Monaco Conference: Saving the World Financial Systems
On April 25th I spoke on a round table at the XIth International CIFA FORUM in Monaco on Saving the World Financial Systems with Luca Fantacci and my good friend Dan Mitchell. Click here for a video clip of an interview after my talk. Below that are my thoughts from the discussion.
If you incorrectly identify the fundamental cause of a problem, you will most certainly prescribe an inappropriate solution. The cause of the crisis was government policy, both monetary and fiscal. How likely is it that those in power will identify the causes as their own actions and suggest appropriate cures?
For those that say the cause of the crisis was purely financial innovation; all human progress is by definition base on innovation because anything that is better is different. Clearly not all innovation is better, but all innovation is different from what existed before. To squash innovation is to end human progress.
The Federal Reserve, and an increasing number of Central Banks around the world, seem to believe that their role is to prevent market corrections, to ensure the “Great Moderation.” Every time the housing market attempted a correction, (before the Great Recession), which is a natural and healthy process in the free markets, various government agencies took some action to support the market.
The Fed often over-expands the money supply to eliminate natural market corrections. This effectively provides a major incentive for banks to take on more risk. Thus the Fed reduces short-term liquidity risk at the expense of increasing credit risk.
This only increased the magnitude of the inevitable correction as for many in the housing industry, the knowledge that government policy makers could and would act in an aggressive manner to save the housing market made them significantly less willing to act to reduce risk than they would have otherwise had the market been a free market. Look at the stock market today and the level of inappropriate risk taking based on financial repression and the belief in Central Bank “puts.” By 2007 most of the CEOs of major banks had not been through a major correction thanks to this repetitive put, thus didn’t know just how bad things could get so where ill prepared to handle the crisis, which only served to exacerbate it.
- Fed monetary policy created a rapid appreciation in residential real estate values with obscured the risk in lending in this sector.
- Residential builders and developers did not have easy access to capital markets and were willing to pay variable interest rates when Bernanke inverted the yield curve.
- Heavy regulatory burden including (Privacy Act, Patriot Act, SOX) make banks not be cost competitive with the “shadow” banking system.
- The capital standards created by the regulators, under Basel, created strong incentives for banks to hold home mortgages to meet capital requirements. — In a truly private banking system, some banks would have still done this, but it is highly unlikely that the vast majority of bans would all be making the same mistake.
One of the primary ways a Central bank controls the monetary supply is through the banking system, by encouraging banks to lend more money. One way that Central Banks can affect this is to allow the largest banks to increase their leverage. Smaller banks will eventually have to follow; if they do not, they will end up with a lower ROE than their larger competitors, making themselves vulnerable to being acquired. This would allow the larger acquiring bank to leverage the “excess” equity of the smaller bank.
In early 2006 Bernanke rapidly increased interest rates and created an inverted yield curve. He held this for more than a year, from July 2006 to January 2008, (one of the longest yield curve inversions in history). Banks have to engage in economic forecasting to manager their interest rate risk. That was no evidence that would have led bankers to anticipate a 425% increase in interest rates in 2 years. The unanticipated pace and magnitude of rising interest rates left banks with negative margins. Of course Bernanke and Greenspan insist there were no errs in policy during the 2000s – a dangers sign that the current Chairman cannot admit to any mistakes.
