The 2008 financial crisis, like the euro crisis, had its origin in the failure of regulatory institutions. Despite heavy scrutiny and sweeping reforms, is the financial system now any safer? In these edited extracts from his book ‘Economics for the Common Good’, TSE chair Jean Tirole looks for answers in the post-crisis financial landscape.
No financial instrument or transaction is bad in itself, provided that a) the risk is well understood by the parties using it, and b) it is not used to put an uninformed third party at risk. Properly used, financial instruments contribute to the dynamism of the economy. It is more constructive to engage in the inevitably technical debate about market and regulatory failures than to reject wholesale the achievements of modern finance. But it is undeniable that these instruments make financial supervision more complex, that “financial innovation” is often just a way of getting around the rules and exposing small investors or taxpayers to major risks, and that the numerous abuses should be eliminated.
Low interest rates
Very soon after the 2008 crisis began, the US, European, and British central banks provided much liquidity and thereby reduced interest rates to close to zero — in other words, to negative levels allowing for inflation. Japan has had an interest rate below 1 percent since the mid-1990s; in 2017, it is zero.
Low interest rates in downturns provide liquidity. Yet low interest rates have gigantic redistributive effects (for example, from savers to borrowers) that are not always desirable. They can also encourage financial bubbles and risk-taking, laying the foundation for the next crisis. And when nominal rates hit zero, the central bank can no longer use them to boost the economy.
What if low interest rates are not a temporary phenomenon? What if monetary policy is unable to reenergize the markets and prevent recessions and unemployment? One certainty is that there has been a decrease in interest rates on safe assets since the 1980s. If low interest rates are here to stay, we will have to rethink macroeconomic policies.
Nothing is without risk
We need to respond vigorously to the failures of financial regulation, and to reduce the frequency and scale of crises, but we cannot eliminate the danger. Prudential regulation and supervision are more art than science, but there are some general principles we can use.
In 2008, a number of economists, including myself, recommended protecting regulated institutions against the risk of contagion from the unregulated sector; increasing their levels of equity capital and putting greater emphasis on liquidity; making regulation more countercyclical; monitoring the pay structures of senior bank officers so as not incentivize excessive risk taking; allowing securitization, but supervising how it is used; monitoring the rating agencies; rethinking the “regulatory infrastructures”; and, in Europe, creating a supervisor on the European level within the ECB. Regulatory reforms have gone in part in this direction.
Safer systems
Regulators, central banks, and governments have been forced to intervene to rescue financial institutions they did not regulate through bailouts, buying up toxic products, and loosening monetary policies. Reforms should now aim to prevent as much as possible the shadow banks difficulties from spreading to the regulated sphere.
The current state of our knowledge should encourage us to be humble. Economists still do not know enough about how prudential regulation ought to operate, including the extent to which investors should be held responsible for their investments in regulated institutions and, of course, about the proper calibration of capital and liquidity requirements.
However, if the reforms are implemented, the financial system will prove to be less risky than before: the Basel III reforms seem to be headed in the right direction. An increased requirement of equity capital, the introduction of a minimum liquidity ratio, the inception of macroprudential measures in the form of countercyclical equity capital buffers, a greater use of centralized exchanges instead of over-the-counter markets, institutional reforms (for example, the creation of the European Single Supervisory Mechanism) — all are genuine improvements.
Danger areas
There are still, however, major areas of risk. For one thing, regulatory principles differ from their implementation and supervision. It is important that the transposal of international accords into national laws and the supervision of banks by national regulatory authorities not vitiate the spirit of the accords.
Macroeconomic concerns include slower global growth, more volatile financial markets, and the challenge of how to exit low interest-rate policies without compromising growth.
Other concerns stem from the combination of geopolitical risk and local economic conditions — for example, in Europe political shocks such as the UK’s Brexit vote, the political uncertainty over the EU, the structural weakness of certain economies, the significant proportion of unproductive loans still on European (especially Italian) banks’ balance sheets, and the intimate connections between banks and sovereign states. There is uncertainty about how China will transition from a catch-up economy to one on the frontiers of technology and institutional design (including managing its credit bubble and reforming financial markets). In the emerging economies, over-indebtedness in foreign currencies may put businesses and banks in difficulty if the local reliance on commodities is associated with inadequate risk management.
