"Beware the crisis around the corner"

Clive Crook in the Financial Times:

Remember that the US authorities, acting out of concern over moral hazard, let Lehman fail. In a way, they were right. It was not too big to fail: its collapse did not imperil the payments system and its counterparties did not fold. Yet praise for that principled decision was less than universal. Many argued, and continue to argue, that it was the worst mistake of the whole saga. The authorities are unlikely to forget this when another institution – which, regardless of its size, might be “too interconnected to fail” – looks ready to topple. And everybody knows it.

The precondition for big financial busts is always the same: unwarranted optimism. When everybody gets it into his head that inflation is tamed, interest rates will stay low, asset prices will keep rising and economic growth will never stop, overborrowing is sure to follow. In other words, moral hazard is only one factor reducing perceived risk. In a prolonged upswing, investors feel safe regardless – not because a bail-out will protect them from losses, but because they expect no losses.

Also, in that kind of climate people will tend to make the same mistakes. Many small banks making bad bets on property may be safer than a system with a few big ones doing the same thing – but only a little. The first small bank to fail might cause a crisis of confidence that would bring down others, and then the rest. After 2007-09, what government is going to risk finding out?

So judge the new rules by one criterion above all. In the words of a former Fed chairman, William McChesney Martin, do they take away the punch bowl before the party gets going?

Interest rates that take into account asset prices as well as general inflation are part of this, of course. But when it comes to financial regulation, the key thing is rules that recognise the credit cycle, and change as it proceeds. Most important, as argued by Charles Goodhart in these pages, capital and liquidity requirements should be time-varying and strongly anti-cyclical. In good times, when lending is expanding quickly and financial institutions’ concerns about capital and liquidity are at their least, the requirements should tighten. Under current rules, they do the opposite.

Fixing financial regulation is a hugely complex task, and the details matter. But no repair – whether it concentrates on ending “too big to fail”, on separating commercial and investment banking, or you name it – is going to succeed unless this simple principle is adopted. Financial institutions will oppose the idea, because it amounts to a tax on their growth. Of the many battles that one might fight in this area, this is one that simply has to be won.

Posted via email from Jim Nichols