Andrew Lilico: What an inquiry into the banking crisis probably wouldn't tell us - six reasons why it happened

Following the recent debacle of the RBS IT "glitch" and the Barclays LIBOR-fixing scandal, there have been a number of calls for a wide-ranging public inquiry into the banking crisis and its causes. I think that would be a bad idea. The reason is that, by its nature, such an inquiry would focus on personalities, processes, and particular institutions. It would thus end up, at best, describing what happened. There have been many many inquiries that have covered this territory, including major inquiries by the Financial Services Authority and the Treasury Select Committee. There would be nothing valuable added by another one of this form.

What most public inquiries have made only limited progress in understanding is why. Saying what some individuals and institutions did is of only limited interest if one does not understand properly why they did it. In the case of the FSA's main report - the Turner Review - the mystery of why was sidestepped, because the Turner Review (in section 1.4) rejects almost the entire structure of finance theory as it has been developed since the late 1950s (rejecting it, shamefully, without even name-checking the great men that produced it or pausing for a moment to contemplate how they might explain these events using their theories). Since Turner threw away all the theories that might make the behaviour of the 2000s any kind of mystery, there was no question of why remaining. Simply describing the events was sufficient.

There have, on the other hand, been many detailed reports by bodies such as the Bank of England and the European Parliament that did cover the question of why. Those of you familiar with my own writings will recall this was a favourite topic of mine in late 2008 and early 2009. Given that it has not gone away and there are once again questions being raised about why the banking crisis occurred, let us remind ourselves of the key cause of the financial crisis.

We shall not here attempt to cover every single contributory factor – this article will be long enough as it is.  But what we shall offer will hopefully be enough to see how one might grapple with the mystery of why.  In particular, according to modern finance theory such crises fundamentally arise because of an initial over-estimation of returns and/or underestimation of risks, followed by a subsequent downgrading in view.  The question then is why that happened, and to what extent there was nothing regulation (and other government policy) should have been trying to prevent it, to what extent regulation failed to prevent it when it should, and to what extent regulation (or other policy) actively made things worse.

1) Natural mistakes associated with innovation

When new innovations arise, the expected returns from them and the risks associated with them can be difficult to assess. Often this leads to their being under-valued initially (the personal computer may well be an instance of this).

Subsequent up-grading of expectations results in increased growth and asset valuations. Occasionally new innovations are significantly over-valued initially. Classic examples of this may include the railways, electricity, radio, and dotcom companies.

When expectations are down-graded, there are asset price crashes and collapses of a number of the companies that over-participated on the basis of over-optimism. The 2000s saw very considerable growth in the participation in various financial market innovations, particularly those associated with securitisation and natural partners thereof such as growth in wholesale money markets. It isnatural that in periods of transition with growing use of new innovations, there will be increased leverage. If expected returns and risks have been assessed accurately, some increase in leverage is an appropriate and efficient symptom of transition.

However, it seems very likely, now, that, as with certain other new innovations, there was over-participation in these financial market innovations. With a downgrading in expectations and an upgrading in risk assessments, asset prices fell and some of those companies that had over-participated came close to collapse.

2) Increased dependence of regulatory badging, combined with the international coordination of regulation, and with mistakes in that regulation

Over the past 25 years, a core concept in regulation has been the idea that ordinary retail capital-providers (purchasers of retail financial products such as mortgages; ordinary depositors; ordinary small shareholders) are not competent to conduct their own monitoring of the robustness of financial institutions; or, if they are so competent, that they lack incentives to provide adequate monitoring, preferring instead to rely on the monitoring done by others. Instead of diversified individual assessments, financial robustness checking came to be seen as the responsibility of financial regulators.  At the same time, financial regulation came to be enormously coordinated, internationally, through devices such as the Basel Accords and the European Union Single Market Programme.

Regulators conducted their own supervisory analysis and risk assessment, but also made use of a small number of ratings agencies.

The net result was that the number and methods of financial robustness analysis were very small and very similar, and the corresponding requirements imposed on financial companies (such as capital requirements) were again done in broadly the same way.

A consequence was that when an event occurred which defeated the risk analysis of this narrow set of actors and methods — a set of new innovations that models based on past data could not properly risk-model, engaged in by the market on a scale that defeated analysis of spillover effects — when this narrow set of actors got it wrong, they got it wrong for everybody. Risk was systemically coordinated nationally by financial regulators and coordinated internationally by international regulation and ratings agencies, as well as the internationalised financial linkages which these international regulations and agencies had facilitated.

3) The belief that governments would intervene in various ways to limit downside risk

The most obvious is the view that governments would not allow house prices to fall in an environment in which political popularity was intimately connected to the rise and fall of house prices — governments taking the credit when prices rose and the blame when they fell. An implication of this is that lenders would be willing to provide excessive credit for mortgages, and products constructed from mortgages, such as collateralised mortgage obligations, and would be perceived as having reduced downside risk.

Related to this is the idea that governments were expected to bail out financial institutions, in particular by sparing depositors and bondholders, which I explored in considerable detail in a report for Policy Exchange.  Such guarantees for creditors distort banking behaviour in a number of ways, including:

• The optimal proportion of bonds in the total capital structure will rise;
• The optimal proportion of high-quality capital buffers (in particular, equity buffers) will fall. This will involve some combination of a fall in the amount of equity, relative to debt, and a rise in the riskiness of the balance sheet;
• Optimal liquidity ratios will fall — banks will want to become less liquid;
• Optimal remuneration schemes will involve more risk-taking;
• Optimal balance sheet size for the banking sector will rise.  Indeed, ultimately banking sectors will continue to expand in size until they become so big that the risk of the government that backs them failing rises (cf the situations in Ireland and Spain).

4) Weak internal risk management and poorly-constructed remuneration incentives

Once the key final providers of capital — the purchasers of retail financial products, depositors, shareholders, etc. — did not take responsibility for assessment of the risk-taking of institutions (regulatory authorities) it became necessary for regulatory agencies to take a closer interest in these.

Otherwise, there was moral hazard — workers gained on the upside from bonuses if their risks turned out well, but had only limited downside losses if their risks turned out badly.

The key discipliners of downside risk in a market setting would be the providers of fixed charge loans — depositors and bondholders.  But these were not monitored under the system as it evolved.

This issue appears not to have been understood by regulators.

Recent issues at RBS and Barclays simply fall under this category.

5) Regulatory get-arounds

Regulation needs to specify activities that are forbidden or controlled. But there is the incentive for firms to devise ways to restructure their activities — either by adapting what is done or adapting who does it — so as to get around restrictive regulations. This appears to have happened in the 2000s, when financial innovations allowed extensive use of off-balance sheet activities and the use of relatively high-risk AAA-rated investment instruments in liquidity silos.

Regulatory hubris is a constant danger. A classic error is to attempt to regulate away an activity, and instead merely chase it outside the regulatory net to somewhere it does even more harm than if it had been left alone in the first place.

6) Weaknesses in monetary policy regimes leading to excessively-low interest rates

Interest rates were too low during the 2000s.  For many analysts, that is true with the benefit of hindsight.  Others of us argued it at the time.  We can see a number of reasons for this.

First, inflation targeting naturally tends to create asset price cycles by keeping interest rates too low for too long following a shock of the nature of the dot-com and 911 shocks of the early 2000s.  Second, the advent of the euro meant that policy interest rates were too low for several parts of the Eurozone.  Third, policymakers used low interest rates to try to curtail the house price crash of the mid-2000s, retarding that in damaging ways and distorting other economic activity in the process.   Fourth, inflation targeting will generate a flawed response to an event such as the growth of China, which by its nature tended to depress price pressures from the mid-1990s to mid-2000s (via impacts on manufactured goods import prices) and then contributed to them from the mid-2000 to today (via impacts on commodities prices).

We have only scratched the surface of most of these topics here.  But the message should be that the key question for policy is not what happened in the financial crisis – the sort of issue that would inevitably be the focus of a public inquiry.  It is why it happened.  Why it happened is something that (pace the Turner Review) can be explained using the tools of modern economic theory.  We are now in the process of introducing very widescale regulatory reform in response – some of which is damaging, but some of which addresses these problems directly.

We don’t need more inquiries.  We need regulatory reform – and that is well underway.