Fault Lines: How Hidden Fractures Still Threaten the World Economy (29 page)

Credit as a key to opportunity and as a means to the consumption you deserve, or debt as sin and as a mortgaging of a future you will never have—these two opposing views run through American history, with the former gaining ascendancy during boom times and times of rising inequality, and the latter gaining ground in downturns, when sobriety or rank pessimism returns. They represent a way of rephrasing the question I started with earlier: do we want to harness finance’s creative energies, or do we think finance is so dangerous that most people should not have access to it and it should be stuffed back in the box it came from? Society’s attitude toward financial reform hinges on whether it believes people and firms, by and large, can be trusted to make sensible financial decisions when given the means to do so.

The academic debate on this question is not conclusive. Even as research in behavioral economics tells us that some people make consistent mistakes in their financial decisions, it also tells us that a lot of behavior is rational and sensible. Indeed, as I argue throughout this book, it is typically not the rationality of the decision makers that is a problem. Rather, it is whether the apparent payoffs from decisions fully reflect the costs and benefits to society. Our goal should be to make decision makers internalize the full consequences of their decisions, rather than prevent them from making decisions altogether.

More generally, even if we conclude that some people took on too much debt during the boom, shutting off their access to some markets or limiting their financial choices (typically through legislation restricting the products, prices, or institutions they have access to) is paternalistic, undemocratic, and the surest way to ensure that the protected never have the opportunity to learn or improve themselves. Of course, we need to ensure they are given every opportunity to understand why certain choices are poor choices and to recognize the mistakes people traditionally make so that they can change their behavior. We should also ensure that they are protected from rank predators. But limiting choice is not the answer.

Free societies do revert to more paternalism and more constraints on choice following a crisis. It is natural to blame the crisis on the greater freedom to choose: if only choice had been more restricted (and, of course, with hindsight, it is crystal clear what the restrictions should have been), we would not have made the bad choices that were made, or so goes the thinking. The overall trend in civilized democratic societies, however, is to expand choice for all, not constrain it, let alone constrain it for only some. From a practical standpoint, regulations that limit choice may be popular in the aftermath of a crisis but will inevitably be whittled away as the memories of the crisis fade. And enacting regulations that will soon be outmoded and voted down carries an inherent cost: it creates a momentum for deregulation among the public that could go too far. It is better to get regulation right than to err in either direction.

In sum, if we reject the view that finance is a largely useless activity, or that we can keep its benefits only for a select and knowledgeable few, then the purpose of reform should be to draw out what is best in finance for the largest number of people while minimizing the risk of instability.

What guiding principles must reforms adhere to? Let me outline the key ones and then go on to a concrete example.

A healthy financial system that benefits citizens requires competition and innovation. Oligopoly implies easy profits for the incumbents, profits they are loath to jeopardize by taking on risk. By contrast, the goal of broadening access, to reach new and underserved customers as well as future innovators, requires a financial system that is willing to take reasonable risks, and thus it requires competition. This is not a popular view at a time of crisis in a free-market economy, for the natural tendency is to blame the market and factors like competition that make it free.

One of the main concerns during the Great Depression was that prices were too low, and the mistaken diagnosis was excessive competition. The New Deal solution was to prop up prices by forming cartels. To smooth the political path for the needed legislation, words like “economic cannibalism” and “cut-throat price slashing” were used to describe competition.
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Formerly “rugged individualists” became “industrial pirates.” Regulations meant to create cartels and suppress competition became “codes of fair competition,” while various forms of officially sanctioned collusion were described as “cooperative behavior.” Of course, incumbent firms were fully complicit in the regulation and cartelization of the economy, for it made things easier for them.

The concerns during the recent crisis centered primarily on the underpricing of risk. Once again, it would be tempting but wrong to blame competition between banks. The right approach would be to reduce the various distortions to the pricing of risk that stem from actual and potential government intervention, as well as from herd behavior. We should not worry so much about rugged individualism as about undifferentiated groupthink, for that is the primary source of systemic problems.

A competitive system is also likely to produce the financial innovation necessary to broaden access and spread risk. Financial innovation nowadays seems to be synonymous with credit-default swaps and collateralized debt obligations, derivative securities that few outside Wall Street now think should have been invented. But innovation also gave us the money-market account, the credit card, interest-rate swaps, indexed funds, and exchange-traded funds, all of which have proved very useful. So, as with many things, financial innovations span the range from the good to the positively dangerous. Some have proposed a total ban on offering a financial product unless it has been vetted, much as the Food and Drug Administration vets new drugs. This proposal probably goes too far, as many products are minor tweaks on previous ones, are not life threatening, and cannot really be understood until tried out. Modest and free experimentation should be allowed but proliferation limited until regulators are satisfied they understand the innovation well, and the systemic risks it poses have been dealt with.

More generally, in an ever-changing global economy, stasis is often the greatest source of instability, for it means the system does not adapt to change. Competition and innovation, by contrast, help the system adapt, and if properly channeled, are key to ensuring variety, resilience, and therefore dynamic stability. Critics will be quick to point out that competition and innovation lead to greater instability during the run-up to a crisis: after all, securities like the CDO squared and the CDO cubed were so devilishly difficult to price that they had no market once mortgages started defaulting. However, it is not competition per se, but rather the distorted banker incentives and the distorted price of risk that led to the creation of these instruments.

As I argue in
chapter 7
, some of the incentives to take excessive risks may have resulted from a breakdown of internal governance within banks, and some from a breakdown of external governance. These mechanisms need to be fixed, and I discuss some options below. But the primary reason for a systemic breakdown is invariably the underpricing of risk. One reason for underpricing is irrational exuberance: initial, moderate underestimates of risk feed on each other until they become a frenzy. Usually, though, such bubbles rarely occur out of the blue. The underpricing of risk in the period leading up to the recent crisis stemmed, in part, from anticipated government or central bank intervention in markets. And certainly, since the crisis hit, the Treasury and the Fed have intervened massively in markets, thus verifying the expectations. We need to find a way to dispel the notion that the government or its agencies will prop up a market, whether the market for housing or the market for liquidity.

As damaging as government intervention to help specific markets is government intervention to prop up specific financial institutions. The essence of free-enterprise capitalism is the freedom to fail as well as to succeed. The market tends to favor institutions that are protected by the government from failing, asks too few questions of them, and gives them too many resources for their own good. Moreover, such protection distorts the competitive landscape. We have to aim for a system in which no private institution has implicit or explicit protections from the government, one in which every private institution that makes serious mistakes knows it will have to bear the full costs of those mistakes.

As we emerge from the panic, righteous politicians feel the need to do something. Regulators, with their backbones stiffened by public disapproval of past laxity, will enforce almost any restrictions, while bankers, whose frail balance sheets and vivid memories make them eschew any risk, will be more accepting of such restrictions. But we tend to reform under the delusion that the regulated institutions and the markets they operate in are static and passive, and that the regulatory environment will not vary with the cycle. Ironically, faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated. By contrast, the misconception that markets will govern themselves is most widespread at the top of the cycle, at the point of maximum danger to the system. We need to acknowledge these differences and enact cycle-proof regulation, for a regulation set against the cycle will not stand. To have a better chance of creating stability throughout the cycle—of being cycle-proof—new regulations should be
comprehensive, nondiscretionary, contingent,
and
cost-effective.

Regulations that apply comprehensively to all levered financial institutions are less likely to encourage the drift of activities from heavily regulated to lightly regulated institutions over the boom. Such a drift has been a source of instability, because its damaging consequences come back to hit the heavily regulated institutions in the bust, through channels that no one foresees. For example, the asset-backed securities that Citigroup had placed in thinly capitalized off-balance sheet vehicles came back onto its balance sheet when the commercial paper market dried up, contributing immensely to Citigroup’s troubles. We have to recognize that because all areas of the financial sector are intimately interconnected, it is extremely hard to create absolutely safe areas and imprudent to ignore what happens outside supposedly safe areas.

Regulations that are nondiscretionary and transparently enforced have a greater chance of being adhered to, even in times of great optimism. Compliance can be more easily monitored by interested members of the media and the public, thus offering some check on the regulator. The regulated also have a good sense of how regulations will be implemented. One example of such regulation is the FDIC Improvement Act of 1991, which mandates that regulators take a series of ever more stringent actions against a bank as its regulatory capital drops below specified levels. The weakness in the act is that regulatory capital is hard for the public and the press to measure in real time, so it is difficult to gauge whether regulators are following through on the requirements of the law. Nevertheless, the act suggests a possible direction for new regulation.

Wherever possible, regulations should come into force only when strictly necessary: they should be triggered by adverse events rather than be required all the time. Such contingent regulations have two effects. First, because they kick in only some of the time, they are less cumbersome than regulation that is not contingent, and banks will not invest as much ingenuity in trying to evade them. Second, the level of the regulatory requirement—such as the required level of capital—can then be increased if necessary, so that it has the desired effect when really needed.

Finally, regulations that are not particularly costly for the regulated to implement or for the regulator to enforce are less likely to be evaded or ignored. Moreover, they are likely to have more staying power as memories of past problems fade.

Let us apply all these principles to a concrete question: how do we prevent the systematic tail risk taking that nearly destroyed the financial system? I have focused on two related examples of tail risks—the risk of default embedded in senior asset-backed securities and the liquidity risk inherent in financing potentially illiquid assets with very short-term debt. I examine detailed proposals for reducing such risk, because measures that seem reasonable at first glance often raise more concerns on closer examination.
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As I argue in
chapter 7
, there are huge incentives at every level in the financial system to take on these tail risks if they can be concealed from those assessing performance. Those giving up the tail risk are willing to pay a premium to do so, while those taking it on and downplaying the eventual risk of payout can treat the premium as pure profit, the product of their natural brilliance rather than merely a compensation for risk. The premium paid by those selling the risk increases in proportion to the anticipated loss if the risk actually hits (they pay more if they think earthquakes will do more damage); and the higher the premium, the more of the risk the sellers are willing to take on (because they do not anticipate being around when their firms have to make good the loss). Too many firms will be eager to take on risks that have extremely costly consequences, and they will compete to take the risk at too low a price. The net result is that too much of the risk will be created.