It’s the System, Stupid

The future of financial regulation has, sadly, become a political issue – liberals have generally piled in behind lots more red tape and conservatives have largely buried their head in the sand. So a recent article by the uber-liberal New York Times columnist Paul Krugman was a refreshing departure from the norm for its trenchant rejection of two liberal shibboleths – too big to fail and bring back Glass-Steagall.

We believe that the U.S. banking sector is too concentrated, but that is on anti-trust grounds, not because of concerns about too big to fail. There’s no reason to believe that breaking up the banks into smaller units will make the system itself any safer. “Lehman wasn’t all that big,” is Krugman’s timely reminder that we had a crisis across the whole financial system, not the collapse of one or two behemoths that pulled the other banks into the abyss. The real problem is not that a financial institution becomes too big to fail, but that is is too systemically important to fail – size may be less important, as Stan Fisher, the governor of the Central Bank of Israel puts it, than being “too connected to fail”.

The second liberal orthodoxy, endorsed by former Fed Chairman Paul Volcker, is that separating retail banking from investment banking will create a firewall to protect the boring everyday business of taking savings and making loans from the hazards created by the risk-taking banks. This separation was enshrined in the Glass-Steagall Act of the 1930s, as a direct response to the financial contagion that led to the Great Depression. Yet even then, as we discuss in The Road From Ruin, there was little evidence that ‘universal’ banks that combined boring and risky banking were the cause of the problem. Nor is there any evidence this time round – Bear Stearns and Lehman were solely investment banks. Moreover, AIG wasn’t a bank at all. And that’s the problem – in thinking about financial risk, you cannot ignore the so-called “shadow banking system”.

We have been here before. A century ago, banking customers could choose to put their money into banks, which enjoyed a system of mutual support to stop depositors’ losing their money, or into less regulated banking trusts, which had no such protection. Given the choice between boring banks that offered lower returns and risky trust banks offering higher returns (the trusts could, for example, play the stock market), enough customers put returns above safety that when the trusts started to topple in the financial crisis of 1907 they nearly brought down the whole system. In the end, the financial system of a hundred years ago was saved by a private-sector bailout led by the great J.P. Morgan.

Times may have changed but the lesson is clear – if enough risk builds up across the system then the distinction between boring and risky banking is meaningless. Government will then have a choice between bailing everyone out, or letting the whole system collapse – and, given the consequences of the latter, the bailout becomes the only responsible option.

With these two pillars of the liberal house of financial safety gone, what’s left? Here Krugman’s typical decisiveness deserts him. Limits on leverage get his lukewarm endorsement – “an obvious necessity – but I am worried about how easily they can be enforced” So too, restrictions on financial innovation, which ”determined bankers could evade”. And that’s about it.

Krugman is reluctantly falling in line with two more oft-heard simple solutions to the problem of systemic risk. Clearly excess leverage was a problem, so to some, including Alan Greenspan, the answer is getting banks to leverage less by increasing capital requirements. The problem here is that there is no magic number. Before the crisis the allowable ratio of capital to borrowing was 8% – banks thought this was too high (banks make money by using as little capital as possible) so they came up with clever ways round the rules, such as securitization. So bumping the capital adequacy limits up to 12%, 15%, or 20% will incentivise more evasion. Maybe you can try to stop that using Krugman’s second weapon, restrictions on financial innovation, but, as he admits, this will probably fail as the innovation and the money flows into less-restricted parts of the financial system.

These conclusions are not surprising – all too often throughout history governments have tried to deal with the symptoms of the last financial crisis and, in so doing, sown the seeds of the next, as we describe in The Road From Ruin. What we need is new thinking that deals with the real causes of the crisis.

We think that the solution has got to come through managing systemic risk better. Part of the problem was that financial institutions were simply driving blind, unaware from the predictions of their internal risk models about the risks that were building up across the whole system. It is nowhere near as sexy as slapping new rules on what banks do but effective regulation means helping the sharing and aggregating of this information so that the financial system can manage this risk better. Once the bubble burst, the chaotic collapse of Lehman and others infected the rest of the system, so the second plank of our reform package would be to get banks to maintain ‘living wills’ to reduce the distruption when they fail (an idea that is being discussed as part of the reform bill in Congress) and to get banks to issue contingent capital to avert some of the need for government bailouts.

Neither of these solutions has the bold smack of saws like ‘if a bank’s too big to fail, it’s too big’ but the question in hand is the America’s future prosperity, not who should win ‘America’s got Talent’. Nor is financial regulation alone the whole solution. Corporate governance urgently needs refrom – if all the incentives from shareholders are for managers to maximise short term profit is it any surprise that all the banks securitized and leveraged to the same ridiculously profitable levels? Financial literacy and consumer protection are crucial too (as, indeed, another Krugman article amply illustrates).

Kudos to Professor Krugman for stepping out of the trenches of liberal orthodoxy. Is it too much to hope that leading conservatives and Wall Street will follow suit and make this a more constructive debate?