CHAPTER 6. Comments on “Redesigning the Contours of the Future Financial System”

Il SaKong, and Olivier Blanchard
Published Date:
July 2010
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Philip Lowe

“Redesigning the Contours of the Future Financial System” does a particularly nice job in summarizing:

  • what went wrong;
  • the potential changes to regulatory arrangements; and
  • how financial systems are likely to evolve over the years ahead.

I don’t plan to go over this material in detail, but instead I would like to make a few general observations.

If there is a central theme to these observations, it is that we need to take the time to get the details of new regulatory arrangements right, and there needs to be scope for different countries to tailor solutions to their specific circumstances, but to do so within a globally agreed framework.

There are many reasons why things went wrong. But, at least in my view, most of these have their roots in the underestimation of risk during the boom. The paper states it very nicely, that “financial institutions were excessively optimistic about asset prices and risk.” This underestimation of risk is, of course, not something that is new, and it will surely happen again. All financial cycles have their origins in people thinking that favorable cyclical developments represent some form of favorable structural change. What is different this time is the damage that this error did to the world economy.

This underestimation of risk was a global phenomenon, reaching almost every corner of the world. But importantly, the impact on financial systems was not uniform across the world. So while it has become common to talk of the global financial crisis, this is really a misnomer. It has not been a crisis in all financial systems. Rather, it has been a crisis in the financial systems of many of the advanced economies of the North Atlantic. And this crisis arose out of the decisions by a relatively small number, perhaps 40 to 50, of large, internationally active banks. Particularly problematic were these banks’ purchases of structured credit instruments in off-balance-sheet vehicles financed by short-term debt.

In contrast, we did not see a crisis in the financial systems in Asia, in Australia, or in a number of other countries. And in most of these cases, banks have continued to effectively intermediate between borrowers and savers.

These differences suggest that care needs to be taken in fashioning a global regulatory response. Some global tightening of standards is clearly appropriate. And equally importantly, so too is a review of supervisory practices, which the paper could give more attention to. But as we do this work, we need to ensure that responses to deal with problems in one part of the global system are right for the parts where there were fewer problems. If we do not do this, some countries may end up incurring costs to address problems in other countries’ financial systems. This would seem to be inappropriate.

Some of these potential costs were discussed in the paper, and the most important of these is the possibility of slower economic growth. A tightening of regulatory requirements on capital, liquidity, and the amount of maturity transformation that banks can do will increase the spread between what depositors’ receive on their funds and what lenders pay for their funds. Or put slightly differently, society will pay more for financial intermediation. One possible effect of this is that it will lead to a lower level of investment, and thus ultimately a lower capital stock, and thus lower GDP per person.

Now even if this is the case, our societies may be prepared to pay this cost, especially if the benefit is durable stability—as Kodres and Narain put it, we may be prepared to move down the risk-return frontier. But it is not obvious to me that the financial systems in every country are currently a long way from where they should be on this frontier. Some financial systems clearly were in the wrong place and that needs to be corrected, but for other systems, the picture is less clear cut.

For a number of countries, it is plausible to argue that a move to a significantly different place on the risk-return frontier would probably not improve economic welfare. That does not mean that improvements are not required. But it does mean that financial regulation in these countries does not need to be completely rethought. Going forward, as we frame new rules and supervisory approaches, we need to do so in a globally coordinated way, but one that recognizes that the starting point differs across countries. This means that flexibility in the application of a globally agreed framework needs to be part of the solution.

A second general issue that I would like to touch on is how policymakers deal with episodes in which risk appears to be underestimated—as I said before, I see this is at the heart of the current problems. As was noted in the paper, part of the answer here is macroprudential supervision and, in particular, the possibility of moving prudential instruments—including capital ratios—in a countercyclical fashion.

In principle, this is an excellent idea—if risk is building up, then supervisory requirements should be tightened. It is difficult to disagree with this. But realistically, I also see it as being difficult to implement effectively, at least in many financial systems. This means that we need to be careful in not overpromising what can be achieved here by regulatory policy alone.

One of the main difficulties lies in the political economy of discretionary countercyclical policy. What we are asking supervisors to do is to tighten up when things are going very well and where they assess that aggregate risk is rising, but where private investors either do not see this risk or are happy to accept it. I know that they should be prepared to do this if they think the market has got it wrong, but I wonder whether they will be able to follow through when it comes to the crunch.

If history is any guide, the forces against them are likely to be strong indeed. After all, in the last boom, there were many central banks writing in their Financial Stability Reviews that risk was being underpriced, that the overall level of risk was rising, and that leverage was building up in difficult-to-measure places. Despite this, these warnings were largely ignored and, in many cases, did not lead to a material policy response by central banks and regulators. Perhaps in the next boom things will be different, but history suggests caution!

This political economy problem is one reason why some have argued that there should be a form of Taylor-like rule that forces supervisors to act. In my view, the possibility of reaching any type of international consensus on how this rule might work is remote, and even if a consensus could be reached I am not sure it is a good idea.

Unfortunately, assessing financial system risk remains more art than science. It is possible that this may change over time, but progress to date on measurement has been slow. Part of the difficulty is that financial system risk is multidimensional. There are no fixed formulae. It depends on the complex interaction between credit growth, asset prices, the pace of innovation in the financial system, and the competitive environment. This measurement problem poses a major roadblock to developing a rule. And even for monetary policy, where the objective is clearer and can be directly measured, people have rightly avoided rules. The same is likely to be true here.

So where does this leave us? Inevitably, good countercyclical policy requires good judgment and significant courage. The lessons from the recent experience should at least assist in the development of a set of “traffic lights” that assist supervisors in making the necessary judgements. When these traffic lights turn orange, they should lead the supervisors to ask more questions and increase the intensity of their supervision. Here, it is as much about the supervisory practices as it is about the rules.

But we should also be thinking about prudential requirements that, de facto, become more binding in the good times, even without discrete adjustments by the supervisors. One example of this might be a limit, say 90 percent, on the proportion of a dwelling that can be secured by a mortgage. In normal times, when lenders are reasonably careful, such a restriction is not likely to be that binding. But in a boom it might be expected to bite more severely, given the apparent preparedness of lenders to lift loan-to-valuation ratios when confidence is high and asset prices are rising. There may be other ideas along these lines.

The third issue is the future shape of the financial system. “Redesigning the Contours of the Future Financial System” asks a whole series of questions about the size and shape of tomorrow’s financial systems. Most of these are too hard for me to answer. So, I just want to make one general observation drawn from the experience in Australia, which I suspect is not atypical.

That observation is that if one set of financial institutions is too tightly regulated, another set of institutions inevitably springs up to intermediate between those who have the money and those who want the money.

The only way to stop this is very heavy regulation of all financial intermediation. In our own case, we went through this in the 1970s, implementing ever tighter financial regulation to catch the institutions developing at the fringe, for it was these institutions that were causing the problems. In the end, we didn’t like where this took us, with distortions and inefficiencies popping up all over the place. So we got to the point that the only sensible course was to change direction and to liberalize.

I want to make it clear that this does not mean that a tightening of regulation is not appropriate—it clearly is. The recent experience has been so terrible in a number of countries that significant change is needed. But we must be careful, and there is a balance to be struck. Money is very fluid, especially in a boom, and there is always a fringe. Clamping down too hard on the center of the system risks pushing the intermediation somewhere else, and as we found out in the 1970s, we did not like the consequences of that either.

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