Regulation and the financial crisis
Eamonn Butler recently wrote an article for the Times arguing that regulation's role in creating the financial crisis has been underappreciated. Chris Dillow has responded arguing that, as banking crises have been a feature of economic life since the Industrial Revolution, this is a bit of a red herring.
The problem with the argument Chris puts forward is that he is conflating the relatively high frequency of banking crises around the world with the systemic stability of the British financial system. While banking crises may be fairly commonplace the modern British financial system has actually been quite stable. The last serious deposit bank failures were in 1878 when the City of Glasgow Bank and the West of England & South Wales District Bank failed. That means there is an important question to be asked about why a system that has been quite stable for more than a hundred years has failed on such a spectacular scale; we can't just put the financial crisis down to the inherent instability of the system and do need to work out what went wrong.
That's where a report I wrote last year comes in. It put forward a comprehensive account of how inept regulation and poor policy choices drove the financial crisis.
Low interest rates encouraged more borrowing and riskier lending. Combined with a perception that lasting economic stability had been achieved these low interest rates led to a systematic underpricing of risk. At the same time, regulations and government sponsored institutions in the United States encouraged lending to marginal customers. Fannie Mae and Freddie Mac, backed by the Government, bought 44 per cent of all subprime securities. Planning regulations in the UK and the US increased price volatility as, when the supply of housing is extremely inelastic, shifts in demand are almost entirely reflected in prices. All this was instrumental in building up an asset bubble.
Regulators were unable to respond effectively. The Bank of England felt hamstrung by EU rules - whether it should have or not - and lacked the information needed to exercise its lender of last resort function thanks to losing responsibility for bank regulation under the tripartite structure. As far back as 2002 the British Bankers' Association were warning that the Financial Services authority was failing to pay sufficient attention to systemic risk. That isn't because it was regulating with too light a touch, Europe Economics found that compliance costs were up 50 per cent under the FSA, but because it focussed on box ticking rather than the broader health of the financial system.
Once the asset bubble started to burst, international regulations exacerbated the crisis. Studies for the US Federal Reserve System confirmed they were procyclical as far back as 2004. Common capital adequacy rules encouraged firms to hold similar assets and respond in similar ways in a crisis, amplifying herd behaviour. If the rules force everyone to do the same thing then the resulting lack of diversity makes crises more likely and worse when they happen. At the same time, mark to market regulations forced firms to price their assets on the basis of markets that had temporarily ceased to exist. Had mark to market regulations been in place in the 1980s every one of the United States’ ten largest banks would have become insolvent.
Clumsy responses to the financial crisis made things even worse. Regulations on short selling hurt hedge funds and, in doing so, made things harder for banks by preventing them getting funding by issuing convertible bonds.
In one way, Chris is right. The debate over whether or not this crisis would have happened in a world of no regulation probably is a bit of a red herring. It's an interesting academic question and one that is worth thinking about for its own sake and in case we wind up needing to build a financial system from scratch if this crisis really goes apocalyptic. However, even with the present system's travails it is unlikely that such a world is on the menu.
Instead, the more important debate is probably over why our financial system has turned from being relatively stable, able to survive the Great Depression in good working order, to a basket case. As the analysis above, and in more detail in the TPA report, aims to demonstrate, I don't think that the answer is that regulation had too light a touch. Instead, the problem was that the particular set of regulations and policies in place encouraged the build up of an asset boom and then made the financial system far more vulnerable to it bursting.