Avinash Persaud is Chairman of Intelligence Capital and Elara Capital, Emeritus Professor of Gresham College and a former Deputy Chair of the Overseas Development Institute (ODI). He has also led the regulatory sub-committee of the UN Commission (“Stiglitz Commission”) on Financial Reform.
Financial memories must be the shortest. Before the Great Northern Credit Crunch which began in 2007, a growing number of policy-makers from advanced economies flirted with the idea that if emerging market financial crises come along once every seven years or so, might it be better to just plan for them rather than have some suffocating alternative? Greater financialisation was considered a measure of progress and a common rallying call was “let finance be free”. But the Credit Crunch reminded many 'crisis-deniers' of how traumatic financial crises can be. In the shadow of the crisis we have returned to a more nuanced consensus, one that existed in a prior age: mobilising savings for domestic investment is a prerequisite of sustainable development, but so too, is a financial system that achieves this without accentuating boom and bust.
It has long been known that banking crises follow financial liberalisation. The orthodox response was to do it slowly, while more liberal circles wanted to get the sequence right. But more important than speed or sequence are the objectives. In the ten years prior to the recent crisis these were transparency, standardisation of value and risk measures, and removal of restraints to financial trade, like transaction taxes or capital for the trading book of banks. It was considered self-evident that achieving this would automatically deliver an effective financial system, though also fool hardy for regulators to second guess what the system should look like.
While there is undoubted merit in these objectives, the manner of their pursuit contributed to financial systems that were larger, yet more fragile; that had high degrees of trader liquidity, but little systemic resilience.
I believe it is one where a shock in one quarter can be absorbed by another, not spread and amplified across all others. For this to happen we need to have a financial system where the different parts, assess, value, hedge and trade the same assets or activities differently. This is not because they have different information, forecasts of the world economy, or risk appetites, but because they have diverse objectives, or more precisely, liabilities.
Systemic liquidity comes not from the amount of turnover or size of the markets, but the degree of effective heterogeneity. When a surprise leads to a sudden jump in the precautionary demand for cash, and all banks have to sell assets to raise cash, the financial system would be better able to absorb this stress. Life insurance funds or pension funds would value these same assets on the basis of their ability to meet a future pension or insurance liability and as a result decide that the assets are now cheap and should be bought from the bankers. This not only makes the financial system more resilient, it does so in the economic interests of customers of these different institutions and without the requirement for onerous amounts of unproductive capital.
At the heart of this approach is the notion, that it is economically sensible to have different institutions value the same assets differently if they have different liabilities. But this notion is in contradiction with practices that are put in place to support transparency and common standards – such the use of third party credit ratings and bureaus.
If all financial institutions are required to value the assets in one way through their audit rules, their capital adequacy calculations or solvency rules, then when one sector sells an asset it induces others sectors to sell more, aggravating market runs. For at the root of systemic risks is not risky assets, but homogeneous behaviour. Homogeneity, not size, determines whether a financial system is shallow, fragile and prone to falling over. The commonality of standards and rules supports trading activity in quiet times, giving the allusion of financial depth.
We must not confuse modes of operation with goals. As I discussed at a DEGRP event on economic transformation and inclusive growth this month in Washington D.C, transparency, common standards and removing trading restrictions are good modes of operation, but they are not the ultimate goal: to create a financial system that is resilient and serving the multiple needs of consumers of finance.
This is not a vague exhortation. There are simple, rule-based ways of doing that can be made consistent with international obligations. We could require a value accounting system that recognises who has time to sell and who does not, such as the mark-to-funding system. We could nurture heterogeneity by recognising that there are different types of risks, for example, market, credit and liquidity, and that different financial institutions have diverse capacities for these risks by virtue of their different liabilities. What’s more, they should be required to put up capital against any mismatch between their risk capacity and risk taking, thereby encouraging them to stick to taking risks they each have a natural capacity to absorb.
The innate diversity of any economy, small or large, rich or poor, must not be artificially snuffed out, by sacrificing long-term investment and systemic resilience on the altar of short-term trading liquidity.
How can economies be transformed to higher levels of development by finance, and avoid the pitfalls of excessive financialisation? - DEGRP/ODI event at World Bank April 2014
Governor of Bank of Kenya's presentation at DEGRP/ODI event at World Bank April 2014
Finance for Development: a research agenda - a research report by Thorsten Beck
Financial Sector Debate with the Governor of the Central Bank of Ghana - DEGRP event September 2013