Unchaining the Invisible Hand

The increasing inter-connectedness of markets has coincided with the increased frequency of financial crises.  Authorities have responded to this trend with increasingly frequent and technical regulations.  One example of this is the Basel accord, established in 1988, which established capital requirements for internationally recognised banks.  Currently, as a result of the revised Basel III agreement, the G20 countries are preparing to implement new banking rules and regulatory policies to safeguard the financial market from further crises.

The Basel accord established minimum capital requirements related to banks’ assets.  These were weighted by risk.  For example, sovereigns like OECD countries had 0% capital requirements considered to be effectively risk-free (perhaps hard to believe considering the current crisis among sovereign states like Portugal and Greece), while corporations had 100% capital requirements.  The purpose of this was to harmonise capital requirements internationally and facilitate better monitoring of investment risk.  Regulatory bodies, designed to safeguard the financial system, have often made matters worse.  The Basel Regime of regulations has proven ineffective and even damaging to global capital markets: It is based on financial risk modeling, which has been argued a weak basis for regulatory capital requirements; it incentivizes arbitrage, and is vulnerable to regulatory capture.  Because banks want to make a profit, they looked for ways to get around this system, such as transferring assets to off-balance sheets.  This has led to a moral hazard manifest in conglomeration, deposit insurance and the widespread use of derivatives.

Typically, the IMF gives subsidized loans.  Private creditors are saved and public creditors are left with the burden. Barry Eichengreen, professor of economics and political science at the University of California Berkeley and author of many books on financial markets and crises, writes that “the pattern of financial bailouts has distorted the operation of financial markets by allowing creditors to exit with a minimum of losses.” Current distortions encourage investors to lend without due regard for risk—investors do not have to face the consequences of a bad investment, and are thus not incentivized to act in a way conducive to proper market function.  Creditors get high returns on risky sovereigns, knowing that they will be bailed out if things go wrong.

Basel I clearly did not help to prevent the 2008 crisis, and it is not clear that Basel III will be more effective.  This is largely because it does not deal with the moral hazard problem of incentivized risk-taking. As Eichengreen emphasizes, you can’t change human behaviour—the subprime mortgage crisis is attributed to the greed and corruption on Wall Street.  Because we can’t change human behaviour, we must change policy to channel this behaviour into desired outcomes.  Basel III advocates new regulatory policies such as higher minimum capital requirements and further supervision of derivative contracts.  As the G20 countries prepare to draft proposals to put Basel III into place, the effectiveness of these new requirements will become apparent through the implementation process, projected to begin in January and progress through 2019.

In the past, there was less regulation.  Banks operated with full liability of their holdings, so the actors involved had more to lose.  This allowed for a safeguarded financial system, which in no way compares to the financial system of today.  International financial systems are increasingly complex and have many players.  It is not realistic to expect to be able to regulate and monitor efficiently.  A framework must be provided in which market discipline guides and strengthens institutions, without heavy reliance on regulation and interference.

-Stami Zafiriou

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