Government influence in many leading banks is likely to continue for some time and has damaged the dogma of ‘efficient’ markets
In September 2008, the global financial system came perilously close to total collapse. We can now safely assume that the prospect of total systemic collapse is behind us, even if individual financial institutions are by no means yet out of trouble.
To have reached this stage, we all owe thanks to those politicians and central bankers who recognised the severity of the crisis and had the courage to abandon their traditional beliefs and practices to prevent disaster. In scope and scale, the range of policy instruments to help stem the crisis was unprecedented. Therefore, it is difficult for policy makers to predict the long-term consequences and, more pertinently, when and how these extraordinary measures can be withdrawn.
To use a medical analogy, the global financial system has suffered a major cardiac arrest. Death has been averted, but the patient is still in intensive care; a situation that is likely to remain for some time. While some individual financial institutions are in relatively fine shape, the system as a whole is going to require significant attention from governments, central banks and regulators before it can return to unsupported growth.
Among the significant consequences of the crisis, two stand out. The first is the death of the efficient market hypothesis — the belief that loosely regulated markets could take care of everything and that the government did best by staying out of the way. There was also an assumption that, as a consequence, markets were efficient and self-correcting, and that mispricing in the long term was therefore impossible.
We now know the first assumption to be largely false, and that, even if markets are self-correcting in the long run, the consequences of them doing so are too painful to contemplate. As economist John Maynard Keynes is alleged to have said: ‘The market can remain irrational longer than you can remain solvent.’
The demise of the view that ‘the market is always right’ is going to have implications for policy makers, regulators and all major companies. And while complete government control of the economy is hardly a prospect in most countries, a return to largely unfettered private markets is also unlikely.
A second major consequence has been the emergence of the government as a major participant in the financial sector in ways that only a few years ago would have been considered unacceptable. This entry (or in some countries, re-entry) of the state into the heart of financial services to prevent systemic collapse will be difficult to reverse, raises significant policy questions and will be long lasting.
In many countries, governments now find themselves as owners or major shareholders in large financial institutions. They might also have significant exposure to the health of those same institutions (usually banks) through guarantees, asset protection schemes and toxic asset assumptions.
The dilemma for governments is whether to act as a shareholder or steward of the economy. On one hand, they would like to rebuild balance sheets, widen margins and reduce costs. On the other, increasing the flow of low-cost lending into the economy and maintaining employment are also priorities.
Increasing pricing power by building a dominant market position is attractive to the shareholder but anathema to competition authorities. Restructuring banks to reduce their complexity and overall risk exposure might be attractive to shareholders, but not to politicians if it diminishes the clout of ‘national champions’. Improving returns to public finances, while preserving competitive institutions in national hands, will also establish competing priorities.
Significant government involvement in financial services will be a central feature of the landscape for many years to come. The financial system itself is likely to operate under a very different set of fundamental rules and assumptions than in the past. But we are by no means home and dry yet.
Philip Middleton is head of Ernst & Young’s financial services government practice for Europe, Middle East, India and Africa. The Government in financial services – options and dilemmas report is available from [email protected]
