Tell them it is human nature

9 Jul 09
IAN MULHEIRN | The banking white paper fails to address the causes of last year’s financial collapse and should focus more on rules and less on regulator discretion

The banking white paper fails to address the causes of last year’s financial collapse and should focus more on rules and less on regulator discretion

What caused the crash of late 2008? It would be comforting to think that those designing the new framework of financial regulation would do so informed by a full appreciation of the answer. But, in the debate over regulation – to which the Treasury’s white paper this week is a major contribution – important lessons of the crisis are being overlooked.

Macroeconomic causes aside, there were two main drivers of the financial and ensuing economic meltdown: inadequate regulatory rules and common-or-garden human nature.

After waking from the collective boom-time reverie, policy-makers are in danger of missing the behavioural point. The macro-prudential agenda appears to be focusing more on the discretion of sagacious regulators than on promoting a better rules-based system. As the Treasury’s paper this week put it: ‘Constraining the inherent pro-cyclicality of financial markets will require an element of discretion.’ Yet an overreliance on the proposed Council for Financial Stability will make the failures of the past more likely to recur.

The accurate, but partial, conclusion of the post-mortem on the origins of the crisis was that the regulatory rules governing finance were ineffective. Financial innovation meant that new products and institutions were beyond the reach of the existing rules.

Meanwhile, an ‘underlap’ of responsibility between the Bank of England and the Financial Services Authority meant that nobody raised the alarm about dangerous levels of debt across the financial sector. This has led many observers to suggest that, since the rules failed, more regulator discretion is needed to allow those who referee the system to adapt to this fast-changing environment. A nice idea – in theory.

The important question of how to ensure that banks are holding enough capital to cushion themselves against losses is a good test case for how this might work. There is widespread consensus on the need to force banks to raise their capital reserves in good times to protect them from collapse in the bad times – so-called ‘dynamic provisioning’. The difficulty is how to do it, and the Treasury’s white paper largely left that argument for another day.

Those who emphasise past regulatory failure advocate some kind of independent panel, similar to the Bank’s Monetary Policy Committee, to monitor systemic risk and tell banks to increase their capital buffers when things start to overheat. This would presumably be a power that would sit with the proposed council. But working out the difference between a sustainable and an unsustainable growth in lending, without the benefit of hindsight, is a near impossible task. And, in the confusion, regulators are exposed to capture by the soothing siren calls of the City.

Boom mania and collective delusion were major ingredients of the subsequent bust, and very few stood aloof from it. In 2006, for example, the International Monetary Fund went out of its way to explain how banks were less vulnerable than ever to credit or economic shocks. In the same vein, others, in extolling the efficiency of markets, convinced themselves that risk was spread to those most able to bear it rather than those least able to understand it. So a reliance on groups of ‘experts’ to judge when things are getting risky suggests a naivety about the behaviour of human beings that would be touching if it wasn’t so potentially catastrophic.

A rules-based approach to capital requirements therefore merits a much closer look. Some will argue that rules themselves can be watered down once people get complacent in the good times. But at least such an institutional constraint requires transparent public debate to change it. And that is a better safeguard against spurious and seductive arguments, made behind closed doors, in a system that relies purely on the judgement of a few experts.

The regulatory system that emerges from the financial debacle of the past two years must recognise the weaknesses of the human beings who run it. The business cycle will always be with us. But until we finally grasp our own susceptibility to the stories we tell, and design institutions that can save us from ourselves, we can expect financial and other bubbles to continue to grow and burst with devastating results.

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