How overregulation could threaten economic recovery by Nicholas Boys Smith
A year and a half after its inception, the credit crunch is still the major issue facing the UK economy. What caused it, how to alleviate the immediate pain and how to prevent a recurrence of this type of crisis in the future are critical questions around which there remains much confusion. In a paper released today by the independent think tank Reform, I argue that the causes of the crisis mean that a measured response is required, and warn that an overreaction could prevent a long-term economic recovery.
It is now eighteen months since the collapse of one of Bear Stearns’s credit hedge funds lit the credit crunch bonfire. Banks (including Bear Stearns) have been going up in smoke ever since and the fire has now spread to the real economy. Perhaps hardly surprisingly, with every day that has passed the voices prophesising the need for a fundamental reconstruction of every pillar of the market economy grow ever louder and more confident. From bank regulation, via market liberalisation and free capital flows through to classical economics itself, none of the foundations of the Friedman-Reagan-Thatcher consensus are now unquestioned. To mis-cite Francis Fukuyama, history has started again.
So what went wrong in the acronym-packed world of high finance? At its heart the credit crunch is a narrow term describing an unprecedented loss of mutual confidence between banks and a consequent failure to lend to each other and into the wider economy – hence the economic knock on effect on us all.
Leaving aside the debate on the right macro-economic response to the consequent recession, what emerges from a detailed examination of the causes “on the ground” is that it was not just greed and misplaced ideas about risk, but an inappropriate and short-sighted regulatory regime which incentivised complexity and regulatory arbitrage. Seven key drivers explain the credit crunch.
- The Asian “savings glut” made credit cheaper and easier than ever before – leading to downward pressure on investment “yields” and investors’ subsequent’ “search for yield”.
- Pushed beyond a certain point, securitisation ceased effectively to pool risk with a wider range of investors better able to bear it, but simply increased the degree of risk, ignorance and opacity in the market system. Banks’ directors, credit agencies and regulators all failed to understand this.
- Banks in the US were encouraged to advance loans to the least well off.
- Bank directors misincentivised their staff with too great a focus on the short term.
- Bank directors systemically took too much risk – and regulators allowed them to do so even though much risk “hedging” was more apparent than real.
- The regulatory framework placed insufficient focus on liquidity and failed to take adequate account of off balance sheet vehicles.
- Central banks failed to react clearly or quickly enough to the early danger signs, causing banks to loses confidence in each other.
The credit crunch therefore does not diminish the fundamental case for free trade, competition and transparency in financial services together with appropriate government regulation. Rather, it enhances it. Policymakers must take a measured response to strengthen the long-term stability of the UK economy. Improvements to international financial services regulation are required, but it is precisely the rigid, rules-based regulatory approach of the last twenty years that has enabled banks to get away with excessive risk-taking in ways which effectively by-passed the intent of the detailed legal requirements.
Instead the route to building up a more credible capital base is in moving beyond the crude ratios of Basel I or the more sophisticated ones of Basel II. Regulators should be able, more precisely, to adjust banks’ capital requirements to the stage of the economic and credit cycle (i.e. build up capital in the good times) or to the strategy of an individual bank (i.e. requiring more capital to cover new probably illiquid types of investment which are not yet “in the rules”). A similar credit crunch should never again cause such fear for bank solvency.
By contrast, the urge to micro-regulate all aspects of financial services must be resisted. It may be politically attractive but it will limit future innovation and long-term economic growth. Banking-style regulation of hedge funds would also damage the crucial role they play in supplying financial innovation and increasing market liquidity.
Perhaps even more frightening, a retreat to protectionist policy in the face of massive flows of investment from the East would merely mean repeating the route of the 1930s.
This is emphatically not a case for no change. Governments around the world should act to improve the regulation of the worlds’ banks and prevent the type of regulatory arbitrage that has undermined the system. This will constrain much of the structural risk-taking from institutions which are fundamental to the smooth functioning of the world economy. Going further, however, and attempting to micro-regulate every aspect of financial markets will not ease the pain of the next two years. It will just make us all poorer in the long run and make the next economic downturn (and there will always be one) deeper, darker and more protracted.
Nicholas Boys Smith is a Consultant Director of Reform, an independent think tank whose mission is to set out a better way to deliver public services and economic prosperity.
