“Ten years of procrastination” Andrew Cornford

“Ten years of procrastination”, Talk at the session, Ten years after the crisis, where are we ?, of  the second symposium of the Association to Renew Research and Education in Economics and Finance (AREF), 25 -26 June 2019, University of Fribourg (Switzerland)

The beginning of the Global Financial Crisis (GFC) is usually identified with the increased attention in 2007 to widespread mortgage defaulting in the US. Serious delinquencies on subprime mortgages had begun in 2006. The end of a long boom in house prices accentuated the problems due the rise in delinquencies. Early hopes that the disruption could be contained were disappointed.

The dangers of a more general collapse of the housing market were underestimated. These dangers were due to links to the larger US financial system and to financial systems abroad. At the heart of the US financial system were securitised mortgages and derivative securities constructed from them. These formed important parts of the balance sheets of banks and other financial institutions, and the liabilities of these institutions became an important investment for foreign (principally European) banks. Containing the resulting vulnerabilities was a task principally for the US Fed whose provision of funding extended to foreign banks as well as to domestic institutions since the exposure of the former far exceeded the capacity of European central banks to provide crisis financing.

The policies adopted in response to the GFC had to address the danger of financial collapse and the downturns in economic activity triggered by it. The threat to macroeconomies was met with stimulus measures. The scale and character of both sets of measures varied among countries, reflecting both differences in national contexts and in ideas concerning appropriate macroeconomic policies.

Regarding the latter the initial responses of China and the US were very large, while those of European countries were smaller and in the much discussed cases of the financing of Greece and to a lesser extent of other so-called peripheral countries of the EU were part of macroeconomic and financial restructuring programmes which contained – often painful – terms and conditions regarding both living standards and privatisation. Reliance on programmes involving substantial reliance on fiscal policy were – except in China – gradually replaced by increasing reliance on monetary policy, in particular on low and eventually zero interest rates.

In what follows I shall concentrate principally on major features of the programmes of financial reform – in other words on the longer term policy and regulatory response – and the ideas with which they are associated. Concerning the increased reliance on monetary policy as the GFC drags on I shall have little to say. Several economists – perhaps particularly forcefully those of the Bank for International Settlements – have emphasised the distortionary impact of an extended period of low or zero interest rates. The investments financed during such a period are more likely to be in sectors such as finance and construction which make only a small contribution to productivity growth. Moreover cheap finance is often used for speculative investments and share buybacks.

In discussion of programmes of financial reform it is convenient to distinguish between those in the US and in other countries. The latter will be covered here by the reform programmes of the Basel bodies, the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS). The distinction is anomalous since the US is a member country of both the FSB and the BCBS, and the City of London is now a major international banking centre with a substantially larger number of foreign financial institutions than New York. But despite this anomalousness, more than is the case of other countries with a substantial involvement in cross-border financial activities the reform process in the US responds to its own national priorities.

The principal focus of United States reforms was the perceived need for the restoration of the financial system’s stability. This largely overrode public concerns fuelled by the belief that the financial sector itself was the main source of the crisis which had left fragile institutions and infrastructure in its wake. The results were reforms which avoided radical options like nationalisation or the break-up of large banks. High levels of compensation for bankers were left in place. Despite the shortfalls in the performance of the principal bank regulators prior to the GFC their responsibilities were preserved as agents for much of the implementation of post-crisis reforms. This left the effectiveness of these reforms vulnerable to too cosy a relationship between the regulators and the institutions they continued to regulate.

Much of the United States reform agenda was set out in the Wall Street Reform and Consumer Protection Act, usually referred to as Dodd-Frank. This lengthy piece of legislation has been described as embodying “a compendium of crisis diagnoses” as well as some longstanding proposals for reform of the country’s banking system. Most importantly for the objective of preventing further financial crises it prescribed more transparent market-based trading of derivatives; greater responsibility for institutions carrying out securitisations through minimum mandatory financial participation (“skin in the game”); increased regulatory authority for the restriction and management of bailouts; authority to cap banks’ growth into still larger institutions; and restrictions on commercial banks’ participation in proprietary trading (the Volcker rule).

After the passage of Dodd-Frank there was a need for the formulation of 398 new rules for the financial sector. Three years after Dodd-Frank became law only 155 of these rules had been finalized.

The approach to reform embodied in Dodd-Frank has been criticised for its piecemeal character. Attention here includes the still inadequate accounting for the relation of particular banking risks to financial infrastructure and macroeconomic conditions, i.e. their macroprudential dimension. For example, liquidity risk is due not only to a bank’s balance-sheet mismatches between assets and liabilities and to the saleability (or lack of it) of its assets but also to conditions in financial markets which can alter risks as they change. Such criticisms point towards the need for a more fundamental integration of the concept “macroprudential” into regulation than that of Dodd-Frank.

Like Dodd-Frank the regulatory agenda of the Basel bodies was conditioned not only by shortcomings highlighted by the GFC but also by the continuation of longstanding reform initiatives.

Central to the reshaping of regulatory regimes was the strengthening of standards for banks’ leverage, in other words institutions’ exposures to risk in relation to protective layers of capital. The development of international capital standards for this purpose dates back to the 1980s. The task was entrusted to the BCBS. The main outcome of the BCBS’s work has been successive editions of the Basel capital framework, which have gone by the official titles of Basel I, Basel II, and Basel III. These have been parallelled by corresponding directives and regulations of the European Union.

The Basel capital framework initially addressed primarily credit risk. However, owing to developments in the financial markets and in banking operations there was an extension of its scope from 1996 onwards – firstly to market risk and then to operational and liquidity risk.

The first edition of the Basel capital framework was originally designed for internationally active banks. However, by the second half of the 1990s it had become a global standard and had been incorporated into the prudential regimes of more than 100 countries.

The current version, Basel III, consists of three Pillars. Pillar 1 prescribes minimum regulatory capital requirements. Pillars 2 and 3 concern supervisory review of capital adequacy and the achievement of discipline in banks’ risk management through disclosure to investors.

Both the coverage and the definitions of the different subjects of the Basel capital framework have been extended and made more precise during the period of the revisions leading to Basel III. While the result comprises gains in comprehensiveness, the price has been an increase in complexity and in the burden imposed on regulators and supervisors regarding implementation of the rules.

Unlike earlier editions, Basel III specifies rules (the Liquidity Coverage Ratio and the Net Stable Funding Ratio) responding to the long recognised observation that banks’ fragility is frequently first manifested in the illiquidity of its funding capable meeting short-term withdrawals and in the insufficiency of its longer-term funding required to match its assets, off-balance sheet exposures and other commitments.

Where do these reform agendas leave us ? Today I can only briefly make some observations on what seem to me to be some of their major shortcomings – shortcomings likely to be all too evident in a future financial crisis.

1. Several academics, Sheila Bair, and some national regulators like Neil Kashkari and Tom Hoenig of the US have argued forcefully for higher capital requirements (which, inter alia, would be more in line with historical experience) than those in the Basel capital framework.
2. The issue of international capital movements and their control – or its absence – is largely ignored in the regulatory reform initiatives despite its importance in any agenda covering macroprudential issues.
3. More attention needs to be given to the issue of size and concentration in banking sectors, an issue now at last becoming increasingly topical beyond the banking sector. Here several matters are pertinent such as monopoly pricing power, the incentive to greater risk taking by institutions too big to be allowed by governments to fail; and the powerful contribution large banks are capable of making to political lobbying and the coverage of financial issues in the press.
4. Banks’ structure and corporate governance are subjects closely linked to their size. There have been steps in some European countries towards structural reform, in particular through separation of banks’ retail from their other activities. In the United Kingdom this has led to the ring-fencing of retail banking from investment banking and related activities. Elsewhere in Europe the resistance of the banking lobby seems to have stymied more widespread radical steps on this front.
5. Ethics and staff conduct in banks have figured prominently in reform agendas. Without good standards here the relations of financial institutions to other parties will lack the partly invisible mortar essential to the confidence in the absence of which finance can become dysfunctional. The principal response so far to the widespread ethical lapses of the GFC has consisted of tighter rules for staff remuneration.

An alternative approach could have been a re-examination of access to limited liability as part of structural reform of banks. Revisions to the legal framework might involve the separation of units carrying out exclusively the functions of investment and merchant banks such as advice, transaction services, position taking and trading in financial and commodity markets. These units could become partnerships, long a common legal form among investment banks but one widely abandoned in Wall Street from the 1980s onwards. The partnership would achieve a better alignment of interests between institutions and their top management and other employees.

6. Much attention has recently been given to the issuance of short-term liabilities outside the regulated and insured banking system – so called shadow banking. The FSB has launched a work programme to strengthen the oversight of shadow banking but there are not yet internationally agreed policy measures to bring it under greater control. Various possibilities have been raised here: the institutions involved could be brought within the regulatory perimeter with restrictions on their permitted activities and the imposition of reserve requirements; alternatively the issuance of money could require a government license.

What I have mentioned are just some of the more widely discussed shortcomings of current reforms of regulatory agendas for banks. Others which might be considered at least as or more important include the following: inadequate reforms of the rules for banks’ exposures to structured finance (securitizations, complex derivatives, etc.); the continuing inappropriate attribution of zero risk weights to banks’ exposures to sovereigns; and the absence of a capital charge for interest-rate risk in the banking book.

In completion of this brief review of the reform agenda, I should like to emphasise two issues: firstly, the dependence of both finance and too much of the reform agenda on the mechanistic models currently still dominant in the academic discipline of financial economics; and, secondly, the largely top-down character of financial regulation. I shall not spend time on the first issue since it will inevitably be the subject of other more complete interventions at this symposium.

So my concluding observations today will concern shortcomings of the emphasis on top-down regulation in the literature of financial economics. This emphasis accompanies insufficient attention to implementation issues under the headings of both risk control and supervision. Risk control in banks with several layers of management – and this includes the great majority of large diversified banks – is often ineffective because of the way in which information is filtered up through management at different levels. Despite nods to the vital role of good supervision in the stability and functionality of the financial sector its prerequisites are an underappreciated part of the culture of finance. More attention to implementation issues under the headings of risk control and supervision may not be susceptible to inclusion in elegant conceptualisation. However, it would bring financial economics closer to the reality of its subject-matter.