Is the present crisis really the result of insufficient banking regulation?

29 April 2009

Speech to a luncheon hosted by the Institute of Economic Affairs in London

Bryan Gould has claimed that the present crisis is the result of a “free and unregulated” banking market, and his view is widely shared.

Banking crises are not new of course – they have been a recurring feature of the economic landscape for many decades, indeed for centuries.  There have been scores of banking crises even since 1945, though of course none with such far-reaching impact as the present one.

And they have occurred in so-called “light touch” regulatory regimes and in very intrusive “heavy touch” regimes.  They have occurred where banks are privately owned and where they are state-owned.   As Mervyn King has observed, “banks are dangerous institutions.  They borrow short and lend long.  They create liabilities which promise to be liquid and hold few liquid assets themselves.  That though is hugely valuable for the rest of the economy.  Household savings can be channeled to finance illiquid investment projects while providing access to liquidity for those savers who may need it.”1

In my view, while I don’t want to argue that banking regulation caused the present crisis – crises occurred long before we had banking regulation – I do want to argue that banking regulation may have increased the risk and/or severity of the present crisis by creating the impression that bank regulators were effectively able to ensure that banks which complied with regulatory rules were never going to fail. 

That is not what regulators claimed of course, but that was the impression which many people had.  Depositors felt reassured and, even more dangerously, so did bank directors. 

I well recall asking a man who had just been appointed to the board of one of the large UK clearing banks after a long career as a senior official in the UK Treasury how he found being a director of a bank.  “Funny you should ask that”, he replied.  “I was a bit concerned at first.  Banking is all about measuring and pricing risk, and of course I’ve not had to do that at the Treasury.  I was greatly relieved to find, after becoming a director of a bank, that all I had to worry about was whether we were complying with the Bank of England’s rules.” (This was prior to the establishment of the FSA.)

After we in New Zealand established an approach to banking regulation involving very few rules, but requiring bank directors to sign off detailed quarterly disclosure statements, and attest to the fact that their bank had appropriate risk controls in place, the managing director of a large Australian bank with a subsidiary in New Zealand came across the Tasman to argue that we should not be doing this.  “Most bank directors”, he said, “know absolutely nothing about banking.”  I accepted this argument, but said that in that case he should find people who did know something about banking, and not expect the Reserve Bank to determine what was prudent for each bank in the system.

Probably as a consequence of a widespread perception that bank regulators “had things under control”, banks have felt able to substantially increase their leverage over the last half century, to dramatically increase their dependence on short-term wholesale market funds, and to sharply decrease their liquid assets.  To quote Mervyn King again, “forty years ago, the clearing banks in London held around 30% of their assets in short-term liquid instruments.  Today that liquid assets ratio is about 1%.  For the major UK banks, almost 25% of customer loans are now funded by short-term borrowing in wholesale markets.  At the turn of the new century it was close to zero.”

So it is at least plausible that, by giving everybody a sense that regulation could and would prevent at least major banks from getting into trouble, banking regulation may have increased the risk of a crisis.

Of course, there are plenty of other factors which increased the risk of crisis (we had plenty of banking crises before we had banking regulation):

  • Disaster myopia.   Christopher Fildes’ law of the financial cycle says that “disasters happen when the last man who can remember what happened last time has retired”.  As the last crisis fades from our memory, risk appetites start to increase again – and this is probably encouraged by the widespread use of such tools for the measurement of risk as Value at Risk (VaR).  If the period over which volatility is measured by VaR is a period of relative stability and calm, VaR will greatly understate the real risks being run.  Black swans don’t get detected by VaR!  (Andrew Haldane of the Bank of England, in an excellent paper, quoted the Chief Financial Officer of Goldman Sachs telling the Financial Times as saying that “We are seeing things that were 25-standard deviation moves, several days in a row.”  Mr Haldane notes that 25-standard deviation moves should occur only once in hundreds of billions of years, let alone on successive days, and pointed out that of course the Goldman Sachs model was seriously flawed.2)
  •  Low interest rates across the yield curve encouraged the search for higher-yielding alternatives and that inevitably led to riskier investments, including housing and other forms of real estate – encouraged by the widespread myth, at least in English-speaking countries, that house prices never go down.  And why were interest rates so low across the yield curve?  Monetary policy may have been too loose in some major countries, and further down the yield curve we saw huge inflows of capital from countries with a high propensity to save and high propensity to export – particularly China and Japan.  Plenty of central bankers had warned about the dangers of these macroeconomic imbalances in the world economy, but while everybody was prospering – China growing at double-digit rates based at least in part on very strong growth in exports and the US and other developed countries more than happy to spend on the basis of money borrowed from the Chinese – nobody wanted to do anything about it.
  • Particularly in the US, there was strong encouragement (even pressure) on banks to extend credit to highly marginal borrowers to buy homes.  Banks presumably succumbed to that pressure without too much resistance in the belief that house prices would always rise – or at least would never fall.
  • And borrowers were encouraged to take on loans which they had relatively little chance of servicing for the same reason – house prices would always go up.  That attitude was encouraged in many US states by the practice of non-recourse lending.  Borrowers were in a “heads I win, tails the bank loses” position.
  • The very restrictive zoning of residential land in some major US states – and in the UK, Australia and New Zealand – appeared to validate the belief that house prices would always go up.  (Median house prices reached nine, ten and eleven times median gross household income in some urban areas of California in 2007, at least partly because of restrictive zoning of residential land.  By contrast, median house prices were only three times median household income in some urban areas with less restrictive zoning laws, such as Atlanta and Dallas-Fort Worth.)
  • The remuneration structures of senior bank executives, and traders, also created the wrong incentives.  Too many bankers saw an opportunity to earn many millions of pounds adopting high risk trading strategies – with little personal downside if those strategies proved flawed.  Indeed, to the extent that even retaining their jobs depended on at least maintaining market share in a highly competitive environment, many senior bankers felt obliged to match the behaviour of their competitors.  As the CEO of Citigroup said, as long as the music plays, we all have to keep dancing.
  • There was a failure on everybody’s part to understand the significance of the inter-connectedness of the banking system.  Bankers made an assessment on the creditworthiness of counterparties on the basis of their balance sheets, without being fully aware of the extent to which the assets on those balance sheets depended on the creditworthiness of third parties – something which may well have been encouraged by the existence of banking regulation (and credit ratings).
  • There was also a failure to understand the complexity of, and risks involved in, many of the products which were widely traded in recent years.  This failure was almost certainly widespread both in senior management and on bank boards.
  • And then of course we have Akerlof and Shiller’s (or was it Keynes’s?) “animal spirits” – very much related to disaster myopia.

So what to do?   There’s no great hurry to do anything: risk aversion is now so high that there is little or no risk that bankers are going to be taking on too much risk any time soon!

I’m not sure what the right answer is, but some observations:

  • Looking for a new international consensus on how to regulate banks is probably unwise and doomed to failure, for the reasons which Dani Rodrik outlined in The Economist about six weeks ago: large countries won’t surrender sovereignty over bank regulation; the last big attempt to coordinate the approach to banking regulation (Basel II) took years to accomplish and still didn’t prevent the crisis; and different countries will rightly choose different points on the trade-off between bank safety and bank innovation.
  • At least as difficult as getting a consensus on the best way to conduct banking regulation but arguably even more important is finding a way to reduce the macroeconomic imbalances in the international economy.  Yes, I understand Milton Friedman’s argument that, provided the public sector is in surplus and the exchange rate is floating, balance of payments deficits should be of no concern to policy-makers.  But of course in most major countries the public sector is now a very long way from being in surplus, and at least one of the key exchange rate pairs (the US dollar against the yuan) is a long way from floating.
  • The argument for adopting a counter-cyclical approach to minimum capital requirements sounds entirely sensible, but it is not at all clear how that would work in practice.  At the top of the cycle, when optimism is high and asset prices rising, the last thing which the market requires is better capitalized banks, so there would be a considerable risk that banks would work hard to evade a requirement to hold additional capital.  At the bottom of the cycle, when pessimism reigns, the market wants to see a solid cushion of capital, and would not take kindly to a lower required capital position.
  • I like the suggestion of Raghuram Rajan, a former chief economist at the IMF, who argued recently that “instead of asking institutions to raise permanent capital, ask them to arrange for capital to be infused when they or the system is in trouble.  Because these ‘contingent-capital’ arrangements will be entered into in good times when the chances of downturn seem remote, they will be cheap (compared with raising new capital in the midst of a recession) and thus easier to enforce.  Because the infusion is seen as an unlikely possibility, firms cannot raise their risk profile, using the future capital as backing.  And since it comes at bad times, when capital is scarce, it protects the system and the taxpayer.”3
  • I also have a good deal of sympathy with some measure of oversight over bank remuneration structures, although saying that is just another way of saying that bank directors are being hood-winked by bank managers, or that bank directors are no longer focused on protecting the interests of bank shareholders – and there is probably some truth in both those contentions.
  • Although not an immediate priority, with property prices weak and possibly still falling, in the longer-term there is a need to relax the overly-tight zoning of residential land, especially in countries like the US, Australia and New Zealand, with abundant land relative to population.
  • Perhaps the greatest need is to make bank failure a realistic option for banks which are today seen as “too big to fail”.  Under present arrangements, some banks are too big to be allowed to fail, and that has been amply demonstrated in recent months.  The problem is that too many bank directors and bank managers have traded on that belief, and will continue to trade on that belief.  They have operated on the basis that they can take very large risks (sometimes even larger than they were aware of): if their gambles pay off, they reap very substantial personal rewards, and rewards also for their shareholders; if their gambles do not pay off, they may still reap substantial rewards in the form of “separation payments”; shareholders may get hurt, but at least depositors will be bailed out by taxpayers.  That is a totally unsatisfactory situation.  I have some sympathy with the view of Nassim Nicholas Taleb, the author of The Black Swan, who earlier this month wrote “Nothing should ever become too big to fail… Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing”.

As we listen to those calling for yet more intrusive bank regulation, it is worth recalling that every single bank crisis since 1945 has been caused by one of two factors:

  • fraud (think BCCI or Barings), and bank regulators (and even bank directors) have little or no chance of detecting that until it is too late; or
  • a dramatic fall in asset prices, typically property prices, and bank regulators seem to be no better able to predict those than are bankers.




1 “Finance: A Return from Risk”, a speech to the Worshipful Company of International Bankers at the Mansion House, by Mervyn King, 17 March 2009.

2“Why banks failed the stress test”, a paper used as the basis for a speech given at the Marcus-Evans conference on stress testing, by Andrew G Haldane, Executive Director for Financial Stability at the Bank of England, on 9-10 February 2009.

3Quoted from The Economist of 11 April 2009

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