paper/research/report/essay
Making Sense of the GFC: Where did it
Come from and what do we do Now?
Ian Harper^1 and Mike Thomas^1
The collapse of the global financial system following the events of September
2008 was unprecedented in its global reach and the response elicited from gov-
ernments. The Global Financial Crisis has called into question the basic assump-
tion of Efficient Markets Theory that traded financial instruments will always
have a market price indicating that capital markets as well as depository insti-
tutions can suffer liquidity crises or runs due to asymmetric information. This
paper traces the causes and implications of the GFC, focusing especially on the
Australian financial system and its regulation. Attention is drawn to the need
to review financial sector regulation in light of the GFC in order to rebalance
the mix between competition and regulation in financial markets. But the
paper also notes the danger of over-regulation with its potential to stifle inno-
vation and constrain the risk-allocation function of financial markets.
Keywords: asymmetric information, banking, financial markets, financial
regulation, global financial crisis.
1. Repeating History?
The timely appearance of historian Niall FergusonsAscent of Money(2008) is a helpful reminder that financial crises are nothing new. In a similar vein, Charles KindlebergersManias, Panics and Crashes(1978) was required reading for an earlier generation of economists on the cusp of financial deregulation in the 1980s.^2 An even earlier generation might recall Charles MackaysExtraordinary Public Delusions and the Madness of Crowds(1852). Financial markets are prone to waves of senti- ment irrational exuberance which unleash herd behaviour, driving market prices and trading volumes away from rational fundamentals. At one level, the Global Financial Crisis (GFC) is just the latest in a series of bubble events scattered through the history of financial markets. We are witnessing the rapid deflation of an asset-price bubble that took a decade and a half to inflate. As asset prices collapse in the face of widespread de-leveraging, credit markets seize up and banks stop lending. This merely transmits the contagion to the real economy where businesses struggle to raise working capital and suffer sharply declining sales volumes as households rush to repair their balance sheets cutting consumption, increasing saving and repaying debt.
(^1) Access Economics Pty Ltd. (^2) Soon after joining the Reserve Bank of Australia (RBA) in 1983, Harper was presented with a copy of Kindlebergers book and advised to acquaint himself with how common financial crises were and what little impact regulatory authorities like the RBA seemed to have on preventing their recurrence! JEL classification: G Correspondence: Ian Harper, Director, Access Economics, Level 27, 150 Lonsdale Street, Melbourne, VIC 3000, Australia. Email: Ian.Harper@accesseconomics.com.au ECONOMIC PAPERS, VOL. 28, NO. 3, SEPTEMBER, 2009, 196
196
2009 The Economic Society of Australia
doi: 10.1111/j.1759-3441.2009.00033.x
The Great Depression following the stock market collapse of 1929 is the episode most commonly identified as a parallel to current events. In Australias case a closer match is the Depression of the 1890s. This too was preceded by an asset-price bubble the great boom in land prices of the 1880s^3 which was in turn fuelled by a boom in commodity prices, predominantly wool. Land was the primary security held by banks against their lending to farms, businesses and households. As land prices plummeted, banks foreclosed on loans, triggering further declines in asset prices as borrowers scrambled to repay debt. Soon banks found they were insolvent or suspected of being insolvent which sparked devastating bank runs by depositors frantic to retrieve their savings. Bank runs finished what the land bust left undone; half of Australias banks suspended payment or failed outright during the worst of the crisis in 18931895. One key difference between the two Depressions and the current Great Recession is the avail- ability and use of macroeconomic stabilisation policy, that is, fiscal and monetary policy. Although there is still debate over whether US President Franklin RooseveltsNew Dealwith its emphasis on public works shortened or lengthened recovery from the Great Depression, there is consensus that the US Federal Reserves refusal to ease credit conditions exacerbated the depth of the downturn.^4 Active and coordinated use of expansionary fiscal and monetary policy distinguishes official responses to the current crisis from historical experience. But it remains true that we have no experience of a crisis of the apparent depth and extent of the GFC where stabilisation policy was extensively deployed. There is no history to guide our expectations in this regard. At least two other features distinguish the GFC from earlier episodes of equivalent magnitude. The first is the backdrop of the emergence of China and India as world economic powers. Together these countries account for around one-third of humanity; the world has never experienced economic transformation from subsistence agriculture to manufacturing (in the case of China) and services (in the case of India) on such a scale. Nor has the time frame been so compressed. The Industrial Revolution in Europe took more than a century to deliver increases in per-capita income which have emerged in China in just thirty years. The rapid growth in China together with a high saving rate and a managed exchange rate produced enormous current account surpluses which in turn fuelled capital inflow and domestic leverage in the developed West, most especially in the United States. The so-called savings glut lowered real interest rates around the world which encouraged borrowing and risk-taking by investors keen to improve their yields above historically low risk-free rates of return.
2. An Unfolding Theoretical Revolution
At the same time that imbalances were emerging between rates of economic growth in the develop- ing East and those of the developed West, a revolution in the theory of financial markets was unfolding. Modern finance theory dates from the publication of Harry Markowitzs doctoral thesis, The Theory of Portfolio Selection, in the early 1950s. By the 1970s significant advances had been made, especially in the area of information efficiency drawing on the work of Fama (1970) and his research on the Efficient Markets Hypothesis. This path-breaking work in finance theory coincided with a resurgence of interest in the properties of competitive markets more generally and a growing disaffection with government intervention. Scholars associated with the University of Chicago, both the Universitys Department of Economics and its Graduate School of Business, were immensely influential in both domains. They forged theoretical links between standard theorems in economics, establishing the welfare-enhancing properties of competitive markets for goods and services, and the characteristics of competitive, information-efficient markets for financial assets. They pioneered the Theory of Public Choice which cast doubt on established notions of government intervention in the workings of the market. These ideas underpinned a wave of deregulation in the late 1970s and into the 1980s, nowhere more thorough or complete than in financial markets.
(^3) For a review of the lead-up to the Depression of the 1890s, see Michael CannonsThe Land Boomers(1966). (^4) The classic exposition is Milton Friedman and Anna J. Schwartzs,A Monetary History of the United States 18671960(1963).
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Fama continued to explore the ramifications of his theory for our understanding of the role and function of financial intermediaries. It had been understood since the publication of seminal work by Arrow and Debreu (1954) that markets for contingent claims which were complete and charac- terised by perfect information left no room for intermediaries of any kind. In short, economic agents trading on their own account in what amount to insurance markets, in which all risks are insurable, can arrange their consumption optimally both over time and across different states of the world to maximise their utility. The apparent robustness of Famas notions of information efficiency in com- petitive financial markets led him to speculate (Fama, 1980) that banks and other balance-sheet financial intermediaries ought to be seen as no different in essence from portfolio managers or mutual funds, passively aggregating assets and issuing claims that add nothing to the properties of the underlying assets. Moreover, if banks are essentially no different from other portfolio managers, they ought not to be regulated in any way differently from other portfolio managers. This conclusion flew in the face of established practice if not the theory of financial intermedia- tion. In practice, banks had been regulated very differently from other parts of the financial system for decades, primarily on account of the history of regular and occasionally devastating bank runs in countries around the world. To suggest that banking should be deregulated and placed on a par with portfolio management was confronting to established authorities. Indeed, there was a back- lash as scholars of banking began to articulate more formally the reasons behind their traditional assumptions that banks and other financial intermediaries were essentially different from general traders in financial claims.^5 Traditional notions that banks transform the maturity and liquidity of financial claims, that is, that they are not passive holders of securities but actually manufacture new claims where none existed before, were translated into terms that modern finance theorists could recognise as more than just institutionalist arm-waving. An especially important develop- ment in this regard was a renewed emphasis on the asymmetry of information in financial markets and the related notion of market incompleteness. Asserting that financial intermediaries serve no purpose in a world of symmetric and complete information is correct as far as it goes but not espe- cially informative. Recognising asymmetry of information and incompleteness of financial markets not only restored a role for financial intermediaries but helped to explain why they might behave pathologically from time to time and possibly require some form of public intervention to ensure their stability, if not their efficiency.
3. Changing Direction in Public Policy
Australian public policy towards financial institutions and markets was heavily influenced by these developments with the publication of the Australian Financial System Inquiry (Campbell) Report in 1981. The Campbell Report (1981) recommended far-reaching deregulation of the Australian financial system, including removal of interest rate and lending controls on banks, freeing entry to the Australian banking system by domestic and foreign contenders and floating the Australian dollar. Greater scope for competition was seen as a spur to efficiency and innovation in the financial system. The potential impact on stability was not ignored, however, with the report recommending an overhaul of prudential regulation to undergird new freedoms with capital controls and regulatory supervision. Recommendations of the Campbell Report were substantially implemented by the Hawke-Keating Government during the mid-1980s. With the election of the Howard-Costello Government in 1996, the opportunity arose to review more than a decade of experience of financial deregulation. The Financial System (Wallis) Inquiry (1997) was established to assess whether the reforms of the 1980s had delivered the gains envis- aged at the time and whether these gains had been achieved at any cost to the stability of the financial system. The Inquiry was also asked to recommend changes to the configuration of Australias financial regulatory framework in the light of experience and with an eye to likely future developments in financial systems both in Australia and overseas. The Wallis Report (1997)
(^5) See Franklin Allens Presidential Address to the American Finance AssociationDo Financial Institutions Matter?(2001) for a survey of relevant literature.
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concluded that Australias experience of financial deregulation had been positive, that gains in efficiency and innovation had been forthcoming as anticipated and that episodes of instability, although not absent, had been well managed. The Wallis Report made a series of recommendations concerning Australias institutional frame- work for financial regulation which reflected its interpretation of the forces for change then bear- ing on financial institutions and markets and in the light of the prevailing intellectual climate. These built on the notion that financial markets would play an increasingly important role within financial systems over time at the expense of traditional financial intermediaries. Behind this conclusion lay the observation thatsecuritization the conversion of non-traded financial claims (e.g. mortgages) into marketable securities through bundling and credit enhancement was rapidly gaining acceptance as a means of accessing capital markets directly rather than indirectly via traditional financial intermediaries. This in turn was linked to steady reductions in the extent and severity of information asymmetry flowing from the ubiquitous rise of information and commu- nications technology (ICT). Information was becoming cheaper to access and analyse, giving participants in financial markets greater confidence in their dealings with one another. This was nowhere more evident than in the waning dependence of large corporates on commer- cial banks and the increasing ease with which they accessed capital markets directly, albeit with the assistance of investment banks. But even borrowing by individuals and households, while initiated through banks and other traditional financial intermediaries, was increasingly securitized into capital markets via special purpose vehicles (SPVs). Mortgages, car loans, personal loans and consumer credit were, one by one, moved off the balance sheets of traditional intermediaries into SPVs, securitized and sold to capital market investors keen to improve their investment yield above rates available on bank-intermediated claims like deposits and bank-accepted bills of exchange. Not only was this migration towards financial markets an observed fact, it was consistent with the predictions of Efficient Markets Theory and, ultimately, ArrowDebreu Contingent Claims theory. As information asymmetry declined in importance, balance-sheet intermediation, with its reliance on a thick margin of capital of absorb risks, would become too expensive relative to the alternative of direct (non-intermediated) finance between issuers and purchasers of securities. As financial markets became more information-efficient, they would come to dominate balance-sheet intermediation because they facilitated borrowing and lending at lower cost given the substantial savings in capital. Perhaps ironically, banks themselves spearheaded the rush to securities markets, driven partly by a desire to establish beachheads in the new financial territories and partly to economise on capital. The profitability of banking was increasingly dependent upon initiating and securitizing loans rather than holding them to maturity on balance sheets; for the same capital out- lay, a bank could generate more revenue by speeding up its balance sheet through loan origina- tion and securitization than it could through traditional lending. Moreover, the emerging dominance of markets was to be welcomed as it represented a gain in the economic efficiency of intertemporal exchange. Capital could be freed from the balance sheets of financial intermediaries and allocated to more productive uses elsewhere in the economy. Banks and other financial intermediaries like life insurance companies found themselves with excess capi- tal and under pressure from share markets to repay capital to shareholders; or find ways to gener- ate higher returns to justify the retention of more capital than was strictly needed to perform their functions. Hence, the 1990s and early 2000s were characterised by numerous mergers among financial institutions, some of them on a grand scale (e.g. the merger of Citibank with Salomon Smith Barney and Travellers Insurance to form CitiGroup), as markets sought to rationalise the allocation of capital to intermediaries whose technology had essentially been revolutionised or so it was thought at the time. It was against this background that the Wallis Report recommended a reconfiguration of Austra- lias financial regulatory arrangements. To begin, the Report recommended that prudential super- vision of financial intermediaries be moved from the RBA, Australias central bank, to a newly established, stand-alone integrated regulator. The chief rationale for this recommendation was to
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align Australias regulatory framework with the anticipated consolidation of balance-sheet inter- mediaries across sectoral lines, that is, banks merging with insurers and non-bank depositories. The RBA had only ever supervised banks; insurance companies and non-bank depositories were regu- lated by separate regulators, some of them State-based rather than Federal agencies. Furthermore, there was a view that the RBA would approach the supervision of insurance companies as if they were banks given its history and experience. Notwithstanding the perils of creating a new regulator by combining elements of existing regulators, the Wallis Report nevertheless plumped for inte- grated regulation as consonant with likely future developments in the Australian and international financial systems. The new regulator, the Australian Prudential Regulation Authority as it was to become, would undertake prudential regulation and supervision of traditional balance-sheet intermediaries, namely, banks, insurers and non-bank depositories. The idea was to bring within the purview of one authority intermediaries whoseraison detrewould gradually erode as the mooted transition from intermediaries to markets unfolded. Such a transition might not be smooth but it would affect all balance-sheet intermediaries alike. Integrated regulation could help to ensure that the transition occurred at an appropriate pace and in the least disruptive fashion to the stability of the overall financial system. A second and concomitant recommendation was to strengthen the role of market regulation. Unlike intermediaries, financial markets did not require prudential regulation; indeed, the absence of capital-backing and the need for minimum capital standards lay at the heart of the anticipated efficiency gain from the use of markets rather than intermediaries. If they required any at all, capital markets needed regulation only to enforce market conduct and disclosure, not prudential standards. Although the Wallis Report imbibed the force of the Efficient Markets Theory to the extent of accepting a gradual transition from financial intermediaries to capital markets, there was no wholesale acceptance of the efficiency (let alone stability) ofunregulatedfinancial markets. Nevertheless, the regulatory philosophy underpinning the Wallis Report (see especially chapter 5) accepted that financial intermediaries rather than financial markets required more intensive regulation. This not only reflected the history of instability sparked by periodic crises centred on financial intermediaries but the clear implication of Efficient Markets Theory that financial markets can be relied upon to deliver more efficient if not necessarily more stable outcomes.
4. What went Wrong?
The chief lesson of the GFC to date is that capital markets can suffer the equivalent of a run on the banking system. The notion that markets are swept by waves of sentiment from time to time is not new; nor is the observation that asset prices overshoot their fundamental values as asset-price bubbles inflate and subsequently burst. The GFC is in fact the result of the bursting of a global asset-price bubble inflated by a glut of savings seeking higher yield through leverage. Central banks may even have abetted the bubbles formation by failing to tighten monetary policy early enough and long enough. One among many of the debates to ensue from the crisis will be the appropriate role of central banks and monetary policy in countering inflation of asset prices along- side that of goods and services prices. The truly startling dimension of the GFC is not that asset prices deflated suddenly as borrowers sought urgently to de-leverage their positions but that markets for certain assets simply ceased to operate, most notoriously markets for Collateralised Debt Obligations (CDOs) and Credit Default Swaps (CDSs). In both cases investors and the authorities struggled to determine aggregate exposures and the capacity of issuers to honour redemptions on a massive scale. Efficient Markets Theory contemplates asset prices moving to whatever level is needed to clear the market in the face of changing expectations of future cash flows. There will always be a market price, even if it gyrates wildly from day to day or minute to minute. But the complete disappearance of markets is an altogether different matter. So much of the modern approach to financial regulation, accounting and even executive remuneration assumes not only that market prices always exist but that they are efficient estimators of the true risk-adjusted value of expected future cash flows.
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Mark-to-market rules only make sense when the market price exists and bears some relation to the underlying value of a security. When markets closed, the very basis of assessing the solvency of entire institutions evaporated. Assumptions too about the liquidity of portfolios requiring little if any cash on account of the tra- dability of securities were proven utterly unfounded. Forcing institutions to mark to market when markets themselves were in such disarray was obviously foolish and regulators wisely suspended these requirements for an indefinite period. But the lesson had been learned: market prices are not the universal fixed point they had been assumed to be in the light of Efficient Markets Theory. The GFC has exposed market prices as far less reliable for the range of purposes to which they have been addressed than would have been credited even twelve months ago. Shaking the mark-to-market principle as the GFC has done is to rock the worlds financial house at its very foundations. Why did markets suddenly disappear? Buyers fled from sellers because they no longer trusted what the sellers were telling them about the securities they were trying to sell. Furthermore, buy- ers had no way of corroborating for themselves the claims being made by sellers. In short, asym- metric information struck capital markets with a vengeance and the normal exchange of securities ground to a halt. So severe was the collapse of confidence that even banks, institutions intimately familiar with information asymmetry, refused to accept claims on each other. Central banks have been obliged to intermediate between banks at the core of national financial systems because they would not trust each other. So deep has been the crisis of confidence in the creditworthiness of even the most creditworthy borrowers that national governments have been forced to guarantee claims issued by top-rating borrowers within their jurisdictions, including banks as well as subsi- diary levels of government. The closure of capital markets is the equivalent of banks suspending payment in the face of a run. In both cases holders of claims are left with securities that cannot be exchanged for cash. Starved of cash, businesses and households face the prospect of imminent bankruptcy unless drastic reductions in expenditure can be effected. What starts as a liquidity crisis rapidly escalates into a solvency crisis. Bitter historical experience of bank runs and their consequences for the real economy gave birth to modern central banking and prudential regulation of banks. The rise of cap- ital markets in tandem with Efficient Markets Theory convinced many observers that the world had moved on from such destructive financial pandemics, founded as they were in information asymmetry and hence uniquely affecting balance-sheet intermediaries. Capital markets, however, are founded on informationsymmetry, with regulatory intervention aimed at improving the sym- metry of information only at the margin through compulsory disclosure. The GFC demonstrates that capital markets can portray merely the illusion of information symmetry and that, once confi- dence has been shattered, tradable securities can be no more liquid than claims on a failed bank. Moreover, SPVs hailed as an innovation in information symmetry given their vaunted transpar- ency have proven to be no such thing. Securitization itself has been discredited as potential inves- tors reject asset-backed securities, including famously Residential-Mortgage-Backed Securities (RMBSs), on the grounds that they cannot be certain that such parcels of claims do not include toxic assets (non-performing sub-prime mortgages in the case of RMBSs). Yet the very process of securitizing claims against assets removed from the balance sheets of banks and other intermedi- aries was supposed to eliminate their opacity and hence to obviate the need for expensive capital to back them. Securitization was held out as a revolutionary technique precisely because it exploited the information symmetry in capital markets to by-pass balance sheets, economising on capital and avoiding prudential regulation into the bargain. But the story turns out to have a different ending. Information asymmetry is more pervasive than first thought and many of the SPVs held out to capital market investors as transparent have emerged as just as opaque as bank balance sheets. That they have not been regulated like bank balance sheets explains why the GFC is a repeat of history. Periodic irrational bank runs severely destabilise unregulated banking systems, to the point where inefficiencies introduced by bank regulation are judged worth the cost to secure greater systemic stability. It now appears that the
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same is true of capital markets. Even if episodes of instability are less frequent in capital markets on account of their inherent information advantage over intermediaries, the systemic instability induced by crises of confidence in markets appears no less lethal to economic activity than bank runs. It has taken more than a century to refine central banking and prudential regulation to reduce both the incidence and economic fall-out from bank runs. Even now the elaborate regimes of pru- dential regulation in force around the world are not flawless and may well have contributed to the growth of securitization. Another of the debates to emerge from the GFC will be how to re-design prudential regulation, especially capital controls on intermediaries, so as to avoid exacerbating the very problem such regulation is supposed to forestall. But a far bigger debate will be how to impose the equivalent of capital controls on markets and their various operators, including SPVs, investment banks and hedge funds. It has long been understood that banks can over-extend credit if the risks of doing so are not faced squarely by those who stand to benefit from excessive lending. Indeed, notwithstanding this knowledge, the GFC has exposed areas in which incentives for exces- sive risk-taking are still calibrated inappropriately, for example, the remuneration of financial mar- ket and bank executives. Finding ways to internalise systemic risks inherent in capital market arrangements in a cost-effective manner, that is, not throwing out the baby with the bathwater, will be a key challenge for policy-makers in the aftermath of the GFC.
5. What should we do Now?
There are three specific tasks for financial regulators going forward:
- strengthen the soundness and security of the financial system (both intermediaries and markets) to rebuild trust;
- develop and build in automatic stabilisers (if only to ease their own burden in times of stress); and
- find ways to reduce uncertainty (which inevitably stampedes the herd).
In the current episode, Australian regulators and financial institutions appear to have fared at least as well as their peers abroad while operating a system that is extensively influenced by global developments. Experience of strife in the banking sector in the early 1990s and the collapse of HIH, which was Australias second largest insurer at the time, in 1998 may have served us well, both in avoiding the worst outcomes and managing through the GFC to date. Successive Austra- lian Governments have also left regulators to get on with their job and resisted overt interference, something that cannot be said of jurisdictions elsewhere in the world. Reforming the system post- GFC should allow significant discretion to the regulators whose knowledge and expertise gained through the crisis should temper the regulatory response and obviate the need for intervention on a Draconian scale. There may be no panacea for what ails the global financial system but a number of promising tonics for specific maladies have been proposed by the relevant authorities. These include recom- mendations emanating from the UK Financial Services Authority, the G20, the International Monetary Fund (IMF) and the Basel Committee on Banking Supervision based at the Bank for International Settlements.^6 There is an understandable emphasis in these statements on coordi- nated implementation given the need to discourage regulatory arbitrage and to allow an accurate assessment of worldwide systemic risks. Reconciling the wishes of pro-market and pro-regulation forces on either side of the Atlantic (even with a more receptive ear in the White House) as well as the emerging powers in Asia may prove challenging.
(^6) The following links contain references to relevant official statements: http://www.bis.org/review/r090330a.pdf; http://www.bis.org/review/r090217e.pdf; http://www.bis.org/review/r090313a.pdf; http://www.bis.org/review/ r090319a.pdf; http://www.g20.org/Documents/g20_wg1_010409.pdf; http://www.g20.org/Documents/Fin_Deps_ Fin_Reg_Annex_020409_-_1615_final.pdf; http://www.fsa.gov.uk/pages/Library/Corporate/turner/index.shtml; http://www.imf.org/external/pubs/ft/gfsr/2009/01/index.htm.
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Turners Review (2009) advocates harsh medicine: increasing the minimum quality and quantity of capital in the global banking system to levels significantly above existing Basel requirements, especially against trading book activities and introducing a maximum gross leverage ratio to pre- vent excessive growth in the absolute size of balance sheets. Increasing capital requirements is likely to reduce the number of bank failures and the frequency of government bail-outs of institu- tions deemed too big to fail. However, even well-capitalised banks including the major Australian banks have struggled to obtain adequate funds at times during the crisis. When liquidity in the wholesale capital markets dries up, no level of capital may be adequate to ward off potential insolvency. The problem of illiquid markets is perhaps the most resonant feature of the current crisis. The complete disappearance of buyers (including even arbitrageurs, hedgers and speculators) from major financial markets, especially over-the-counter markets for derivatives, reinforces disaffection with Efficient Markets Theory and the appeal of Behavioural Finance Theory championed by Rich- ard Thaler, Daniel Kahneman, Robert Schiller and others. In the behaviourist world, markets are subject to waves of irrational exuberance and despondency, failing from time to time at enormous social cost and creating a role for activist public policy. Implications for finance education and policy- making are potentially far-reaching. The unanticipated extension of central banks traditional role of lender-of-last-resort to market-maker-of-last-resort during the present crisis must be analysed and lessons drawn for the future. The same is true of government efforts to backstop stressed financial institutions, most notably in the United States: what are the longer-term implications of taxpayer-funded bail-outs on this scale? The thorny questions of which institutions and markets should be regulated and how to deal with institutions that are too big to fail must be addressed. The G20 Working Group wants to cast the regulatory net over all systematically important institutions, markets and instruments, including especially large complex financial institutions. There is a strong push to regulate many non-vanilla financial products, typically traded in OTC (over-the-counter derivative) markets and often complex in nature, including derivatives. The preferred option is to establish regulated clear- ing houses or create standardised versions of these products that can then be traded on regulated exchanges. Hedge funds and private equity houses, both heavily implicated in trading behaviour seen as fomenting the current crisis, are also squarely in regulators sights. The long-simmering debate about the appropriate target for monetary policy will inevitably heat up. The doctrine of pre-emption is difficult to effect in practice, not so much because bubbles are hard to identify or that the market is wiser than central bankers the NASDAQ bubble and the global house price bubble were both identified and analysed long before they burst but rather because modern structured finance can create virtually unlimited leverage almost regardless of central banks attempts to control the monetary base. Monetary policy alone is unlikely to prevent the formation of future asset-price bubbles, let alone prick them before they inflate to dangerous sizes. Although regulators ponder how to exert central bank influence over asset prices, there is clear consensus that capital buffers should be built up during the good times, when conditions are more conducive to bubbles forming, to provide sufficient reserves to absorb losses during periods of stress. Counter-cyclical capital regulation may do as much if not more than monetary policy to forestall the formation of bubbles by acting directly on the capacity of lenders to increase their leverage. Policies to improve transparency, reduce information asymmetry and restore trust in financial institutions and markets are clearly required. Investors may initiate a move away from complex and opaque financial products and doing business with complex and opaque institutions but regu- lators will also encourage them in this direction. There is a continuing role for simple, universally understood and reliable indicators of risk, such as credit ratings. The much-maligned agencies that rate financial products in return for a fee from the issuer have been exposed as suffering a conflict of interest. Cheaper than setting up a new arm of the bureaucracy to replace rating agencies is the option of issuers paying fees to the regulator instead, who then distributes them to the credit rating agencies. This removes any incentive for rating agencies to manipulate the truth and also enables
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authorities to ensure that ratings are derived according to appropriate standards. Another way to bolster the integrity of counterparties is to ensure that the seller retains some exposure to the underlying risks being sold. For example, European banks will be required to keep on their books a portion of the securitized products they originate. One of the biggest risks moving forward is over-reaction by regulators and politicians. Not unlike the markets themselves, regulators need to guard against extreme swings in sentiment on their part and that of their political masters. Proposals to limit a banks exposure to another bank may reduce the risk of financial contagion but so can effective monitoring of exposures to counterpar- ties, improved transparency and disclosure of off-balance-sheet exposures. Requirements for additional capital will compromise allocative efficiency and this cost needs to be taken into account when setting new requirements. Also, corporate boards have a responsibility to shareholders to ensure that capital reserves are adequate but not excessive. Sufficient flexibility must be retained to ensure that shareholders can expect to earn a reasonable return on their invested capital. Securitization and financial innovation have had their reputations severely tarnished by the closure of markets and massive write-downs incurred by those exposed to complex financial instruments. Yet CDOs opened the mortgage market to individuals and households who never would have qualified for a loan from their local bank. By going directly to capital markets for funds, mortgage brokers forced banks to be more competitive and broadened access to credit. Similarly, CDSs allowed buyers of corporate bonds to hedge against default by the issuing company. Measures to ensure that originators retain some exposure to underlying risks and possess sufficient capital to pay out on claims, as well as central clearing houses or exchanges to provide liquidity and transparency are to be commended. Beyond that, the market should be left to decide which products live or die. The GFC has re-emphasised the potential for competitive markets to deliver devastatingly costly episodes of instability. The history of financial regulation consists largely in balancing the wealth- enhancing properties of competitive markets against the wealth-destroying propensities of market instability. Financial innovation, deregulation and securitization have significantly improved access to finance by individuals, households and businesses around the world. This has in turn generated substantial increases in wealth. But a mixture of misdirected incentives, misconceived theory and inadequate regulation has brought an abrupt end to the good times. The challenge coming out of the GFC is not to sacrifice competitive financial markets on the altar of stability: there can be no return without risk. The root cause of the GFC is an imbalance between market competition and financial regulation. An appropriate response is to re-balance regulation and market competition, and not to over-react by replacing one set of extreme outcomes with another.
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