The risk-management approach to financial regulation has been around for a long time and it has failed consistently. It has not only failed to promote safer economic decisions and prevent the emergence of crises, but it has also failed to provide a relevant protection against major financial problems. Since at least 1864, with the imposition of capital adequacy ratios on national banks, regulators have tried to establish adequate buffers against expected and unexpected financial losses. Over time, the calculation of those buffers (liquidity, loan provisions, capital equity, etc.) has been refined, and Basel II was supposed to provide the latest improvements in this area. The current crisis has already made Basel II obsolete and many economists have noted the importance of accounting for liquidity issues in addition to loss issues.
Recent reports (e.g., CRMPG, BIS, IMCB, FSF, and the Department of the Treasury) have suggested that risk management can be improved by accounting for systemic risk and liquidity risk, and by making capital adequacy ratios more countercyclical. In addition, improvements were suggested in terms of reinforcing the role of risk officers in the governance of companies and in terms of remuneration methods.
Two of the major drawbacks of these proposals are that, first, like all previous risk-management policies, they do not deal with the core cause of financial instability and, second, they aim at being the least “intrusive,” which gives them only a very indirect impact on the management of financial stability.
Regarding the latter point, the philosophy of the past and current regulatory approaches has been to let individuals take whatever risk they find appropriate given market signals. Regulation is just there to tweak costs and returns in order to give an incentive to make “prudent” decisions as defined by arbitrary ratios of capital and liquidity (as well as by insurance premiums). As a consequence, as long as financial institutions meet the regulatory ratios, they are assumed to be safe and prudently managed, no matter how risky their asset positions and funding methods are. In addition, financial institutions can self-righteously complain further supervisory scrutiny if they meet their capital requirements, which greatly limits the effectiveness of supervision. All this is rather a permissive approach to financial regulation that is highly reluctant to forbid unsustainable financial practices. This is all the more so that economic agents are willing, and are forced by market mechanisms, to use those financial practices to improve their economic situations (unfortunately without consideration for the long-term indirect consequences of their choices).
Regarding the former point, the core cause of systemic financial crisis is the growing use of Ponzi finance over enduring periods of economic expansion. Ponzi finance means that the servicing of a given amount of debts requires the growing use of refinancing operations and/or liquidation of assets at rising prices. Ponzi funding methods are usually associated with crooks like Madoff, but the most devastating Ponzi processes are those that involve legal economic activities that are at the core of the economic growth process. Consumer finance for the past twenty years and the mortgage booms of the past ten years were Ponzi processes that involved honest and creditworthy borrowers who just wanted to improve their standard of living; lenders were more than eager to promote this trend to maintain their profitability and competitiveness, which was seen as a proud achievement of American free enterprise. Thus several Ponzi processes were at play and they all were used “judiciously” to maintain economic growth and business activities.
The problem with the type of Ponzi processes that we have experienced, is that, no matter how sophisticated and well informed financial players are, and no matter how efficient financial markets are, it always fails; and when it does, no buffer, no matter how high it is, can protect against the collapse. Pyramid Ponzi processes cannot be “risk managed.”
To better prevent the emergence of Ponzi processes an emphasis should be put on cash flows (rather than accounting profit) and on how economic entities plan to meet their financial commitments. Rather than asking, “Will you pay on time?” to determine creditworthiness, a more relevant question would be, “How will you pay on time?” And rising collateral price and access to refinancing channels should not be used to determine the expected capacity to repay of a borrower. Collateral liquidation (and so price) would only be used as a defensive means to protect banks against unexpected default, rather than as an offensive means to grow market shares and lending volumes. Ponzi processes should be eliminated or discouraged, no matter how good (or necessary) they appear for the competitiveness and (short-term) improvement of standards of living.
All financial institutions should be regulated, and the restructuring of the financial system should be based on promoting hedge financing of economic activities. By focusing on the financial practices of financial institutions, strong financial stability will be promoted and economic growth will proceed on more solid grounds (albeit probably at a slower pace).