People's welfare has been jeopardised by the greed of financial institutions and by incompetent regulators, argues former Central Bank economist Michael Casey
As is now all too familiar, a few financial institutions in the US and in other developed countries have made horrendous mistakes over the past few years that now threaten the economies of Europe and North America. These mistakes were motivated by greed and were allowed to happen by a systemic failure of financial regulation. It is as if the US Food and Drug Administration allowed toxic drugs to be sold without testing them. The welfare of ordinary people has been put in jeopardy by grasping institutions and inadequate regulators.
The regulators knew that institutions had become involved in sub-prime lending. They assumed that risk was being priced correctly. They never asked the fundamental question: If a borrower cannot be trusted to service his mortgage at the going rate of interest, why assume he will service it at a higher rate? They allowed a dash for growth at the expense of quality.
The regulators didn't ask the right questions when these sub-prime mortgages were packaged up and sold on to other institutions. The regulators seem to have assumed that this would spread the risks just as happens when a bookie lays off big bets. After a while they lost sight of how much risk was in each package and which institutions now held the packages. The situation deteriorated in front of their eyes and became the financial equivalent of mad cow disease.
The financial regulators didn't bother to consider the dangers of these suspect packages being used as collateral for further debt- creation and the "pyramid" aspect of such leveraging. Pyramid schemes are outlawed in most countries when operated by consumers but it seems that financial institutions can build pyramids with impunity even though these pose huge, macroeconomic threats at a global level.
Did the regulators not know that property prices had been rising at unsustainable rates for several years in most of their countries? Did they not know that the governance and incentive systems of the banks they supervise are designed to exploit booms to the maximum, almost regardless of risk? We should all know by now that banks and other financial institutions, including rating agencies, are greedy and never learn from their mistakes. Recent history is full of examples of egregious misjudgments by banks and other financial institutions whose top executives don't understand how derivative products work. But then why should financial institutions mend their ways when they know they will be bailed out by the central banks? This problem, known as "moral hazard", continues unabated; in fact it is now endemic.
In the UK the regulators have known for years that Northern Rock financed itself to a significant extent from the wholesale interbank market. They also knew that if problems of confidence occurred in that market then banks like Northern Rock would quickly run out of liquidity. Yet nothing preventive or pre-emptive was done. Bureaucrats rarely act in a timely fashion. The question must also be asked whether regulators are too close to the institutions they regulate.
Modern economies need banks to channel money from savers to investors. When this mediation job is undermined economies suffer, living standards fall and unemployment increases. If the financial system as a whole gets into trouble as a result of contagion or the collapse of the pyramid, economies will go into serious recession.
That is why central banks now have no option but to provide emergency liquidity to the wholesale market and to named banks. But this means that their monetary policies have been hijacked, postponed or even abandoned. (So far the Bank of England is the only central bank trying to maintain some semblance of its monetary policy.) In the US, monetary policy is now in tatters with interest rates reduced to help the banks, and the ECB, which ironically has expressed serious concern about inflation, is not far behind. This means that inflation is likely to get out of control. Thus Mary and Seán Citizen will pay the price for bank greed and regulatory inadequacy.
The intervention of central banks will probably assist the recovery of share prices thus protecting the wealthy shareholders in society, but this will be at the expense of ordinary citizens who will have to pay more for the average basket of goods and services.
The final irony is that banks may push up their mortgage rates to compensate themselves for having to pay a little more for interbank funds. Thus, the mortgage-holder will also be asked to pay for the problems caused entirely by financial greed and the failure of regulation. The sight of anxious, elderly people queuing in the cold to rescue their life savings is powerful testimony to the injustice of the economic system we all live under.
So what should be done? Clearly we cannot have a situation where a handful of institutions create toxic products, contaminate large swathes of the financial world, threaten entire economies and hijack national and international policy-making on inflation. It is simply not acceptable.
The regulatory architecture will have to be radically changed by the relevant international bodies - the International Monetary Fund (IMF), the Bank for International Settlements and the OECD. And this does not mean throwing even more bureaucrats at the problem. There clearly need to be much more severe sanctions on the individuals who design and sell toxic products. It is time to consider a special form of taxation of financial institutions along the lines recommended years ago by Prof James Tobin, a Nobel prize-winning economist. If properly designed, such a tax would limit reckless trading and financial instability, and could also provide emergency funds if the need arose in the future.
The onus of sorting out messes should be passed from central banks - and the public at large - back to the financial institutions themselves. This would, for the first time, make them accountable for their own actions.
Michael Casey is a former chief economist at the Central Bank and member of the board of the IMF