Daniel Daianu: Regulators and supervisors are supposed to learn

In Paulson's remarks of last Friday there is a statement, which deserves close attention. Thus he said: "We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system's stresses". And he referred to hundreds of billions, which are meant to cover rising mortgage-related losses. I am intrigued by this statement because these losses would not have contaminated the system so profoundly, inside and outside the US, unless transmission mechanism had not been at work so intensely. The media is nowadays replete with condemnations of greed, which, for many, would be quintessentially behind this financial crisis. Greed should always be blamed. But is greed only to be blamed for the whole mess? What about the flaws of the originate and distribute model, which has spread out risk ubiquitously and enhanced its systemic emergence - against the backdrop of global markets. What about the skewed pay schemes in the financial industry, which have stimulated reckless risk-taking at the expense of necessary prudence (not to mention the ethical dimension these schemes carry)? What about the nonchalance of rating agencies in assigning investment grade values to more than questionable derivatives (CDOs and CDS's)? What about conflicts of interest which plague the financial system? What about banks engaging in casino-type transactions on a massive scale? And not least, what about the "shadow" banking sector (including hedge funds and private equity funds), with its extreme leveraging and speculative operations, which is very lightly or not at all regulated? 

I have alluded to these features of the very core of world financial industry in previous articles. I highlight them again in order to underline a thesis: the root cause of this crisis is an inadequately and under-regulated financial system. By this I have in mind the effects of the 1999 Phil Gramm-Leach-Bliley Act, too. One should recall that this act triggered a further wave of deregulation in the financial industry, which brought about, inter alia, a plethora of fancy and poorly understood products in terms of the risks they carry. Toxic are not mortgages per se, but badly constructed securities, which are based on them as well as arteries that make financial markets opaque. Toxic have proved to be the packaging and repackaging of financial products with their increasingly unclear valuation and increasing non-tradability. Toxic are reward schemes that shape the decisions of managers and agents in markets and make their behaviour irresponsible when judged from a systemic perspective. Toxic are misleading quantitative models. Not addressing these and other problems would be totally wrong. In the housing industry originates the trigger but not the structural causes of this financial crisis. 

The argument that more, or new regulations would stifle financial innovation I find baffling. Because, as I hope it is clear to everybody by now, not every financial innovation is benign. The issue at stake is the lack of proper regulation and supervision. The enormous mistakes, which have been made by allowing finance to develop its own, highly risky, "raison d'tre", have to be undone.

A legitimate question arises. How does it come that we do not learn from previous episodes of crises? I recall again the warnings sent by Alexander Lamfalussy almost a decade ago, by Warren Buffett, Paul Volcker and others years ago. How does it come that stern warnings regarding a looming crisis have not been listened to attentively? At a recent conference in Nice, where I sat on the same panel with Nout Weelink, the governor of the Dutch central bank, he mentioned greed as a driving force behind people's propensity to forget and repeat behavioural patterns that are conducive to euphoria, excesses, over-indebtedness and finally, panic and crisis. A famous book on financial crises by the MIT professor Charles Kindleberger traces the same sequence of mindsets and behavioural patterns. I accept this explanation but not without qualification. A market economy involves cyclical movements and ups and downs. Entrepreneurial spirit lifts the economy, but together with the herd instinct can also bring it down by overshooting. This is indisputable and a reflection of the functioning of free markets. But modern economies do need regulations in order to be as civil as possible to their citizens, as they need public policies. As traffic needs rules and lights in order to protect people's lives the same can be said of regulations that try to limit collateral damage and enhance the production of public goods, restrict negative externalities, in a market economy. A lax monetary policy can lead to higher inflation and, ultimately, to a recession when its tightening takes a toll on the economy. But a lax monetary policy cannot, by its own, cause a meltdown of the financial system. This is the crux of the matter: structural features of the "new" financial system, including a breakdown of due diligence, have brought upon it the threat of total collapse.

Regulators and supervisors are supposed to think about the good of economy/society and not pursue peculiar interests. And they are supposed to learn! They may espouse ideological beliefs (be more free marketers, or more interventionists), for none of us is devoid of intellectual kinship. But, even so, they are supposed to learn and think in terms of what is good for society, have a good grasp of systemic risks. Vested interests can have a long arm and try to influence regulations and supervision (the mortgage industry pressed Congress heavily to roll back state rules aimed at stemming the rise of predatory tactics used to place homeowners in high-cost mortgages). But this has to be strongly resisted, by all means. There is something which regulators and supervisors should know: financial markets are, par excellence, volatile and prone to instability. Likewise, the efficient markets hypothesis is a fantasy. In the real world we need regulators and supervisors who have a good understanding of how financial markets do function, who do not succumb to market fundamentalism. They should never underestimate systemic risks and be always alert when it comes to financial stability.

I am not arguing that we can prevent strains and crises completely. But we can try to limit damage and for that to happen we need to learn from mistakes and build up better, more effective and comprehensive regulatory and supervisory set-ups.

 

PS. I wonder how much profit has been made by the US financial industry during the past decade, in excess of the previous decade, as compared to the cost of the bailouts underway.