In finance we distrust

Around the world,, the debate about financial regulation is coming to a head. A host of arguments and proposals is in play, often competing with one another - and thus inciting public and political confusion. 

One approach to financial re-regulation - supported by arguments of varying persuasiveness - is to limit the size and scope of financial institutions.

Some claim that smaller entities can fail without impairing the system, thus sparing taxpayers the cost of a bailout.

But if systemic risk emerges in ways that are not yet fully understood, smaller banks may all fail or become distressed simultaneously, damaging the real economy. 

A second, hotly debated argument is that limiting banks' size and scope has relatively low costs in terms of performance.

This point is used to bolster a third argument: large institutions have undue political influence and thus “capture” their regulators.

Put bluntly, large and profitable financial institutions will find a way to get the regulatory system they want - one that is compatible with a highly profitable trading super-structure that goes beyond the requirements of hedging and seeks to maximize short-term gains.

A second approach, on which there is substantial agreement in principle, is to limit leverage.

The main argument is that high leverage contributes powerfully to systemic risk - a condition in which asset prices move in a highly correlated way, and distress, when it occurs, spreads quickly. Leverage is also partially caused by misperceptions of risk and mispricing of liquidity. It is desirable to constrain leverage, but not to the point of increasing the cost of capital and investment.

Moreover, few would disagree that, as the complexity of the system increases, gaps and asymmetries in terms of information, knowledge, and expertise are multiplying.

Such asymmetries impair market performance in a variety of ways, and conflicts of interest are particularly dangerous in such an environment because they create an incentive to exploit precisely these advantages. 
 

Rigorous disclosure requirements that include conflicts of interest are one way to limit the potential damage. Or the conflicts can be limited by regulating the scope of financial institutions.

 For example, asset management, distribution, underwriting and securitization, and proprietary trading would be separated in various ways.

This approach has the added advantage of preventing different risk profiles and their appropriate capital requirements from getting mixed up in the same entity and balance sheet.

There are two other ways to address complexity and asymmetries. One, widely adopted in developing countries, is simply to impose restrictions on products (for example, derivatives and hedge funds) on the grounds that the upside in terms of risk avoidance far outweigh the costs - less access to capital and reduced risk spreading.

The other way is to try to reduce the informational gaps or their impact by regulating the expertise and incentives surrounding the rating process (the failure of which had serious consequences in the current crisis).

At a somewhat deeper level, there are two conflicting threads running through the public debate surrounding the crisis.

One is the “perfect storm” position: there were very many failures, misperceptions, informational asymmetries, and complexities, as well as much repugnant behavior, but it never occurred to market participants, regulators, or academics that the aggregate effect would be a near-collapse of the system.

Critics of that argument maintain that sophisticated players understood the systemic risks, didn't care, and cynically played the game that they helped to create - in some cases for enormous profit.

It now seems universally accepted (often implicitly) that government should establish the structure and rules for the financial system, with participants then pursuing their self-interest within that framework.

If the framework is right, the system will perform well. The rules bear the burden of ensuring the collective social interest in the system's stability, efficiency, and fairness.

But in a complex system in which expertise, insight, and real-time information are not concentrated in one place, and certainly not in government and regulatory circles, reliance on such a framework seems deficient and unwise.

Moreover, it ignores the importance of trust.

A better starting point, I believe, is the notion of shared responsibility for the stability of the system and its social benefits - shared, that is, by participants and regulators.

It is striking that no senior executive of whom I am aware has laid out in any detail how his or her institution's expertise could be deployed in pursuit of the collective goal of stability.

The suspicion that underlies much of today's public anger is that these institutions, having influenced the formulation of the legal and ethical rules, could do more to contribute to stability than just obey them.

The finance industry, regulators, and political leaders need to create a shared sense of collective responsibility for the system as a whole and its impact on the rest of the economy.

This set of values should be deeply embedded in the industry - and thus should transcend haggling over regulation. It should take precedence over narrow self-interest or the potential profit opportunities associated with exploiting an informational advantage. And it should be thought of as an addition to the guiding norms, rules, and ethics associated with “normal” times.

Some will object that this idea won't work because it runs counter to greedy human nature. Yet such values shape other professions. In medicine, there is a huge and unbridgeable gap in expertise and information between doctors and patients.

The potential for abuse is enormous. It is limited by professional values that are inculcated throughout doctors' training, and which are bolstered by a quiet form of peer review.

By itself, such a shift in values and the implicit model that defines roles certainly will not solve the challenge of systemic risk. Neither will fiddling with the rules.

Taken seriously, however, it could help provide an ongoing reminder of the importance of the financial sector to the broader well-being of the economy. It might even help start rebuilding trust.

Michael Spence, a Nobel laureate in economics and Professor Emeritus at Stanford University, chairs the Commission on Growth and Development. Courtesy Project Syndicate
  

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