Forget about Hedge Funds. The real issue is market transparency.

By: Wolfgang Münchau

If a week is a long time in politics, it is an eternity during a financial crisis. The credit market crisis is entering its second month and growing worse. Friday’s US employment report was a reminder, if any was needed, that the risk of an American recession is non-trivial and rising.

There is a further risk, that an economic slowdown could reverberate back to the credit markets through an increase in defaults on segments of consumer debt and corporate loans. As defaults in these other areas rise, one set of investors would demand compensation from another set, which optimistically agreed to provide this assurance through credit default swaps.

Another channel of potential global contagion is the exchange rate. If US interest rates fall over the next few months, so might the dollar. This crisis is not going to be over in a week. Even if it appears to be, for example if the money markets were to stabilise, there is a danger that it will come back in some guise later on.

The two obvious questions that arise are: what should we do right now and what lessons are to be learnt beyond the immediate future? I have no original advice to offer on the former, other than what central banks and fiscal authorities will almost certainly do in any case: cut interest rates, offer tax relief – and do it fast.

Yet there is a well-known problem with interest rate cuts: markets may rightly or wrongly believe that central banks have lost sight of their price stability objectives. To make rate cuts more credible, it is essential that we tackle some of the causes of the crisis right now.

Speaking at last week’s conference in Frankfurt on the ECB and its watchers, Stephen Cecchetti of Brandeis University gave a detailed analysis of what he called a crisis of collateral.* Banks do not know what their collateral is worth during a liquidity squeeze as it is not marked to market. Since large parts of the market for structured finance products are over-the-counter, I have heard the suggestion that one possible solution would be to drive it on to an exchange, which would allow investors to price their holdings.

But for this to happen with any success, one needs a lot more transparency. Some of these products are so opaque that many investors do not, and possibly cannot, understand what they are buying. Perhaps the Germans should, during the remaining months of their Group of Eight presidency, try to talk about financial regulation – this time not about hedge funds, which are a domestic political obsession, but about market transparency in a wider sense. The answer cannot be another set of Basle capital adequacy rules, which were partly responsible for the bubble in the credit market in the first place, as regulatory compliance induced banks to offload credit exposure into unregulated conduits. The purpose of regulation should be to be to help create an orderly market.

Another important question is whether and to what extent central banks have contributed to this crisis. For example, are central banks over-reliant on economic models that leave no room for money and asset prices and that manifestly failed to produce warning signals ahead of the current crisis? I would even go further and ask whether it is a good idea in principle to appoint leading monetary academics to the top positions in central banks when their academic reputation rests to a large extent on models they helped create in the first place. Could we really expect these central bankers to take a pragmatic view and say: “OK, our models did not work, let’s dump them”?

Another problem is ineffective bank supervision, which has recently become acute in Germany, where commercial banks are regulated by both the Bundesbank and a separate banking supervisor. While there is an agreed way the two share the work, some duplication and friction still arises. We might therefore want to consider whether we should stop the trend towards separating responsibilities for monetary policy and banking supervision. I am not saying we have to change all of these things. But we must have a debate.

In this list, I have not yet mentioned the rating agencies. I am less convinced of regulation here, as there is really no evidence of persistent market failure. Smart investors have always known to treat AAA ratings with a pinch of salt. There are still dumb investors out there, in some European banks for example, who believe they have no problems as they are sitting on AAA-rated assets. But this is a learning-curve problem. Rating agencies have made a series of mistakes but this does not logically imply a need for regulation. Regulation is needed in cases where the market cannot by itself find a solution. What the rating agencies should do in their own interest is to take a hard look at their mathematical models. If not, someone else will grab their business.

The real issue is not the rating agencies but the lack of transparency in the credit market, the dominance of “marked-to-model” pricing and central bank policies that unwittingly encourage the build-up of asset price bubbles. The clear danger that policymakers now face is a moral hazard that could lead to another bubble. To escape this dilemma, the best course of action is to use all the tools for financial and macroeconomic stabilisation now and at the same time start addressing the underlying causes of the crisis.

*www.ifk-cfs.de

Send your comments to munchau(at)eurointelligence.com

© The Financial Times Limited 2007

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