We’re fooling ourselves if we blame the recent crisis on character defects unique to our time, be it unusually lax regulators, particularly shortsighted politicians, or financial market participants avaricious beyond the norm.
Truth is, each of these qualities fluctuates with the prevailing social mood: they’re inherently pro-cyclical. When it would be ideal from society’s point of view for them to zig, they tend to zag. Nor is there much reason to think this is going to change anytime soon. We’re human, all too human, and so would be well advised to insulate critical social systems from our long-term shifts in sentiment.
Easier said than done, though. Not only because designing foolproof (or, more accurately, resilient) systems isn’t easy, but also because even assuming we do there’s every chance our progeny will find a way to undo them during the next great wave of optimism.
Still, we can but try.
Adair Turner (chairman of the UK Financial Services Authority) and Mervyn King (Governor of the Bank of England) are both acutely aware of this dilemma. Far more than any other senior financial markets officials, they try to get at the deeper underlying causes.
On Monday, October 25th, King gave a talk in New York entitled “Banking: From Bagehot to Basel, and Back Again”.
“The real failure was a lapse into hubris – we came to believe that crises created by massive maturity transformation were problems that no longer applied to modern banking, that they belonged to an era in which people wore whiskers and top hats. There was an inability to see through the veil of modern finance to the fact that the balance sheets of too many banks were an accident waiting to happen, with levels of leverage on a scale that could not resist even the slightest tremor to confidence about the uncertain value of bank assets. For all the clever innovation in the financial system, its Achilles heel was, and remains, simply the extraordinary – indeed absurd – levels of leverage represented by a heavy reliance on short-term debt.”
And: “Of all the many ways of organising banking, the worst is the one we have today.”[1]
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Both see financial markets as inherently unstable. Unlike other markets, they appear incapable of managing their own affairs. Thus, from Turner:
“If instead we believe that liquid financial markets are subject for inherent reasons to herd and momentum effects, that credit and asset price cycles are centrally important phenomena, that maturity transforming banks perform economically valuable but inherently risky functions, and that the widespread trading of credit securities can increase the procyclicality of credit risk assessment and pricing, then we have challenges which cannot be overcome by any one structural solution.”
King is even more explicit:
“A market economy has proved to be the most reliable means for a society to expand its standard of living. But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system. We know that there will always be sharp and unpredictable movements in expectations, sentiment and hence valuations of financial assets. They represent our best guess as to what the future holds, and views about the future can change radically and unpredictably. It is a phenomenon that we must learn to live with. But changes in expectations can create havoc with the banking system because it relies so heavily on transforming short-term debt into long-term risky assets. For a society to base its financial system on alchemy is a poor advertisement for its rationality.”
Both settle on similar, and equally blunt, solutions.
After reviewing and to varying degrees approving of measures such as levies and taxes, the Basel III framework, programs to deal with “too big to fail” institutions, and enhanced resolution procedures, they each conclude only one reform has a chance of being truly effective. Namely much, much higher capital requirements. Neither nominates a specific figure but both clearly favour a multiple of anything currently proposed.[2]
King: “The broad answer to the problem is likely to be remarkably simple. Banks should be financed much more heavily by equity rather than short-term debt. Much, much more equity; much, much less short-term debt. Risky investments cannot [sensibly] be financed in any other way.”
While similar in principle, Turner suggests an additional component:
“Instead two elements should form the core of the regulatory response to the crisis: much higher bank capital and liquidity requirements and the development of new macro prudential through-the-cycle tools. Together these can help address the fundamental issues of volatile credit extension and asset price cycles.”[3]
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Both recognise only too well that the maturity transforming, risk-taking functions that were recently taken to such extremes can’t easily be done away with.
King put it simply: “”[It’s] difficult because it is the nature of the services – not the institutions – that is the concern.” If suppressed in one area (through, for example, instituting narrow banking), these functions will inevitably pop up somewhere else. Some new “shadow banking” system, perhaps, there to grow and mutate until somewhere in the distant future it produces a fresh crisis, and cries for yet another bailout.
I’m more and more inclined to agree, not only with this diagnosis (which I’ve never doubted), but with their proposed solution.
This is a change from my thoughts in January. Then, I favoured reining in and insulating the banking system itself in various ways while allowing the wider financial system to operate largely on the basis of caveat emptor. In other words, within standard civil and commercial laws they could do as they liked, but only in the full knowledge the cavalry wouldn’t arrive if they messed up.
Now, I’m increasingly persuaded this latter condition is unrealistic; if a new shadow banking system did go berserk, there’s every chance the government of the day would feel it had to step in. That being so, it may be best to forget about trying to force different functions into different silos, and instead settle on this simpler approach of far less regulation and much higher capital requirements that would apply across the whole financial system. At least then there’s a chance this constraint could be sustained, even in the face of a new period of extreme optimism.
In order to ensure an even more robust system (as well as introducing another layer of market discipline), both King and Turner are adamant that creditors to the financial system should take the hit before taxpayers, and should know that they’ll have to do so. No argument; this is a pet bugbear. From “Money, Credit and Financial Systems”:
“One of the more grievous errors made during the depths of the crisis was to load the burden of bailing out the financial system onto taxpayers while giving creditors a free pass. It’s easy to see why depositors should for the most part be exempted (to do otherwise would have been to induce panic and unilaterally change the understood rules of the game), but creditors of failing banks should either have been forced to take a haircut, or had some portion of their holdings converted to equity. Not only would this have had the salutary effect of boosting capital at no public cost, but the banks’ indebtedness would have been reduced at the same time.”
“As well as playing hell with the public finances, this decision ensured that public faith in the fundamental fairness of the official response to the crisis was profoundly undermined, and understandably so. Whether it was done out of fear and panic, or because of the uncomfortably close relationships between government and the major players in the financial system, I don’t know, but the “fat tail” costs of this decision are likely to be very high indeed.”
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There is a more elegant, market-based solution than this forced high capitalisation approach, one that would generate natural constraints on credit growth, that has the potential to be genuinely resilient. At least in theory. I touched on it in the title essay of this site:
“In the absence of a lender of last resort, and given the rate of credit creation would tend to be set by the most conservative banks (since, through the process of daily clearing, banks expanding credit more rapidly would equally quickly lose reserves to their less adventurous fellows), a specie based, 100% reserve free banking system would probably be both surprisingly conservative and require only the most light-handed regulation.”
I still think that’s true, although having looked more deeply into the theory and history of free banking, I’m no longer convinced 100% reserves are necessary. Largely unregulated, gold-based, fractional reserve free banking systems worked well for lengthy periods in Scotland, Canada and Hong Kong, amongst others.[4]
With the best will in the world, though, I can’t imagine governments giving up control over money and credit by acceding to the reintroduction of gold[5]in any form, much less to a full, denationalised version of the gold standard. Besides, how could any proposal to radically free up markets possibly succeed when almost everyone is convinced they failed precisely because they were deregulated?
No, the die was cast once the notion progressively took hold from the early part of last century that it was the government’s job to protect depositors, manage interest rates and underwrite economic growth. It doesn’t matter that the long-term consequences of this shift (despite the best of intentions) have been almost uniformly harmful. A deep conceptual shift took place over the last 60 to 80 years and I don’t see how it can be reversed. Perhaps the breakdown of the existing financial order (should the authorities be desperate enough to push the current trend of QE and fiscal deficits to extremes) could create the circumstances where such a radical shift in attitudes is conceivable. Perhaps, although even then it’s impossible to know what form it might take. In any event, one couldn’t possibly wish for it; the path there would be littered with casualties and catastrophe.
We must hope a safer way out of the current mess is eventually found. A slow return to sanity, perhaps born of a growing recognition that a far less malleable reality underlies all these monetary arabesques. A focus on production, on savings and investment, on prudence, on assisting the necessary transitions and restructurings rather than impeding them, and last, but by no means least, on helping and protecting all those amongst us who are vulnerable.
To better the odds, it would help to have a reasonably clear goal to aim for in the restructuring of our battered financial systems[6], one that’s not too arcane, that can be widely grasped. Of the alternatives on offer, King’s and Turner’s broad approach[7] seems not only politically possible, but also most likely to be effective.
I’d add only one rider; that the longstanding role of central banks in so freely supplying reserves[8] to the system (and/or making reserves almost entirely irrelevant) should also come under the microscope. Without being constantly underwritten in this fashion, financial systems could not have grown as they did over the last century. Under the older system of widespread reserve requirements, a given level of base money could only give rise to so much credit creation. This could be bad enough, to be sure, as we saw in the repeated cycles of boom and bust in the 19th century, but without the certainty of reserve availability (whether through growth in base money or reduced reserve requirements), the excesses of recent decades would have been impossible.
If this need for long-term restraint in the provision of reserves were broadly accepted amongst professionals, it’s possible to imagine that message being effectively conveyed to the public, much as one can with Turner and King’s approach. They both share a kind of commonsense acceptability. First though, the reality of what happened over the last 80-100 years has to be seen for what it is.
It’s no coincidence that in the hundred years to 1900, consumer prices in the US halved while in the next hundred they multiplied by over twenty times. Or that along the way, and certainly not only in the US, credit metastasised like a cancer. Today, debt outstanding almost everywhere is so unthinkably large that it paralyses policymakers. Its rapid unwinding would tear through economies like a cyclone, leaving chaos and devastation in its wake. Trying to prop it up, on the other hand, solves little or nothing and risks an even worse crisis in the future.
And this is progress?
We’ve managed to dig an exceptionally deep hole. Getting out of it will require clear sightedness, not only about what we need to do, but also about how we got here. Regardless of how we approach it, tough times lie ahead.
The tragedy is we seem determined to take the illusory, apparently easier roads first.
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1 That’s also my view. As I wrote in July 2007 on Ultimi Barbarorum: “Put simply, if the financial system is to be deregulated (which I certainly favour) then participants must not be saved from their own foolishness. If the political decision is made that protection is to be provided, then fairly stringent regulation ought to continue. What we have is the worst of both worlds.”
2 For example, King notes “Bagehot would have been used to banks with leverage ratios (total assets to capital) of around six to one.” That is, non-risk weighted capital of 15%+.
3 I think he’s probably right. As he says “Higher continual capital and liquidity requirements will still however leave the economy vulnerable to destabilising up-swings in credit supply and asset prices, deriving from the interaction between maturity transforming banks, credit securities markets, and self reinforcing credit and asset price cycles.” Amongst his suggestions are: varying capital and/or liquidity requirements across the cycle; imposing constraints, like LTV limits; and being willing to tailor these by broad category of credit so as to better target those sectors that are going off the reservation.
4 In theory, of course, a free banking system could operate with a strictly limited amount of fiat base money substituting for gold. Given the ease of producing it, however, and all the normal political temptations, it’s hard to imagine the necessary discipline lasting all that long.
5 Martin Wolf wrote a piece at the FT a week ago entitled “Could the world go back to the gold standard?” It’s a useful tour of the alternative ways in which gold might be reintroduced into the financial system. He concludes that none of them would work, and that many would do direct harm. Despite my preferences in an ideal world, I’m inclined to agree with him. Only a pure gold standard, entirely free of variously linked national currencies, and operating within an equally free international banking system would have any chance of working properly.
6 Some financial systems don’t fit this description at all. Australia, for example, which sailed through the crisis with minimal damage, or even disturbance (albeit with the early need for some comprehensive government guarantees).
There were good reasons: the excesses of subprime lending were largely avoided, both in terms of domestic origination and the purchase of exotic overseas securities; banking leverage was not extreme; regulation was tighter and more effective; the economy benefited from its strong commodity export orientation; government indebtedness was (and still is) extremely low, and early and aggressive steps were taken to stimulate the economy.
Whether this (partly deserved) good fortune holds in years to come is another matter. The level of household indebtedness in Australia is as high, or higher, than anywhere else in the world, as are housing prices in relative terms. A large external imbalance, and the heavy reliance of the banking system on wholesale offshore funding, adds to the vulnerability. It’s a dangerous combination.
7 Labelling the combination of high capital requirements and creditor liability in the event of a crisis as “King’s and Turner’s approach” is of course merely a form of shorthand. While it does seem to fairly reflect the essence of their respective views, they have differences (as noted above), are still engaged in a long and complex process, and also view many of the more conventional reform measures as potentially useful.
8 Reserves are base (or “high-powered”) money held by the banking system. Under our current structure, that means vault cash and cash reserves held with the central bank. The latter provides the means for each bank to meet its daily obligations to the clearing system as cheques, transfers and other payments from all banks are processed and netted out. When reserve requirements were still central to the system, a bank without reserves in hand (or at the very least the absolute certainty of being able to borrow them from other banks or, at worst, the central bank) not only couldn’t extend credit, it wasn’t even in a position to meet its existing obligations. As reserve requirements were progressively reduced, however (or dispensed with entirely), their effectiveness as a constraint largely vanished. It mattered then only that the central bank made sure sufficient reserves were in place to ensure comfortable daily clearing, which of course they’ve done for decades.
Money, Credit & Financial Systems 