November 20, 2012 6:21 pm

Banking must not be left in the shadows

Market economies change, so the measurement systems should keep pace, writes Gary Gorton

The financial crisis again showed that in market economies bank runs recur, over and over. Even when new legislation succeeds in preventing them, crises return because market economies morph due to innovation. During the crisis, much of this innovation was found in the “shadow banking” system. On Monday, regulators on the Financial Stability Board issued recommendations to reduce risks in shadow banking. It is a belated yet welcome sign of its importance to finance. However, there is much more to learn.

Much of this remaining lesson concerns how to get the banking system back on its feet as fast as possible after a crisis. Just to emphasise the significance of this: non-mortgage asset-backed securitisation was the size of the entire US corporate bond market by issuance. That securitisation system is now moribund. Can we re-create confidence? Can we design financial regulation so that bank runs do not recur? I wish the answer were a resounding yes but, for several reasons, I am worried it is no.

First, banking reform is usually complicated by the backlash against bankers after a crisis, which confuses banks with bankers. In financial crises, the government and society act to save a banking system that is about to crash and burn: as Ben Bernanke, Federal Reserve chairman, noted in his testimony before the US Financial Crisis Inquiry Commission, 12 of the 13 largest US financial institutions were on the verge of insolvency in 2008.

That’s why such crises are “systemic”. Historically, during a crisis, banks have suspended convertibility, have been bailed out, nationalised, subsidised, covered by blanket deposit guarantees and so on. There is no case where a society intentionally liquidated its banking during a financial crisis. But here’s the rub: saving the banking system means saving the bankers. And that means that debate over reform is overtaken by anger at bankers. Bankers push back, regulators act tough and politicians make noises. In the cacophony, reform, if it happens at all, risks pushing banking into new shadows in future.

Addressing the details of the recent financial crisis leaves open the larger question of how it could have happened in the first place. Without answering that question, any proposed changes are backward looking. One of the findings of the Financial Stability Board report is that the global shadow banking system grew to $62tn in 2007, just before the crisis. Yet we are only now measuring the shadow banking system. How did such a banking system grow without us noticing – and could it happen again? So a second crucial issue is measurement, in the new world of derivatives, off-balance sheet vehicles, securitisation and new forms of money.

Measurement is the root of science. Our measurement systems, national income accounting, regulatory filings and accounting systems are useful but limited. Market economies change. The financial system changes. Isn’t it clear that the measurement systems should also change to keep up? National income accounting, one of the greatest achievements of economics, was built largely as part of the second world war effort and intimately involved the government, which had an interest in understanding the capacity of economies to go to war. Now we need to build a national risk accounting system. The financial crisis occurred because the financial system has changed in very significant ways. The measurement system needs to change in equally significant ways. The efforts made to date focus mostly on “better data collection” or “better use of existing data” – phrases that, at best, suggest feeble efforts. A new measurement system is potentially forward-looking in detecting possible risks.

Another problem is conceptual. Why weren’t we looking for the possibility of bank runs before the crisis? The answer is that we did not believe a bank run could happen in a developed economy. Modern macroeconomics and financial economics were developed during the recent period when there were bank runs in neither the US nor in Europe. The idea was that the economy had outgrown such problems. We did not understand that bank money is vulnerable to runs.

Why did we think that? For no good reason. But, when an economic phenomenon occurs over and over again, it suggests something fundamental, such as other laws of economics – the laws of supply and demand, for instance, or the law of one price. Another law, we now know, is that privately created bank money is subject to runs in the absence of government regulation.

The writer is professor of financial economics at Yale and the author of ‘Misunderstanding Financial Crises’. He was a consultant to AIG Financial Products for 12 years

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