GLOBAL FINANCIAL CRISIS

Global Financial Crisis

Global Financial Crisis

Introduction

In April of this year the G7 finance ministers, worried about growing financial turbulence, endorsed the approach to regulatory reform presented to them in a report from an eminent group including the Chairman of the UK's Financial Services Authority, the President of the Federal Reserve Bank of New York, and the Chairman of the US Securities and Exchange Commission.

The report began with an honest recognition of past failure: 'A striking aspect of the turmoil has been the extent of risk management weaknesses and failings at regulated and sophisticated firms.' There followed a series of detailed recommendations, the essence of which was embodied in three core themes: greater transparency, greater disclosure and stricter risk management by firms. In other words, nothing new. The Committee was repeating the tired trinity that has defined financial regulation for the past three decades. The trinity failed, and without a new approach the regulators will fail again.

That failure had two closely related origins: regulation failed to keep up with the institutional changes that in 30 years have transformed financial markets; and the regulators accepted that firms had the technical skills, expressed in their mathematical risk models, to manage risk better than the regulator could.

Thirty years ago most loans, to businesses and to individuals, were made by banks, or specialist institutions such as building societies. The deregulatory fervour of the 1980s changed all that. Credit markets became 'disintermediated'; instead of banks acting as intermediaries between savers and borrowers, the markets took over. A significant proportion of borrowing (though still less than half) is now packaged into securities that are sliced and sold through a myriad of financial intermediaries. Investment banks, like Lehman Brothers, Merrill Lynch and Goldman Sachs, were at the centre of this process, taking on massive amounts of debt relative to their capital base (becoming highly leveraged) in order to deal profitably in the complex web of markets. Guiding their operations were their mathematical risk models, statistical models that measure the riskiness of their operations against patterns of past market behaviour. The firms claimed that they could manage risky markets, and the regulators swallowed that claim. Faith in transparency, disclosure and risk management by firms is at the heart of the financial regulation today. While the investment banks have disappeared, the same philosophy persists at the heart of financial regulation.

Yet at the same time it is generally accepted that a core purpose of financial regulation is to mitigate against systemic risks, like a global credit crunch. Such risks are externalities, their cost to the economy as a whole is greater than the cost to a firm whose actions are creating the risk.

But if regulators focus on risks that are recognised by firms already, and neglect systemic risk, why do we need regulation at all, other than to enforce best practice? Firms will manage their risks well enough, using systems that are inevitably (and properly) market sensitive. The flaw is that in the face of systemic market failures even the most ...