The causes of the crash
In “Verdict on the Crash” we argue that government failure and not market failure is responsible for the collapse in financial markets.
It is now widely accepted that the boom and bust, culminating in the Great Depression of the 1930s, arose as a result of catastrophically mismanaged monetary policy. So, it is natural that we should start by examining monetary policy to see if it was a cause of the crash of 2008. And so it turns out to be.
Low interest rates led to monetary aggregates expanding, an asset-price boom, low saving and a boom in consumption. Higher asset prices raised the value of collateral against secured loans thus encouraging more lending and higher leverage whilst reducing the apparent risk faced by lenders and borrowers. Low interest rates encouraged unsustainable borrowing, consumption and investment and exacerbated the problem of global imbalances.
For six years from 2001, the U.S. Federal Reserve sent the message to participants in financial markets that, if the markets were to fall, the Fed would underpin them. No wonder any consideration of risk went out the window. Policy in the UK was also irresponsible and, though over a shorter time. Our current Prime Minister went round telling everybody that he had abolished boom and bust. Is it any wonder that people under-priced risk?
But, notwithstanding all this, why where the complex securitisation instruments that brought the banks down created and traded in such magnitude and why did they become poisonous?
Firstly, the U.S. Community Reinvestment Act, backed up by progressively tightening state regulation, more or less forced banks to lend to bad risks. By 2005, the U.S. mortgage giants had explicit targets to provide over 50% of their financing to people on below median incomes.
In other ways, government policy and capital regulation had a big part to play. Fannie Mae and Freddie Mac drove and developed the market in securitised mortgages. They were the creation of politicians and underwritten by government. The providers of capital knew that there was an implicit government guarantee if things went wrong.
Of course, nobody forced the British banks to buy these instruments. But international banking regulations led to two tragic consequences. They radically distorted the activities of banks, encouraging them to take on gearing in more and more complex ways – and to give the impression that they had offloaded risk through securitisation.
Secondly, they strongly encouraged the adoption of similar types of risk models throughout the banking system. Regulation has treated the system in such a uniform way that, if problems arose in one bank, the failure of the whole system was virtually guaranteed!
Readers should take a look through the FSA handbook. The full handbook contains ten sections. The section entitled “Prudential Standards” is divided into 11 sub-sections. The sub-section “Prudential Sourcebook for Banks, Building Societies and Investment Firms” is made up of 14 sub-sub-sections.
The sub-sub section “Market Risk” is divided into 11 sub-sub-sub sections. The sub-sub-sub-section on “Interest Rate PRR” has 66 paragraphs. This is what regulators call “principles-based, light-touch regulation”. As far as I could see, based on this example, there could be over 1,100,000 paragraphs. Remarkably, I could find nothing on liquidity risk, the main failing of Northern Rock.
The evolution of regulation over the last 20 years has encouraged the markets to pass responsibility to the regulator. The most important relationships are now between banks and their regulators. Sadly, shareholders gave up monitoring. They were encouraged to think it was not necessary.
Government regulation has created a welfare state for bankers. If big banks are told they are too big to fail, the both creation of megabanks and their failure are inevitable. What we need is not more powers vested in regulators – who have shown that they cannot remove whatever imperfections may exist in markets – but deregulation. This should be combined with some simple changes to the law to ensure that banks are held properly to account by markets and that bankers do not get rich at the taxpayers’ expense.
A longer version of this article will appear in the Yorkshire Post