Re-Regulating the

Financial System

Mario Tonveronachi and Elisabetta MontanaroUniversity of Siena, Italy

IDEAs Conference on “Re-regulating global finance in the light of the global crisis”Tsinghua University, Beijing, China, 9-12 April 2009

2

Why did “It” happen again?

Roots:

International financial architecture

Laissez-faire approach to financial regulation

3

International Architecture

After the end of Bretton Woods

Dominance of private international finance

Persistent external imbalances are funded with mobile and volatile capitals

Speculative and ponzi positions global fragility

4

Fundamentals of Current Regulation

Laissez-faire approach to risk-taking This has been the mayor financial innovation of the last twenty years

Maniacal focus on capitalisation Disregard of the traditional tenets of banking, i.e. liquidity and

provisioning

Ability to fine-measure risks (firms) and fine-assess them (supervisors)

Expected and unexpected risks. Fat tails.

A market-friendly approach by supervisors Recent proposals converge on giving even more discretionary

powers to supervisors and to new Global Boards, without changing the rules of the game

5

Effects on the financial structure

Liberalisation and de-regulation produced:

Higher financial returns

Enormous increase of financial deepening

6

Financial deepeningFinancial deepening and financial multiplier

Development of key financial aggregates, 1970-2007. Deflated by GDP, 1970=100 Averages for Canada, Japan,Uk, US, Germany, Italy and the Netherlands

Sources: 1970-2000, G. Schinasi; 2001-07, R. Traficante

7

Financial pyramid

Expansion of financial assets characterised by:

An increasing pyramid of volatile liquidity

An increasing pyramid of debt

8

Pyramid of Volatile Liquidity

Inverted pyramid ordered in terms of liquidity of decreasing quality

The growth of assets was concentrated on the areas of liquidity of lower quality

In Minskyan terms, highly speculative and ponzi positions dominates the areas of worse liquidity

Since flight to quality means flight to better liquidity, an increase of fragility follows

Pollution of secondary liquidity produced by the increased contiguity between banks and markets

Private securities

Public debtPrimary liquidity

Secondary liquidity

Derivatives

9

Financial Pyramid and Debt

Growth potential coming from finance exceeds potential growth coming from real determinants

Can finance push real growth to its own level?

Permanently no, since it cannot dictate the pace for the determinants of real growth

Yes, for a while, relaxing the liquidity constraints of non-financial units

The rate of growth of aggregate demand accelerates as a consequence of the growth of indebtedness by non-financial units

10

Financial Pyramid and Debt

However:

The increasing weight of the debt service steals resources from the dynamics of aggregate demand

In Minskyan terms, debtors’ margins of safety continuously decrease

When the degree of indebtedness reaches a point where cash flows are not enough to service the debt, interests are capitalised and the debt takes an autonomous upward dynamics. Debtors increasingly shift into ponzi positions

In these conditions the economy structurally requires very low interest rates

When interest rates required for financial stability become significantly lower than the rates required for monetary stability, deleveraging and debt deflation sooner or later necessarily follows

11

Increasing Fragility

Let’s look at the U.S. experience

Components of U.S. Debt/GDP

0

1

2

3

4

19

45

19

48

19

51

19

54

19

57

19

60

19

63

19

66

19

69

19

72

19

75

19

78

19

81

19

84

19

87

19

90

19

93

19

96

19

99

20

02

20

05

20

08

Household Non Fin Sector State&Local Govs. Fed Gov. Financial Sector

12

Increasing Fragility

The US experience suggests an increasing mutual interaction between fragility and monetary policy

Starting from the mid-80s, the trend of Fed Funds rate has nothing to do with the trend of inflation

LEGENDA

- Fed Funds = average quarterly nominal effective rate- Inflation = CPI quarterly % change on year earlier

January 1983 - December 1993

0

2

4

6

8

10

12

19

83

-1

19

84

-1

19

85

-1

19

86

-1

19

87

-1

19

88

-1

19

89

-1

19

90

-1

19

91

-1

19

92

-1

19

93

-1

Fed Funds

Inflation

% January 1994 - December 2008

0

2

4

6

8

10

12

19

94

-1

19

95

-2

19

96

-3

19

97

-4

19

99

-1

20

00

-2

20

01

-3

20

02

-4

20

04

-1

20

05

-2

20

06

-3

20

07

-4

Fed Funds

Inflation

%

13

Increasing Fragility

LEGENDA

- Fed Funds = average quarterly nominal effective rate- GDP, % change = quarterly % change on year earlier

January 1983 - December 1993

-2

0

2

4

6

8

10

12

14

19

83

-1

19

84

-1

19

85

-1

19

86

-1

19

87

-1

19

88

-1

19

89

-1

19

90

-1

19

91

-1

19

92

-1

19

93

-1

Fed Funds

GDP %

% January 1994 - December 2008

-2

0

2

4

6

8

10

12

14

19

94

-1

19

95

-2

19

96

-3

19

97

-4

19

99

-1

20

00

-2

20

01

-3

20

02

-4

20

04

-1

20

05

-2

20

06

-3

20

07

-4

Fed Funds

GDP %

%

The trends of Fed’s rate and of % change of GDP are highly related. Fed’s policy is also responsive to GDP movements

14

Increasing Fragility

USA. January 1983 - December 2008

-2

0

2

4

6

8

10

12

14

19

83

-1

19

84

-3

19

86

-1

19

87

-3

19

89

-1

19

90

-3

19

92

-1

19

93

-3

19

95

-1

19

96

-3

19

98

-1

19

99

-3

20

01

-1

20

02

-3

20

04

-1

20

05

-3

20

07

-1

20

08

-3

0

200

400

600

800

1000

1200

1400

1600

Fed Funds S&P's 500

%

LEGENDA

- Fed Funds = average quarterly nominal effective rate- S&P's 500 = averge quarterly index at constant prices, CPI January 1959=100

In the last part of the period assets’ prices enter de facto into Fed’s responses

Correlation coefficients Fed Funds rate versus Inflation GDP % S&P’s 500 1999-2008 0.31 0.30 0.87

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Increasing Fragility

Every time the Fed tried to push interest rates towards ‘normal’ levels it was obliged to go back, and increasingly so, each time validating more fragile positions

Stages: Financial liberalisation and de-regulation increase financial fragility. Monetary policy validates fragile instruments and positions. Financial fragility accumulates further, thus increasing the constraint on monetary policy and its inefficacy. An so on.

As Jan Kregel aptly commented on the above analysis: “The rescue via low interest rates validates the fragile financial instruments that are developed in each phase, and they become built into the system as the frame for even more fragile instruments and structures”

A long-term Minsky Process was let inflating, which finally exploded in 2008

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A Radical Change of Perspective

International financial architecture and regulation

Basel’s systemic preconditions. Their inefficacy opens two routes: Maintain a laissez-faire approach to risk-taking and incorporate macroeconomic

anti-cyclical measures into the existing micro-stability scheme (the solution favoured by most current proposals)

Adopt a structural approach to regulation in order to transform the same financial structure into the systemic precondition for stability (our proposal)

We should:

Completely abandon the Basel construction

Over-regulate for at least the next 10-15 years

Simplify regulation, lower its costs and reduce supervisors’ discretionary powers

Increase the autonomy and responsibility of local jurisdictions over a common international regulatory base

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A New Approach

General lines: Oppose a rentier-approach to wealth accumulation. This is possible with a

financial structure that does not allow for highly risky financial instruments and institutions

Regulation must not evaluate fat tails, but must slim them down

Shift from a risk-measurement to a risk-control approach to regulation

We propose to:

Introduce structural measures for avoiding hard-to-value risks, limiting paper-value financial deepening and the size of intermediaries

Regain focus on margins of safety, particularly on liquidity and provisioning

Re-direct incentives towards a sustainable financing of the real economy

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Main Features of Our ProposalStructural Measures

Regulators agree on “a positive list of financial instruments and institutions. Anything that is not explicitly allowed is forbidden” (Buiter, 2009). Among “institutions” we include organised markets

Hard-to-value and hard–to-manage instruments and intermediaries are not permitted

Common rules extend to all leveraged financial firms

Regulated institutions are not permitted to have direct or indirect relations with countries not adopting a basic regulation homogeneous with their own

Foreign banks are allowed to operate only as subsidiaries

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Main Features of Our ProposalStructural Measures end Leveraged institutions are not allowed to enter into securities and

derivative contracts not traded in organised secondary markets

Supervisors are obliged to set up clear and binding crisis resolution procedures for all leveraged institutions

False information to the supervisory authorities and attempts to skim off value from the institution are considered as corporate fraud and are subject to criminal prosecution. They thus include all significant misstatements not only of allowances for credit and portfolio losses, but also of provisions

Separation of leveraged financial firms from Collective Investment Schemes (CIS), insurance companies, pension funds and commerce

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Main Features of Our ProposalPrudential Measures

All prudential requirements must be observed both on a stand alone and consolidated basis

Foreign subsidiaries have to met regulatory requirements on a local basis

Fair value accounting is applied neither to the banking nor to the trading book The banking book is evaluated at amortised cost The trading book is marked to market A specific Reserve the trading book is set up to smooth the effects of

potential gains or losses on the income account

21

Main Features of Our ProposalPrudential Measures

Capitalisation

Maximum limits to un-weighted leverage ratios are imposed, distinguishing between banking and trading books

The maximum leverage for the trading book is lower than the one allowed for the banking book. The trading book is defined in terms of its gross value, at market prices

Maximum leverage requirements are established in relation to categories of intermediaries defined in terms of size intervals. Larger the size, significantly lower is the maximum permitted leverage ratio. The size refers to consolidated balance-sheets, distinguishing between the banking and the trading books

22

Main Features of Our ProposalPrudential Measures

Liquidity

Coefficients to limit maturity mismatches are introduced

Different liquidity requirements for the banking and the trading book

For the banking book the liquidity requirement is an increasing function both of the value of the book and of the customer funding gap

For the trading book the liquidity requirement is an increasing function of portfolio’s market value

Liquidity requirements must be met with cash and/or risk-free assets

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Main Features of Our ProposalPrudential Measures

Dynamic provisions are introduced as a direct function of interest income. Fiscal treatment of provisions must follow supervisory rules, and not vice versa

Lower regulatory requirements coming from risk transfer are admitted only when risks are integrally shifted to unconnected subjects and no new obligations are linked to them