, chairman of the UK’s Financial Services Authority, argues it does not.* Financial systems are important servants of the economy, but poor masters. A large part of the activity of the financial sector seems to be a machine to transfer income and wealth from outsiders to insiders, while increasing the fragility of the economy as a whole. Given the extent of the government-induced distortions in the system, even the fiercest free marketeer should accept this. It is hard to see any substantial benefit from the massive leveraging up of the economy and, above all, the real estate sector, that we saw recently. This just created illusory gains on the way up and real pain on the way down.
As Mr Turner notes, the promise of securitisation has turned out to be partly illusory. Arguments used in its favour – “market completion” and the ability to extend credit more widely – look highly questionable. Particularly striking was the failure of the credit default swap market to give any forewarning of the financial crisis (see chart). At bottom, the invention of complex securities hugely exacerbated the information and incentive problems inherent in complex financial systems. Even the frequently heard argument that more market liquidity is better than less is far from unimpeachable: it exacerbates rational carelessness.
So what is to be done? In answering this question, one has to start from a recognition of the chief dangers: first, the high-income countries, with their low underlying rate of economic growth and huge costs of ageing, cannot possibly afford another crisis; second, the big issue is the impact on the economy.
Against these standards, what is one to make of ideas now being floated? Three common ideas need to be put in their place.
One idea, popular in US Republican circles, is: “just say no” to bail-outs. This is a delusion. Since financial institutions are powerfully interconnected, the government cannot credibly commit itself to not rescuing the system when in peril.
Another idea, popular among US liberals, is that the chief issue is “too big to fail”. Mr Haldane shows that the implicit insurance to huge banks is bigger than to smaller ones. He agrees, too, that economies of scale in banking are modest. The challenge of managing such complex institutions is enormous. Finally, the diversification these institutions seek is ultimately illusory: they are all exposed to economy-wide risks.
Yet it is important not to exaggerate the significance of size alone. One point is that some of the systems that navigated the crisis relatively safely – Canada’s, for example – are dominated by a stable banking oligopoly. Another is that, as happened in the US in the 1930s, the collapse of many small and undiversified banks can be highly destructive. Size matters. But it is certainly not all that matters.
A third notion is that the big issue is regulatory completeness. It is argued that if only oversight had been effectively imposed, the pattern of overleveraging and default could have been halted. This, too, is unlikely. It is hard to regulate finance against the incentives of those who run it. Fixing the problem has to include changing incentives in simple and transparent ways. To put it bluntly, participants have to fear the consequences of making serious mistakes, not just be told to stop.
In the end, halting the financial doomsday machine is going to involve fundamental changes in policy towards – and the structure of – the financial system. There are two broad approaches now under discussion. The official one is to make something roughly like the present system far safer, by raising capital and liquidity requirements, moving derivatives on to exchanges and enforcing prudential regulation. The alternative is structural reform. Which is the least bad option? I plan to address that issue next week.
* What do banks do, what should they do? www.fsa.gov.uk
Copyright The Financial Times Limited 2010.
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