Government failure caused the financial crisis

A very interesting statement was published, 12th May, in the Daily Telegraph (UK), in which fourteen leading economists - authors of the new IEA study, Verdict on the Crash - explain how government failure caused the financial crisis and why politicians’ calls for tighter regulation are misconceived. The statement reads:

The prevailing view amongst the commentariat (reflected in the recent deliberations of the G20) that the financial crash of 2008 was caused by market failure is both wrong and dangerous. Government failure had a leading role in creating the conditions that led to the crash.

● Central banks created a monetary bubble that fed an asset price boom and distorted the pricing of risk.
● US government policy encouraged high-risk lending through support for Fannie Mae and Freddie Mac (which had explicit government targets of providing over 50pc of mortgage finance to poor households) and through the Community Reinvestment Act and related regulations.
● Regulators and central bankers failed to use their considerable powers to stop risks building up in the financial system and an extension of regulation will not make a future crash less likely.
● Much existing banking regulation exacerbated the crisis and reduced the effectiveness of market monitoring of banks. The FSA, in the UK, has failed in its statutory duty to “maintain market confidence”.
● The tax and regulatory systems encourage complex and opaque methods of increasing gearing in the financial system.
● Financial institutions that have made mistakes have lost the majority of their value. On the other hand, regulators are being rewarded for failure by an extension of their size and powers.
● Evidence suggests that serious systemic problems have not arisen amongst unregulated institutions.

As such, no significant changes are needed to the regulatory environment surrounding hedge funds, short-selling, offshore banks, private equity or tax havens.

A revolution in financial regulation is needed. The proposals of the G20 governments and the EU are wholly misconceived. Specific and targeted laws and regulations could restore market discipline.

These should include:

● Making bank depositors prior creditors. This will provide better incentives for prudent behaviour and make a call on deposit insurance funds less likely.
● Provisions to ensure an orderly winding up, recapitalisation or sale of systemic financial institutions in difficulty. Banks must be allowed to fail.
● Enhancing market disclosure by ensuring that banks report relevant information to shareholders.

This should be reinforced with central bank action to ensure that:

● Proper use is made of lender-of-last-resort facilities to deal with illiquid banks.
● The growth of broad money is monitored together with the build-up of wider inflationary risks.

Yours faithfully,

Dr James Alexander, Head of Equity Research, M&G; Prof Michael Beenstock, Professor of Economics, Hebrew University of Jerusalem; Prof Philip Booth, Professor of Insurance and Risk Management, Cass Business School; Dr Eamonn Butler, Director, Adam Smith Institute; Prof Tim Congdon, Founder, Lombard Street Research; Prof Laurence Copeland, Professor of Finance, Cardiff Business School; Prof Kevin Dowd, Professor of Financial Risk Management, Nottingham University Business School; Dr John Greenwood, Chief Economist, Invesco; Dr Samuel Gregg, Research Director, Acton Institute; Prof John Kay, St John’s College, Oxford; Prof David Llewellyn, Professor of Money and Banking, Loughborough University; Prof Alan Morrison, Professor of Finance, University of Oxford; Prof D R Myddelton, Emeritus Professor of Finance and Accounting, Cranfield University; Prof Geoffrey Wood, Professor of Economics, Cass Business School.

The book referred to above is Verdict on the Crash: Causes and Policy Implications, by the authors of the statement above and published by the Institute for Economic Affairs, London. (A pdf version of the book can be downloaded from the IEA site. )

The summary of the book reads:

• To some degree, UK and US monetary policy was to blame for recent problems in financial markets, thus replicating previous boom and bust episodes both in the UK and overseas.
• US government policy, by encouraging banks to lend to people with poor credit records, was a contributory factor in undermining US banks’ balance sheets. This problem was exacerbated both by the presence of the securitisation agencies, Fannie Mae and Freddie Mac, and by dishonest behaviour by some US borrowers.
• International bank capital regulation did not reduce the risk of insolvency. It may have contributed to the crisis, however, by encouraging all banks to have similar risk models, by lulling banks’ counterparties into a false sense of security and by making banks accountable to regulators rather than to market participants.
• Both international and domestic regulation also encouraged banks to make their activities more opaque than would otherwise have been the case, thus contributing to the build-up of risk.
• The management of the crisis by the UK public authorities exacerbated the problems rather than eased them. Both the slow reaction of the Bank of England and the use of market-value accounting rules in inappropriate circumstances made liquidity problems in the wholesale banking market worse.
• Market monitoring of banks was less effective than it should have been. The presence of regulation was probably a contributory factor to this. Banks over-leveraged, however, in ways that, ex post, were clearly inappropriate.
• Short selling by hedge funds played no significant part in the crisis. The use by regulators of credit ratings to set regulatory capital has undermined their integrity. As such, attempts to regulate ratings agencies and hedge funds further are likely to be damaging.
• While regulators might now understand how to prevent the crash of 2008 from happening again, they have demonstrated that they have no special gifts of foresight that justify confidence in the view that regulation would be effective in preventing future problems in financial markets. In general, the public authorities welcomed the innovations in financial markets that many commentators suggest are at the root of the problems we face now.
• Public choice economics suggests that financial market regulation should be based on very clear principles, with regulators being given specific objectives. This involves a complete reversal of recent trends in financial regulation.
• The most important specific objective that should be given to bank regulators is the protection of the payments system. Regulation should also ensure that those who provide capital to a bank should not be sheltered from the risks.
• Specific legal mechanisms should be brought in to achieve these goals. A variety of approaches is possible, and these would not involve detailed regulation of the activities of banks.
• Such an approach to regulation would ensure that the risk of failure fell squarely on a bank’s shareholders and counterparties rather than on taxpayers.

Go forth ... and read.