Wasting a crisis

By: Richard Portes

We are on the verge of ‘wasting a crisis’. In both Europe and the US, reform of financial regulation is either taking the wrong directions or stalled. Politicians are picking the easy targets that they believe will appease public opinion or caving in to well-connected, well-financed lobbying by the resurgent big banks.

 

That is not for want of good analysis by academics and others. We understand what happened, why it happened, and what could lessen the risk of a future crisis of this magnitude.[1]  The best of the regulators, as well as the Financial Stability Board, have some agreement on the appropriate solutions. But they are not calling the shots. And the national regulators are often part of the problem rather than the solution. They are reluctant to collaborate with each other and with supranational institutions, partly for fear of losing some of their authority, partly because they too face strong lobbies and are subject to regulatory capture.

 

Let us start where our political leaders started – and, mainly, seem to be ending: tax havens, bonuses, regulating hedge funds, private equity, and credit rating agencies. We then consider the banks themselves, macroprudential regulation, and regulating the markets. We conclude with an important set of cross-border issues that hinder progress in many of these areas.

 

Tax havens had nothing to do with the crisis, nor with preventing or mitigating future crises, but they were an easy, convenient target. And they are disappearing. That is good, but we might wonder why they were not shut down earlier, since the major countries always had the instruments of pressure that they have finally used.

 

The quick return of big bonuses is offensive, as was the overall widening of income differentials we saw in the two decades preceding the crisis. But anyone who criticised greed should not be surprised that there is no shame, and calls for new, higher standards of behaviour are unrealistic. Bonuses may have encouraged ‘short-termism’. But caps will be evaded, one way or another, as the big financial firms compete for stars who, they believe, contribute much more to profits than whatever bonuses they need to offer them. Even if enforced, new compensation rules will not significantly curb dangerous risk-taking, nor instil long-term incentives. After all, most employees of Bear Stearns and Lehman Brothers had much of their personal wealth invested in their companies’ shares – and lost it. The right policy response to deal with extreme inequality is to raise taxes on very high incomes (not those over £150,000, but those over £1,000,000, say) and to tax wealth.

 

The draft Alternative Investment Funds Directive proposed by the European Commission without external consultations and embraced by indignant parliamentarians and some heads of government is another misplaced, irrelevant effort. There is no evidence that hedge funds or private equity had any role in causing the crisis, although hedge fund deleveraging has been a part of the process through which the financial crisis has hit both asset prices and the real economy. Still, the funds were not as highly leveraged as the big banks, and they played no part in the emission of toxic securities, relatively little part in their absorption. These institutions require more regulatory oversight only insofar as they behave like banks and do maturity transformation with unduly high degrees of leverage.

 

The European Commission and Parliament rushed to regulate the credit rating agencies, and now the US Congress may take similar measures. But this is precisely the wrong way to go. Rather than registration, surveillance, and monitoring their models, which will have no effect whatsoever, the right policy would be to remove the agencies from the regulatory system. That is, eliminate the ‘regulatory licence’ which gives the ratings a direct role in limiting investment choices by asset managers and banks. The regulators have in effect outsourced to the agencies their own responsibilities for evaluating the riskiness of institutions’ portfolios, while eliminating the institutions’ responsibilities for due diligence. And official ‘recognition’ of a few agencies is one reason for the highly oligopolistic structure of the industry and its dysfunctional incentives, which in turn underlie some of the shocking practices that were an important element in the creation and sale of toxic assets. The SEC and some congressmen have raised the fundamental issues, but it seems unlikely that they will take effective action. In Europe, policy-makers underestimate the importance of the regulatory licence.

 

The banking sector was already overly concentrated before the crisis. It is now more so, and there will be many more failures of small and medium-size banks, with resulting further ‘consolidation’. The remaining big banks have even more power. Far from being humbled by their egregious errors, they are vigorously, and successfully, opposing reforms that might reduce their profitability or their capacity to ‘innovate’, for which read ‘generate new kinds of overly complex, opaque, highly profitable financial instruments and activities.’ The banks are not just too big to fail, they are too big and too complex to regulate, even to manage effectively, or to control risk. But only Neelie Kroes has any apparent desire to break them up – the UK Competition Commission and FSA and US Department of Justice and financial regulators have no appetite for this, nor do finance ministries.

 

There has been some serious discussion among officials of setting capital ratios that rise with bank size or simply taxing banks on the basis of their assets. This is feasible and might be effective, but ministers and legislators have so far shown little interest. A ‘Tobin tax’ on financial transactions would doubtless reduce their volume – if it were enforceable, which is highly unlikely. But that would have little effect on size or concentration in the financial sector. Moreover, at any realistic rate, it would not curb speculation, and some analyses suggest it would raise rather than lower volatility in financial markets. This is a bad idea whose time has fortunately not come – another reason to be thankful for the exit of Peer Steinbrück.

 

The bottom line: nothing much will be done about the banks and their modus operandi, despite – or because of – their highly vocal concern about ‘overregulation’ and the supposed proliferation of national-level constraints on their activities. The US Treasury’s proposal for a new agency to protect the consumers of financial services is perceived by the banks as a threat sufficiently serious to warrant strong opposition, which may well gut it, even if the new agency is created.  Some initiatives – including public ownership – and the deleveraging process itself will for a time reduce the degree of globalisation of the big banks, but probably not enough to ease the severe problems of cross-border regulation and crisis resolution.

 

The only potentially effective policy instrument here is the excellent ‘living will’ proposal that big banks be required to propose detailed, pre-packaged resolution procedures that would apply when regulators judged that the bank had gone beyond the stage where prompt corrective action could save it. These would be agreed ex ante with all the bank’s regulators, which would require some degree of ex ante acceptance of burden sharing across regulatory jurisdictions. But this would not be in the form of burden-sharing rules that would apply uniformly, regardless of the particular circumstances of the institution. Many policy-makers who have opposed such rules therefore seem keen on the living will. It would have the additional, important benefit of forcing the banks to unwind some of the most complex features of their organisational structures – the many and interlocking subsidiaries and branches whose primary purpose is often tax avoidance and whose secondary effect is to hinder effective control and risk management by the centre.

 

We know what to do for macroprudential regulation, an essential new component of a reformed regulatory regime: some combination of countercyclical capital ratios, liquidity ratios, leverage ratios, and perhaps mortgage loan-to-value ratios. The banks will complain that this is all too complex, too constraining, so the outcome is likely to be a relatively weak set of requirements, with the ratios set too low to make much difference. There is one important consequence of such macroprudential regulation, however, that has been somewhat neglected. Although business cycles may be more highly correlated across countries now than in the past, they are still to a considerable extent national, as are some asset price bubbles (e.g., within the eurozone, we saw housing price bubbles in Ireland and Spain while German housing prices actually fell). That implies that the parameters of countercyclical macroprudential regulation have to be set at a national level, which in turn implies that the host regulator rules. That means that branches of global banks would be treated differently in different countries – an unsustainable position. Hence there will be pressure on cross-border banks to go from branches to subsidiaries.

 

New regulation of securities markets is likely to be weak. It is widely recognised that the US Commodity Futures Modernisation Act of 2000, which precluded any regulation in this area, was a major mistake, but proposed changes are minor. The pressure to move some over-the-counter transactions to central counterparties has finally had some effect, but just as the banks have dragged their heels as long as possible before conceding this, so they will fight to retain opacity for the most lucrative transactions. They maintain that many of these instruments are so tailored to customer requirements that their specificity makes it impossible even to put them through central counterparties, much less to permit exchange trading. But it is only exchange trading that could really provide the transparency necessary for effective regulatory oversight and control. That transparency, and the limits on specificity, the commoditisation of these instruments, would make them much less profitable. And if some specificity is lost, so much the better – it is the complexity and lack of transparency that has turned out to be dangerous.

 

It is not surprising that the lobbying effort here is intense and likely to be decisive. And some segments of the non-financial sector have been lobbying too, with effect, by claiming that even routing swaps through a central counterparty would require them to put up large amounts of collateral. In any case, their interest rate and foreign exchange derivatives are not particularly dangerous – but credit default swaps (CDS) are, not so much in their original form as insurance, but in the way the market morphed far beyond this role.

 

It is even more unlikely, however, that there will be any move to enforce exchange trading for CDS contracts. Nor will there be any attempt to ban ‘naked’ credit default swap (CDS) contracts, where the buyer is not insuring against credit risk on a holding of an underlying bond, but rather is simply taking a position on which way the market’s perception of the riskiness of a firm or sovereign will move. These instruments have been a potent source of destabilising speculation, even market manipulation. There is no justification for these instruments as beneficial hedges, and since the cost of funds for issuers must stay above the CDS price, the market can be a key link in a vicious circle that brings an institution down. And that major weakness in our financial structure seems likely to survive, simply because the market is so profitable for a few big banks.

 

Finally, the problems of cross-border competition and obstacles to cooperation are formidable. Competition in the labour market makes it difficult for any national regulator to enforce really hard-hitting curbs on potentially harmful compensation practices. Competition among financial centres leads to regulatory arbitrage and unwillingness of national regulators to disadvantage their own large cross-border institutions. Memoranda of (mis)understanding among regulators, with no binding force and bureaucratic obstacles to quick action, are useless when crises come. Again, the only feasible and effective way of organising resolution of a large, complex financial institution in distress is the ‘living will’ proposal. Some politicians, including the British Chancellor of the Exchequer, seem keen on it. But we need broad agreement among the major countries. That could be well worth the considerable effort it would require.

 

Overall, then, the perception that we have avoided catastrophe has already weakened the momentum for serious reforms, and the obstacles are formidable. We know the lessons of the crisis but may be unable to apply them. That would be a huge missed opportunity.

 

 

[1] See M.Dewatripont ,et al.,eds., Macroeconomic Stability and Financial Regulation, CEPR, March 2009; V. Acharya and M. Richardson, eds., Restoring Financial Stability, Wiley, 2009; M. Brunnermeier et al., The Fundamental Principles of Financial Regulation, CEPR and ICMB, 2009; and a wide range of contributions on www.VoxEU.org .

 

The author is Professor of Economics, London Business School, and President, Centre for Economic Policy Research

 

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