It should be clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations, market efficiencies, and the techniques of modern finance. That faith was stoked in part by the huge financial rewards that enabled the extremes of borrowing, the economic imbalances, and the pretenses and assurances of the credit-rating agencies to persist so long. A relaxed approach by regulators and legislators reflected the new financial zeitgeist.
All the seeming mathematical precision that was brought to investment, all the complicated new products, including the explosion of derivatives, that were intended to diffuse and minimize risk, did not work as had been claimed. Instead, the vaunted efficiency helped justify an explosion of weak credit and an emphasis on trading along with exceedingly large compensation for traders.
If those remarks sound critical—and they are meant to inspire caution—let me also emphasize that the breakdown in financial markets and the “Great Recession” since 2007 are also the culmination of years of growing, and ultimately unsustainable, imbalances between and within national economies. These are matters of failures of national economic policy and the absence of a disciplined international monetary system.
Take the most familiar and egregious case. The huge surpluses China has accumulated from its external trade reflect the view of the Chinese government that it is desirable to have rapidly growing export industries that support employment growth. China was willing to build up trillions of short-term dollar assets, mainly US securities paying low interest rates—and thus kept the process going. Conversely, the United States happily utilized that inflow of low-interest dollars from China to sustain heavy consumer spending—much of it on Chinese products—a growing budget deficit, and eventually an enormous housing bubble.
Or consider the current European crisis. At its roots are years of growing imbalances within the countries of the eurozone. As in other parts of the world, the ability to borrow at low rates bridged for a while the proclivities of some countries to spend and import beyond their means, while other countries saved and invested, tending to reinforce an underlying gap in productivity between national economies.
Those were fundamentally matters of public policy—the result of decisions on taxing, spending, and exchange rates; they were not a reflection of the characteristics of the financial market. But neither can we ignore the fact that financial practices helped sustain such imbalances. In the end, the build-up in leverage, the failure of credit discipline, and the opaqueness of new kinds of securities and derivatives such as credit default swaps helped facilitate, to a truly dangerous extent, accommodation to the underlying imbalances and to the eventual bubbles.
All these developments derive in some part from the complexity implicit in the growth of the so-called shadow banking system—the nondepository banks, hedge funds, insurers, money market funds, and other largely unregulated entities that grew enormously in size after 2000—a system that by June 2008 was roughly the size of the traditional banking system. In the end, the consequence was to intensify the financial crisis and to severely wound the real-world economy. Even today, four years after the first intimations of the subprime mortgage debacle, high indebtedness and leverage, impaired banking capital, and a pervasive loss of confidence in a number of major financial institutions constrict an easy flow of credit to smaller businesses, potential home buyers, and consumers alike.
Where do we stand?
The first international response has been to review the capital standards required of commercial banks. How much capital should such banks be required to retain relative to their loans? That’s an old question. Shortly after I left office as chairman of the Federal Reserve in 1987, the Basel I agreement was completed, setting out so-called risk-based capital standards for banks to be adopted by all financially important countries. That agreement was, indeed, a success. Standards for maintaining adequate capital were raised and a degree of international consistency achieved. Those goals remain critically important, and as illustrated by the Basel agreement, capital standards for banking can be agreed on and enforced by national regulators, such as central banks, rather than await legislation in individual countries.
Review of those capital standards for banks—now with the further consideration of standards for the liquidity they should maintain—is widely perceived as a central element in the current reform effort. Some would contend it is the central element. I do not want to discount the importance of such work. We do need, however, to be conscious of the practical difficulties and limitations of setting capital and liquidity requirements. Those problems have long been evident in the effort to enforce the standards established by the earlier Basel agreements. Not surprisingly, they reappear in the ongoing negotiations to strengthen those standards. We see differences in national perceptions, reinforced by intense lobbying by affected institutions, whether central banks, commercial banks, or investment banks. In establishing standards for banks the tendency may be to bend toward a least common denominator, weakening the standards and allowing them to be unevenly applied. Resisting such pressures must be a priority for regulators.
There is the larger conceptual and unsettled question of the extent to which such standards should be applied to the “shadow” banking system I have referred to. When we talk of “systemically important” shadow banks and say they should be regulated, what precisely do we mean? How will their failures affect the entire financial system? These are matters for legislation, complicated further by the need for enough international consistency to resist “forum shopping”—the transfer of operations to less well regulated countries.
The need for regulators and supervisors to take account of new institutions and markets has spawned the new phrase “macro-prudential”—to me cumbersome nomenclature. Just what it implies about the actual practice of regulation is obscure. “Systemic surveillance” or “broad market oversight” seems to convey better what is necessary and desirable. Someone, some agency, some group, should be charged with taking a holistic view toward assessing financial markets and institutions, with particular attention to the interconnections among them, whether domestic or international. Potentially dangerous inconsistencies and instabilities—the growth of the housing bubble based partly on securitized subprime mortgages would be a good example—need to be recognized and assessed. Whether that assessment need carry with it specific regulatory responsibilities and enforcement authority (for instance, setting and enforcing capital standards for “nonbanks” such as hedge funds) will likely vary from country to country. But there can’t be much doubt that success will require international consultation, exchanges of information, and in some areas coordinated action.
These days, finance flows far more freely across national borders than trade. Technology tightly links the operations of big banks and markets. Hedge funds and equity funds, securitized products—even equity markets—are more and more international by nature. Only the most draconian and destructive regulatory measures could stop this interconnectedness.
Today in Europe we see all those realities play out in real time in extreme form. Among nations dedicated to a common market and a common currency, the tensions are great. The plain implication, to me, is not to retreat from an integrated eurozone. Right now it is a question of building protection for European banks and countries that are at risk and faced with financial breakdown. But ultimately what is needed is a new institutional structure that will require greater consistency in banking and financial standards and, more broadly, will also require stronger discipline in fiscal and economic policies.
There is no compulsion to carry that process of integration so far in the world more generally. The financial breakdown and the resulting severe impact on economic activity do, however, point to the need for international coordination beyond the accepted need for common capital standards.
Among the more obvious areas is agreement on international accounting standards. The groundwork has been well advanced for over a decade. Full success, however, still awaits a definitive decision on those standards by the SEC in the United States. I would add to that a more elusive but equally important consideration: auditors who are truly independent and approach their responsibilities with a certain skepticism. American authorities are now considering, among other means to that end, a requirement that auditors of corporate accounts regularly be changed.
Given the weaknesses and conflicts exposed by the crisis, the role and structure of credit-rating agencies also need further review. So far, no fully satisfactory approach has been set out, but surely this is a matter for international consideration. Current efforts directed toward reform within the major firms such as Moody’s and Standard & Poor’s should help, but other approaches need emphasis. Reliance on the formal ratings issued by an oligopoly of the dominant credit-rating agencies could be reduced by greater, perhaps more focused, competition from other agencies. It would also help to establish standards for competent “in-house” determinations of credit standards, a matter touched upon by the Dodd–Frank legislation passed in July 2010.
More immediately important, and it seems to me more amenable to structural change, is the role of money market mutual funds (MMMFs) in the United States. By grace of an accounting convention, those funds are permitted to meet requests for withdrawals upon demand at a fixed dollar price so long as the market valuation of fund assets remains within a specified limit around the one dollar “par” (in the vernacular “the buck”). Started decades ago, money market funds today have trillions of dollars heavily invested in short-term commercial paper, bank deposits, and recently, and notably, European banks.
Free of capital constraints, official reserve requirements, and charges for deposit insurance, these MMMFs are truly hidden in the shadows of banking markets. The result is to divert what amounts to demand deposits from the regulated banking system. While generally conservatively managed, these funds are, in troubled times, demonstrably vulnerable to disturbing runs, as was highlighted in the wake of the Lehman bankruptcy after one large fund had to suspend payments. The sudden impact of that suspension on the availability of business credit in the midst of the broader financial crisis compelled the Treasury and Federal Reserve to provide hundreds of billions of dollars by resorting to highly unorthodox emergency funds to maintain the functioning of markets.
Recently, in an effort to maintain some earnings, many of those funds invested heavily in European banks. Now, with no official protection of liquidity, they are actively withdrawing those funds, adding to the strains on European banking stability.
The time has clearly come to harness money market mutual funds in a manner that recognizes both their structural importance in diverting funds from regulated banks and their destabilizing potential. If indeed they wish to continue to provide, on so large a scale, a service that mimics commercial bank demand deposits, then strong capital requirements, government insurance protection, and stronger official surveillance of their investment practices are called for. Simpler and appropriately, they should be treated as ordinary mutual funds, with redemption value reflecting day-by-day market price fluctuations.