Wednesday, December 12, 2012

Elements of a stable financial system

It's hardly a hell raising demand for revolution, but this speech by Michael Cohrs of the Bank of England is worth a quick read and offers some pretty encouraging signs that authorities -- in the UK, at least -- are moving (slowly) toward financial regulations that seem pretty sensible and might really help avoid future crises or make them less frequent. I read it as a kind of wish list, but of wishes that are fairly realistic.

On a theoretical level, perhaps the most important thing Cohrs calls for is greater awareness of economic and financial history, with the idea that we might prepare our minds better for the natural instabilities that seem to create crises so frequently:
At the heart of much of the current policy debate is how the FPC, PRA and FCA develop better processes for anticipating the next problem – whether the problem is an asset bubble, poor risk mismanagement or a flawed or misunderstood financial product. And these are important steps to take. But it seems to me there is an inherent tendency for policymakers to re-fight the last war. As I said above, I am a believer that understanding the past provides a foundation on which to assess the future. But we shouldn’t pretend we can eliminate financial crises completely. Nor that the next crises will necessarily be a carbon copy of the last one.
My anxiety about getting financial regulation to better mitigate future risks has its roots in the issues one sees in the financial crises of the past couple of hundred years or so. Virtually every type of financial institution has been the cause of a crisis at some point in history – country banks back in 1825, universal banks in 1931, small banks in the 1970s, savings and loan companies in the 1980s, international banks in the 1980s and 1990s (debt crises in Latin America and Asia respectively), and even a hedge fund in 1997.
Pretty much all types of financial institution got involved in the problems of 2007/2008. The roll call included insurance companies (although thankfully not those in the UK) alongside investment banks as well as some more traditional commercial and mortgage banks. I find it hard to see a common thread (other than high leverage ratios) amongst the types of institutions that struggled or the mistakes that they made. It is not clear that the reforms we are putting into place today would have, or could have, averted all the problems faced in these crises. Therefore, experience tells me its origins are unlikely to be in an institution and from a product that is obvious to us now. ... I realize this uncertainty is rather unhelpful.
Actually, I think it is very helpful. Nothing is more dangerous than belief that now , as we know how things can go wrong, we can probably perform a few engineering tricks and hence avoid further problems in the future. This was the facile belief furthered in the decade prior to the past crisis, especially in basic textbooks of economics and finance and research papers furthering belief in the inevitable "spiral to efficiency" of modern markets (infamously described in this rather embarrasing 2005 paper by Robert Merton and Zvi Modie, which was published even as the markets were on the verge of collapse!).

Cohrs goes on to discuss a number of ideas all being pursued with the idea of making finance more "sustainable." These include establishing simple rules by which large institutions can be wound down and let fail safely when they ought to (this might include using penalties or taxes to establish insurance funds beforehand to handle such events), making financial institutions LESS CONNECTED and changing the culture of finance as well so that financial institutions themselves "ensure they can be regulated." Ok, that final one may be a rather huge challenge.

The good thing is that people from the Bank of England are going around saying these things. Let's hope they can manage to put some of these principles in place, especially in some globally consistent way.


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