Q In the wake of the financial crisis what has been the focus of your research?
A My research looks at the evolution of the financial services sector, the nature of financial architecture, as well as the inadvertent ways by which changes made after the crisis have benefited some groups and not benefited others. I am also starting to look at the evolution of the alternative investments world, which is the complement to the formal banking sector. All of that is really looking at the business models which led to the financial crisis, our responses to the crisis and asking what next?
Q What surprised you about what came out of the research?
A First, I think people have still not paid enough attention to the business models of the different institutions and, second, is the fragmentation in terms of both understanding the problem and devising the response. You have huge amounts of emphasis on individual parts of the problem that collectively do not constitute a solution. In essence, the same pathologies that led to the crisis — which is that we didn’t understand the interconnections in the financial services sector — are still in evidence.
Q Let’s go back to the crisis itself. What can we now say was the cause or causes?
A What has become clear is that the crisis was not the fault of a handful of greedy bankers sitting on Wall Street, nor was it a ‘black swan’ event. It happened because a system was set up to implode. The subprime crisis, collapse of the Collateralised Debt Obligation (CDO) market, meltdown of inter-bank lending and the need for massive government intervention were all predictable results of changes in business models and industry architecture.
Q What do you mean by industry architecture?
A The ‘rules of the game’ through which businesses interact. With regulations favouring securitisation, we granted a massive subsidy to all things securitised. Basel (the global voluntary banking standard) and solvency (plus national legislation) put faith in credit ratings as a guide to how much capital to hold, or how much money to put in any type of asset, making ratings agencies the lynchpin to pricing and setting demand for a host of financial products. And we had (and still have) no qualms about allowing these guarantors of quality to be paid by issuers, to be profit-maximising companies, and to suffer no penalty for getting it wrong. Throw in the desire to let financial innovations run unsupervised (legitimised by the moral imperative of neo-classical economics), however much they changed the balance between recognition of income and realisation of risk, and we had a recipe for evolutionary disaster.
Q It is, perhaps, easier to see this in hindsight? But what about the people and organisations involved at the time? Why did they effectively go along with it?
A Investors — especially the ‘unexciting’ kind, such as more traditional German banks and US pension funds — were focused on maximising returns for any given rating. Investment banks were intent on maximising revenues for issuing new securities and CDOs. Ratings agencies wanted to maximise revenues per employee, spending less time and effort understanding increasingly complicated structures. Meanwhile, politicians and regulators saw credit expansion and were content with the growth it created. They were unconcerned about how credit was allocated (ultimately, to those who could not pay back), how risk was reshuffled (in ways difficult to track via CDO/credit default swaps or other derivatives) or how much credit was created (leading to unsustainable leverage, and to credit-fuelled demand poised to collapse).
Q So, everyone saw the plus sides of what was happening and buried their heads?
A As with any bubble, regulators who predicted this at the time were side-lined, and market participants burned by their inability to time their short bets. But this ultimately had to stop — and stop it did.
Q But what about what has happened since? Surely the changes which have been introduced tackle many of the issues you raise?
A Unfortunately, rather than a systemic rethink of the financial services world, the past few years have produced a clutter of regulations, primarily intended to limit banks’ size and scope and increase buffers for capital and liquidity. This ignores the fact that a systemic crisis of confidence will test the limits of any buffer, no matter how big.
Q The big question must be whether these actions avert a future crisis?
A Since they would not even have averted the previous one, the point is debatable! Take, for instance, the recent emphasis on separating wholesale and retail banks, evident in the Volcker, Vickers and Liikanen Commission recommendations. While many of these provisions seem sensible, even a full separation would not have saved us from the Lehman collapse (nor that of Northern Rock), or the need to put hundreds of billions into American International Group, Fannie Mae and Freddie Mac. It is foolhardy to think that any government would (or indeed should) allow a pure wholesale bank with systemic connections to collapse. While the fear of ‘agency costs’ and ‘moral hazard’ is understandable, they are often seen narrowly, without even considering historical precedent. The US savings and loans crisis of the 1980s reminds us that business models and governance, not size, drive reckless behaviour.
Q So, what needs to happen?
A We would ask regulators for a shift in direction. What is needed is a credible, comprehensive and understandable model of the financial system that covers both regulated and unregulated players, and which explicitly focuses on their systemic interdependencies.
Q What should be the objectives of this renewed financial system?
A First, it should provide an aggregate level of credit, effectively allocating credit to those who need and can repay it, and be resilient to crisis. This must be clearly laid out and trade-offs between these objectives considered. In such a model, mainstream finance theory must be complemented with a better institutional model of the sector, as well as an appreciation of the behavioural predispositions of its actors. Regulators should familiarise themselves with the changing business models of regulated entities, and focus on governance. They should employ scenario planning to evaluate policy responses in context.
Q But if the world is to be reshaped in this way what is the role of financial institutions in bringing this about?
A Financial institutions should be part of this debate, shifting from a defensive mentality fending off regulation, to a creative one acknowledging systemic concerns. Our experience from having facilitated such debates, both for the UK Houses of Parliament, and in the World Economic Forum, suggests much mileage can be had.
Q In effect you are calling on regulators and institutions to be much bolder in coming up with solutions and safety measures to prevent another crisis.
A Yes, because the reality is that the current approach of piecemeal regulation is more likely to shift rather than reduce risk and recklessness. Regulators and politicians find solace in easy rhetoric of ‘good’ versus ‘bad’ banking, of ‘lending’ versus ‘casino capitalism’. Yet they still allow ratings agencies to play the same role, with the same corrupting incentives, and let Basel III and Solvency II place their faith in them. This appears wrong-headed. Regulatory frameworks could use a blend of ratings and market- and crowd-based mechanisms to establish credit risk and related capital requirements.
Q And what would be — or should be — the role of speculators in all this?
A Speculators (especially short-sellers) could become useful signal setters who help spot fault lines. Rather than wishing them away, policy-makers and regulators should consider how to use them to make the system safer. Regulation may seek to revamp governance, moving beyond banks alone. For instance, ratings agencies could be strengthened if their payment model was re-thought, and if they were partnerships with some liability, as opposed to publically traded companies. We need a bolder approach: one that looks at the financial system as a whole and considers the right rules, roles and incentives to maintain stability. Changing regulators’ skillset is essential. More crucial yet is a frank debate about what type of financial service sector we want, domestically and internationally, and how to make it robust.
Q Isn’t one of the problems that regulators don’t have the skills or resources and some of the regulatory bodies have similar deficiencies?
A Undoubtedly, up-skilling and updating are in order. At the local level, regulators tend to be underpaid, understaffed, and have limited understanding of business models. Traditional (‘orthodox’) macroeconomists and finance theorists still dominate the debate, and regulators’ porousness to the sector has reduced. Internationally, the Financial Stability Board should play a key role, yet is currently staffed by a part-time head and has limited clout over national regulators. Even if it had adequate resources (which is not currently the case), it would need a stronger direct mandate to match a situation where actors play globally and regulators answer locally. Finally, banks and other participants in the sector react defensively, rather than pushing forward a discussion on the sector’s future. This needs to stop. The current game of cat and mouse between regulators and regulates is only weakening the system we are building, and making us oblivious to systemic side effects. It is time for a serious, systemic rethink of the sector, focusing on how its business models operate, and an intelligible public debate on how to improve them for the good of society as a whole. Both are long overdue.