Recent events have demonstrated that the financial market structure that has evolved over the past twenty years is a powder keg – the detonating device was the bursting of the 2004 to 2007 credit bubble. In considering where we go from here, two separate issues need to be addressed: how to deal with financial bubbles and the design of a new financial market regulatory structure.
Counter-cyclical bank capital requirements may help to deal with the first problem but regulatory reform presents more formidable difficulties. The problem here has been exacerbated by the forced financial restructuring that has taken place during the crisis management of the past few months. We now have a much more concentrated financial services industry and one in which large investment firms have been merged with deposit-taking banks. The financial landscape is now dominated by huge financial conglomerates which markets will correctly perceive as being far too systemically sensitive to be allowed to fail. Hence the whole moral hazard issue is thrown into even sharper relief.
There are two possible regulatory responses to this situation. The first is to try to put banking back in its box; to reverse the trends of the past twenty years by dismantling the financial conglomerates and re-imposing strict activity constraints on deposit-taking institutions. This was the US response after the 1929/33 crash not only from the legislature in the form of the Glass Steagall Act but also from the leading banks themselves (National City Bank and Chase National Bank), who of their own volition announced that they were disposing of their securities affiliates because events had shown that commercial and investment banking should not be mixed.1 It is ironic that today’s response is in the opposite direction: non-bank investment firms have either been eliminated (Lehman), pushed into the arms of banks (Bear Stearns, Merrill Lynch) or induced to re-charter themselves as deposit-taking banks (Morgan Stanley, Goldman Sachs). Unscrambling these new universal banking conglomerates would, however, present enormous practical difficulties and is probably unrealistic.
The second approach is to neutralise moral hazard by subjecting financial institutions to a comprehensive regulatory framework which would also see regulators acting in a much more intrusive, investigative and, if necessary, adversarial manner. Crucially, this new regulatory approach would have to be truly global since national authorities are at present inhibited from taking action that might induce regulated activities to move to more accommodating financial centres.
Mixing banking and securities
Fifteen years ago, I argued that banks’ increasing involvement in securities activities worldwide could eventually lead to a repetition of the 1929/33 banking meltdown.2 My analysis rested on the observation that if banks were permitted to diversify away from non-core banking activities the moral hazard that is known to promote excessive risk-taking in traditional banking would be extended to these other activities, in particular securities markets. The question then was whether ‘the mixing of banking and securities business can be regulated in such a way as to avoid the danger of a catastrophic destabilisation of financial markets’3. After considering all the regulatory options, I concluded that there was no solution: “Allowing banks to engage in risky non-bank activities could either destabilise the financial system by triggering a wave of contagious bank failures – or alternatively impose potentially enormous costs on tax payers by obliging governments or their agencies to undertake open-ended support operations.”4
The prevailing view amongst finance academics at the time, as reflected in a critical review of my book in the Journal of Finance, was that financial structure was largely irrelevant to the question of systemic stability.5 According to the conventional wisdom we had learned from the 1929/33 crash, a monetary contraction such as occurred then could be neutralised by injecting reserves into the banking system and a flight to quality, because it merely redistributes bank reserves, “is unlikely to be a source of systemic risk”6. This widely held view of the behaviour of financial markets turns out to have been entirely misguided. As we have witnessed in recent months, a major shock arising from publicised losses on banks’ securities holdings can have a domino effect on financial institutions, leading ultimately to a seizure in credit markets which central bankers, on their own, are powerless to unblock. Only drastic government intervention – guarantees for money market funds, guarantees for interbank lending, emergency deposit insurance cover, lending directly to the commercial paper market, and partly nationalising the banking industry – has prevented a full repetition of the 1929/33 financial meltdown.
In addition to underrating the importance of financial market structure, finance academics have also largely neglected the well-documented boom/bust characteristic of asset and credit markets. In my recent book on the South Sea Bubble, I analysed the behaviour of South Sea stock prices and concluded that, even when judged against the valuation techniques available at the time, there is overwhelming evidence that the South Sea boom represented an irrational bubble7. My central thesis was that, taken together with other more recent boom/bust episodes, the events of 1720 lend force to the argument that national authorities must intervene to head off unsustainable financial market booms. I was also critical of revisionist histories of financial upheavals such as the South Sea Bubble that have tended to stress the rationality of investors and downplay the idea that financial markets are inherently unstable and prone to bouts of euphoria and panic.8
What we have witnessed in recent months is not only the fracturing of the world’s financial system but the discrediting of an academic discipline. There are some 4000 university finance professors worldwide, thousands of finance research papers are published each year, and yet there have been few if any warnings from the academic community of the incendiary potential of global financial markets. Is it too harsh to conclude that despite the considerable academic resources that go into finance research our understanding of the behaviour of financial markets is no greater than it was in 1929/33 or indeed 1720?
1 Edwin Perkins, The Divorce of Commercial and Investment Banking, Banking Law Journal, June (1971) p.523.
2 Richard Dale, International Banking Deregulation: The Great Banking Experiment, Wiley-Blackwell 1993.
3 Ibid, p.2
4 Ibid, p.43
5 Book review by Richard Herring, Journal of Finance, September 1993, pp. 1553-1556
6 Ibid, p. 1554.
7 Richard Dale, The First Crash: Lessons from the South Sea Bubble, Princeton University Press, 2004
8 See eg. Peter Garber, Famous First Bubbles, Journal of Economic Perspectives, Spring 1990; Larry Neal, The Rise of Financial Capitalism, International Capital Markets in the Age of Reason, Cambridge University Press, 2000.