Friday, April 18, 2008

Buiter on the failure of financial capitalism

(Naked Capitalism) We have the rare spectacle of Willem Buiter admitting he doesn't have an answer, but in fairness, he is looking at a throny problem.

Buiter considers the question of what to do about the financial sector once the crisis has passed. He provides a scathing assessment of the workings of financial capitalism, but is pessimistic that regulation can be effective. Highly paid traders will outsmart supervisors; regulators, out of prolonged contact with their charges, will be corrupted intellectually, identifying overmuch with the industy's world view; the minders will be inclined to one of two extremes, either to restrict bank activity unduly, or to go too far overboard in their salvage operations should anything bad happen.

There is a flaw in Buiter's reasoning, however: he assumes the status quo ante will return in the absence of government intervention. Enough pieces of critical infrastructure are hopelessly impaired that I doubt that will happen.

The biggest, and one that poses a major conundrum, is that private securitization has ground to a halt. It depended on credit enhancement, which is now suspect, and has also become scarce and costly. The monolines are no longer in that business; with bank balance sheets impaired, there are far fewer credit default swaps protection writers. Plus, given concerns about counterparty problems leading to more generalized failures in the CDS market, it's not clear how receptive investors would be to CDS as the means for providing credit enhancement.

Plus with so many investors burned directly or indirectly by supposed AAA paper that fell rapidly from grace, it may take a generation before memories fade and willingness to buy the product returns.

So in the US, we see Fannie and Freddie stepping into the credit enhancement breach, even though that will soon create problems of its own.

That is a long-winded way of saying that the industry is already losing important businesses that led to high profits, swagger, and outsized pay. Give it two more bonus cycles, with the attendant job cuts, and you'll see a humbler, easier to contain players.

The critical step seems to be to recognize that banks (both the investment bank type as well as traditional commercial banks) are wards of the state and to treat them accordingly. That in turn means not being hesitant to restrict the scope of their business. If you want to take risks, fine, go be a private partnership and don't expect any help if you screw up.

My short list (some of them cribbed or adapted from a proposal by Amar Bhide) of what to do would be:

1. Force as much OTC activity as has reasonable trading volume onto exchanges. That means at a minimum interest rate swaps, currency swaps, and credit default swaps. Yes, this will require standardization and some buyers will lose access to variants they might have liked. Too bad. Protecting the economy and the taxpayer is more important than indulging every investor's pet need.

This of course will also considerably lower the profitabilty of the industry. Again, too bad. They screwed up and cost the populace a ton of dough. There are consequences for mistakes of that magnitude. They should consider themselves lucky not to have been subject to public beheadings.

Lower profits for banks has positive consequences. It means less talent and other resources are sucked into the FIRE economy (and remember, the FI in that equation are at best service providers to the real economy, and worse, when they become too large, parasites).

2. Prohibit off balance sheet vehicles.

3. Prohibit Level 3 assets; allow only Level 1 and strictly defined and audited Level 2 assets. This means regulators will not have anything overly arcane to assess; they ought to be able to get a clear picture of risks, processes, and exposures if they are dogged.

4. Prohibit these regulated institutions from lending, providing other funding, or investing in concerns that have Level 3 assets.

Hedge funds would continue to be unregulated. I might also prohibit any unregulated entity from going public. Speculators playing with investors' money is tempting enough; having them have even less skin in the game via a public floatation makes it easier for them to get so large as to pose a danger. Yes, this can create problems of succession, but Wall Street dealt with it for a hundred years or so. These guys ought to be smart enough to figure it out.

I'd also have pretty draconian penalties for breaking the rules, the sort that can have individuals involved and their supervisors forfeit a lot of dough and go to jail.

Thus I'm not as pessimistic about the ability to leash and collar the industry, perhaps because I lived in it briefly when it was more heavily regulated and it functioned much better for society as a whole than it does now. And the bankers still made a very nice living, although nowhere near as egregious as the pay scales of late. The real constraint is political will, and I don't think things have gotten bad enough yet for the public to demand an end to rule by finance. But that attitude will change if real estate prices fall another 10%.

From Buiter:
The worst outcome of the current financial crisis would be a return to the status quo ante that produced the pathologies, anomalies and contradictions that are its root causes.

I believe that the Western model of financial capitalism - a convex combination of relationships-based financial capitalism and transactions-based financial capitalism - has, in its most recent manifestations (those developed since the great liberalisations of the 1980s), managed to enhance the worst features of these two ideal-types and to suppress the best. This period has been characterised by a steady increase in the relative dominance of the transactions-based financial capitalism model in the overall financial arrangements of the world, most spectacularly in the US, the UK, and such smaller countries like New Zealand and Iceland, somewhat less in most of continental Europe and elsewhere.

The key policy issues created by the recent excesses of the financial sector, once the immediate financial crisis has been euthanised, are those of governance and regulation. Governance issues include prominently the question of remuneration for top managers and superstars. I will not address this issue here. Regulation (and public ownership) inevitably become issues in all industries where widespread, systemically significant externalities, free rider problems and public goods features ensure that decentralised, competitive outcomes are inefficient. They are especially acute in the area of financial intermediation, because leverage permits the scaling up of financial activity to astronomical levels in no time at all. The damage that can be done by a rogue individual, a rogue firm or a rogue instrument is unparalleled among legal business activities.

Financial intermediation is playing with fire; there is no escape from this. Any economic activity undertaken for profit or power which has trust and information as its two key inputs is bound to be vulnerable to abuses, distortions, excesses and deception.

Effective financial intermediation is also a key and necessary feature of any economic system capable of delivering sustained increases in material well-being. If every economic agent were required to be financially self-sufficient, we’d all still be living in trees.

Getting ex-ante financial surpluses from economic agents whose planned saving exceeds their planned capital formation matched efficiently with the ex-ante financial deficits of economic agents whose planned capital formation exceeds their planned saving can, given time, increase the productive efficiency of an economy by orders of magnitude.

Transactions-based financial capitalism emphasizes arms-length relationships mediated through markets (preferably competitive ones), is strong on flexibility, encourages risk-trading, entry, exit and innovation. It is lousy at endogenous commitment: reputation and trust are not a natural by-product of arms-length relationships. Commitment requires external, third-party enforcement.

Relationships-based financial capitalism emphasizes long-term relationships and commitment. It has, however, compensating weaknesses. Investing time and other resources in building up relationships with customers creates an insider-outsider divide that is very difficult to overcome for new entrants. It also encourages, through the interlocking directorates of the CEOs and Chairmen (seldom women) of financial and non-financial corporations, a cosy coterie of old boys for whom competitive behaviour soon no longer comes naturally. At its worst, it becomes cronyism of the kind that was one of the key ingredients in the Asian crisis of 1997.

The financial system that during the first decade of this century ruled the roost in the US, the UK, increasingly in continental Europe and in its outposts in Australia, New Zealand, Iceland etc., combined many of the weaknesses of the transactions-based system (opportunism, myopia, lack of commitment), with the worst features of the transactions-based system - a dreadful clubbiness and homogeneity of outlook and perspective, and a ruthless closing of ranks when the sector as a whole was threatened with legislation or regulation. Let me just remind you of some of of the issues that prompted vigorous lobbying: the taxation of non-doms; taper relief under the UK capital gains tax for private equity magnates; tax havens; proposals for reporting obligations, transparency and audited accounts for highly leveraged financial entities above a certain size, regardless of their legal nature and regardless of what they call them selves; anti-cyclical capital adequacy requirements and liquidity requirements for highly leveraged entities.

It’s time to learn from these lessons and to act on what has been learnt. Acting now would not mean rushing into hasty if-it-moves-stop-it forms of regulation. We have had 20 years to think about this. It is clear where the problems are. In the past 20 yearns, the financial sector has, starting as a useful provider of intermediation services, grown like topsy to become an uncontrolled, and at times out-of-control, effectively unregulated, hydra-headed owner of licenses to print money for a small number of beneficiaries. The sources of much of these profits turned out to be either a succession of bubbles or Ponzi schemes, or the pricing of assets based on the belief that risk disappeared by trading it. This belief that there is a black hole in the middle of the financial universe that will attract, absorb and annihilate risk if the risk it packaged sufficiently attractive and sold a sufficient number of times is closely related to the firm conviction of every trader I have ever met, that he or she can systematically beat the market. The fact that all traders together are the market did not constrain these beliefs. General equilibrium and adding-up constraints are not the markets’ forte.

So is tighter regulation of the financial sector, and especially of highly leveraged entities above a certain size the answer? It would be part of the solution if we could find and keep the right regulators and design and implement the right regulations. Here, however, I hit a blind wall.

Quis custodiet ipsos custodienses?
Who polices the police or, more to the point, who regulates the regulators? No doubt they are formally accountable to some departmental minister or even to Parliament/Congress. But does that fill me with confidence their their actions will promote efficiency and fairness? No, it does not. If regulation is to be effective, it may have to be hands-on and quite intrusive, if only for the regulator to acquire the information (s)he requires to make an informed judgement.

Effective supervision runs into some rather impenetrable obstacles.
First, a $5 million dollar a year trader will run rings around a $150,000 a year regulator.

Second, regulators involved in intrusive and hands-on regulation are virtually guaranteed to be captured by the industry they are meant to be regulating and supervising. This regulatory capture need not take the form of unethical, corrupt or venal behaviour by the regulators or members of the private financial sector. It could instead be an example of what I have called cognitive regulatory capture, where the regulator absorbs the culture, norms, hopes, fears and world-view of those whom he regulates. We cannot just appoint ethical Vestal Virgins to be regulators, regulators who start out pure and stay pure despite their daily associations with people who don’t instinctively play by the rules of the House of the Vestals

Third, even if (1) and (2) don’t apply, regulators will serve their own parochial, personal and sectional interests as much as or even instead of the public good they are meant to serve. No bank regulator wants a bank to fail on his or her watch. As a result, either excessively conservative behaviour will be imposed by the regulator on the regulated bank or other financial intermediary (ofi), that is, we will have if-it-moves-stop-it-regulation, or the regulator will mount an unjustified bail out when, despite the regulator’s best efforts at preventing any kind of risk from being taken on by the regulated entity, insolvency threatens.

I don’t know the solution to this conundrum. To minimise the risk of the first two problems emasculating regulation, any regulation will have to be as much arms-length and impersonal as possible, rather than invasive, intrusive and hands-on. A further key requirement is that institutions that are deemed too big and too systemically important to fail should be de-coupled from their owners and their top management if a publicly organised and/or funded rescue effort is mounted.

So any institution-specific support operation should require that the entire board and top management resign and leave without even a bronze handshake, the minute an agreement is reached. A special resolution regime (along the lines the FDIC runs for insured deposit-taking banks) with Prompt Corrective Action and a special form of regulatory insolvency that can be invoked by the regulator before the financial entity at risk is balance sheet insolvent or cash-flow insolvent. The shareholders should get nothing up front, but would have to take their place at the end of the line of claimants to whatever value can be realised under the special resolution regime.

The regulator as deus ex machina, doing his philosopher king bit in the disinterested pursuit of the public good is a dangerous fiction. Attributing competence and disinterested benevolence to regulators is as sensible as relying on self-regulation by the financial sector. So there will have to be a messy compromise. Clearly, things got badly out of hand in the private financial sector this past couple of decades, and the sector’s capacity to take on excessive risk will have to be restricted severely if we are to avoid another credit orgy of the kind we saw during the years 2003-2006. But am I confident that regulators will do more that bolt the door after the horse has bolted – never to return? I am not. But I am ready to be pleasantly surprised.

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