By Joseph Stiglitz
October 22, 2008 | Guardian.co.uk
Our financial system has failed us. Part of the reason it has performed so poorly is inadequate regulations and regulatory structures. Everybody agrees that lack of confidence in our financial system is a problem. But how can there be a restoration of confidence when we have simply given the banks more money to lend recklessly? We have changed neither the regulatory structures, the incentive systems, nor, in the US, even those who are running these institutions. As we taxpayers are pouring money into these banks, we have even allowed them to pour out money to their shareholders.
It is hard to have a well-performing modern economy without a good financial system, but financial markets are not an end in themselves. They are supposed to mobilise savings, allocate capital and manage risk, transferring it from those less able to bear it to those more able. In America, and some other countries, financial markets have not performed these functions well. They encouraged spendthrift patterns, which led to near-zero savings. They massively misallocated capital. And they created risk, did not manage it well and left huge risks with ordinary Americans, who are now bearing huge costs because of these failures. These problems have occurred repeatedly and are pervasive. The failures in financial markets have effects that spread out to the entire economy.
There are three related reasons for these failures: (1) poorly designed incentive structures, (2) inadequate competition and (3) inadequate transparency.
Strong competition is an essential aspect of well-functioning markets. But information imperfections often limit the extent of competition. America's financial markets have gone beyond these natural limitations of competition to engage in anti-competitive practices. Lack of competition helps explain banks' supernormal returns in good years. In many markets, small- and medium-size businesses have access to only one or two lenders. That is part of the reason that bank failures are of such concern. As banks fail, information about credit worthiness held within these institutions is destroyed, and it will take time to recreate. In the meanwhile, access to credit may be limited and/or expensive.
The failure to have strong competition enforcement has meant that there are a number of institutions that are so large that they are too big too fail. That provided an incentive to engage in excessively risky practices. It was heads I win (they walk off with the profit), tails you lose (we, the taxpayers, assume the losses, because we simply couldn't let them fail).
Even Adam Smith recognised that unregulated markets will try to restrict competition.
Markets only work well when private rewards are aligned with social returns. Incentives matter, but when incentives are distorted, we get distorted behaviour. In spite of their failure to perform their key social functions, financial markets have garnered for themselves in the US and some other of the advanced industrial countries 30% or more of corporate profits - not to mention the huge compensation received by their executives. But the problem with incentive structures is not just the level, but the form - designed to encourage excessive risk-taking and short-sighted behaviour.
Finally, markets often fail to produce efficient outcomes (let alone fair or socially just outcomes) when information is imperfect or asymmetric. But information imperfections and asymmetries are at the centre of financial markets - that is what they are about. Our financial markets have even worked hard to exacerbate these problems, as they created non-transparent products that were so complex that not even those who created them fully understood them. This non-transparency is a key part of the credit crisis we have experienced over recent weeks.
We need to ring-fence the core financial system (commercial banks, pension funds, et cetera). We have seen the danger of allowing them to trade with risky unregulated parties. There will be ancillary benefits in restricting their dealing with offshore secretive banks, whose raison d'être is, for the most part, regulatory and tax evasion, facilitating terrorism, drugs and corruption.
We need more transparency to ensure that incentive structures do not encourage excessively risky short-sighted behaviour and to reduce the scope of conflicts of interest - our financial markets are rife with them. At the very least, they need to be disclosed. We need countercyclical capital adequacy/provisioning requirements and speed limits. We need to proscribe predatory lending - many of our problems are a result of lending that was both exploitive and risky. We need a financial products safety commission to make sure that the products purchased by, say, a bank or pension fund are safe and appropriate, designed to manage the risks they face; and a financial systems stability commission, to assess the overall stability of the system.
Part of the problem has been our regulatory structures. If government appoints as regulators those who do not believe in regulation, one is not likely to get strong enforcement. We have to design robust regulatory systems, where gaps in enforcement are transparent. Relatively simple regulatory systems may be easier to implement and more robust, and more resistant to regulatory capture.
Well-designed regulations may protect us in the short run and encourage real innovation in the long. Much of our financial market's creativity was directed to circumventing regulations and taxes. Accounting was so creative that no one, not even the banks, knew their financial position. Meanwhile, the financial system didn't make the innovations that would have addressed the real risks people face - such as how to stay in their homes when interest rates change - and indeed, have resisted many of the innovations that would have increased the efficiency of our economy. By reducing the scope for these socially unproductive innovations, we can divert creative activity in more productive directions.
The agenda for regulatory reform is large. It will not be completed overnight. But we will not begin to restore confidence in our financial markets until and unless we begin serious reform.
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