The Future of Finance


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This is a free e-book from the London School of Economics. It includes several stand alone chapters. Each one of them is written by a different expert or professor. The main underlying topics include how to manage and prevent future financial crisis. And, what would be the best financial regulatory framework to do just that.

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The Future of Finance

  1. 1. The Future of Finance. London School of Economics July 2010 A few summarizing thoughts on this tome extracted by Gaetan “Guy” Lion. 1) Hyman Minsky's model is hot. His model that the credit cycle is exacerbating the business cycle is at the essence of the macroeconomics and regulatory concerns that all the authors have. In other words, when the going gets good we over-lend to booming sectors because collateral values go up. This quickly turns into speculative schemes that are not self-financing anymore. The whole edifice of cards crumbles as borrowers default, collateral values decline, and financial institutions extending the credit fail. During the crash creditors retreat for their own survival and credit dries out just when it is most needed. Too much credit extension on the way up and not enough on the way down, that's how the credit cycle exacerbates the business cycle. 2) Real estate is truly the special sector most prone to exacerbated credit cycles because it is the most convenient and prevalent form of secured financing worldwide. 3) The body of financial reforms either passed or contemplated does not go far enough. And, will most probably lead to other financial crisis as they won't be able to restrain the volatility of the credit cycle. We need to develop policy metrics that track specifically real estate financing along with responding policy measures that restrain such financing when deemed excessive. We need to implement higher capital requirements in general and especially when undertaking real estate lending. We need to reduce credit risk by mandating by law much lower LTV ratios (80% or less). 4) The Central Banks need to develop a framework of financial stability policies in addition to monetary policy. They have to track more precisely the overall debt level (Debt/GDP, etc…) and come up with dynamic policy tools to lean against the wind of the specific sectors where excessive credit formation is taking place. This is different from just using an interest rate lever that affects the entire economy indiscriminately. 5) There are also many debates about "narrow banking" whereby any bank accepting federally insured deposits should be very restricted to very safe lending and investment activities. The U.S. financial reform goes timidly in that direction by limiting banks engagement in proprietary trading, derivatives, and alternative investments (hedge funds, private equity, etc...). But, the consensus is that the U.S. financial reform does not go far enough. Yet, Europeans are lagging behind the U.S. in this regard. Within this “narrow banking” debate some of the authors use the colorful metaphor of splitting the “utility” from the “casino” or the plain vanilla retail banking and payment system functions from the Wall Street domain. So, the utility would be very tightly regulated just like any utility is. And, there would be a regulatory framework so the 1
  2. 2. financial system grid would be a lot more resilient to the failure of any financial utility just like the electricity grid is resilient to any area incurring a temporary black out. 6) Compensation of the financial sector needs to be restructured. As is, financial executives' compensation resembles a very profitable Call Option. Financial executives are motivated to undertake the maximum risk to reap the maximum gain leading to large personal bonuses. That's because if their strategy fails such financial executives bear very little financial consequences. The Call Option at worst has a value of near zero when the institution fails. This is because gains are privatized. But, losses are socialized (bail outs, etc...). The authors suggest this has to change. Some of them propose that bonuses be placed in some equivalent of an escrow account for up to 10 years to give time for the risk to materialize on the transactions that generated the bonuses. This would curb the risk taking behavior on Wall Street. And, it may have prevented the Bear Stearns, Lehman Brothers, and AIG failures. 7) The issue of "borders" is really challenging. This entails how to enforce and implement international coordination between countries. One author suggests a WTO for the financial sector. It also entails how to regulate the "shadow banking" sector that by definition usually escapes regulations. If the border issue is not resolved, financial institutions will continue to play regulatory arbitrage and register their activities where the regulatory environment is most lenient. This historically leads to a regulatory race to the bottom whereby the domestic financial sector complaints it can’t compete against the more lightly regulated overseas competitors. And, the regulators eventually acquiesce to such political pressure. 8) The moral hazard of tacit government backing is often debated. Moral hazard would be prevented if all creditors besides insured depositors would experience the full brunt of a financial institution’s defaulting on their debt. And, several authors think it should be the case. But, others acknowledge that by doing so you would exacerbate the systemic risk within a fragile financial system. The solution of a “living will” is mentioned whereby specific regulatory measures would be taken to resolve a failing institution in an orderly manner so as to minimize or avoid costs to the taxpayers (bail outs). 2