The FT’s Martin Wolf smacks down any hope that the new regulatory overhaul will prevent financial crises from happening again in the future.
Proposals for reform of financial regulation are now everywhere. The most significant have come from the US, where President Barack Obama’s administration last week put forward a comprehensive, albeit timid, set of ideas. But will such proposals make the system less crisis-prone? My answer is, no. The reason for my pessimism is that the crisis has exacerbated the sector’s weaknesses. It is unlikely that envisaged reforms will offset this danger.
At the heart of the financial industry are highly leveraged businesses. Their central activity is creating and trading assets of uncertain value, while their liabilities are, as we have been reminded, guaranteed by the state. This is a licence to gamble with taxpayers’ money. The mystery is that crises erupt so rarely.
The problem remains: Looting, looting and more looting. As long as you’ve got that public guarantee — and nothing about the new regulatory scheme hints at taking that away — the game for everyone is to maximise risk.
Lucian Bebchuk and Holger Spamann of the Harvard Law School make the big point in an excellent recent paper.* Its focus is on the incentives affecting management. These are hugely important. Still more important, however, is why a limited liability bank, run in the interests of shareholders, is so risky.
In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses. In contemporary banks, leverage of 30 to one is normal. Higher leverage is not rare. As the authors argue, “leveraged bank shareholders have an incentive to increase the volatility of bank assets”.
Think of two business models with the same expected returns: in one these returns are sure and steady; in the other the outcome consists of lengthy periods of high returns and the occasional catastrophic loss. Rational shareholders will prefer the latter. This is what one sees: high equity returns, by the standards of other established businesses, and occasional wipe-outs.
It’s seemingly basic stuff, but Wolf argues it forcefully, and the matter of looting is the core of the problem.