Ills lie dormant in global finance

Lowy Interpreter

In America, the momentum for reform resulting from the 2008 financial crisis has dissipated, with Wall Street's continuing resistance weakening the initial political vigour.

Some progress has been made. In due course, banks will have to hold more capital and meet liquidity requirements. US regulatory responsibilities have been rearranged, with more focus on systemic risk. The 2300-page Dodd-Frank legislation was passed in 2010.

But the structure of finance is largely unchanged. The financial sector contains many institutions which have a de facto government guarantee because they are 'too big to fail', and the non-bank (shadow) financial sector remains systemically vulnerable. These two aspects present a formidable reform challenge.

If 'too big to fail' was a concern in 2008, the problem is now worse. The US banking sector is more concentrated, with numerous institutions at least as big, complex and interconnected as Lehman Brothers, whose failure in September 2008 is now widely regarded as a serious policy error. No policy maker will risk another Lehman failure.

Nor are the distorted incentives which come from the implicit 'too big to fail' guarantee confined to the formal banking sector. A substantial part of the 2008 rescue was directed at supporting the shadow banking sector: non-banks such as Goldman Sachs were given the protection of bank status even though they had not been supervised as banks beforehand; failing non-banks such as Bear Stearns were assisted into mergers; insurance company AIG was bailed out, and the huge money market, facing collapse, was given an official guarantee.

The shadow banking sector was central to the problems of 2008. It generated many of the mortgage-backed securities which funded the housing boom and gave loans to people who couldn't afford them. It created the layered collateral chains of short-term funding and the complex derivatives which obscured the underlying realities. It traded without recognition of counterparty risk, thus distorting financial prices. Moreover, it existed largely outside the supervisory framework, relying on the fiction that it was a 'buyer beware' market, where market discipline prevailed, losses could be absorbed and firms could become insolvent with no more consequences than a routine bankruptcy.

Addressing these issues requires more restructuring than has occurred or is in prospect. The key is to ensure that failing institutions can be identified early and 'resolved' quickly (closed, merged or re-capitalised) without systemic impact. It's easier said than done. Just as retreating armies are inevitably chaotic, collapsing financial institutions will always be mired in delay, denial and confusion.

The lessons taken from 2008 add to the ambiguity. The public was unhappy with the bailing out of the big financial institutions, especially as management seemed to avoid the consequences of their mistakes.

This has revived long-standing concerns about moral hazard: helping troubled institutions which took too many risks just encourages them to take too many risks next time. Thus the Dodd-Frank legislation makes provision for bank liquidation but explicitly prohibits taxpayer bailouts. As this would seem to prohibit the sort of policy actions which saved the system from total collapse in 2008, in practice ways will be found around this prohibition. This sort of 'constructive ambiguity' has always been part of the stock-in-trade of prudential supervisors, but this accidental outcome of conflicting objectives just ensures confusion and delay in the event of a crisis.

Running parallel with national attempts to make the financial sector less fragile are the international rule-writing efforts centred on the Bank for International Settlements in Basel. The global nature of the 2008 crisis created momentum to rewrite the inadequate Basel II Rules. This international coordination has made it easier to impose higher capital and liquidity requirements, with the Basel rules discouraging countries from competing with each other to provide the most lenient regulatory framework. Similarly, the G20 has exerted pressure to bring derivatives within a safer central-counterparty framework.

These international measures are, however, painfully slow, not only resisted by countries jealous of sovereignty, but by the finance lobby. For key structural issues, international rule-making has had little to offer. The US (with the Volcker Rule), the UK (with the Vickers 'ring fence') and Europe (with the Liikanes proposal) are each going their own way to separate banks from the shadow banking sector. Even coordinated efforts to sort out a failing institution across international boundaries seem problematic.

Despite the modest achievements of this reform process, there is little danger of a repeat of 2008 any time soon (although Europe still has a long way to go before its banking sector is secure). The misjudgments and foolishness of the pre-crisis decade are still too fresh for these mistakes to be repeated just yet. The shadow banking sector has shrunk. Supervisors are feeling bolder.

The pity, however, is that the crisis was not used more effectively to drive substantial reform ('You never want a serious crisis to go to waste'). The process of financial deregulation which took place over the two decades preceding the crisis created a pro-cyclical hyperactive sector where there was too much credit creation, too much leverage, too much trading, too much financial engineering and too much risk taking. In countries where the financial sector has substantial political power, such as America, these problems are dormant rather than resolved.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.