• Forecasting and interpreting the financial crisis:

• Part 1. Theoretical standpoints

• Part 2. Statistical data and problems to be solved

• Part 3. Example: history of US regulation

• Part 4. Example: recent reform proposals

• Forecasting and interpreting the financial crisis:

• John Taylor and the black swan• International unbalances (the role of China)• Role of capital gains (some postkeynesians too)

• But, which role for the financial sector?• Are the interests of the financial sector a major cause

of the crisis?

• Naturalism, institutionalism and conventionalism

• Visions of the working of the economy• Nature versus history

• Nature first: Market forces allow the material and natural factors operating behind monetary events to generate efficiency in the determination of both the relationships among variables and their level.

• History first: The material conditions affect the relationships among variables, but the historical evolution of the institutions determines their level.

• Visions of the working of the economy• History first

• Institutionalism: The historical evolution of the institutions describe the scenario. Yet, no sistematic theoretical explanation of this evolution is offered.

• Conventionalism: A theoretical explanation of the formation of institutions and conventions affecting the level of economic variables is offered. This explanation has much in common with historical materialism.

• History first

• Institutionalism assumes that the rules that tend to prevail are those coming from a process of social selection and reflecting the ability of the participants (individuals, groups and institutions) to adapt their behaviour to the environment in which they operate.

• (Commons, Veblen, but also some recent post keynesian literature)

• Conventionalism: The evolution of institutions and conventions is the result of the different interests and desires of the social groups and of their relative ability to impose them. Conventions reflect agreements among different stake holders, as they have evolved and established themselves, but also value judgements over distributive rules.

• (Classical and Marxian approaches, Sraffa and the followers of the “surplus” approach, sometimes Keynes and Kaldor)

• Medina Echavarría, comparando los enfoques clásico e institucionalista, afirmaba el carácter pre–teórico del segundo:

• ‘El concepto de institución, por acertado que sea el haberlo destacado en su carácter fundamental, aparece la más de las veces tosco y sin refinamiento teórico. Si esto vale en general como doctrina sociológica se comprenderá fácilmente la resistencia de los economistas tradicionales a dejarse convencer por los institucionalistas. Pues argumentan que como lo ocurrido en la escuela histórica, no han conseguido ofrecer una teoría económica en estricto sentido. En realidad tienen razón, pues de hecho en el movimiento institucionalista la teoría económica ha tendido a quedar disuelta bien en un empirismo sociológico, ya en una interpretación sociológica de la historia’.

• (“Economía y sociología”, 1941, pp. 79 – 80).

• Conventional theories conceive income distribution as a historical and conventional phenomenon.

• The material conditions of production constrain the relation between distributive variables, but do not determine their level.

• The level of these variables depends on the way in which the conflictual relations among different groups and institutions find solution over a certain historical period.

• In Sraffa’s work (including his early ones on money) the formation of legislation and of policy is part of the way in which these conflicts find solutions.

• Conventions (i.e. rules, customs, values, etc.) also enter in the determination of the level of distributive variables.

• They reflect the relative power of those participating in the economic processes and their ability to impose specific choices and behaviours to other individuals and institutions.

• Conventions, policies and legislation are the result of agreements among different interest-groups and in turn also depend on value judgements over distributive rules.

• The maintenance or rejection of existing conventions depends on the evaluations of the distributive rules prevailing in the society over a certain historical period.

• Changes in the existing conventions can be relevant for the formation of policy and legislation.

• The data on income distribution, on the growth of the financial sector and on the evolution of financial innovation have recently stimulated the critical literature to look for possible links among these phenomena.

• In what follows, in order to identify the existence of links among them, we will examine these phenomena by using a historical and conventional approach.

• The existence of these links has been overlooked by the dominant approach, which considers the determination of income distribution a by-product of an allocation process that market forces make efficient (market efficiency hypothesis).

• The use of a historical and convention approach, on the contrary, allows one to put the determination of income distribution at the centre of the stage.

• This may lead to considering the interests of the financial sector a major cause of the recent crisis.

Figure 2 – USA: income share of the top 1% of the population, 1913-2006(dotted line excludes capital gains)

USA: average income of top 1% and bottom 90% of population, 1933-2006.

Profit share in income increased at the expenses of wage share.

The financial sector benefited from this change more than the non-financial one.

The rates of interest and profit underwent similar movements.

The wage rate was stagnant and benefited little from the rise in labor productivity.

Consumption was supported by loans to low and middle income groups

Lending activities and other financial transactions to foreign and domestic sectors grew at higher rates than international trade and GDP.

Between 1977 and 2007 international trade on goods and services increased 11 times.

During the same period financial transactions in the foreign exchange markets increased

175 times (only traditional products)

281 times (including derivatives contracts on exchanges and interest rates, but excluding those on credits, equities and commodities, which have been growing in the last years at the highest rate)

Domestic debt too increased beyond the needs of productive activity after 1980. In USA it was relatively stable from 1950 to 1980, moving from 140% to 160% of GDP, and jumped from 160% to over 350% from 1980 to 2007

1950-1982 1982-1998 1998-2007

GDP 3.4 3.4 2.8

Domestic debt 4.0 5.7 6.8

Financial sector’s debt 10.4 10.1 9.5

Non financial sector’s debt 3.6 4.7 5.5

Households’ debt 5.6 5.3 7.6

Mainstream literature has analysed the relationship between financial development and inequality, arguing that the former tends to reduce the latter (for a review see Demirgüç-Kunt and Levine, 2009)

Perfect credit markets reduce inequality by bringing about the efficient exploitation of personal qualities, material endowments and the growth potentials of the economy. Credit market imperfections hold back the achievement of these results, but are counteracted by deregulation and financial innovation, which tend to eliminate rent positions.

Other literature has focussed on the influence of the “financialisation” of the economy on effective demand, growth and distribution (for a review see Hein, 2009).

One important line of research focuses on the changes in the relations among workers, managers and shareholder, which occurred after the monetarist counter-attack to the labor movement of 1979-82.

Boyer (2000) describes the new institutional forms brought about by these changes and formalises a model in which growth is finance-led, instead of wage- or profit-led, as in Bhaduri and Marglin (1990).

The choice of the managers to increase dividend payouts, as demanded by shareholders, plays a central role. It increases capital gains and the earnings of financial rentiers. The rise in capital gains has a negative influence on investment, but a positive one on the ability to borrow of the household sector. Owing to this positive effect, consumption can increase and enhance effective demand, growth and profits.

Another line of research is proposed by Palma (2009) . For him, the study of the financialisation of the economy and of the crisis makes analytical sense if it goes beyond the financial aspects and considers the political settlements and distributional changes in which these phenomena occurred.

For Palma the main cause of the crisis is the development of a new “technology of power”, call it neo-liberalism or neo-conservatism, which, after 1980, has been able to achieve political consensus on a distribution of income unequal and high rent-based in representative democracies.

Panico, Pinto and Puchet (2010), like Palma (2009), examines the financial system by going beyond its technical aspects.

It considers the links between the expansion of this sector and income distribution, arguing that the expansion of the lending activity of the financial industry can affect the level of demand and of production and generate changes in the income shares of workers and capitalists, even if the rates of wage and profits remain constant.

It allows one to contend that the expansion of the financial sector has contributed to the recent increase in inequality by reducing the income share of the workers.

The study is complementary to those attributing a central role to “capital gains” and to the new “technologies of power”.

It can give support to other points of contention:

1. financial innovation and those forms of regulation, which permit the enlargement of the size of the financial industry, can increase inequality;

2. the recent crisis is the consequence of the financial industry’s attempts to increase its turnover and earnings, by weakening financial regulation and the ability of the authority to control systemic risk;

3. The financial industry is interested in the introduction of forms of regulations that allow its lending activities to grow at a higher rate than other parts of the economy;

4. On the contrary, a society that is committed to the stability of the distributive shares should be interested in the introduction of forms of regulations that make the lending activities of the financial industry grow in line with total wages.

I will not present in what follows the theoretical model that leads to these conclusions.

I will focuss instead on the evolution of financial regulation in USA and on some recent attempts to reform it proposing an interpretation in terms of historical conventionalism.

In this analysis the evolution and regulation of financial markets and the formation of monetary policy are the results of the historical re-composition of the conflictual relations among social groups (workers, owners and managers of productive and financial firms) and among economic, social and political institutions.

Financial regulation is seen as a result of the processes determining the conventions (social agreements) that affect the distribution of income in the economy, rather than as a way to deal with the “imperfection” of market forces in order to move towards “normatively optimal” equilibria.

By focusing on distributive aspects and on the conflicts and power relations among different groups and sectors of the economy, this interpretation tries to clarify aspects of the recent historical experience and of the current debate, which are missed by other approaches.

Financial regulation is traditionally divided in:

1. Structural regulation,

2. Prudential regulation,

3. Management of the crises.

Miskin (2001) has proposed a classification of different forms (or tools, instruments) of regulation that is broadly used.

He focusses more on points 1 and 2 of the traditional presentation and lists 4 different groups of instruments.

Group 1 (structural regulation)

Group 1 can be used to control the size, the scope and the degree of competition among financial firms:

1. controls of entry,2. limits on economies of scale,3. limits on economies of scope and diversification,4. limits on pricing (e.g. interest ceilings).

They can also be used to control the quality of management and the exposure to risk of the individual firms.

Group 2 (prudential regulation)

Group 2 can be used to enhance the ability of depositors and other operators to evaluate the behaviour of the managers:

5. capital requirements,6. disclosure requirements,7. banks’ auditing and other tests.

They tend to strengthen market discipline by reducing the degree of asymmetric information between those who supply and those who demand financial services.

Group 3 (prudential regulation)

Group 3 aims at reducing the probability of systemic distress by assessing beforehand the management’s exposure to risk:

8. supervision.

It may be discretionary or rules-based and may be enforced by the imposition of penalties.

To make the enforcement effective, legislation may endow the authorities with different degrees of power on these matters and may even allow them to dismiss and replace the managers of financial firms at their will.

Group 4 (management of crises)

Group 4 aims at reducing the probability of bank runs by protecting depositors from the loss of their assets:

9. liabilities insurance.

Financial regulation as an equilibrium between market discipline and effective supervision

I will argue that the experience shows that the financial industry seems to prefer the former to the latter.

New Deal and Bretton Woods eras

In those years governments and societies showed limited faith in market discipline and legislation endowed the authorities with substantial powers over financial firms.

Regulation introduced liabilities insurance (Group 4), attributed a major role to Group 3, in the form of discretionary supervision, and made an important use of Group 1, i.e. of the four forms of structural regulation listed above.

It aimed at reinforcing the position of the authorities by strengthening their discretionary powers and by avoiding that the financial sector grew more than other sectors.

As White (2009, p. 39) claims during the New Deal and the Bretton Woods eras banks’ troubles ‘fail to show up on the radar’

As to Group 2, the forms of regulation listed above as (5), (6) and (7), they had limited relevance in those years.

Capital ratios were used, but they did not replace the evaluation of the competent supervisor, who had the final word in the identification of the managers’ behaviour towards risk exposure. (capital ratio as markers)

Post New Deal and Bretton Woods eras

Financial regulation changed significantly after the New Deal and Bretton Woods eras.

The limits on competition prevailing until the 1970s constrained the ability of financial firms to adjust to the new situation generated by the oil shocks.

The regulatory regime had to be modified because it had become impossible to guarantee the profitability of financial firms by limiting competition.

Regulation could be reformed in different ways.

Interest ceilings and other limits on competition were lifted in USA and Europe.

In USA the process of financial innovation was autonomously accomplished by the private sector. It was attended by a reduction of the resources attributed to the regulatory authorities and by a general climate that enhanced the ability of firms to elude controls.

In continental Europe, the process of liberalisation and financial innovation was instead guided by the authorities and did not deprive them of the ability to control the management of financial firms and the stability of the system.

In USA, during the 1970s and 1980s, Group 1, the first four forms of regulation, discretely underwent major changes.

Unlike what had happened before, rejections of bank’s charters became infrequent and the Department of Justice eased opposition to horizontal mergers under Reagan administration.

States’ laws and agreements and Fed’s decisions weakened the barriers to branching and geographical competition.

Finally, Regulation Q on interest ceilings was gradually eliminated.

Group 2, tools (5), (6) and (7), also underwent major changes.

The Financial Institutions Regulatory and Interest Rate Control Act of 1978 obliged banks to disclose more information and introduced a new Uniform Interagency Bank Rating System, named CAMEL.

In 1981 capital ratios, previously used by supervisors as first indicators of the risk exposure of a firm, became compulsory.

Group 3, Supervision, underwent a contradictory process that, on a whole, weakened the powers of the authorities.

On the one hand, the Financial Institutions Regulatory and Interest Rate Control Act of 1978 strengthened the enforcement powers, allowing the authorities to remove bank officials for personal dishonesty, but not for incompetence.

On the other hand, the reduction in the resources limited the ability of the authorities to effectively control a sector growing in size and complexity.

Bank examinations changed in quantity and quality for the reduction in the amount of resources made available to regulators, particularly during the Reagan administration, as part of a general plan to reduce some forms of government intervention in the economy.

Owing to the reduction of resources, surprise examinations lost relevance and the authorities limited the scope of their reviews and enhanced a regular dialog with banks’ managers and board members.

In the 1990s the US legislation on regulation further accomplished the process of liberalisation by formalising the abolition of the limits on competition and the emergence of universal banking.

Moreover, it explicitly introduced a rules-based approach to supervision in order to replace the approach previously adopted that was based on the discretionary evaluations of the authorities.

In 1991 The Federal Deposit Insurance Corporation Improvement Act explicitly introduced a rules-based approach to supervision.

In 1994 the Riegle-Neal Interstate Banking and Branching Efficiency Act definitely eliminated all barrier to nation-wide branching.

In 1999 the Gramm-Leach-Bliley Financial Services Modernization Act permitted universal banking within a structure of a financial holding company

The Federal Deposit Insurance Corporation Improvement Act of 1991 introduced the so-called “prompt corrective actions”.

Banks were classified according to five categories of risk exposure, defined by financial ratios calculated by dividing the value of risk-weighted assets to that of capital.

The thresholds of risk exposure were automatically calculated and when banks crossed them, mandatory actions, which increased monitoring and restrictions, inevitably applied.

The Act removed the authorities’ discretion and formalised the change from a discretionary to a rules-based approach to supervision.

To evaluate their risk exposure the Federal Deposit Insurance Corporation Improvement Act obliged financial firms to provide for regulators an amount of information larger than before.

These new obligations and the obstacle set to the authorities’ forbearance gave the impression that firms were more strictly constrained.

Yet, the removal of discretionary powers from the authorities enhanced the ability of financial firms to evade controls.

‘By ruling out discretion, banks were able to develop new complex financial instruments that are not subject to statutory standards and allow them to assume more risk with existing capital. The most notorious of these were of course, the mortgage-backed securities that were held off-balance sheet in Structured Investment Vehicles (SIVs) that skirted the rules-based control system that was sufficiently rigid that it was difficult to quickly adjust to innovations. Banks were able to increase their risk and hence their return, while regulators appeared to be faithfully executing their mandates’

(White, 2009: 36).

‘The genesis of the most recent collapse has part of its root’ in the shift to the rules-based regime.

(White, 2009: 36)

‘The fast changing character of the financial system increased the challenge to federal bank supervisors, who had a relatively rigid rules-based statutory supervisory regime, who faced an increasingly complex and evolving banking system, adept at increasing risk’

(White, 2009: 37)

The introduction in the 1990s of rules-based forms of regulation has been presented as a consequence of the problems caused by the discretionary forbearance of the authorities during the banks’ crisis of the 1980s.

There are elements however suggesting that other factors, including the lobbying activities of the financial industry, can have played a role in the formation of this piece legislation.

For some literature (see Mishkin, 2001; Berger, Kyle and Scalise, 2001), the 1991 Federal Deposit Insurance Corporation Improvement Act was introduced at a time when politicians criticised supervisors for being too though, not too relaxed.

The theoretical debate on monetary policy and the actions taken in this field since the late 1980s moved in a direction opposite to that of the Federal Deposit Insurance Corporation Improvement Act.

The failure of the monetarist experiment and the development of the “institutional design” literature, inspired by Rogoff (1985), promoted the view that in monetary policy competent and independent judgement works better than any conceivable rule.

The central banks’ reforms implemented since the late 1980s moved from the view that monetary rules do not work and endowed these institutions with discretionary powers, checked by transparency and a high degree of technical independence.

The Federal Deposit Insurance Corporation Improvement Act contradicts this tendency: it replaces a rules-based for a discretionary approach to regulation.

This contradiction raises doubts on the claim that this piece of legislation was a consequence of the problems caused by the relaxed standard applied by the authorities in the 1980s.

Its introduction may have been favoured by the pressures of the financial sector to reduce the power of the authorities to increase its turnover and revenues regardless of what happens to systemic risk.

Finally, the role of lobbying activities in the formation of monetary legislation has been consistent, at least if we consider its dimension.

The size of the lobbying activities of the financial sector is testified by the US Senate information(see www.opencongress.org and the organized presentation of this information in www.opensecrets.org ).

According to these data, the financial sector spent 1.1 million dollars for House Representative for “campain contributions” during the election cycle 2007-2008.

In 2009 it spent 0.85 million dollars for each member of the Congress for “lobbying activities”, i.e. 1.04 million dollars for each House Representative.

The financial sector has the highest quota of all sectors of the economy both in “campaign contributions” (on average 19.4% during the period 1990-2010) and in “lobbying activities” (on average 14.7% during the period 1998-2009)

Recent reform’s proposals

The reforms proposals of the FSB and of the Basel Committee on Banking Supervision can be examined by using the previous framework for financial regulation, adding to Mishkin’s classification some new elements on crisis solutions and on financial infrastructures.

Both institutions declare that it is necessary to achieve a new balance between market discipline and official oversight, because the balance existing before the crisis was wrong.

Both institutions take into account the resistance of the financial industry to specific forms of regulation.

They emphasize the importance of strengthening the effectiveness of supervision, but their proposals do not contain specific solutions for these issues.

They focus instead on strengthening the loss absorbing capacity of financial institutions and on distress’ resolvability possibly avoiding high costs for the tax-payers.

As to the proposals on the forms of regulation acting on the degree of competition of the financial sector (Group 1), they focuss on SIFIs, like the Dodd-Frank Act, but then they mainly devise interventions on “market discipline” (Group 2).

The literature sometimes recognises the resistance of the financial industry to forms of regulation acting on the competitive structure of financial markets.

Yet, these elements are occasional and not consistently integrated in the approach that this literature follows.

Cornford (2010, p. 6) recalls that in London suggestions to introduce reforms on the structure of financial conglomerates (Group 1) have produced rumblings about possible moves to other jurisdictions.

Schinasi and Truman (2010, p. 17) have noticed that some reformers advocate breaking up SIFIs into more transparent, focused, and specialized institutions that are easier to regulate, supervise, rescue, or resolve. Yet, they conclude, the political will to consider this approach seriously does not exist.

Schinasi and Truman (2010) have also underlined disappointment for the gap existing into the statements the Basel Committee’s originally envisioned in a document sent out in December 2009 and the agreements reached on July 26, 2010, when the Group of Governors and Heads of Supervision - the oversight body of the Basel Committee on Banking Supervision - reviewed the Basel Committee’s capital and liquidity reform package. (Group 2)

The agreements provided many concessions favorable to the banking industry, including a less demanding definition of Tier 1 capital, less stringent liquidity requirements, and a lower leverage limit (only 3 percent) phased in over a longer period ending in 2017.

The Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced on September 12, 2010 a strengthening of capital requirements (Basel III) and fully endorsed the agreements it reached in July 2010.

Although the agreement announced in September 2010 constitutes progress, it is clear that the Committee could not reach a consensus on earlier implementation of important elements of reform. That a consensus could not be reached is disappointing: excessive leverage and poor liquidity-risk management by the major global banks played an important role in creating the conditions for the global crisis. … This mixed record to date by the regulators and supervisors is not reassuring for the prospects to agree on the difficult reform trade-offs and decisions that are yet to be taken and implemented on both sides of the Atlantic, including those pertaining to SIFIs, over-the-counter derivatives markets, and resolution mechanisms for cross-border banking problems.(Schinasi and Truman, 2010, p. 11)

The provisions on SIFIs of the Dodd-Frank Act (Financial Stability Oversight Council authorising the Fed to set more stringent standards, the Volcker Rule and the Lincoln Provision) are also seen as progress (Group 1), like the FSB’s proposal to set financial infrastructures for derivatives markets in the form of Central Counterparties (CCPs).

The CCPs should interpose themselves between buyers and sellers of derivatives, assuming the contractual rights and obligations of both parties.

The benefits of CCPs are: (1) reduction of domino effects of the failure of single counterparty, (2) increased transparency resulting from the CCP’s records of transactions, (3) liquidity providing to this extension of the interbank markets.

Supervision

The FSB Report explicitly refers to the need to reinforce the powers and the resources of the supervisory authorities:

We will call for a strengthening of the mandate, powers and resources of supervisory authorities where appropriate and recommend a range of actions to render supervisory tools and practices more effective. (FSB, 2010: 6)

Yet, the recommendations of the Report refer vaguely to measures that can strengthen the discretionary powers of the authorities over the management of financial firms.

They can be summarised by the following four items:

1. production of knowledge on corporate governance, on the working of the financial system, and on measures and quantitative models to evaluate the risk exposure of financial firms; (improve general knowledge and stress tests - Group 2)

2. improvement of collection and treatment of data and information; (Group 2 again)

3. improvement of coordination among supervisory authorities at home and abroad;

4. ‘an appropriate number of sufficiently skilled supervisors overseeing systemic firms’ (FSB, 2010: 6) (Group 3)

Only item 4 refers to measures that can affect the discretionary powers of the supervisory authorities over the management of financial firms.

The call of the FSB Report for more effective supervision ends up by sounding as a mere acknowledgement (without any practical consequence) of the role that this instrument can play in the overall organisation of financial regulation.

Conclusions

The current reactions of the national and international authorities to the financial crisis are producing some progress in micro-prudential regulation and in the resolution of firms’ crises.

Interesting proposals are also emerging in the organisation of core financial infrastructure, particularly in relation to the treatment of derivatives contracts.

None the less, the literature shows preoccupation for the evolution of financial regulation and the future stability of the financial system.

The source of this preoccupation is the ability of the financial industry to affect national legislation and international agreements in ways that are not considered reassuring in the face of the recent experience.

The preoccupation is mainly related to the content of the 2010 agreement, known as Basel III, reached by the Group of Governors and Heads of Supervision of the Basel Committee on Banking Supervision.

The reference to the ability of the banking industry to affect legislation exists.

Yet, it is occasional and does not lead to an analysis that systematically oppose the interests of this industry to those of society as a whole, drawing from that clear conclusions on what is necessary to improve regulation.

For instance, although there is a consensus on the fact that before the crisis regulation was not working effectively because the balance between market discipline and official supervisory oversight was wrong, there is hardly any preoccupation for the fact that the current reactions to the crisis by the national and international authorities is essentially focussed on actions related to market discipline.

The need to restore the discretionary powers of the authorities over the management of financial firms is broadly overlooked.

By moving from an analysis of the conflictual interests of the different groups of society, the approach here presented suggests instead that this outcome is due to the ability of the financial industry to affect national legislation and international agreements, an interpretation that is only occasionally acknowledged by the dominant literature.