In preparation for my panel at the Future Summit on Tuesday, I’ve started putting together my thoughts on how regulation can “reflect learning from the crisis”. I thought I’d divide my thoughts into two sections – the system-level “lessons learned” from the crisis that are emerging, and then the “so what” action items that might guide policy-making. Here are some of my notes so far – would be great to get your comments and ideas.
1. We need to critically question the models and assumptions of economics and finance – see Greenspan’s testimony to congress. We were wrong, and not just in the details. Let’s not make the mistake of placing blame or reinterpreting events so as to justify the crisis in light of our current thinking! As Christiane Amanpour said at Davos, a crisis is a terrible thing to waste.
2. We should explore models that explain how crises are produced endogenously by the system, rather than experienced as exogenous shocks under neoclassical economic theory. Recent experience shows that the system produces the crisis itself. To understand why, we need to go back and read Minsky, Keynes in the proper context and pay more attention to the cognitive and complexity studies of markets.
3. Regulation becomes part of the system almost before it is enacted, and participants inevitably game the system. We have to build in regulation in a way that it consciously acts counter-cyclically, and doesn’t merely serve to hide systemic risk or divert attention from the real issues. The goal of regulation should be to correct market failures and improve stability, not punish sectors.
4. Let’s be aware of false dichotomies and combat ideological thinking – the “markets v regulation” debate might be a red herring that forces people to defend ideologies rather than come up with good solutions. It’s always been clear that both markets AND regulation are required – the question is where markets are efficient, stable and fair, and where regulation is required to help markets achieve these goals (particularly the last two). Let’s replace slogans and ideology with open analysis and the exploration of new ideas.
5. Beware “experts”, especially those implicated by the crisis. We should question incentives and assumptions at every step and look outside the usual set of advisors and commentators for new perspectives and ideas.
“So what” – action items and ideas for regulatory shifts
A. Let’s work to banish what Andrew Haldane calls “Disaster Myopia” – the forgetting of crisis during the good times. Regulation could require financial institutions to do proper, extreme stress tests and “fire drills” across their businesses.
B. We should look to substance and behaviour, not names, arbitrary categories and structure, when deciding who and how to regulate. “If it looks like a bank, quacks like a bank, it should be regulated like a bank” – Adair Turner, FSA. AIG got into trouble acting like a bank. Credit Derivatives are unregulated insurance products. Problem!
C. Let’s reduce complexity and leverage whereever possible. Bring products onto exchanges so that we see them, and have clear rules for collatoral and ways of netting off in times of trouble. Higher levels of leverage might require higher and more costly collatoral, capital requirements and reserves.
D. Let’s fix the incentive issue so that we don’t “privatize profits and socialize gains”. This might mean that we place size limits on institutions so that nothing becomes too big to fail, and therefore enjoys an implicit solvency guarantee from the government.
E. We should, as far as possible, regulate what Shiller calls “snake oil”. We’ve learned that people don’t make informed decisions on financial products, and advisors on commission don’t help them in this regard. This is a tough one to implement, but important. Complex, leveraged products which return massive fees to dealers while handing high levels of risk to buyers are not appropriate for most wholesale investors, let alone the retail market.
F. Above all, let’s help people understand the changes that are being made. Minsky wrote “Meaningful reforms cannot be put over by an advisory and administrative elite that is itself the architect of the existing situation. Unless the public understands the reason for change they will not accept its cost; understanding is the foundation of legitimacy for reform.” Of course, that means our experts and politicians both need to understand first, which is no easy matter – but let’s try and build both consensus and understanding around regulatory change, not just among the financial and business communities, but across the public at large.