22 June 2009

Reform of Financial Regulation or Reform Finance by Regulation

Regulating the finance industry is back in the headlines. Obama has made his pitch. The EU summit avioded an outright row on the subject and chancelor Darling is massaging down expectations of much change in Britain.
Regulating finance misses the point. Finance needs wholesale reform. Here are a few ideas:

The quack principle: if it quacks like a duck it's a duck. All ducks shoud be covered by the same regulations. The current crisis has its origins in the shadow banking sector. These are financial instruments which allowed investors a higher return than conventional banks could offer. Their competitive advantage was that they didn't have to bother with capital requirements or other prudential rules which impose a cost on banks. And when they collapsed there were none of the safeguards that the rules provide. So if it borrows short term to lend long term, it's a bank; make it follow the same rules.

Leaning against the cycle: provide credit more during the bad times and less during the good times. This idea goes all the way back to Keynes and it is why central banks lower interest rates during the bad times and raise them in the good times. In the good times any fool can make money and so the banks spent the first part of the naughties lending foolishly. In the bad times, banks call in their loans and companies go to the wall. Reform needs to reverse this behaviour. Keynes thought that if necessary finance should be brought under public ownership if that was the only way to make it counter the cycle.

Stop securitising bank assets: When banks bundle up parts of their loan books and sell them off as securities, they create a market that shouldn't exist. The banks know more about what the securities contain than any buyer. This is the classic "market for lemons" we learn in Economics 101. Before the crisis buyers looked to ratings agencies to rectify the information asymetry. It didn't work. The new idea is that banks should hold 5% of any security they issue to give them the incentive to be honest. Like that will work, as our American cousins say.

Control leverage: limit the amount that can be borrowed against an asset. This is like limiting a mortgage to 90% of the house price. Central banks should be able to limit the "loan to value ratio". This should have been one of the lessons of the 1929 crash, when people buying shares "on margin" created the instability that caused the crash. On margin meant the buyer paid 10% and borrowed the rest from the broker. When stocks fell in value the brokers asked for another 10% and if it wasn't available the stocks were sold. More sellers meant the price went down and a vicious spiral pushed the crisis over the edge. In the recent crisis all kinds of leverage were invented by hedge funds and private capital houses - with the same effect. Once prices fell the sellers were forced to pile in selleing more.

And so back to the bit about the ducks.

There are at least four ideas in this blog that deserve morespace. I will come back to these ideas.

No comments:

Post a Comment