Re: Beware the crisis around the corner

Dear Mr. Crook,

Thanks for the article in today's Financial Times.

Your approach on rejecting categorically 'the restoration of Glass-Steagall act' and 'too big to fail' concept reminds me of the blind men and elephant story - from Indian fables - http://en.wikipedia.org/wiki/Blind_men_and_an_elephant

The real issue of the implementation can only be resolved when the issue of political funding is sorted. The real conflict of interest arises when the politicians who are elected to make decisions for the welfare of all are funded not by tax-payers money by the wall-street and other big businesses. Unless, this issue is tackled, you will see that even a dynamic elected leader like Barack Obama is nothing more than a 'domesticated representative of the vested interests'

Regards,

Pradeep Kabra

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Beware the crisis around the corner
By Clive Crook
Published: January 3 2010 19:36 | Last updated: January 3 2010 19:36

The US economy is sickly, but the mood of impending doom has lifted. The response of US and other authorities to the emergency is unfinished business and needs continuing attention – but in 2010, if the crisis continues to ease, the danger is that politicians will relax and minds will wander from the need for new financial rules.

The next model of US financial regulation is unclear. The House of Representatives has passed a bill concentrating on regulatory structure: that is, on which regulators are responsible for what. What the Senate will do is anybody’s guess. Important as the regulatory organisation chart may be, however, it is not the key thing. The rules regulators apply are what matter.

The need for better rules is greater now than before the crisis. Critics of the US government say its response has made another financial collapse more likely – and they have a point. They worry about institutions that are too big to fail. The authorities encouraged consolidation as a way to restore short-term stability, but at what cost in the longer term? Attacking this concentration, critics say, is crucial.

One way to do this, they argue, is to restore the Glass-Steagall separation of commercial and investment banking. Create a heavily regulated, safe, utility-like system of deposit-taking banks and fence it off from the more lightly regulated casino of the securities markets. You would get institutions that are both smaller and more conservatively run.

It sounds plausible, but the debate over a new Glass-Steagall is unhelpful. The degree of interest in the idea is puzzling. After all, the financial collapse did not show that universal banks are more hazardous than separated commercial and investment banks. If anything, it showed the opposite.

Investment banks such as Bear Stearns and Lehman Brothers were thought to pose big systemic risks even though they were not deposit-takers. Moreover, the commercial banks that failed did so mainly through losses in traditional banking. So far as dealing in securities was concerned, the repeal of Glass-Steagall actually made little difference: the law permitted most of the securities transactions that commercial banks were undertaking when the crisis hit. Forget Glass-Steagall.

“Too big to fail”, on the other hand, is no distraction. It matters, and the reason why is familiar. A financial institution thought, or explicitly deemed by the authorities, to be too big to fail has a licence to take excessive risks. The problem is moral hazard. The implicit government guarantee will make its managers less cautious, and its creditors too. The burden of prudential oversight falls entirely on regulators, one they cannot hope to carry alone.

All this is correct – but it is not the whole, or even the larger part, of the problem. Remember that the US authorities, acting out of concern over moral hazard, let Lehman fail. In a way, they were right. It was not too big to fail: its collapse did not imperil the payments system and its counterparties did not fold. Yet praise for that principled decision was less than universal. Many argued, and continue to argue, that it was the worst mistake of the whole saga. The authorities are unlikely to forget this when another institution – which, regardless of its size, might be “too interconnected to fail” – looks ready to topple. And everybody knows it.

The precondition for big financial busts is always the same: unwarranted optimism. When everybody gets it into his head that inflation is tamed, interest rates will stay low, asset prices will keep rising and economic growth will never stop, overborrowing is sure to follow. In other words, moral hazard is only one factor reducing perceived risk. In a prolonged upswing, investors feel safe regardless – not because a bail-out will protect them from losses, but because they expect no losses.

Also, in that kind of climate people will tend to make the same mistakes. Many small banks making bad bets on property may be safer than a system with a few big ones doing the same thing – but only a little. The first small bank to fail might cause a crisis of confidence that would bring down others, and then the rest. After 2007-09, what government is going to risk finding out?

So judge the new rules by one criterion above all. In the words of a former Fed chairman, William McChesney Martin, do they take away the punch bowl before the party gets going?

Interest rates that take into account asset prices as well as general inflation are part of this, of course. But when it comes to financial regulation, the key thing is rules that recognise the credit cycle, and change as it proceeds. Most important, as argued by Charles Goodhart in these pages, capital and liquidity requirements should be time-varying and strongly anti-cyclical. In good times, when lending is expanding quickly and financial institutions’ concerns about capital and liquidity are at their least, the requirements should tighten. Under current rules, they do the opposite.

Fixing financial regulation is a hugely complex task, and the details matter. But no repair – whether it concentrates on ending “too big to fail”, on separating commercial and investment banking, or you name it – is going to succeed unless this simple principle is adopted. Financial institutions will oppose the idea, because it amounts to a tax on their growth. Of the many battles that one might fight in this area, this is one that simply has to be won.

clive.crook@gmail.com