The near-complete collapse of financial systems worldwide has exposed fundamental weaknesses in their architecture and in how they are regulated. In calling for measures to “guard against systemic risk,” the G20 summit has begun the process of reconstruction by recognizing that the system in its entirety, not just individual institutions, must be regulated.
Unfortunately, the G20 communique offers only more of the same prescriptions for managing systemic risk that the Financial Stability Forum, the US Federal Reserve and others have put forward.
These proposals have focused on the problems caused by poor transparency, over-leveraging, outsized financial institutions, tax havens, bad incentives for financial bosses and credit rating agencies’ conflicts of interest. All of these are important, but they miss a fundamental point.
No one now denies that the past year’s sharp downswings in housing and equity prices, which followed long upswings — far above historical benchmark levels — helped to trigger and fuel the crisis. As these downswings continue, there is a danger that they, too, may become excessive, dragging the financial system and the economy even deeper into crisis.
Containing systemic risks, therefore, requires not just ensuring transparency and managing leverage in the system, but also recognizing that these risks vary along with asset values. If institutions that were heavily exposed had understood this, they would have raised their capital buffers during the run-up in housing and equity prices in order to protect themselves against the inevitable reversals. But, as we now know, they did not.
One reason for this failure is that pillar 1 of the Basel II Agreement, which outlines how banks around the world should assess credit risks and determine the size of capital buffers, makes no explicit allowance for long-swing fluctuations in asset markets. Instead, it relies on value-at-risk measures that link risk to standard notions of short-term market volatility.
PRESUMPTION
The problem here is that these measures implicitly assume that risk declines when markets are doing well; they demand less capital during calm periods and more capital during volatile periods. In effect, the presumption is that capital losses are random, so the sharp reversals and losses that usually ensue after excessive upswings in prices are disregarded in risk calculations.
Indeed, because standard measures of the probability of default fall when the economy is doing well and rise when it is not, capital requirements based on these measures tend to be pro-cyclical. But this increases systemic risk rather than reducing it.
The G20 has now called for revising the Basel II standards so that capital requirements become countercyclical, and Spain’s experience with such requirements suggests that doing so is a step in the right direction. But such revisions of Basel II are not enough, because bank portfolios — especially those of international banks with large trading books — are vulnerable to the risks stemming from long-swing fluctuations in asset markets.
As a result, not only are countercyclical measures needed, but bank capital requirements should vary inversely with the boom-and-bust fluctuations in the asset markets to which they are heavily exposed. Bank defenses need to be fortified during excessive upswings in asset prices so that they are able to weather the inevitable reversals.
The connection between financial risk and asset-price swings emerges from the use of a new approach — Imperfect Knowledge Economics (IKE) — to understanding risk and fluctuations in asset markets. This approach implies that more can be done to reduce systemic risk beyond reforming how risk is measured and how capital buffers are determined.
IKE acknowledges that, within a reasonable range, the market does a far better (though not perfect) job in setting prices than regulators can. But it also recognizes that price swings can become excessive in the sense that participants may bid asset prices far from levels that are consistent with their long-term value.
History teaches us that such swings are unsustainable, and that the more excessive they become, the sharper and more costly the eventual reversals are — and the graver the consequences for the financial system and the economy. The lesson of this crisis is that excessive swings need to be dampened with a set of prudential measures.
‘GUIDANCE RANGES’
One possible measure is to announce “guidance ranges” for asset prices, with targeted variations of margin and capital requirements, not to eliminate but to help damp down movements outside these ranges. The key feature of these measures is that they are applied differently depending on whether an asset is over- or under-valued relative to the guidance range. Their aim is to discourage trading that pushes prices further away from the range and to encourage trading that helps to bring them back.
Improving the ability of financial markets to self-correct to sustainable values is the entire point of prudential regulation. By contrast, wholesale restrictions on short-selling (and other such measures that pay no regard to whether an asset is over- or under-valued) — an option that some have suggested — could actually lead to greater instability. Rules that are beneficial in some circumstances may become counterproductive in others. So the idea that what the world needs now is more fixed rules will not do.
Unfortunately, contemporary economic theory, with its presumption of perfect price discovery in asset markets, has discouraged economists and policymakers from paying any attention to the role of asset-price swings in managing systemic risk. Today’s global crisis shows that we can no longer afford to ignore this vital factor.
Roman Frydman is professor of economics at New York University. Michael D. Goldberg is professor of economics at the University of New Hampshire.
COPYRIGHT: PROJECT SYNDICATE
Could Asia be on the verge of a new wave of nuclear proliferation? A look back at the early history of the North Atlantic Treaty Organization (NATO), which recently celebrated its 75th anniversary, illuminates some reasons for concern in the Indo-Pacific today. US Secretary of Defense Lloyd Austin recently described NATO as “the most powerful and successful alliance in history,” but the organization’s early years were not without challenges. At its inception, the signing of the North Atlantic Treaty marked a sea change in American strategic thinking. The United States had been intent on withdrawing from Europe in the years following
My wife and I spent the week in the interior of Taiwan where Shuyuan spent her childhood. In that town there is a street that functions as an open farmer’s market. Walk along that street, as Shuyuan did yesterday, and it is next to impossible to come home empty-handed. Some mangoes that looked vaguely like others we had seen around here ended up on our table. Shuyuan told how she had bought them from a little old farmer woman from the countryside who said the mangoes were from a very old tree she had on her property. The big surprise
Ursula K. le Guin in The Ones Who Walked Away from Omelas proposed a thought experiment of a utopian city whose existence depended on one child held captive in a dungeon. When taken to extremes, Le Guin suggests, utilitarian logic violates some of our deepest moral intuitions. Even the greatest social goods — peace, harmony and prosperity — are not worth the sacrifice of an innocent person. Former president Chen Shui-bian (陳水扁), since leaving office, has lived an odyssey that has brought him to lows like Le Guin’s dungeon. From late 2008 to 2015 he was imprisoned, much of this
The issue of China’s overcapacity has drawn greater global attention recently, with US Secretary of the Treasury Janet Yellen urging Beijing to address its excess production in key industries during her visit to China last week. Meanwhile in Brussels, European Commission President Ursula von der Leyen last week said that Europe must have a tough talk with China on its perceived overcapacity and unfair trade practices. The remarks by Yellen and Von der Leyen come as China’s economy is undergoing a painful transition. Beijing is trying to steer the world’s second-largest economy out of a COVID-19 slump, the property crisis and