Our guest blogger today is Emmanouil Schizas. Emmanouil is a Policy Adviser with the SME Affairs unit at the Association of Chartered Certified Accountants (ACCA). His work focuses on the impact of regulation on small firms, SMEs’ access to finance and the public procurement market, as well as enterprise skills and training.
Emmanouil studied Economics and Human Resource Management in Athens, Greece, before moving to London to study Accounting and Finance. After graduating, he worked for two years as a researcher for the UK’s Financial Services Skills Council before joining ACCA in 2008.
Amidst the flurry of recent reports and opinion pieces pronouncing the death of market capitalism, one cannot help but feel that a less extreme, but equally groundbreaking, consensus is emerging.
According to this, over-reliance on market discipline has caused the credit crisis and made large-scale bank bailouts inevitable. The errors of market participants can now only be rectified by governments acquiring an increasing stake in and control over the banking sector. And, going forward, the all-important utility of financial intermediation can only be safeguarded through tough prudential regulation and intensive supervision.
A recent working paper by Aslı Demirgüç-Kunt and Luis Servén of the World Bank reviews the evidence on state involvement in finance and government responses to financial crises to see whether the principles of the old consensus, the sacred cows of financial and macro policies, are still alive.
Are blanket guarantees inevitable?
Demirgüç-Kunt and Servén find that preparedness, not decisiveness, is the key element of any response to a financial crisis.
They argue that because politics and panic make for bad economic policy, crisis management decisions should be made outside of an actual crisis, through public commitment, in good times, to a containment plan. Such a plan should allow government to quickly identify salvageable banks by accurately assessing the sector’s solvency, and transparency is crucial to its success.
But the authors’ more resonant argument, backed by empirical studies (1, 2 ), is that such a plan need not resort to bailouts –because these are unlikely to make a recession shorter or shallower. Rescue policies inform future risk-taking behaviour with long-term effects. Blanket guarantees and liquidity support may encourage excessive risk-taking that will, in time, beget another crisis. This, coupled with the fact that even creditworthy states may not be able to afford credible blanket guarantees, means such measures are far from the only way to deal with financial crises.
What should be the role of the state in the financial system?
The authors concede that recapitalisation, or even state ownership, of banks are common features of financial crises, and a short-term necessity in many cases. They argue, however, that responses that use the market to pick winners and losers are better value for taxpayers’ money, especially in less developed economies with incomplete institutional frameworks.
Based on empirical studies, Demirgüç-Kunt and Servén offer a different view of long-term government ownership, arguing that it results in lower productivity and growth, and is disproportionately harmful to lower-income countries with weaker property rights protection. In the absence of incentives rewarding the efficient allocation of capital, state banks have historically aligned their lending policies to political interests (1,2,3), a practice which, especially in weaker institutional environments, tends to create financial instability rather than limit it.
If bureaucrats can’t be bankers, can government rescues still work?
Assuming no substantial information failure, government can still recapitalise banks without biasing lending decisions by adhering to the following rules:
- Capital injections to banks should be matched with private funding and must not be sufficient to bail out all banks.
- Private creditors should be made to bear the initial losses through state purchase of preference shares.
- Finally, banks making use of government capital should be required to adhere to strict capital requirements, suspend all dividend payments and adjust compensation structures until the government is bought out.
Where information failures do occur, a bad bank solution can be considered wherein the non-performing assets of insolvent institutions are carved out and eventually sold. This solution, however, relies heavily on well-developed private markets and institutions.
Is more regulation the answer?
The authors note that the goal of financial supervision and regulation should not be to limit risk taking but to ensure it is neither subsidised nor discouraged. Financial crises cannot be regulated away, but their frequency and consequences can be managed.
They also note that implementation of the Basel accord has introduced a false dilemma of better but complex prudential regulation v. improved transparency and supervision. Incorporating market-generated information into the risk assessments of banks could improve supervision while acknowledging the complexity of the risks involved. Credit default swap or subordinated debt markets can be used to force financial institutions to send appropriate signals, as long as market participants are guaranteed regular flows of robust information and the certainty that government will refrain from bailing out failing institutions.
Finally, they propose making the authorities accountable for the costs of the financial ‘safety net’ through a system of fair value accounting for such subsidies and deferred compensation packages for regulators.
Should central banks target property and asset price inflation?
Monetary policy shares at least some of the responsibility for the recent financial turmoil. However, calls for central banks to take action against asset (especially property) price bubbles may be misguided.
Such intervention would need to be very highly precise as not all asset bubbles threaten financial stability, and even so might be too blunt an instrument, or too inefficient. It is very difficult to spot bubbles at an early stage, save through the use of arbitrary rules of thumb prone to costly misidentification errors. Even when this is possible, monetary policy will affect all asset prices, including those that are not synchronised. Moreover, the magnitude and timing of interventions are likely to be unsustainable in the face of slowing or falling output.
The authors point instead to a second type of intervention. Macro-prudential regulation aims to prevent feedback loops between asset price bubbles and credit supply. This relies on making capital adequacy requirements countercyclical by focusing on the rates of growth, not the absolute levels, of risk-weighted assets. A key advantage is that institutions are thus discouraged from becoming too big and interconnected to fail.
Such measures are not common for a number of reasons. Their effectiveness is not guaranteed and they could dampen financial innovation. But most importantly, as with any measures targeting asset prices, they rely on extremely strong political will – dampening economic growth will never be popular.
Is there a role for capital controls during financial crises?
In theory, capital outflow restrictions should buy the authorities some time in which to make use of fiscal and monetary policy before a country’s currency and central bank come under pressure. On the other hand, restrictions on capital inflow are seen as an ex-ante prudential measure that might mitigate financial turbulence in the future.
In practice, the enforcement of capital controls is difficult and there is little empirical evidence to suggest that they work. The substantially higher returns offered to investors by foreign assets (often amplified by currency movements) tend to more than compensate for the additional cost of moving capital. As international financial integration deepens, the broader range of options available to investors tends to make outflow controls even less practical, while penalising small investors and borrowers who have fewer options. In fact, unless controls are comprehensive, they will merely funnel the movement of capital towards unrestricted outflows – and sophisticated investors will always find ways around restrictions.
Conclusion
Demirgüç-Kunt and Servén conclude that private-owned financial systems, despite their inherent instability, are essential to development. The risk of financial crises cannot be regulated away, but appropriate prudential regulation and oversight can make sure that risk is not being subsidised or taxed. Monetary policy and capital controls are not effective substitutes for such regulation.
And when, despite regulation, crises do occur, policymakers must be prepared. They must appreciate the changes in market participants’ incentives and not mistake the necessary short-term responses for appropriate long-term policies. This is a delicate balancing act, made all the more difficult by increasing financial integration across borders. But, according to Demirgüç-Kunt and Servén, it is a lot better than toppling over.
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