Small World

Market crashes are inevitable, but financial innovation and globalization have massively increased our vulnerability to them. Unless we make big regulatory changes—changes on a global scale—we should prepare for more years like this one.

For example, in the United States, when the net worth of an ordinary deposit-taking bank falls to a certain point (but before it gets to zero, so the bank is not yet insolvent), a procedure overseen by the Federal Deposit Insurance Corporation kicks in. The bank is acquired, its shareholders are wiped out, its depositors and creditors are protected, and its business is wound up in an orderly fashion. At present, there is no such procedure for non-banks, and this needs to be remedied. It is why Bear Stearns had to be forced (over the course of a weekend) into a merger, and Lehman Brothers (over the course of another) into a disorderly bankruptcy—an event that many observers regard as the immediate cause of the financial crash, of the subsequent part-nationalization of America’s biggest banks, and of the severe recession that is now taking place.

Under a wide new umbrella of regulation, which watches non-banks as closely as banks, new attention will also be paid to the dangers of leverage. Without excessive leverage, there would have been no financial crisis, even if every other mistake had still been made. Too much leverage weakened the industry and doubled down on the bets it had made. When the bets went wrong, the system crashed.

There is a catch, however. In moderation, leverage is essential. It is how financial firms make money. They hold a base of capital, let’s say in the form of low-yielding government securities. Then they borrow, either from depositors or in the capital markets, and lend on at a higher price. The higher the ratio of loans to capital, the greater the leverage, and the larger the profits. But the price you pay for a narrow base of capital is greater risk of insolvency if things go wrong, since capital is the reserve that a bank or non-bank holds against unforeseen losses. An age-old rule of finance, often forgotten but never repealed, is that higher returns entail greater risks.

One way or another, the new regime is going to tell banks and non-banks to hold bigger reserves of capital. To be sure, the new agenda for financial regulation will turn to myriad other issues as well: oversight of complex financial derivatives; a central clearing system for those products (at the moment, most derivatives are sold “over the counter,” which makes them less liquid and riskier to hold); new liquidity requirements; rules for pay and incentive schemes for financial executives, to discourage reckless bets; extra supervision of housing loans; new curbs on the role of rating agencies; and much more. All of these matter, but the critical points will be to insist on more capital, and to apply this rule more broadly, so that its reach extends beyond traditional banking, making the entire financial industry, and hence the wider economy, more resilient.

Of course, these regulations will exact a price. The financial industry will grow more slowly. Banks and non-banks will be less eager to grant loans, especially to marginal borrowers. Investment might suffer. Finance will be less exciting, and there will be a lot less money to be made.

As much as the industry may choose to stress the other reasons, it will resist because of that last one. It will argue, among other things, that stricter rules would put it at a disadvantage relative to foreign competitors. As memories of the crisis fade, regulators will likely be sympathetic to this argument. They usually have been before. And this time around, they will be big bank shareholders in their own right. When governments come to divest the enormous stakes they acquired in these firms during the crisis, they will face an intriguing conflict of interest: the stricter the capital requirements they impose on banks—the safer they make the system—the less those shares will be worth.

In the past, though, the clinching argument in debates about how tightly to regulate finance has been the need to compete and thrive in the global financial system. Do Americans want their financial firms to be global champions? Or do they want them overrun by (less stringently regulated) foreigners in their own backyard? Under the onslaught of continuing innovation, broader and more effective financial regulation would be difficult to achieve in any case. If governments cannot bring themselves to co-operate, the cause may be hopeless. A country can go it alone in setting tighter rules, but must expect to lose business if it does.

Why, you might ask? Surely well-regulated markets promote trust and confidence, which reduces costs. Business will migrate to those jurisdictions. True, but it is a question of balance. After a certain point, stricter rules (on holding low-yielding capital, say, or on minimum levels of liquidity) add more to the cost of doing business than they subtract. In a globally integrated financial system, firms, within limits, can choose their regulator. For example, the Sarbanes-Oxley Act, written in haste to tighten accounting rules and improve corporate governance after the Enron scandal, is partly responsible for the rise of London over New York as the global center for initial public offerings of corporations. In any case, even if the U.S. did choose to go ahead with tighter regulation on its own, it still would not be safe. Financial operations are internationally connected. Some risk would remain that a financial crisis born of poor regulation abroad might spill over at home.

The crash has focused minds. Interest in coordinated intervention and financial rule-making has surged. But national regulators still go about things in their own way, and they are jealous even now of their independence. At one post-crash meeting of finance experts, I heard how difficult it would be to persuade Europe’s governments to create a single securities or banking regulator for the European Union—even though Europe’s governments have a long history of pooling sovereignty and cooperating closely. When I asked about creating a single global financial regulator—a big idea, you might think, whose time has come—I received incredulous looks. “That will never happen.”

Just like American house prices would never fall? With or without better financial regulation, there will be more asset-price bubbles and credit-driven booms; more asset-price collapses and credit-crunch recessions; more economic shocks that propagate worldwide. If the United States wants to weaken these cycles, it will have to strengthen its financial regulators in their long war against the industry’s innovators. More than anything else, what regulators need in fighting that fight is allies abroad.

Clive Crook is a senior editor of The Atlantic, a columnist for National Journal and a commentator for the Financial Times.
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