Seven Lessons from Finance as a Traffic System

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Causes of the Financial Crisis

The world has still not recovered from the most serious financial and economic crisis in recent history. This exposed several aspects of financial system dysfunction which not only increased the instability of the financial markets but also impeded their normal functioning as tools to allocate economic resources efficiently throughout the real economy. Policy maker response to this crisis remains very inadequate and will do little to correct the deep structural flaws exposed by the crisis. 

In this new set of blog posts, we will serialize our 2009/2010 e-book "The Financial Crisis - Causes & Cures" which was written for both the layperson as well as policy-makers at the European Parliament, the European Commission and national finance ministries and regulators. The book may be a bit dated, but the issues are current.

The decades before the crisis were characterized by an exponential growth of the financial sector. The size of financial institutions and the number of financial transactions both outgrew levels that could plausibly be considered to be socially or economically optimal. The problems of excessive size are now clear from multi trillion dollar financial system recue bill that taxpayers have been left with.

Finance also became increasingly short-termist; banks relied on ever shorter maturities of borrowings to fund their operations; and markets came to be dominated by hedge funds and high frequency trading firms who counted their investment horizons in milliseconds not years. This form of just in time finance proved to be immensely destabilizing increasing both the speed and the scope of contagion in the system.

Even as the internet and information era descended, the financial system itself became less transparent. Complex and unregulated over the counter (OTC) derivative markets combined with the growth of off balance sheet structures and a growing number of subsidiaries in tax havens to introduce several layers of opacity. This opacity allowed financial market actors to build up poorly understood but excessive risk in the system hidden from the prying eyes of regulators. It also helped that the regulators were not looking particularly hard. This opacity meant that once the initial shocks hit the system, financial market actors lost confidence in their counterparties since any of them could be carrying toxic assets and there was no way of knowing who was safe and who wasn’t. This amplified the crisis and imposed losses that were far greater than originally estimated.

Banks loaded up on borrowed money with several banks reporting a leverage ratio of as high as 60 in the run up to the crisis. While the going was good, this allowed them to inflate profits and cream off hundreds of billions of dollars of profits and bonuses every year. This leverage and the low prevailing interest rates helped inflate the prices of assets such as houses and put them beyond the reach of ordinary people. Stagnating wages in the middle and bottom of income distributions forced people to borrow and the financial system manifestly failed in its task of supporting sustainable growth in the real economy. At the peak of the bubble, financial market actors cornered a full 40% of corporate profits for themselves highlighting the extent of rent seeking that existed in the financial system.

When the problems inherent in the functioning of the sector did build up to breaking point, governments around the world found themselves held hostage since many of the institutions had become ‘too big’ or ‘too interconnected’ to fail and their bankruptcy would have decimated the larger economy.

Trillions of dollars were spent on bailing out the financial sector around the world though the Bank of England estimates that the real costs of the crisis in terms of damage done to economies is of the order of tens if not hundreds of trillions of dollars.

Clearly, the world cannot afford another crisis of a similar magnitude. The financial system needs serious reform and mere cosmetic surgery alone will not suffice. In this next section we introduce you to some critical lessons that policy makers would do well to keep in mind as they restructure and reregulate finance.

To make these lessons more accessible, we go back to the traffic system metaphor we introduced in the preface.

Lesson 1: We need to focus on the system, not just the vehicles

Imagine if traffic authorities looked only at the roadworthiness of cars, rail engines or airplanes and did nothing else. It would be obvious to anyone that merely having a robust cars or airworthy planes by no means guarantees that the transport system would work well. What matters almost equally as much if not more for traffic systems is the interactions between the individual vehicles or planes.

For traffic managers, rail operators and air traffic controllers this ability to see the system as a whole, find out the points of congestion, the points of breakdown, the points of possible collisions etc is critical to maintaining both the efficiency as well as the safety of the system.

In finance, the focus of almost all regulation up until now has been to ensure that each individual institution is well-run and safe. Minimum capital requirements, the rock bed of banking regulation, were designed to keep individual banks safe and no more. Supervisors too, with few exceptions, looked merely at compliance and governance within individual institutions and risk management systems were designed to safeguard banks not banking systems.

No wonder then, that while regulators and supervisors were happy monitoring their wards, whole swathes of the financial system were neglected. Most important, no one was watching the flow of traffic so the built of systemic risk, the threat of traffic pile ups went unnoticed. Each bank was regulated as though it was the only one on the road. Anyone who drives will know that the real danger while driving on a crowded road comes from other vehicles on the road not the tree by the roadside.

As traffic moves faster the system wide view becomes even more important for safety. True danger in the financial system now, which is bigger and moves faster than ever before, comes increasingly from the possibility of a traffic pile up, not a one off collision with the roadside tree.

This underscores the need for regulators and supervisors to shift their focus from ensuring the safety of individual institutions or mirco-prudential regulation to concentrating on the safety and stability of the financial system as a whole through the use of macro-prudential tools.

Lesson 2: What you cannot see should concern you most

The value of good visibility whilst driving cannot be overstated. In fact, being able to see beyond the confines of your own vehicle is a precondition for being able to drive. The poorer the visibility, the more cautiously you should drive; ignore this and you are likely meet with an accident.

Poor visibility handicaps both the driver of the vehicle as well as the traffic manager responsible for regulating traffic.

For faster moving systems such as rail and air transport, the consequences of having incomplete information are more serious than for relatively slower road transport systems. Missing even one train or plane can result in a disaster. The only time a plane really disappears from the radar and tracking systems of air traffic controllers is when it has crashed.

As our financial system has moved away from the relatively slow days of road traffic towards being ever more interconnected in the manner of railway networks and moving faster as air traffic does, it has become ever more critical for regulators as well as financial market actors to keep track of what is going on around them. Any gaps in knowledge and understanding can be potentially fatal.

Yet these gaps have become ever more yawning. There are whole sectors of the financial markets such as hedge funds that are not under any oversight. Products such as over the counter derivatives have proliferated exponentially with regulators having little or no knowledge of the outstanding exposures. Offshore jurisdictions specialized in providing loose regulatory standards with little or no oversight and the number of subsidiaries and special purpose vehicles that banks set up in these jurisdictions multiplied.

The combination of unregulated financial actors, opaque products and non transparent jurisdictions seriously increased the dangers to the financial system and made almost certain that if and when a serious accident were to happen, the whole financial system would cease to function. Choosing not to drive is the most rational response in the presence of thick smog when visibility is low. The only problem is that in the absence of traffic the whole economy grinds to a halt.

Transparency is the bedrock of a well-functioning financial system. Regulators and supervisors need to know what goes on not just within financial institutions but also across the financial system so financial reforms would need to tackle opaque derivatives, abolish off balance sheet operations and penetrate tax haven secrecy. This would need to be accompanied by efforts to improve counterparty disclosure so other financial institutions do not lose confidence in each other at the first hint of trouble.

Lesson 3: Incentives matter and matter more than you think

If you were paid a lot of money to drive fast; knew that you would not be physically hurt no matter what happened; would not be held personally accountable no matter how many other vehicles you damaged would you not be tempted to be reckless? Many would drive fast all the time.

Something similar happened in the financial system. Traders and bankers loaded up on risk knowing that they could earn enormous bonuses sometimes as much as 100 times their base salary. While they could reap such rewards if their bets paid off the worst the worst outcome if their bets went wrong was that they could get fired. In boom times, such traders have little or no problem finding another job so the personal risk from excessive risk taking is minimal whereas the possibility of gilded rewards is high.

Driven by the incentives of their employees financial institutions became increasingly more leveraged and started taking on ever more liquidity risks by borrowing on shrinking horizons and lending long term.

The increasing use of leverage by financial institutions allowed the managers who ran them to garner ever higher rates of return while increasing the risk of a systemic crash. The high payoff from driving a car fast’ meant that too many drivers drove recklessly and that it was just a matter of time before a serious traffic pile up occurred.

While the incentives faced by employees were no doubt highly skewed, even the shareholders took on excessive risk. Limited liability means that while the upside of shareholder returns is at least theoretically unlimited the downside is capped. Rent seeking opportunities in a financial system that is characterized by high barriers to entry meant that shareholder too ‘drove fast’ enjoying excess returns of 25%-30% return on equity before the systemic risk resulting from their actions blew up in their face in the form of the financial crisis and wiped away large swathes of their wealth.  

Problems with incentives leading to inappropriate behaviour were endemic in the run up to the crisis with the originators of subprime loans, the bankers securitizing them and the credit rating agencies rating them all getting paid by the volume of business. They focused on generating volumes and compromised seriously on quality. That is why the US subprime sector was the trigger of the crisis.

It is clear that incentive problems in the financial system would need to be addressed urgently as part of the reform effort. Reducing rewards for reckless drivers and bankers who endanger other institutions and threaten the stability of the system by capping bonuses would make a big difference. This should be accompanied by an active effort to increase the personal risks associated with reckless behaviour for example through a more stringent reading of fiduciary duties, personal liability laws and a greater use of criminal penalties. Reckless drivers should have their licence confiscated.

Lesson 4: Just in time management can be problematic   

Imagine you move house and start taking a new commuting route. You leave early the first day so as to make sure you arrive in time and drive slowly so you don’t get lost. Next day you drive a little faster and find that you can shave 5 minutes off your commute. The next day you find that the speed limit on the highway you use has been increased so you can drive even faster. If the road is smooth and the traffic predictable you leave less and less safety margin and tend to drive fast so you get to work just in time.

Something similar happened to the financial system.

Thanks to liberalization, deregulation and advances in technology the financial flows became faster and transaction times shorter. This shorter time horizon was evident not just in the securities markets where average holding periods for securities shrank across the board but also in banking where institutions started borrowing on ever shorter horizons.

Borrowing for the shorter term is cheaper than borrowing long term. This is simply due to the fact that the risk of loss increases the longer the duration of the loan. So as liquidity increased in the markets for borrowing and lending, banks increasingly switched to shorter term borrowing to increase profits by reducing costs. By 2007, UK banks, for example, were funding as much as 25% of their lending operations from short term borrowing. Northern Rock was using overnight borrowing to fund some of the 30 year mortgage loans it made to customers. This behaviour was premised on the continuing availability of cheap short term borrowing and left little margin for error.

As with just in time manufacturing, just in time driving, trading portfolios of assets and funding yourself in the short term borrowing markets all work well under good conditions. The risk with all of them however is that even a small problem can cause the process to seize up since there is so little margin for error and very little inventory or holding capacity. It is akin to being stranded at an airport hub or a train interchange point or being stuck in traffic at a highway exit because you left yourself too little time and missed a connection. This is just in finance and the present crisis has only too vividly exposed the vulnerabilities in how it works.

Leaving no margin for error is imprudent whether in finance or in driving. It is clear that driving conditions on a clear day or at the off peak hour will not be the same as driving conditions in bad weather or at office peak times. Similarly, the financial system goes though cycles of liquidity and it is essential in order to reduce systemic fragility that some buffers are kept for when liquidity conditions in the market are not ideal.

Lesson 5: Whatever can go wrong, almost always will

No matter how well one plans and no matter how smoothly things seem to be running, cars, trains and planes will always crash. That is why it is essential to have emergency plans in place as and when this happens to minimise damage, loss of lives and disruptions to others. Airports all have emergency response teams at hand which can be pressed into service at very short notices. Road and rail transport systems have their own equivalents.

However, despite the fact that the latest banking crisis is far from being the first, financial regulators were largely caught unprepared both by the scope as well as the intensity of the crash. There is an urgent need to learn from the current crisis where unprecedented action was needed to provide liquidity support, depositor protection and recapitalization. The size, competence and capacity of the emergency response teams need to be vastly expanded.

Many new and unconventional tools were tried and some were more successful than others. At least some of these should become a permanent part of the armoury of regulators to help minimise the damage that problems in a financial institution can inflict on other institutions. The other lesson learnt was that the mechanisms for dealing with problems at large institutions especially those that have significant cross border operations are completely missing. There is an urgent need to put in place special resolution mechanisms for handling exactly these kinds of emergencies.

Lesson 6: Co-operate across network boundaries

Imagine a system with two countries that share airspace boundaries (it could be two neighbouring countries sharing rail connections or two municipalities with interconnecting roads) with a high volume of traffic that crosses the boundary. A disaster could quickly result if there was not continuous, ongoing and accurate communication and co-operation between the air traffic controllers in both countries.

This unfortunately is how the financial system worked in the run up to the crisis where communication and information exchange between international regulators simply did not keep up with the reality of vastly higher cross border financial flows. Regulators in one jurisdiction did not pool or share information with other regulators. To add to the potential problems caused by this, jurisdictions such as tax havens specialized in hiding information from authorities in other countries so the amount of danger in the financial system went unnoticed and when disaster did strike, there was little if any co-ordination capacity or trust.

Imagine another scenario, where the air traffic controllers of the home country, where the airline is registered are solely responsible for tracking and regulating the flight plan. Clearly, the further the plane gets away from the home airspace, the more difficult it become for the home based traffic controllers to regulate and monitor it.

From the host country’s perspective (the airspace of which the plane is flying in), the combination of three things 1) the loosened home country control 2) the fact that if the plane crashes it would do a lot of damage in the host country and 3) the loss of control over what the plane does in its airspace poses a matter of serious concern.

Yet this is how financial institutions have often been regulated where home countries have been assigned the primary responsibility of regulation. Most were concerned first and foremost with what the large cross border institutions they regulated were doing in the home market. Overseas subsidiaries, branches and other aspects of business were at best of only secondary concern. Regulators did not seem to have learnt much from the collapse of BCCI, an international bank that was able to finance criminal activities primarily because the regulators of each of the countries that it operated in assumed that one of the other regulators was watching it.

Clearly, host countries need to play a much stronger role in financial sector supervision both for their own sake as well as to contribute to an overall improvement in the quality of supervision.

Lesson 7: Trust in God but always wear your seatbelt

Human beings are optimistic by nature. They believe that things will mostly go well. However, this does not mean that they do not take precautions. When you drive out into traffic, the likelihood of having an accident is very low but most people still wear seatbelts which have been shown to protect people in case something does go wrong. There is also a role for regulation which ensured that car manufacturers were mandated to build seatbelts and that wearing them was made compulsory.  

In fact cars nowadays are being built to increasingly stringent specifications and go through rigorous crash tests before they are put out on the road. Financial institutions too need to be subject to increasingly stringent stress tests now that many have been shown to not have been roadworthy. It turns out that the regular road worthiness checks were not being performed stringently enough.  

Regulations in the form of better structures, risk management, governance and safety features such as levels of liquidity and capital will need to be spruced up so each institution in itself is made to run itself to tougher standards that make it more resilient and accident proof. Regular supervisory checks, the equivalent of the annual road worthiness test for cars, will need to be made more frequent, intrusive and benchmarked to tougher requirements.

But there is also the more important question of the fitness and safety of the transport system itself.  The system of traffic signs & lights, speed bumps, barriers, speed cameras and patrol cars designed to make sure that owners do not drive their vehicles recklessly in way that endangers the safety of others and the system was exposed by the crisis as being highly deficient. It needs to be spruced up. We need more traffic signs, bigger speed bumps, better cameras and whole fleets of new patrol cars to make sure that financial traffic keeps running smoothly.

Barriers are needed to ensure that financial institutions of a particular kind only do what they have been authorized to do. A problem in the run up to the crisis was that banks tried to be like hedge funds and hedge funds were stating to behave as banks and in doing so made the system more prone to accidents. More traffic lights backed up by better oversight can help ensure that this does not happen again. Speed bumps and their financial equivalents of countercyclical capital requirements and loan loss reserves should slow institutions down when they are over speeding or if the system is otherwise in a fragile state.

Despite their best intentions, traffic manager sometimes fall asleep at the job or are otherwise distracted and so cannot prevent all accidents. Sometime they cut corners in order to meet targets. Regulators, especially in the absence of full information sometimes fail to do their jobs properly. They are also susceptible to political pressure not to upset booms which are useful for politicians to get elected.

That is why, planes have inbuilt proximity sensors which issue urgent warnings if another plane comes too close so evasive action can be taken. Railway systems often have inbuilt circuit breakers which trigger alarms and sometimes cut off power to trains if they go through a red or yellow signal. Manufacturers have begun to build cars which automatically cut off speed if the sensors detect that the owner is dangerously over speeding or has fallen asleep at the wheel.

We need similar backstop protective mechanisms in finance. For institutions, these can take the form of leverage limits which provides a simple but useful backstop to the more complex but easier to manipulate minimum capital requirements.

For regulators we need constrained discretion where the breach of a first threshold of risk measures that show that an institution is over speeding triggers warnings and increases the discretionary powers of oversight available to enforce compliance. If the first set of measures don’t work and the institution breaches the next set of danger indicators automatic intervention many be triggered in the form of special resolution regimes where institutions are isolated from the rest of the financial system so their failure does not being traffic to a halt. This would be similar to being pulled over by the patrol car.

There is also the need to monitor system level dangers which we know can come about even when no particular institution is being excessively reckless. Warning indicators on system level dangers such as an excessive built up of leverage or maturity mismatches should trigger corrective actions in the form of reduced speed limits that can be enforced for example by increasing capital requirements or liquidity buffers. 

Note: This is an excerpt from the Re-Define Book "The Financial Crisis - Causes & Cures" written by Managing Director Sony Kapoor who is also the Chairman of the Banking Stakeholder Group at the European Banking Authority and a Senior Visiting Fellow at the London School of Economics and Political Science.