How much is enough, Gordon? When does it all end, huh? How many yachts can you water-ski behind? How much is enough, huh? – It’s not a question of enough, pal. It’s a zero sum game, somebody wins, somebody loses. Money itself isn’t lost or made, it’s simply transferred from one perception to another. – Gordon Gecko, Wall Street (1987)
As the Obama administration and the Department of the Treasury publish their plan for Financial Regulatory Reform amid concerns about the political situation in Iran, there is a risk that the crucial reform of the financial sector will be overlooked by the media and, for this reason, the public.
It is crucial that we not overlook this reform. The current economic crisis is the worst the United States and the world have experienced since the Great Depression, and if we can agree on one thing, it is that the financial sector needs to be reformed. The crisis’ was epicenter was the financial crisis that took place in the United States in 2007-2008. As a direct result of the damage caused by the financial sector, US national debt rose from 40% of GDP to somewhere between 70% and 80% of GDP .
These astounding reflect a systemic malfunctioning in the world financial system. Why did the crisis have such a massive impact on the real economy? And what can we do to avoid a repeat of this crisis? Before we answer this question, we need to take a step back and look at the recent evolution of the international financial system. The international financial system has undergone deep transformations in the past four decades. In the 1960s, most banking activity was national, as currencies and customers were based at home. By the 1980s, in contrast, much of banks’ profits came from their international activity.
Today, it surprises no one that French banks have branches in Brazil, London-based American banks accept deposits denominated in Swiss francs from Asian corporations, and lend Chinese yuan to European manufacturers. In addition, nonbank financial institutions such as hedge funds play a much more important role in international trading than they used to.
This evolution and the crisis that followed it beg three basic but fundamentally important questions: What is the financial system made up of? What is its role? Why did the financial sector fail to fulfill its role in recent years, and what can public policy do to ensure that the financial system fulfills its role in the future? Given the financial system’s crucial role in shaping economic development, it is extremely important that we come up with clear answers to these questions.
Indeed, with the right policies, we can rebuild a financial system that helps promote sound economic growth – that is, growth based not on artificial wealth inflation (as typified by the recent US housing bubble) but on productive investment, innovation, and technological progress. In other words, our answers should help us lay the foundations for a socially desirable financial system.
1. What is the financial system made up of?
The financial system is made up of four key actors: commercial banks, non-bank financial institutions (e.g., hedge funds, insurance companies, and other institutional investors, such as pension funds), central banks and other government institutions (central banks, ministries of finance), and corporations. It is thus made up of borrowers (corporations who need to finance investments and capital outlays) and lenders. At the international level, international financial institutions include the International Monetary Fund (IMF) and the World Bank.
2. What is the financial system’s role?
The IMF acts as a lender of last resort for countries in financial distress. The World Bank provides funding and loans to developing countries who cannot obtain sufficient loans in the private sector. The financial system is divided into two markets: the capital market and the credit market. The capital market is itself subdivided into equity markets (such as stock markets, which allow corporations to issue stocks in order to finance their investments, what is called “external finance,” and derivatives markets), private venture capital funds, and foreign exchange markets. The credit market is subdivided into corporate debt markets and, more importantly, government debt markets. It is important to note that neither the capital nor the credit market is a unified market, but rather a set of closely interconnected markets. While the American recession of 2001 was ignited by a stock market crash, the current crisis emerged in the credit market.
Just to have an idea of the orders of magnitude: - the US GDP is about $14 trillion; - the world GDP is about $54 trillion; - the size of the world credit market is $25 trillion; - the size of the world stock market is $37 trillion; - the size of the world derivatives markets is nearly $790 trillion, or 11 times world GDP Credit markets are important because they determine interest rates. In turn, interest rate play an important microeconomic and macroeconomic role: they shape saving and consumption decisions by invividuals and households, they affect the level of business investment, and they have an impact on the exchange rate, which in turn affects exports and imports.
Stock markets have two major functions: they allow corporations to finance their activities without incurring debt, and they allow households to plan for retirement by investing in stocks.
The financial system as a whole has several functions:
- channeling money from those who are willing to lend and are looking for a way to invest their money in order to get a positive return on it to those who want to borrow
- financing government expenditures, by floating government bonds (as Martin Wolf points out, during the Napoleonic Wars Britain’s well-developed credit market gave it a decisive advantage against continental autocracies that lacked these credit markets)
- facilitating the merger of corporations through the combined capital of a large number of people - allows small outsiders to start their own company, thereby limiting incumbents’ ability to dominate a market and spurring intra-industry innovation
- smoothing consumption decisions by allowing people to make consumption decisions according to both their current and expected income and allows people to purchase insurance
- diversifying risk
3. Why did the financial sector fail to fulfill its role in recent years, and what can public policy do to ensure that the financial system fulfills its role in the future?
Two threats are inherent to any financial system: positive bubbles (euphoria), and negative bubbles (panics). These are due to the vagaries of human nature and to the pervasiveness of herd behavior, which, combined with problems of asymmetrical information and moral hazard, increase the likelihood of financial crises. Past crises shed light on the mechanisms that lead to these socially disastrous results – privatized gains, socialized losses.
According to Martin Wolf, “governments should not provide open-ended guarantees to private risk taking. They should insist on transparency. They should preclude related party lending by institutions to which they provide deposit or liquidity insurance. They should ensure that the management and shareholders or failed institutions bear heavy losses.” Flawed government regulation causes moral hazard and allows banks to privatize gains and socialize losses. Excessive risk taking by large financial institutions such as commercial banks and nonbank financial institutions results in huge losses.
Martin Wolf argues that poor public policy, combining lack of fiscal and monetary discipline, increases the risk of systemic panic. These facts clearly point to the necessity for carefully-crafted public regulation of the financial system. What can and should be done to prevent the financial system from taking excessive risk, and therefore to make global finance work for us not only as consumers, but as citizens? In other words, how can we ensure that the financial system provides services that are socially desirable? As Martin Wolf notes, “The U.S. financial system rests on a sophisticated institutional base. It also—and perhaps more importantly—rests on the social behavior and values that sustain those institutions.”
He could have added that these social behaviors can lead to crises through interaction of imperfect information (inherent to any market, and especially financial markets) and herd behavior, or what Yale behavioral economist Robert Schiller calls “irrational exuberance.”
Desirable reforms include, but are not limited to, the following items:
- increased supervision of financial companies: increased capital requirements
- increased supervision of financial instruments: quality control for derivatives to ensure that they are neither too risky nor too difficult to price, as the case currently with so-called toxic assets
- identifying, monitoring and imposing restrictions on the activities of firms (banks, non-bank financial institutions, etc.) that pose a threat to the stability of the financial system
- limiting the maximum legal size of banks to avoid the “too big to fail” issue
- ensuring that all government agencies are well-informed and work together to identify systemic risks and craft appropriate regulatory responses or market-based interventions
- requiring non-bank financial institutions to comply with the same requirements as banks, in order to increase the financial system’s transparency
- requiring that non-bank financial institutions that do not comply with this regulation not be eligible for federal bail-out funds, in order to elimiate (or at least reduce) risks of moral hazard
- significantly increasing the supervision of credit rating agencies
- creating of a regulatory agency charged with approving securities, in order to prevent overly complex and potentially risky securities to emerge and be traded
- drastically increasing in the budget and programs devoted to basic financial education, in order to protect consumers at large from predatory financial practices
- increasing and improving the coordination of national regulatory policies and supervision practicies at the international level in order to avoid institutional arbitrage and the ability of financial operatives to “game” governments
A related issue, which is also at the heart of the current crisis, is the existence of global imbalances that significantly increase the instability of the international financial system, and therefore make crises both more frequent and deeper than they would otherwise be. We will return to this in a later post. In the meantime, a roundtable on international financial regulation coordination organized by The Economist offers some important insights.
