How To Change Financial Regulation

Lord Eatwell (alas, he is not one of ours; he's a former economic advisor to Kinnock) has written this rather interesting article for CiF. It is an attempt to put a little meat on the bones that are the current sentiment that "something must be done" to change the regulation of financial institutions in the light of the current financial crisis. Having attended a talk on the subject of the credit crunch that John Eatwell gave to Queens' College's "FF Society" not so long ago (well he is President of the college, after all), I was pleasantly surprised to see his name pop up on CiF a few minutes ago (I know, why am I reading it at this time of night?). He has a few interesting things to say, alongside a (perhaps a little controversialist) dismissal of calls for transparency, disclosure and risk management as being ill-informed.

What Eatwell does well, apart from display his own understanding of the situation, is help those of us who aren't experts with a bit of all important context:

Thirty years ago most loans, to businesses and to individuals, were made by banks, or specialist institutions such as building societies. The deregulatory fervour of the 1980s changed that. Credit markets became "disintermediated" - instead of banks acting as intermediaries between savers and borrowers, the markets took over. Borrowing is now packaged into securities that are sliced and sold through a myriad of financial intermediaries. Investment banks, such as Lehman Brothers, Merrill Lynch and Goldman Sachs, are (or were) at the centre of this process, taking on massive amounts of debt relative to their capital base (that is, becoming highly leveraged) in order to deal profitably in the complex web of markets. Guiding their operations are their risk models, which measure the riskiness of their operations against patterns of past market behaviour. The firms claimed they could manage risky markets, and the regulators swallowed that claim. Faith in transparency, disclosure, and risk management by firms is at the heart of the financial regulation today.

Yet at the same time it is generally accepted that a core purpose of financial regulation is to mitigate systemic risks, like a global credit crunch. Such risks are externalities; their cost to the economy as a whole is greater than the cost to a firm whose actions are creating the risk. But if regulators focus on risks that are recognised by firms already, and neglect systemic risk, why do we need regulation at all, other than to enforce best practice? Firms will manage risks well enough, using systems that are inevitably, and properly, market sensitive.

The flaw is that in the face of systemic market failures the market is inefficient. Risk is mispriced, with consequences that are all too evident today.

So what can be done to tackle "systemic" risks?

Read the rest here.