This column is a lead commentary in the VoxEU Debate "Banking reform: Do we know what has to be done? "
The European debt crisis had almost led the world to forget about the wounds and ravages caused by the collapse of global finance only shortly before. In 2011, the Indignados and Wall Street Occupiers brought the issue back on the table, but this swept away once again as they let their voice down. As Calomiris (2013) noted, not much has changed in the banking regulatory environment to correct the incentives that led the system into disaster in the first place.
Some fundamental questions, while perhaps sounding rhetorical, are nonetheless crucial and remain unaddressed:
- What room is left in today’s finance for real people in flesh and blood?
- What room is there left for real enterprises of the kind finance should be supporting?
- What room is left for development finance, expected to provide access to greater opportunities and freedoms for the largest lot?
- What room is left for the real geography of local economies and producers, which are overlooked by a financial culture that only sees them as anonymous nodes of ubiquitous networks?
For years, an idea has taken hold whereby developing modern financial markets would lead to efficient risk taking and to growing and innovative economies. This idea has dominated the world economic landscape for the last thirty years and more. Developing countries have inspired their economic development strategies to it. Yet the unconsidered use of those very same factors that prompted its success – breathtaking communication technology development and exasperated market competition – has carried finance way afar from its original purpose, i.e. to serve the economy (rather than to be served by it).
Such factors have rendered the space-time dimension of our global era incommensurable to human action. Time has shrunk dramatically, squeezed by the speed of technology that cuts the past short and compresses the future. It forces individuals to long for everything at once, at almost any cost. There is no disposition for undertaking patient efforts to build for the future. The present is priceless, and finance has become the way to it (Haldane and Davies 2011).
Space has contracted, too. Yes, many of us are now connected through instantaneous and unbounded network links, and this has eased access to financial services, but in the process we have become parts of impersonal relations, framed as entities into grids of statistics and stochastic parameters, managed by artificial intelligence.
When space-time shrinks, this is what takes place in economic contexts where critical phenomena rapidly grow global in scale. The room for decision-making subsides, especially when policy responses require international coordination. Market opinions become unanimous verdicts based on fleeting conventional beliefs, more than on underlying fundamentals. Market operators find it convenient to join the herds and follow the leaders, instead of taking the chance to run countertrend. Expectations align and strengthen market 'sentiments'. Euphoria, uncertainty, and panic mount in sequence, with unprecedented speed and breadth. Information abounds, and yet there is no time to digest it, and its quality runs down if those producing it have an interest in matching market expectations. With compact space-time, short-term delocalised speculative activities prevail over longer-term, locally established productive undertakings.
But then, who values risk, today, in the so-called efficient capital markets? If banks, the ultimate risk assessors, take risks blindly and transfer them to others who in turn do the same – as happened unrestrainedly in the US and Europe for years before the crisis – who is ultimately to evaluate risks responsibly?
Once upon a time, relationships used to link finance to enterprises, creating bonds of shared interests between them as well as channels of privileged information on risks and business opportunities, except that those relationships were exclusive and not accessible by those outside the recognised elites. The development of modern financial markets unhinged such exclusivity, and opened up access to individual ingenuity and merit. It was reckoned that they would democratise the economy. Eventually, the modernism of democratic finance left its place to the post-modernism of short-termism and flat space.
Where to restart?
All this is not to wish for the clock to be set back, as there may not be neglect of the many pros associated with our new space-time dimension. Yet several things should be undone and re-done. Here are a few:
- The criteria for scrutinising financial innovations should be reconsidered. Do innovations produce demonstrable public benefits (Turner 2010)? Do they serve the real economy well? Do they induce those who adopt them to analyse their risks and systemic consequences? And if these were to become unmanageable, would rescue operations with taxpayer money be justifiable? It is fair to let markets experiment with new financial products, but experimentation must be controlled to see if those products truly improve access to capital and risk management, without feeding into speculation. Supervisory authorities should have the power to oppose or to stop financial products that do not pass these tests.
- The perimeter should be restricted for 'robotic finance', which over the years has replaced a finance made of ongoing human relationships and judgment with securitised, automated, arm’s-length contracting (Bhidé 2010). Institutions negotiating structured contracts should operate only within dedicated markets (very much like speed circuits for racing cars)1. They should satisfy high standards of financial strength, should not reach systemic relevance, and should not be publicly guaranteed. They should possess full knowledge of the structure and risks of the contracts they negotiate, conduct thorough analyses of the underlying components (supplementing external ratings with internal assessments), and offer fully transparent information to clients.
- Intermediaries accepting deposits and providing vital financial services to the public should not be allowed to undertake complex transactions that cannot be deciphered by average market players. They could be permitted to offer only 'simple' derivative products for hedging purposes, only up to specific limits. If they wished to invest in complex contracts, they should ringfence their deposit liabilities and vital services from risky activities, purchase costly deposit insurance, and be subjected to higher capital requirements and to strengthened supervision. Deposit-taking intermediaries should not be allowed to base lending decisions only on mechanical evaluation models, without carrying out rigorous counterparty risk analysis.
- Intermediaries extending loan contracts should be strictly required to assess the merit of borrowers, individually considered, through direct analyses of their value creation capacity as well as of the context where they operate. They should become more and more 'glocal – much as has happened in the manufacturing sector (Torres 2002) – that is, capable of navigating across markets globally but also fully integrated within, and knowledgeable of, the local environments which they service, and able to evaluate projects with sound long-term economic potential (Anselmi 2006). They should be incentivised to invest in relationships.
- In this respect, the two-way banks vs. capital markets nexus (Bossone 2010) highlights the banks’ special role as credit assessors, which rests on the exclusive information that they may uniquely extract from borrowers through direct relationships. Banks should be induced to intensify these relationships, and deepen their inner knowledge of their borrowers.
- When securitising loans, banks should be required (as in "Dodd-Frank") to retain ownership of a critical (uninsured) share of the loans to be securitised. This would reinforce their incentives to make best use of their information-extracting and risk-management capacity, and force them to uphold their responsibility for sound credit quality analysis. Allowing full disposal of performing loans weakens banks’ responsibility, thereby eroding their signalling power and distorting investment decisions.
- Investors, on their side, should be called on to scrutinise the loans securitised, repackaged, and sold by the banks, and be fully aware of the risk content of the loan packages they purchase. The 'credit message' on the originated assets should not be lost along the market chain. Transparency of the loan structured products and information on banks’ credit assessment capacity are, therefore, critically important for investors to perform an undistorted reading of bank signalling.
- Incentives should be introduced (some are being considered by the industry and regulators), which would extend the time horizon of investors. First, shareholder rights should be expanded for investors supporting longer-term investments. Second, management compensation should reward long-term performances. And, third, governments should tax short-duration holdings of securities, and incentivise long-duration ones (Haldane and Davies 2011). There should be incentives for intermediaries who are willing to finance viable entrepreneurial ideas from agents (especially young) who have no guarantees to offer other than solid long-term business plans.
- Finally, more radical measures could be considered to facilitate access to money through alternative currency systems complementary to national currencies