Financial system reform from first principles

Alberto Giovannini, 30 January 2010

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An intermediated financial system – where one of the tasks of intermediaries is liquidity transformation – is prone to financial crises. Financial crises are, essentially, the breakdown of financial intermediation, a sudden stop to financial transactions as market participants fear for the value of their investments and consequently demand immediate liquidation (Lagos, Rocheteau, Weill 2009).

Financial crises are costly not only because of frictions such as bankruptcy costs, but also because liquidity transformation is socially productive, since it allows higher-yielding investments. The possibility of market failures therefore justifies a role for regulators.

The tools to prevent financial crises are supervision, capital requirements and the management of the discount window. But the recent financial crisis, and in particular the events of 2008, have shown that these tools are seriously deficient; they did not prevent the build-up of systemic risk and the crisis itself.

In CEPR Policy Insight No. 45, I discuss potential causes of the regulatory breakdown, and suggest a strategy for reform of regulations, with the sole objective, in this paper, of tackling the systemic risk problem. This paper builds on two earlier articles (Giovannini 2008a, b).

In the last few decades the financial system has experienced fast growth and fast transformation, due to the adoption of a capitalist-based economic system by most large economies in the world and to the development of computation and communication technologies.

Securities and derivatives issuance and trading has mushroomed, with two major effects; counterparty risk has increased exponentially and has even spread beyond banks, and liquidity risk now pervades securities markets. In addition, there has been a progressive divergence between functions and institutions in the financial system. As a result, institutional constraints to various financial businesses have become obsolete and inappropriate.

An important example of this imbalance has been the growth of risky investment businesses within banking organisations, whose regulatory constraints on leverage and accounting were designed for client-service businesses, and not for investment businesses. This may have led to excessive risk taking in the run-up to recent financial crises, as the gigantic losses suffered by banks strongly suggest.

Having defined the market failures that characterised financial crises, and having identified the fundamental changes in the financial system that have occurred in the recent decades the paper discusses the pillars of a financial reform strategy. I start from the observation that, despite the phenomenal increase in number and complexity of financial transactions, it is possible and necessary to endow systemic risk managers with the informational advantage over financial market participants that they need to assess the weaknesses in the financial system as they develop.

This will require a wide-ranging reform, in which all market actors who are – or maybe – involved in liquidity transformation disclose to supervisors the full extent of their activities. Another pillar of the reform strategy is a redesign to regulations pertaining to banks (client servicers) and investment managers (capital managers). It is generally agreed that these two functions are characterised by very different risks: hence a clearer institutional identification and separation of them is needed, as well as a uniform treatment of the different organisations within each function.

Acknowledgements: The author thanks Vitor Gaspar, Garry Schinasi and Luigi Spaventa for comments and suggestions.

References

Giovannini, Alberto (2008a). “Reforms that can boost securities marketsFinancial Times online Comment, 31 July.

Giovannini, Alberto (2008b). “Let Banks Be Banks, Let Investors Be Investors,” VoxEU.org, 22 November.

Giovanni, Alberto (2010). "Financial system reform proposals from first principles." CEPR Policy Insight No. 45, 29 December.

Lagos, Ricardo, Guillaume Rocheteau, Pierre-Olivier Weill (2009). “Liquidity in the financial crisis: New insights on the lender of last resort.” VoxEU.org, 16 December.

Topics: Financial markets, Global crisis
Tags: financial regulation, global crisis

Chief Executive Officer, Unifortune SGR SpA and Principal Policy Advisor of the European Commission’s Clearing and Settlement Advisory and Monitoring Group (CESAME)

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