Reflections on the 2008 Global Financial Crisis
What caused it?
The systemic causes were:
Politically-motivated intervention in the markets, especially (in the US) (1) to force banks to lend to incompetent borrowers; (2) to force the taxpayer to underwrite the resulting unrepayable mortgages via Fannie Mae and Freddie Mac.
Policies that lulled investors/depositors into ignoring risk - e.g. deposit insurance.
Over-expansion of money supply by central banks, especially the US Federal Reserve, in the aftermath of the dotcom bubble-burst.
Poor regulatory design - e.g. split responsibilities among regulators, especially in the US, UK; ‘principles-based' regulation based on inappropriate principles, ‘model-based' risk monitoring based on inappropriate risk models.
Ineffective corporate governance in many of the principal players - e.g. Lehman's board included four 75-year olds and a girl guide leader - because of systemic blockages to the exercise of shareholder power.
Fair value accounting, which forced banks to write down and sell assets that they otherwise would not have needed to sell, thus exacerbating the crisis.
Within this distorted and anomalous framework demanded by politicians and implemented by regulators, market players did what would have been expected of them, i.e. they utilised financial technology to exploit the anomalies to the limit for their own personal gain. However, the resultant crisis was not the fault of market players. Market players are not responsible for the integrity of the financial system; that is the responsibility of the politicians and the regulators.
Are the authorities doing the right thing now?
Starting in August 2007, the authorities have responded with dramatic action, including nationalising key financial players, flooding the market with liquidity, banning short selling of financial institution stocks, and devising specific revival packages such as the recently approved US$700 billion TARP (Troubled Asset Recovery Programme).
There has been a very serious risk of complete financial collapse. To the extent that the risk has receded as a result of the foregoing actions, the authorities have done something right.
However, the actions do not amount to a solution, and some have bad side effects. They are also very costly.
The actions have been piecemeal and contradictory (e.g. why save Bear Stearns but not Lehman?);
The ban on short selling of financial and selected industrial stocks is not logical (why no ban on long buying? Why not other stocks?) and dislocates the price formation process.
The TARP will buy up bad assets at (presumably) excessive prices, thus rewarding the most incompetent players the most.
Random nationalisations preserve institutions that should not exist.
There is no vision of where we are headed to.
It is hard to avoid the impression that one former investment banker, (who selects his former colleague investment bankers as advisers), is using public money to bail out his investment banking cronies.
Of the responses of the various national authorities so far, perhaps Britain's recent proposal to take preference shares in the banks (as well as bolster the asset markets) is possibly the best. But there should be conditions attached to the preference shares.
Would another system be better?
The other systems have been tried and have failed:
Disband markets and let the government allocate funds? This is the socialist central planning model, i.e. centralised allocation of capital, which manifestly failed in the former Soviet Union and Maoist China.
Channel funding mostly via banks under discretionary-based regulatory system? This is the Japanese model, which manifestly failed in the 1990s ‘Lost Decade'.
Mix the discretionary-regulated approach to commercial banking with freer (investment banking-type) markets? This was the Swedish approach, which manifestly failed in their banking crisis of the early 1990s.
There are no other models. The market remains the best allocator of funds. However, an appropriate regulatory framework is needed that,
Is more sensitive than the present one to causes of systemic risk;
Allocates regulatory authority for the various aspects of the financial system appropriately. In particular, (a) there should be a single regulator responsible for capital adequacy; (b) a single regulator responsible for conduct of business; (c) the central bank (possibly the same institution as regulator (a)) should have a remit not exclusively focused on inflation.
Through appropriate corporate governance measures which empower shareholders to look after themselves, reinforces self-regulation by and among market players.
Avoids the creation of perverse incentives through appropriate accounting and capital adequacy rules.
How is Hong Kong doing?
So far, Hong Kong has come quite well out of the primary effects of the global financial crisis. It has no collapsing banks. The financial system appears sound.
The secondary effects from the withdrawal of leading global players and the general tension in financial markets may impact the economy, especially since the financial sector is relatively large in Hong Kong.
The mini-bonds scandal highlights that little attention was being paid to the conduct of business of banks. Supervision of conduct of business of all financial institutions should be centralised in a single regulator, probably the SFC.
The Hong Kong Mortgage Corporation, Hong Kong's incipient Fannie Mae/Freddie Mac, should probably be wound up.
The systemic conflicts inherent in the HKMA as bank regulator, market developer, player in the money markets, fund manager for the government should be addressed, e.g. by allocating one or more responsibilities to other institutions.
Senior personnel in key regulatory bodies should be rotated out of office from time to time.
Policy Committee, Hong Kong Democratic Foundation
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