Repairing a failed system

Today’s global financial problems are probably as severe as those faced in the early 1930s. Time will tell. But the top tier of global financial institutions are far bigger than they were back then.

The world’s three biggest banks each have at least $2 trillion of assets on their balance sheets and most of them are in deep trouble. Banks, insurers and asset managers have written off hundreds of billions of assets, and many of them are so entangled with the rest of the financial system that they cannot be allowed to fail.

Collapse of a major bank today would create financial havoc far greater even than what we have already been through in the last year. Creditors of these large financial intermediaries must be protected, or the global financial system itself will collapse. Not surprisingly, the governments of the countries hosting these ‘systemic’ institutions are currently doing all they can to save them, a task that is proving enormously expensive for taxpayers. Bottom-line: long-standing implicit guarantees of financial institutions and instruments have now hardened and broadened dramatically, requiring a fundamental repricing as part of any effort to repair the financial architecture.

The bubble

There is almost universal agreement that the fundamental cause of the crisis was the combination of a credit boom and a housing bubble in the United States and elsewhere. There are many statistics to back this up. For example, in the five-year period from 2002 to 2007, the ratio of debt to national income in the US rose from 3.75 to 4.75 to one. It had taken the whole previous decade to accomplish a feat of similar proportion, and another fifteen years for it to double prior to that. During this same period, house prices grew at an unprecedented rate of 11% per year, in the US, with comparable developments in the UK, Spain, Ireland, Hong Kong and other markets.

“When the ‘bubble’ burst, it signaled a severe economic crisis to come.”

When the ‘bubble’ burst, it signaled a severe economic crisis to come. The median family, whose home might have represented 35% of its total assets and which typically was highly leveraged, would not be able to continue as before, and in the aggregate the global economy and financial system were destined to feel the brunt of it.

It is much less clear, however, why this combination of events led to such a severe financial crisis, that is, why we ended up with widespread failures of financial institutions and the freezing up of capital markets. The ‘systemic crisis’ that ensued reduced the supply of capital to creditworthy institutions and individuals, amplifying the effects to the real economy. There is no shortage of proximate causes. Mortgages granted to people with little ability to pay them back and designed to systemically default or refinance in just a few years, depending on the path of house prices. The securitisation process that allowed credit markets to grow so rapidly – but at the cost of lenders having little ‘skin-in-the-game.’ And there were the opaque structured products that were rubber stamped AAA by the rating agencies more interested in fees than risk assessment. When there is no transparency, no one can be sure who is holding what and who is exposed to whom, causing markets to shut down in a crisis and a ‘run’ on those markets is sure to occur.

What about securitisation and derivatives?

Somewhat surprisingly, securitisation and transferring risk via credit derivatives is not the ultimate reason for the stresses in the global financial system we have seen. If this were the key issue, then capital markets would have effectively absorbed and distributed the losses, and the financial system would have moved forward. Instead, blame needs to be squarely placed at the large, complex financial institutions (lcfis) – the universal banks, investment banks, insurance companies, and, in rare cases, even hedge funds – that are ‘systemic’ and today dominate the financial industry.

The central fault lies in the fact that the lcfis ignored their own business model of securitisation and chose not to transfer the credit risk to other investors.

The whole purpose of securitisation is to lay risks off the economic balance-sheet of financial institutions. But the way securitisation was achieved, especially during 2003-2007, was more for the purpose of arbitraging regulation than for sharing risks with the financial markets. The reason why banks face regulatory capital requirements is that they have incentives to take on excessive risks given their high leverage. Capital requirements ensure that (1) banks find it costly to take on risks; and (2) when they get hit by a shock, there is enough of a capital buffer-zone to protect them. But that‘s not what happened.

To get around the capital rules, banks created a ‘shadow banking sector’ of special-purpose investment vehicles and conduits funded by asset-backed commercial paper that was guaranteed, often fully, by the sponsoring banks themselves through liquidity and credit enhancements. These structures were basically ‘banks without capital.’ Designing things this way allowed banks to transform on-balance sheet loans and assets into off-balance sheet contingent liabilities, and thereby exploit loopholes in regulators’ requirements right under their noses. Measures of risk published by the banks barely moved, even as their institutions exploded with liquidity and leverage. This lack of risk transfer – the leverage ‘game’ that banks played – is the ultimate reason for collapse of the financial system.

Compensating bankers and the responsibility of regulators

It is important to acknowledge that in the period leading up to the crisis, bankers and insurers increasingly paid themselves in the form of short-term cash bonuses based on volume and marked-to-market profits, rather than on long-term profitability of positions created. There was neither any discounting for liquidity risk of asset-backed securities, nor any proper assessment of true skills of their key ‘profit’-centres. All of this helped make regulatory arbitrage the primary business of the financial sector.

The regulators were supposed to vigilantly prevent this from happening. Instead, they were the dogs that didn’t bark in the night. The regulatory architecture and the political pressures they operated under cannot escape blame. In fact, its cracks made the system vulnerable to bankers’ errors and short-term incentives in the first place. In a world without regulation, shareholders and creditors of financial institutions (depositors, uninsured bondholders and others) would put a stop to excesses of risk and leverage by charging materially higher costs of funding. Instead, lack of proper pricing of deposit insurance and too-big-to-fail guarantees of ‘systemic’ institutions have distorted incentives in the financial system. For years, regulation – capital requirement in particular – has targeted individual bank risk, when in fact the justification for its existence resides primarily in managing ‘systemic’ risk. It was to be expected that financial institutions would maximise returns from the explicit and implicit guarantees by taking excessive aggregate risks – unless, that is, these were priced properly by regulators, which they were not.

Back to basics in financial regulation

Current financial regulation is seriously flawed precisely because it focuses on the financial institution’s individual risk as opposed to its systemic risk. Where should the regulators start to fix the system?

“The challenge of redesigning the regulatory overlay to make the global financial system more robust must be met without crippling its ability to innovate and spur economic growth.”

The integration of global financial markets has certainly delivered large welfare gains through improvements in static and dynamic efficiency – the allocation of real resources and the rate of economic growth. These achievements have however come at the cost of increased systemic fragility, evidenced by the ongoing crisis. The challenge of redesigning the regulatory overlay to make the global financial system more robust must be met without crippling its ability to innovate and spur economic growth.

Four changes seem paramount, each addressing either regulatory arbitrage or the externality imposed by actions of individual institutions on systemic stability. In the recent title, ‘Restoring Financial Stability: How to Repair a Failed System’1, my co-authors and I argue that the future regulation should:

  1. Reflect that financial institutions have become large and complex, governing them from the outside has become almost impossible; their high performance groups have bargained for increasingly short-term compensation that has led to excessive leverage- and risk-taking. It is therefore important to change the incentives of traders and key profit centres at large financial institutions with bonus-malus reserve accounts, which penalise employees whose actions trade current profit for future losses. This would essentially bring ‘clawbacks’ into the compensation system.

  2. Prevent obvious regulatory arbitrage (privatising, for example, the financial investments of government-sponsored enterprises) and charge for guarantees – deposit insurance, too big to fail, loan guarantees and the bailout – using marking-to-market that reflects leverage and risk in a continual manner.

  3. Recognise the systemic risk exposure associated with large, complex financial institutions. Then it is important to quantify the systemic risk associated with these institutions and ‘tax’ it through higher capital requirements or deposit insurance fees in proportion to each firm’s contribution to systemic risk rather than individual risk. This is hard to do, but current financial regulations do not even claim to address this central problem. The need for such systemic risk regulation, possibly by augmenting central bank agendas, is only underscored by the growing size of the few remaining players in the financial arena.

  4. Enforce greater transparency of OTC derivatives positions and off-balance-sheet transactions, employing centralised clearing for standardised products and, at a minimum, centralised registries for customised ones so that counterparty risk can be assessed.

Repairing a failed systemSome say these regulatory changes will inevitably inhibit financial innovation. But this gets the whole issue wrong. The goal is not to have the most advanced financial system, but a financial system that is reasonably advanced but robust. That’s no different from what we seek in other areas of human activity. We don’t use the most advanced aircraft to move millions of people around the world. We use reasonably advanced aircraft whose designs are proven reliable and robust. The same is the case with ethical drugs - although we are now in a golden age of biomedical research, our goal is to have only extensively tested products widely used in the market.

Moving forward

“There are many cracks in the financial system, some of which we now know about, others no doubt will be discovered down the road.”

There are many cracks in the financial system, some of which we now know about, others no doubt will be discovered down the road. The eighteen white papers contained in ‘Restoring Financial Stability: How to Repair a Failed System’ describe a relevant issue at hand and corresponding regulatory proposals. A common theme is that fixing all the cracks in the system will shore up the financial house, but at great cost. Instead, by fixing a few major ones, the foundation can be stabilised, the financial structure rebuilt, and innovation and markets can once again flourish.

See also