In case readers haven’t figured it out, I am a big Willem Buiter fan. Even when he is wrong, he is at least forthright and colorful. He does have an appetite for showing off his formidable intellect. Nevertheless, his best qualities are his willingness to take on orthodoxies and authorities, and his vivid, trenchant style. It was Buiter who at the last Jackson Hole conference accused the Fed of “cognitive regulatory capture,” eliciting a firestorm of criticism.
Today Buiter takes up one of my favorite causes: the need to leash and collar bankers. He dismisses the canard so often trotted out in the US, that too many restraints might inhibit financial innovation. Paul Volcker deemed the most important financial innovation in the last 30 years to be the ATM machine. Nassim Nicolas Taleb has dismissed the supposed advantages conferred by the development of the Black-Scholes option pricing model.
Given the considerable costs
gambling innovation hath wrought, the calls to shackle bankers seem completely warranted. If any other class had done this much damage, they’d almost certainly be in jail.
Note the timing of this post. This is pre the G-20, where the Euro crowd is pushing for more financial regulation, particularly with new international mechanisms, while the US is arguing for more coordinated fiscal stimulus. The US does not want to (and won’t as long as the dollar holds as reserve currency) cede control over its institutions. But a good deal more “harmonisation” and coordination is in order.
Buiter provides a long list of reform ideas. I’ve extracted the ones I found most interesting, and I encourage readers to look at the full roster. Be sure to read his comments on self regulation.
Financial regulation is a now-or-never proposition as the sector’s lobbying power is greatly diminished. This column argues that we should embrace robust regulation now, risking over-regulation. Correcting mistakes later would be better than risking another era of “self-” or “soft-touch” regulation.
It is necessary, for political economy reasons, to rush new comprehensive regulation of the financial sector. While it would be better, holding constant the likelihood of the measures being adopted and implemented, not to act in haste, there is now a unique window of opportunity – a period of extraordinary politics, in the words of Balcerowicz – to actually get the thorough regulatory reform we need. The reason is that the private financial sector is on its uppers – down and out – and will not be able to put together much of a fight, let alone its usual boom-time massive lobbying effort to veto radical measures. It is better to over-regulate now and subsequently correct the mistakes than to risk another era of self-regulation and soft-touch under-regulation of financial markets, instruments and institutions.
The objective of macro-prudential regulation is systemic financial stability. This has a number of dimensions:
Preventing or mitigating asset market and credit booms, bubbles and busts
Preventing or mitigating market illiquidity in systemically important markets
Preventing or mitigating funding illiquidity for systemically important financial institutions
Preventing or managing insolvencies of systemically important financial institutions
Other micro-prudential considerations (abuse of monopoly power; consumer protection; micro-manifestations of asymmetric information) should be left to the micro-prudential regulator(s).
Regulation will have to be comprehensive across instruments, institutions, markets and countries. Specifically, we must:
egulate all systemically important highly leveraged financial enterprises, whatever they call themselves: commercial bank, investment bank, universal bank, hedge fund, SIV, CDO, private equity fund or bicycle repair shop.
Regulate all markets for systemically important financial instruments.
Regulate all systemically important financial infrastructure or plumbing: payment, clearing, settlement systems, mechanisms and platforms, and the associated provision of custodial services.
Do it all on a cross-border basis.
Self-regulation is to regulation as self-importance is to importance. The notion that markets, including financial markets could be self-regulating, by properly incentivising CEOs and Boards of Directors and through market-discipline, is prima facie suspect. We decide to regulate markets because of market failure. Then we let the market regulate the market. This is an invisible hand too far. The concept of self-regulation is especially ludicrous for financial markets. Finance is trade in promises expressed in units of abstract purchasing power (money). It scales up and down ferociously quickly. If Airbus or Boeing wishes to double the size of its operations, it takes 4 or 5 years to put in place another set of assembly lines. If a bank wishes to scale its balance sheet and operations ten-fold, all it has to do is to add a zero in the right places. Given enough optimism, trust, confidence and self-confidence, financial activity can, through leverage, be scaled up alarmingly quickly. Once optimism, trust, confidence and self-confidence disappear and are replaced by pessimism, mistrust, lack of confidence and fear/panic, the scaling down of bank activities can occur even faster. Such an industry cannot be left to its own devices.
The importance of public information
Regulation can only take place on the basis of independently verifiable (public) information. Regulators cannot rely on information that is private to the regulated entity. This means that the capital adequacy of the first pillar of Basel II has to be overhauled radically, as its risk-weighting of assets relies in part on internal bank models that are private to the banks…
Regulation financial innovation
Financial innovation in products and institutions is potentially beneficial and potentially harmful. There is a need to regulate financial innovation. I propose the model used in the US by the Food and Drug Administration for pharmaceutical and medical products.
First, there is a positive list of financial instruments and institutions. Anything that is not explicitly allowed is forbidden.
To get a new instrument or new institution approved, there will have to be testing, scrutiny by regulators, supervisors, academic specialists and other interested parties, and pilot projects. It is possible that, once a new instrument or institution has been approved, it is only available ‘with a prescription’. For instance, only professional counterparties rather than the general public could be permitted…..
Clearly, this approach to financial innovation would slow down financial innovation. It may even kill off certain innovations that would have been socially useful. So be it. The dangers of unbridled financial innovation are too manifest.
Yves here. The FDA has recently come under a lot of criticism (deservedly) but that is due in large measure to a lack of commitment to its mandate from deregulation-minded Administrations, budget cuts, and its conflicted position (40%+ of its budget comes from fees paid by the industry for new drug applications, an arrangement created during the Bush Senior presidency. Too high a turndown rate would deter applications. The problems with the FDA are due to a significant degree to nearly 20 years of efforts to undermine its role. And that is not my just my view; I’ve heard this sort of thing from FDA lawyers and former FDA commissioners). Back to Buiter:
Narrow banking vs. investment banking
The distinction between public utility banking/narrow banking vs. investment banking; (the rest) has to be re-introduced. I advocate a form of Glass-Steagall on steroids, with a heavily regulated and closely supervised narrow banking sector, engaged in commercial banking (taking deposits and making loans) and benefiting from lender of last resort and market maker of last resort support. The investment bank sector will also be regulated and supervised, but more lightly, and according to the same principles as other systemically important highly leveraged non-narrow bank institutions.
Universal banking has few if any efficiency advantages and many disadvantages. Economies of scale and scope in banking are soon exhausted. They tend to be fat to fail, have a lack of focus, and suffer from span-of-control negative synergies etc. Universal banks or financial supermarkets use their size to exploit market power and try to shelter their risky, non-narrow banking activities under the LLR and MMLR umbrella of the narrow bank that’s hiding somewhere inside the universal bank….
Mixed public-private ownership
Given the manifest failure of the efficient market hypothesis, it is not at all obvious that systemically important financial institutions should be allowed to be listed companies. Financial institutions’ stock market valuations have been notorious will-o’-the wisps and have, through stock options and other stock-market valuation-related executive remuneration components, contributed to the excessive risk taking during the recent boom. Partnerships, mutual ownership, cooperative ownership, and various forms of public and mixed public-private ownership may be more appropriate for financial institutions. Perhaps we should even consider removing limited liability for investment banks!