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States can protect against market crises

States can protect against market crises

States can protect against market crises through producing laws and regulations that move situations of economic uncertainty towards situations of risk. Critically discuss this claim with reference to ONE case study of your own choosing.

Like traffic fatalities, fiscal crises are bad, hence the less, the better. When we look at financial crises and really think about the historical record (and what was discussed at this conference), financial crises are in essence banking crises. So as with traffic, you can try to make a safer banking sector by having prudential rules and credit standards, and so on. You can also try to make safer bankers and better bank supervisors by exchanging experiences at conferences like these and having the BIS’ Financial Stability Institute train everybody, and instilling market discipline. I am going to suggest instead that the best strategy to prevent future crises should be reducing the number of banks. If traditional deposit-taking, long-lending banks were to play a reduced role in most economies, and therefore the amount of damage bank failures could do was limited, the extent of financial crises would be more limited.

Naturally, this boosts questions of the things economies give up when you lessen the amount of financial institutions, and precisely how feasible or probably it might be to reduce the volume of banking institutions. I will argue on the first point that you are not giving up all that much by reducing the number of banks, that other financial services can replace them easily for both borrowers and depositors. On the second point, I will suggest that the trends in corporate finance and technology are so strongly against traditional banking, that the public policy issue is how to assure sufficient safe exit of banking firms-feasibility of exit is not a problem.

The 1st problem is: why? Why should we be shrinking the banking sector? The answer is simple: we economists now seem to have an exceptionally good understanding of financial crises. Everybody agrees1: imperfect information, regulatory forbearance, connected lending, illiquid collateral, untransparent accounting, deposit insurance not fully creditable, shake it up, add a macroeconomic shock, and presto-a banking crisis. And the consensus on this analysis is actually pretty wide. This is why regulators can call for prediction,2 and then we can talk about making use of early warning.3 Yet, with all due respect, early warning does not seem to work, right? We have known all these things for some time, and we are constantly improving our forecasting, but the problem is not so much warning as acting on the warnings.

At problem is not whether there is certainly time enough to behave, but alternatively, if banking institutions and regulators have a long time to behave, what do they generally do? We all understand that the basic danger is that when an economy has undercapitalized regulated banks, they behave badly, they are subject to a moral hazard, which results in adverse selection in the financial markets. The resulting rolling over and accumulation of bad loans is an enormous drag on growth. You either suffer the cost of recapitalizing the banks quickly at large cost in terms of real output (which was repeatedly the case in Latin America), or you suffer the costs of having wasted a lot of your capital, foregoing growth, and eventually paying a larger bill (which is arguably a major part of what has happened in Japan for the last ten years). This is serious stuff. And we all knew ahead of time both that bank crises are serious and where they were occurring.

In order that is my secondly level: studying, unfortunately, will not often have an effect on behavior in relation to financial crises. Now as a think tank person, I am supposed to believe in the power of learning. My colleagues’ and my only hope of having influence, is that people listen to one of us and say: “Ah ha! Good idea, I’ll do that.” But this does not seem to overcome the incentives underlying bank crises. Consider US-Japan foreign economic relations, specifically financial relations, in the last 20 years.4 What is very interesting is that, going through the history, the amount of transpacific and international exchange in the happy community of bank supervisors was already quite great by the late 1980s. Yet, we still had the US S&L crisis, and prior to that we had the UK land-bubble, and immediately following that we had the Swedish banking crisis, and then we have the ongoing Japanese financial crisis. This lists only some of the instances in only wealthy countries, just to remind everyone this is a universal problem. So even with the best of intentions, real public oversight, best training, best of supervision and, assumedly, mostly non-corrupt civil servants, learning about banking crises does not seem to take place. The US savings and loan crisis ended when there was a political demand ex post; the Japanese banking crisis we are hoping will be ending now that there is a political demand ten years ex post. And there was no shortage of advice or warning to Tokyo from Washington and elsewhere in the bank supervisory community by the early 1990s.

There are actually very basic monetary and nation-wide politics advantages why here is the scenario.5 One will not must be a qualified national politics cynic, nonetheless, to model these functions. There are reasons why banks rollover bad loans and why bureaucrats engage in regulatory forbearance, and it is very difficult to get beyond those. As so often in economic policy, one is caught between the choice of either removing discretion totally, which seems self-defeating since the whole point of the bank supervisory exercise is the judgment of imperfect information, or leaving regulators the discretion to engage in regulatory forbearance (which is sometimes euphemized as “prompt corrective action”).6 So, that is the why. There does not seem to be any easy consistent way to keep banks from falling into crisis if their capital is short once bad times start. We can try to box in bank lending behavior as a useful effort, but there does not seem to be any way to fundamentally remove this difficulty with regulators. So what do you do instead?

Which is my third position. I think we should make a new emphasis, perhaps our primary emphasis, on minimizing the banking sector in market economies. This raises the question of why we have banks, besides tradition and the fact that their buildings look familiar and solid. There are two essential reasons we have banks. The first, on the deposit-taking side, is small depositors supposedly need these institutions in order to conduct their day-to-day transactions and to have a safe place to put their money. The second reason, as grows out of the work of Fama (1985) and Stiglitz (1993), has to do with imperfect information in financial markets. There are certain smaller businesses, or risky businesses, that cannot go directly to capital markets to get their financing, so they have to go to an intermediary. When they go to an intermediary, these businesses must put up some asset as collateral, because only then does the intermediary have the incentive to look through the imperfect information about the firm, make a judgment, and spend a lot of time monitoring the loan. Thus, the argument for banks to exist is both on the depositor’s side and on the corporate finance or borrower’s side.