A great insider’s take on the financial crisis

September 1, 2009

     By Duncan Green     

Normally I’m not a big fan of those ‘roundtable’ pieces in current affairs mags that usually feature 3 or 4 big egos all scoring points and showing off to each other. But the roundtable on the financial crisis in this month’s Prospect magazine is an exception. Featuring Adair TurAdair Turnerner, (the chair of the Financial Services Authority, Britain’s financial regulator, see pic), being cross examined by academics and journos, it won headlines (and an instant backlash from the City) because Turner came out in favour of a Tobin Tax on banking transactions to curb excessive profits, and because he appeared to question the central role of the City in the British economy. But the piece is much more wide ranging and interesting than this suggests. Some excerpts (all quotes from Turner unless specified otherwise):

Scale of problem:
‘What has occurred has imposed huge economic harm throughout the world and so we really do have to work out how to stop it happening again in five or ten years’ time. And that requires a very major reconstruct of the global financial regulatory system, and I don’t mean a minor adjustment.’

The plight of the regulators:
‘For the regulators of the world, once you’ve accepted that you don’t have an intellectual framework of “more market is always better,” you’re in a much more worrying space, because you don’t have an intellectual system to refer each of your decisions, and that requires more judgement and therefore confidence.’

Lessons Learned
‘There are two particular areas where we know the direction of travel but turning it into concrete analysis is tough. First of all, this whole area of macro-prudential policy, the importance of seeing the big picture and having the right levers to pull—we all recognise that we need levers other than micro-prudential ones or other than interest rates alone. There’s something that resides in the middle there, economy-wide capital or liquidity measures which make the system more stable. But one issue here is do we try to hardwire things into the system so that when you go into a boom an automatic formula demands of banks, for example, that they squirrel away more capital? Or should such decisions reside within a body of wise people, some financial stability committee?

Second, we have had a very fundamental shock to the “efficient market hypothesis” which has been in the DNA of the FSA and securities and banking regulators throughout the world. The idea that more complete markets and more liquid markets are definitionally good and the more of them we have the more stable the system will be, that was asserted with great confidence up to three years ago. But what precisely we do as a result of the collapse of that approach is unclear. Does that mean that we as regulators have to sometimes ban new products and say, “I’m going to ban that unless you can prove to me that it is socially useful”?

The finance sector is too big:
‘The fact that the financial services sector can grow to be larger than is socially optimal is a key insight….the whole financial system has grown bigger than is socially optimal.’

Should we treat financial products like new drugs?
‘It is hard is to distinguish between valuable financial innovation and non-valuable. Clearly, not all innovation should be treated in the same category as the innovation of either a new pharmaceutical drug or a new retail format. I think that some of it is socially useless activity. On the other hand, I don’t know whether that means the world would have been better off without any credit default swaps, or simply some credit default swaps. I just think it’s difficult to work out where one can draw the line with this. And that leads me away from the idea that regulators should be saying: product X bad, product Y good, and more towards a set of mechanisms such as high capital requirements which create hurdles for new products, but do not stop those that are of obvious value.

[but then later he adds] one version of that is when a bank comes to us and says “can I produce this product,” and we will say “no, it’s a dangerous product, it hasn’t been test-run.” I think this is the way that we are heading. And I think we will have a bias to conservatism when it comes to new and unproven products. We won’t necessarily say you can’t do this, but we are going to hit it with a large capital requirement.’

On Tobin Taxes:
‘Higher capital requirements against trading activities will be our most powerful tool to eliminate excessive activity and profits. And if increased capital requirements are insufficient I am happy to consider taxes on financial transactions—Tobin taxes, after the economist James Tobin. Such taxes have long been the dream of the development economists and those who care about climate change—a nice sensible revenue source for funding global public goods. The problem is that getting global agreement will be very difficult.’ [note he is not principally supporting a Tobin Tax on either of the two normal grounds – stabilizing exchange rates or raising money for global public goods, but as a way of taxing excessive profits]

On regulatory capture:
‘It’s useful to distinguish two things here, one of which I’d describe as overt lobbying power and another is regulatory capture through the intellectual zeitgeist.

And last word to the FT’s Gillian Tett: ‘Over the past year I have been talking to former true believers and they’re like a priest who has lost faith in the Bible, but still has to go to church, and the congregation is sitting there but he doesn’t know what the Bible is any more.’

September 1, 2009
Duncan Green