Financial Ruin

Aftershocks from the liquidity earthquake. 

Listener: 14 June, 2008. 

Keywords: Macroeconomics & Money; Regulation & Taxation; 

It is usually assumed that light-handed regulation works where there is a competitive market, with backing legislation, such as the Commerce Act and the Fair Trading Act, and a judicial process that vigorously enforces the law. (A decade ago, when it was fashionable, even monopolies, it was said, did not require direct regulation providing there were no restrictions on entry by competitors and sufficient disclosure of information. However, some monopolies so prospered at the expense of consumers that their regulatory regime was sometimes called “light-fingered”.) 

Does light-handed regulation work in financial markets? Many investors in failed finance companies must think other-wise. What they did not understand was that they were investing in enterprises involved in risky activities, some of which would fall over. No doubt the courts will eventually get around to deciding whether any involved fraud, but many of the failures were due to poor managerial judgment (including speculating on the “sure-to-fail”) or bad luck. 

The regulatory law may be incomplete. Many investors had not realised that some financial advisers could not be fully independent because their income depended on the firms they recommended. I don’t know whether the failure to tell their -clients of this conflict of interest was illegal, but I have no doubt it was immoral. 

Light-handed financial regulation issues are not peculiar to New Zealand. Indeed, they are less of a problem here. The Reserve Bank has imposed a firm rather than light-handed regime on our trading banks, and their depositors are pretty safe (a complete collapse of the world financial system aside). The finance companies were outside this regime – a bit like those markets that started outside the walls of a medieval town, thereby escaping the municipal controls but not always offering a better deal. Measures are to be introduced to regulate them, but given the nature of regulation, some horse traders will always find ways around them. 

Overseas, people debate the application of light-handed regulation to privately owned financial institutions, including banks considerably bigger than the entire New Zealand banking system. Their bankers proved far more inventive than those who built our finance companies. They cut back on the reinforcing as they added to their bank investments. Last August’s financial earthquake found these banks’ structures wanting. Bodies of bad debts – involving unimaginably big numbers – are still being found in the wreckage. 

So central are these financial institutions to the running of a modern economy, some had to be rescued by central banks. The bail-out will ultimately be funded by taxpayers. This has led to a demand that these banks be subject to more rigorous regulation. 

The banks’ response has been that only light-handed regulation is necessary. They say that once the liquidity earthquake and its aftershocks are over, they should be able to go about their business with a minimum of interference. (One is reminded of the resistance to robust earthquake standards so buildings can be constructed more cheaply.) Public authorities have irritatedly pointed out they have to clean up the current mess caused by existing light-handed regulation regimes. 

One answer could be, as with New Zealand‘s trading banks, tighter regulation of financial institutions that provide the means of payments (money) necessary to keep the productive economy running. Because of the increasing complexity of the payments systems, recent rescues have included financial institutions that would not normally be thought of as trading banks. Issues to be addressed include the way bankers are remunerated, the degree of supervision, capital-adequacy ratios, the behaviour of the ratings agencies, accounting and valuation principles, increased transparency and conflicts of interest. 

Moreover, given the globalisation of the financial system, there is the problem of cross-country regulation. We are already seeing disagreements between Americans and Europeans on how to handle the current crisis. 

<>If we are lucky, the world will muddle through it and some – but, regrettably, not all – of the sensible, proposed regulations will be implemented on some – but not all – institutions. Others will still set up outside the walls of the City (or Wall Street).