The Next Financial Crisis: Not If But When...

In the last two decades we have experienced three major crises. We are in effect in an age where financial stability is a fairy tale our parents tell us about when revisiting old memories. From Asia in the 1990s, the dot-com bubble and bust of the early 2000s through to the Great Crash we have witnessed first-hand an emerging pattern of prolonged financial instability. From an overwhelming environment of incorrectly priced assets, to a period of realisation and rectification, all these crises appear to have the same underlying causes and more worryingly the same outcome; subsequent crises of increasing effect.



Personally I think the next financial crisis will hit far sooner than many expect. The question that should be on everyone's mind is when and where the next crisis will occur and how we are likely to be affected. Hopefully through foresight, regulation and prudent behaviour, the next period of financial woe will not progress to widespread political and social unrest.

The Radical Shakeup

Here is a brief overview of one set of potential regulatory reforms that has been proposed to parliament. Sir John Vickers and his commission prescribed these changes in a report almost two years ago, and a recent  press release from the Chancellor of the Exchequer offers a glimmer of hope that they may yet me implemented.George Osborne's Speech in Full

The Three Key Goals-

(i)                 Ring Fencing

At the centre of George Osborne’s speech two weeks ago in which he promised an end to light-touch regulation, was the need for widespread ring-fencing in the financial sector. The idea is to separate critical banking-services whose disruption would have a substantial negative impact on households and SMEs, from those deemed superfluous. In doing this the aim is to insulate services essential for a well-functioning economy from negative shocks to other parts of the financial system, thereby preserving the advantages modern banking provides. Simultaneously, the ‘unspoken promise’ that the government will be obligated to step in and bail out floundering banks will be markedly reduced, perhaps then the Lender of Last Resort facility would  more closely resemble that which was originally described by Bagehot. (A fellow classmate of mine discusses LOLR in more detail - (http://evolutionoflolr.blogspot.co.uk/2013/02/lolr-and-financial-crisis-is-it-used-as.html )

(ii)               Loss- Absorbency

Since I have stressed the nature of cyclical losses in the banking sector as being preordained, absorbing these periods of poor growth is critical. Loss-absorbency is not directly a structural modification but is equally as essential. A new leverage-ratio, bail-in process and depositor preference are the tools charged with improving the UK’s ‘primary loss-absorbing capacity (PLAC)’ (HM Treasury, 2012) and ensuring banks are sufficiently capitalised to survive adverse shocks. In effect this is an extension of the capital requirements made under Basel III

Here is what the new PLAC reforms look like:

Source: www.hm-treasury.gov.uk – White Paper Reform

        

(iii)         Increased Competition

The final piece to the jigsaw is the fostering of an environment of healthy competition. Only in a setting of actual competition can the prices of products and services be efficient and the innovation required for sustained growth be cultivated. Through activities such as the divestment of part of Lloyds Banking Group (YahooFinance, 2012) and the acquisition of Northern Rock by Virgin Money (The Guardian Online, 2011) the Government is clearly active in its pursuit of this objective. However, reduction in barriers to entry and pursuit of a more transparent retail banking sector still appears a long way off.

What is needed, and what this framework seems to be aiming for, is a simpler structure. Similar to the way the financial industry looked before the 1970s & 80s, we need to break up the system into components which are both simpler to operate and understand as well as being independent from one another. The result will be an environment whereby individual firms can be allowed to fail without resulting in a great deal of damage to the system as a whole. Furthermore their failure will not result in to quite disconnected parts of the market becoming victims of contagion.

Full report can be viewed at – http://www.hmtreasury.gov.uk/d/whitepaper_banking_reform_140512.pdf

Crisis Resolution - A regulatory paradigm for change

Four weeks into this blog and finally a point has been reached where we can discuss some potential solutions to the regulatory conundrum; namely what reforms might be implemented and how effective these are likely to be (needless to say this post is likely to be a bit longer than the others). Since the autumn of 2008, much change has occurred: In the United States Congress passed the Dodd-Frank act, a move seen by many as a step back towards the Glass Steagall reforms of the early 1930’s. The Basel Committee has once again revised capital, leverage and liquidity requirements, in response to the obvious deficiencies that were identified post-crisis. And Sir John Vickers proposed a mass overhaul of the UK banking system (The White Paper) with the aim of protecting consumer banking from the more risk prone wholesale side (Goodhart, 2011).

                Whilst there is no doubt in my mind that there are undoubtedly positive changes occurring across the globe, my worry is that these new initiatives are too reactive, focusing solely on preventing elements of previous crises from arising again instead of looking to the future. Or, just as futile is the risk of them never being fully implemented. Take for example the liquidity rules imposed on banks under Basel III. These requirements were established on the back of events such as the run on Northern Rock however it appears our memories are fading at a startling rate: just last month regulators in Basel decided to give the banks another four years to meet the targets (The Guardian, 2013). When will policymakers finally crack down on banks?

A framework for change- Simplification and a shift to Crisis Resolution

                In 2008 banks, governments and investors were largely taken by surprise. Many of the banks were running risks they probably didn’t fully understand, moral hazard led to investors not applying pressure on banks to manage risks carefully and the shadow-banking sector became ever-more entwined with the banking system. The crux of it all however was that regulators and politicians were not armed with the tools necessary for effectual resolution. In June 2012 a paper was presented to parliament which aimed at correcting this mistake; ‘Banking Reform: delivering stability and supporting a sustainable economy’. I personally think many of the suggestions it makes are great. Whether or not the reforms it sanctions will be effectively and comprehensively implemented is another question. History indicates that regulators and politicians may lack the conviction to see it through. What follows is a brief overview of the reforms:

The Need For Structural Reform

I previously made the assertion that a complete overhaul of regulation is required in the banking sector to ensure that a well-functioning economy can exist even with the onset of negative shocks to the system. What is called for is a series of structural reforms to the industry as opposed to a complicated mass of unfocused and gutless regulatory measures imposed on operations and industry behaviour. Reforms like these are generally put forward by people who are either inexperienced and do not fully comprehend the impact of the regulations they are proposing or, more worryingly by very intelligent people who are acting like Charles Adams did with the railroads in the 1880s, with the aim of implementing changes that are very elaborate and have a good sound but ultimately have no real significance (McGraw, 1984)(Kay, 2009).

We must be realistic about the ability and effectiveness of regulation. At a lecture to students at Lancaster University Professor John Kay recalled a conversation with a city banker; 'People in the financial regulation industry are no good' -'Well of course they're no good, if they were we would have hired them already'. With this in mind we must expect regulatory measures imposed on the financial system to fail and it is the role of structural reforms to ensure that when widespread economic downturns do inevitably set in, the core functionality of the economy remains intact.

-According to the Financial Times on Tuesday 5th February, the Government appears to agree:

www.ft.com - An end to light-touch regulation

Next I will look at what this structural regulation may look like.

Regulatory Failure or Simply Normal Accidents?

“The history of money, banking, and financial
legislation can be interpreted as a search for a
structure that would eliminate instability.
Experience shows that this search failed and
theory indicates that the search for a
permanent solution is fruitless.”
Minsky (2008, p.349), Stabilizing an
Unstable Economy.

The sociologist Charles Perrow received international recognition after the release of his award winning book; 'Normal Accidents: Living with high risk technologies'. In the publication he looked at the existence of accidents in the highly complex world of engineering and the role organisations play in the context of disasters in general. He identified that conventional approaches to ensuring the safety of personnel within these exceedingly elaborate systems will, ultimately always fail, predominantly due to the presence of two common characteristics referred  to as 'tight coupling' (interconnectedness) and high degrees of 'interactive complexity'.

Increases in the complexity and globalisation of the financial services industry, particularly over the last four decades or so, has led to an environment which shares many  key characteristics with the complex systems Perrow describes. If his theory of Normal Accidents can be applied to the financial sector then The Great Depression, 1997-98 Asian Crisis and recent Global Economic Crisis are the financial industry's very own Piper Alpha, Chernobyl and Space Shuttle Challenger.....Accidents waiting to happen, or in terms of probability, near certainties.

The interdependence of financial markets has led to a financial system that is more connected and more complex than ever before. With this has come an increase in the potential for systemic crisis, an event we were all made abruptly aware of in 2007/08. What then is the answer?

Well the truth is no one really knows. One thing that is universally accepted is that in the event of another crisis the core components to a well-functioning economy; principally the payment system, mortgage system and small to medium enterprise lending segment of the market must remain intact.

With the luxury of hindsight I feel an approach similar to that undertaken by President Roosevelt in 1933 is required - note the marked decrease in banking crises under the Glass Steagall Act from the graph in the previous post. The best option available to policy makers and regulatory architects worldwide is a complete overhaul of the way in which the financial sector and more specifically banks are regulated. -I have discounted free banking as a potential remedy as Hickson and Turner, 2002 illustrate how the 1893 banking crisis in Australia was the natural consequence of an unregulated environment.

The Inevitability of Crises

Charles Goodhart (2011) in his paper on the emergence of a new form of financial regulation argues that regulation policy has traditionally been ‘reactive and backward thinking’, focused solely on the prevention of factors which triggered the last crisis as opposed to looking towards the future in anticipation of the next one. If this is the case then perhaps regulatory bodies need to take a further step back and look not just at what triggered the last crisis but what regulatory failures have led to a long history of banking crises.

Reinhart and Rogoff’s book ‘This Time is Different’ (2008) looks at eight centuries of financial woe, starting with Edward II’s default in 1340 brought about by the Kingdom of England’s on going war with France. In fact going back to the origins of finance, it appears financial crises have always existed. Why is it then that policy makers and regulators around the world still emphasise crisis prevention as their ultimate aim when history shows us that whatever new and improved reforms are made to the financial system, ultimately there will always be another crisis?

The Following diagram comes from the aforementioned book. Looking at the blue line gives some idea of the stubborn presence of banking crises over the last 200 years:

Source: Reinhart and Rogoff (2008) - image from www.debtnation.org

Over the next few weeks in this blog I hope to show how the cycle of expansion, climax, failure and finally re-design exists within all complex systems on the planet and the financial industry is no exception. I aim to show how the pervasive acceptance of the inescapable nature of banking crises is therefore necessary for a new approach to regulation to emerge, one that will make economies better equipped to deal with these crises when (not if) they occur. Only in such an environment will regulatory frameworks be designed to deal with the onset of crises as opposed to implementing inadequate controls designed to somehow magically avoid the unavoidable.

Charles Goodhart - New Architecture of Regulation

Reinhart and Rogoff - This Time is Different