Lessons from the Crisis for Financial Regulation: What we need and what we do not need

In its broad outlines the current financial crisis was foreseen, though not in its specific detail. Virtually all of the major central banks and international financial institutions had been warning about the underpricing of risk and excessive leveraging by 2006/7. the BIS had been warning about it for years. Admittedly few outside the banks themselves knew about the growth and extent of the grey, or shadow, banking system in the guise of conduits, SIVs, etc., and, since a main rationale for this shadowy sub-system was regulatory arbitrage, the banks were not loudly advertising such activities.

So I very much doubt whether insufficient information was a major problem in this crisis. And even if the central banks had had more information, what could they have done with it? There are those who believe that public warnings, based on better information, would help. But I remember Robin Leigh-Pemberton warning the British banks in 1988/89 against making more property loans. And did it make a blind bit of difference? Even if Mother Teresa, the Archbishop of Canterbury and the Pope were to warn against a certain line of bank activities, it would do no good; indeed probably the reverse because immoral actions are usually short-term fun and profitable.

The problem is not information, but the lack of instruments that can be used to counter the bubbles in asset prices and bank lending that precede and create the subsequent bust (and also the will to use such few prudential instruments as may be available to temper an asset price bubble). When I served Eddie George as an adviser on prudential matters, the Bank of England had a financial stability committee, meant in some ways to be the counterpart of the Monetary Policy Committee. But it was not, of course. The MPC sets the interest rate; it has a role and a function. The FSC set nothing; it had nothing it could set; it was just a talking shop, rehearsing potential fragilities and dangers in the financial system, to be later revealed to a public, awaiting with anxious trepidation, in the Bank’s Financial Stability Review.

Now this is better than nothing, but not much. The Bank’s FSC, the BIS and the IMF can warn till they are blue in the face, with the benefit of more and more information, but it will not do much good. What we need are counter-cyclical instruments.

Can we use the one counter-cyclical instrument that Central Banks now have, the interest rate, to counter asset price bubbles? Most economists say, ‘no’; interest rates should be predicated to achieving price stability. Broadly I agree, but I would make two points. First, should not a proper definition of price stability include housing prices; currently excluded from the European CPI; and second even if interest rates were to lean a little against asset price bubbles, (and those in bank lending), for example via Otmar Issing’s second pillar, it probably would not be enough to flatten a strong bubble and bust in asset markets by much.

What else have Central Banks got to counter asset price, and bank lending fluctuations? Most regulation is currently pro-cyclical. The combination of Basel II and mark-to-market accounting further drives the procyclical spiral. Most official, and unofficial, studies of the financial turmoil have been silent on the responsibility of the regulatory system for our present troubles.

At least when the bust does finally come, central banks can help pick up the pieces with liquidity support. But here there are problems too. First there is the stigma issue. Because of this many of the supposed first-round defences, for example lending at the discount-window, or upper band, became largely unusable. Second, when push came to shove, Central Banks were effectively forced to lend to all systemic parts of the financial system on the basis of whatever the latter had available. Is there not a moral hazard in that? Why should commercial banks hold low-yielding safe assets in good times, if central banks will lend on anything that banks can rustle up in bad times?

Central banks did nothing during the asset price and leveraged credit bubble prior to 2007, because there was almost nothing that they could do. And now there are suggestions that central banks should be made statutorily responsible, at least in the USA and UK, for systemic financial stability. You may have heard the phrase, normally attributed to newspaper magnates, that ‘power without responsibility is the prerogative of the harlot’. Well, ‘responsibility without power is the prerogative of a eunuch’. Not only are our Central Banks currently eunuchs in this case, but the life of a harlot probably involves more fun and better earnings than the life of a eunuch.

So, what needs to be done to give our central bank some balls? In broad terms capital and liquidity requirements have, somehow, to be made counter-cyclical, and I would add maximum, time-varying, loan-to-value ratios reintroduced. There are four generic counter-arguments against doing all that:-

First, it raises the cost of borrowing in good times, and hurts in particular the first-time buyer in the housing chain then;

Second, if introduced separately in an individual country, it will just drive the business off-shore;

Third, it may greatly increase the informational burden on banks; and

Fourth, by imposing greater costs on commercial banks during expansionary phases, it will even further enhance the incentive to off-load assets onto associated off-balance sheet entities.

These arguments will be deployed; and central banks need to respond robustly. Moreover the penalties for failure to disclose all associated off-balance sheet business entities need to be reinforced.

Perhaps the most problematical issue is liquidity, because a central bank, as we have now graphically seen, will lend against almost anything when a real crisis hits. My view is that a central bank cannot possibly commit to stand aside in such a case. But it may be able to commit to vary the rate at which it lends depending on the prior history of liquidity maintenance by each bank. If you add to that a Special Resolution Regime such that banks that find higher priced emergency lending driving them towards insolvency can be taken over quickly enough by the authorities, then maybe we can devise enough carrots and sticks to devise a time-varying liquidity scheme. I have already tried my hand at one such proposal in my paper on ‘Liquidity and Money Market Operations: A Proposal’, available on the Financial Markets Group website at LSE. No doubt that can be much improved. Please do so.

Similarly a time-varying LTV needs to be supported by legal restrictions on second mortgages and home equity loans. Germany, I believe, does this. Should anyone, ever, be able to borrow more than, say, 97% of the current value of a property? If not 97%, what would be your preferred figure? 125% as Northern Rock did? And should appraisers of housing values somehow be made legally responsible, or at the very least independent of mortgage lenders and other interested parties in the deal?

As you mostly know, Avinash Persaud and I have proposed time-vary CARs based on growth rates of asset prices and bank lending, and we have further work to do on that, to fill in many of the important details.

So let me conclude. What does a Financial Stability Committee need to give it potency? What I believe that it must have is the power to revise liquidity arrangements, capital requirements and LTVs on a time-varying counter-cyclical basis. One of the war-time slogans in the UK was ‘Give us the tools and we will finish the job’. Currently there are no such proper tools; let us construct them.

11 Responses to "Lessons from the Crisis for Financial Regulation: What we need and what we do not need"

  1. Guest   May 10, 2008 at 3:25 am

    Committee on top of committee more bureaucracy . For one thing the governments should eliminate Central Banks that are private institutions run for profit. That would solve many many problems.

  2. London Banker   May 10, 2008 at 5:46 pm

    Welcome, Professor Goodhart!While I agree that counter-cyclical measures are required to prevent bubbles getting out of hand, I’m not sure that regulators will be any more inclined to use them in the next bubble than the last. Regulators and central bankers seemed determined to pour gasoline on the embers to restart the conflagration whenever it appeared at risk of subsiding. Everyone wanted a bonfire, and wanted it to continue as it ebbed, regardless of how much of the household furniture was sacrificed to the spectacle. Regulators and central bankers proved very pliable and accommodating to the bullying of the investment bankers, and indeed are bending over backwards still to keep the party going by taking impaired collateral and extending extraordinary liquidity facilities.I think until you address the very human failings of the regulators and central bankers trying to please the crowds of bankers on huge bonuses, you won’t fix the problem.

  3. Guest   May 10, 2008 at 7:07 pm

    In the case of the US much could have been done by the Fed that had the authority to regulate mortgage and that failed to used its authority because of a market fundamentalism approach to bank supervision and regulation. The US regulators were literally asleep at the wheel while all the greedy and reckless lending did occur.So while interest rate policy may be an excessively blunt instrument to control asset and credit bubbles the Central Bank (if it regulates and supervises banks) or the the relevant regulatory/supervisory agency has the power and ability to try to control asset and credit bubbles. If it fails to do so it is its own fault!

  4. Guest   May 10, 2008 at 7:41 pm

    Very good analysis. You are essentially saying that Basel II – with its procyclical CAR – is conceptually flawed even before it has been implemented. So time to move to Basel III already? Proably. Please provide links to your cited paper; most interesting.

  5. Guest   May 10, 2008 at 10:52 pm

    Charles this is a very interesting and important contribution; i am not convinced that much cannot be done about credit bubbles and i will write more on this topic on the near future; but you clearly describe the constraints faced my monetary authorities and financial regulators. Welcome to our new Finance & Markets Monitor; it is an honor that yours was the very first contribution to this new forum. Nouriel

  6. Guest   May 11, 2008 at 4:17 am

    "Currently there are no such proper tools; let us construct them."Professor,I have found your commentary rather negative and essentially focussed upon fixing a system that is well proven as inadequate. We have a financial, monetary and economic system that is based on money lending for profit – by interest and inflation. (actually we have two economies; one is the real economy while the second is the Ponzi Pyramid Economy; the casino and the two have become fused together so as to allow the latter to cover its losses from the former).It is today a pure fiat system. This system was developed over 2000 years ago and at the outset was deemed corrupted and vile by those of science and reason of those days. Nevertheless, we have chosen to go for it and remain in it up to our necks, despite it bringing death, destruction and misery to many innocents whenever the ravages of the human will go astray (moral hazard) as they are always, a priori, are prone to do. This system allows the chosen few, banks, to hoard money at an upper societal level (elite where political / bureaucratic toy boys gather to do the bidding), to lay claim over the public energies (work / labour) and purse, and wreak havoc on the unwashed masses always in desperate, a priori, self-agenda and survival. Not only is the current system unscientifically founded, it doesn’t work in terms of civilization and few understand its complexities; it also sucks. It is inadequate or if you like, it is an abortion that allows abuse by a few.One needs no vision to understand the numbers of the game have changed from 2000 years ago (we are now at ~7 billion) and it should be fairly obvious, that the Moral Hazard, that is MAN, in the form of bankers and regulators and all that hangs off them, has NOT changed one iota, excepts perhaps to have become a little more delusional as to the outcomes of their petty plays and oft indiscretions.SOooo, we need a new system; an automatic system that allows the exchange (energies, labour and innovation) of men to flow freely up and down and throughout where the elements of moral hazard, MAN, cannot stop the flow (keep their dirty hands off the cash). Hayek describes the pricing efficiencies of a free-market system, well known, so then we just eliminate all the central bankers from the equation and provide a mechanism for regulation while developing nipples to plug off to the secondary economy. Ephemeralization – Buckminster Fuller.The prime real economies of Nations must remain involitile and the secondary economies be allowed to provide growth as science feeds technology. The whole system is simple and could and should be founded in physics – no problem- the science is available, but…"Technology is easy and if it were not for the moral hazards of men in high places, we could create miracles on a daily frequency" (I said that).Therefore dear Professor, perhaps you look at the wrong end of this wet noodle?respectivelyPeterJB

  7. hlowe   May 11, 2008 at 11:41 am

    Thanks Professor Goodhart!LB and PeterJB, Nice, I trust you could help, unfortunately they who make the rules seems unable. If only we could start over before the system completely breaks.Not much of a contribution from me, just want you all to know I appreciate yours.

  8. Detlef Guertler   May 11, 2008 at 3:05 pm

    Why, Professor Goodhart, do you think Basel II is cyclical? In my view that depends on how the credit ratings are set – if you have reckless rating, as we have seen in the last years, you can inflate even the biggest bubbles. But if the ratings have something to do with the risk of default you can deflate the bubbles much earlier.So that’s what central banks should do: rating. There’s especially one bank I have in mind – the Bundesbank. If it really does what Moody’s was supposed to do trust may return to the lending process and stability to bubbling markets.

  9. Free Tibet   May 11, 2008 at 3:36 pm

    Giving “counter-cyclical instruments” to politically appointed regulators would not be my choice. Establishing rules for prudential management regardless of cycle would be preferable. Regulatory arbitrage, off balance sheet accounting, shadow banking, should have never been allowed. Positive/negative GDP, trumped up measures of inflation, whatever, has no relevance to those basic principles of clarity and trust.

  10. Joe   May 12, 2008 at 11:43 am

    Governments could enforce a countercyclical instrument with a tool they already have. If stamp duty (tax paid on value of house purchase) was 0% for the first 100,000 and then equal to the rate of house price appreciation in the previous year. No regulatory oversight needed.

  11. Anonymous ibid.   May 12, 2008 at 9:42 pm

    Charles Goodhart says, "What we need are counter-cyclical instruments."What we need are properly designed countercyclical instruments. So far, the Federal Reserve and Congress, not to mention the BoE, have managed to expend a huge treasure of economic ammunition on calming the nerves of the people who created the crisis. I don’t disagree that raising capital reserve requirements on banks now may be counterproductive. I do disagree that the bank is the place to focus in designing countercyclical efforts. One wants to use the economy as a whole with which to to lean, not fragile institutions like banks. One might add that the latter is, um, central planning. The proper analysis considers the differential effects on different segments of the economy. In particular, because of wealth polarization, we see the simultaneous emergence of asset price inflation concentrated at the higher end of the income scale and wage deflation at the lower end. Furthermore, the wartime economy the US is running is diverting production away from infrastructure essential to maintaining high productivity and creating inflationary pressures on materials. Consider that each soldier in the field consumes 16 gallons of gas per day, roughly 10 times more than the typical American. The tug on elasticity of demand is coming from the war, not just rising Asian incomes. Countercyclical tools need to be designed to minimize inflation. That means targeting them narrowly: mortgage assistance to non-speculative borrowers, work on the infrastructure deficits which could employ construction workers, unemployment insurance for workers for whom there is no present work, for example. Where these measures increase demand for critical– and inflation-prone– items like petroleum, offsets need to be found. Again, the key is to use aggregate demand from the economy as a whole, rather than try to manage institutions. Fraud instigated or condoned by lenders may well prove to be the dominant factor in the mortgage crisis. To fight that, oversight of the lending process is curative. If the system is free of fraud, allowing lenders to (occasionally) loan out over 100% may sometimes make sense, as when capital improvements to a property would greatly increase its value. We want to regulate with a light hand, but punish lawbreaking consistently and sternly. All this IMHO, of course.