Financial crashes do not occur randomly, but generally follow booms. Through a number of avenues, sometimes regulatory, sometimes not, though often in the name of risk-sensitivity, sophistication and modernity, the impact of current market prices on behaviour has increased. This increased use of market prices has increased the endogeneity of financial market risks. In the economic up-cycle, pricebased measures of asset values rise, price-based measures of risk fall and competition to grow bank profits increases. A critical component of the policy response to crisis should be for bank regulation to act as a countervailing force to the natural decline in measured risks in a boom and the subsequent rise in measured risks in the subsequent collapse.
HT PAREKH FINANCE COLUMNjanuary 10, 2009 EPW Economic & Political Weekly8Do Not Be Distracted by Mr Madoff Avinash PersaudFinancial crashes do not occur randomly, but generally follow booms. Through a number of avenues, sometimes regulatory, sometimes not, though often in the name of risk-sensitivity, sophistication and modernity, the impact of current market prices on behaviour has increased. This increased use of market prices has increased the endogeneity of financial market risks. In the economic up-cycle, price-based measures of asset values rise, price-based measures of risk fall and competition to grow bank profits increases. A critical component of the policy response to crisis should be for bank regulation to act as a countervailing force to the natural decline in measured risks in a boom and the subsequent rise in measured risks in the subsequent collapse. The unveiling of the Bernard Madoff scam on 11 December 2008, a po-tentially $50bn investment fraud, the largest carried out by an individual, is leading people to the false and dangerous idea that the global meltdown in financial markets was caused by variations on this kind of unscrupulous behaviour. We have already heard of greedy mortgage bro-kers in the United States thrusting mort-gages in the arms of the jobless and of in-sider trading scams in London. Unethical banking is an easy answer to a complex issue and one that panders to the preju-dices of those who never thought banking was anything but. The reality is that it is the meltdown in financial markets that tends to blow the cover off scams like “Madoff” and others. Scams prosper in rising markets. When everyone is making money there is little scrutiny. When markets fall, scrutiny returns and scams come unstuck. Warren Buffet, the sage of Omaha and legendary investor, famously remarked “you only find out who was swimming naked when the tide goes out”. But while scams ebb and flow with the boom and bust of finan-cial markets, they rarely cause them. They are symptoms of the environment; wall flowers at the party. The global meltdown would have occurred even if there was not a single illegal and unethical activity. Not one.To think that it was all caused by bad bankers will lead to a few being fined, some being led away in handcuffs, but for the whole thing to occur again, and again. Remember this is the 85th banking crisis, not the first or second. We can draw a few important implica-tions from this observation. If an event with widespread and severe economic and social consequences keeps on repeating itself, the onus is surely on the authorities to change something. Locking up some bankers and chiding others is satisfying, but insufficient. When the existing regu-latory mechanism has failed to mitigate boom/bust cycles, simply reinforcing its basic structure is not likely to change much. Moreover, a type of crisis that re-peats itself cannot easily be put down to new and fiendishly complex instruments. Banking policy needs to moderate the recurring cycle of financial crises, cycles that are not wedded to particular instru-ments, institutions, or individuals. This crisis occurred because of the time- honoured optimism, bred by rising finan-cial markets, that leads to excessive lend-ing and borrowing. This excess is not based on a fraud, though there are always frauds around, it is more pervasive than that. It is based on a triumph of optimism, on a view that risks have indeed, truly, genuinely, this time, fallen compared with last time because of – take your pick – somenewtechnology (railroads, motor cars, electricity, internet) or some new business practice (leverage buy outs, securitisation, quantitative diversification models, global supply chains, etc) or some new exotic markets (South Seas, India, North America, Latin America, Asia). Crises repeat them-selves because regulatory policy – perhaps too distracted by individual rogues – has failed to address the credit cycle.In considering the right policy re-sponse it is important to remember that the banking industry is different from others. When a high street shoe shop fails, its competitors get a bigger share of the business. When a bank fails, its competitors may collapse, partly because banks lend to banks. The externalities from an individual bank failure both to other banks and thence to the wider economy are just so much greater. The regulation of banks must do far more than instil good practice amongst bankers. One of the key purposes of bank regulation should be to internalise the social costs of potential bank failures via capital adequacy requirements. The current approach to systemic regu-lation focuses on the behaviour of individ-ual firms and traders. It implicitly assumes that we can make the system as a whole safe by simply trying to make sure that Avinash Persaud (avinash@intelligence-capital.com) is with Intelligence Capital, London. He is also associated with Gresham College in London.
HT PAREKH FINANCE COLUMNEconomic & Political Weekly EPW january 10, 20099individual banks are safe. This sounds like a truism, but in practice it represents a fallacy of composition. In trying to make themselves safer, banks often behave in away that collectively undermines the system. Selling an asset when the price of risk increases is a prudential response from the perspective of an individual bank. But if many banks act in this way, the asset price will collapse, forcing insti-tutions to take yet further steps to rectify the situation. It is, in part, the responses of the banks themselves to such pressures that leads to generalised declinesinasset prices, and enhanced correlations and volatility in asset markets.Booms and Crises Financial crashes do not occur randomly, but generally follow booms. Through a number of avenues, sometimes regulatory, sometimes not, though often in the name of risk-sensitivity, sophistication and moder-nity, the impact of current market prices on behaviour has increased. These avenues include mark-to-market valuation of assets; regulatory approved market-based meas-ures of risk, such as credit default swap spreads in internal credit models or price volatility in market risk models; and the increasing use of credit ratings, which tend to be correlated, directionally at least, with market prices. This increased use of market prices has increased the endogeneity of financial market risks. In the economic up-cycle, price-based measures of asset values rise, price-based measures of risk fall and com-petition to grow bank profits increases. Market discipline encourages financial institutions to respond to these three re-lated developments by some combination of (i) expanding their balance sheets to take advantage of the fixed costs of bank-ing franchises and regulation, (ii) trying to lower the cost of funding by using short-term funding from the money markets, and (iii) increasing leverage. Those that do not do so are seen as underutilising their equity and are punished by the stock markets. When the boom ends, and asset prices fall and short-term funding to insti-tutions with impaired and uncertain assets or high leverage dries up, leading to forced sales of assets which drives up their meas-ured risk, the boom quickly turns to bust. Instead of reducing the tendency of markets to boom and crash, international bank regulators have increased this tendency through their support for the greater use of market prices in the assessment of risk and value of bank balance sheets. A critical component of the policy response to crisis should be for bank regu-lation to act as a countervailing force to the natural decline in measured risks in a boom and the rise in measured risks in the subsequent collapse. This countervailing force has to be as much rule-based as pos-sible. Supervisors have plenty of discre-tion, but their ability to utilise it is limited by the general short-sighted desire to prolong a boom and by bankerspleading forequalityoftreatment. In a boom, lend-ing, leverage and reliance on short-term liquidity become mutually reinforcing and excessive. To counter this Charles Goodhart of the London School of Economics and myself have proposed, counter-cyclical capital charges on financial institutions (Financial Times, 4 June 2008). Regulators should increase the existing capital adequacy requirements (based on an assessment of inherent risks) by two multiples. The first is related to above average growth of credit expansion and leverage. Regulators should agree on the degree of bank asset growth and lever-age that is consistent with the long-run target for nominalGDP, so that the multi-ple on capital charges rises the more credit expansion exceeds this target. The pur-pose of this capital charge is not to elimi-nate the economic cycle – something which would be unrealistically ambiguous – but to ensure that in a boom, when risk measures are suggesting banks can safely leverage or lend more, banks are putting aside an increasing amount of capital which can then be released when the boom ends and asset prices fall back.The second multiple on capital charges should be related to the mismatch in the maturity of assets and liabilities. One of the significant lessons of the Crash of 2007/08 is that the risk of an asset is large-ly determined by the maturity of its fund-ing. Northern Rock and other casualties of the crash might well have survived with the same assets, if their average funding had been longer. When regulators make little distinction of how assets are funded, there is a tendency for financial institu-tions to rely on cheaper, short-term fund-ing, which increases systemic fragility. If short-term funding of long-term assets carries a capital cost – because it weighs on systemic stability – it will moderate banks’ reliance on systemically adverse short-term funding and encourage them to seek longer-term funding. A combination of these charges should help push banks to develop incentive pack-ages that are more encouraging of longer-term behaviour. A little more is required on this front than just that, though I do not share the zeal of some for governments tobe involved in the micro-decisions of private firms. The structure of regulation should reflect the purposes and powers of the regulatory authorities. Macro-prudential, and micro-prudential, instruments are both needed, but differ in focus and in their needed professionalism. Hence, they should be carried out separately, respec-tively by central banks and by financial services authorities. Again, financial and asset-price cycles differ from country to country. So contra-cyclical policy needs to be assumed more by the host country, thereby shifting some of the emphasis in regulation from the home to the host country. The idea of contra-cyclical policy is not new. Socrates, the Greek philosopher wrote in 450BC “Remember that there is nothing stable in human affairs; therefore avoid undue elation in prosperity or unduedepression in adversity.” It is the failure of policymakers to remember this or to act upon it that has led to the reoccurrence of financial crisis into the modern age. The authorities should lock up the rogues, but should not be distracted bythem from the task of leaning against the cycle. Style Sheet for AuthorsWhile preparing their articles for submission, contributors are requested to follow EPW’s style sheet.The style sheet is posted onEPW’s web site at http://epw.in/epw/user/styletocontributors.jspIt will help immensely for faster processing and error-free editing if writers follow the guidelines in style sheet, especially with regard to citation and preparation of references.
HT PAREKH FINANCE COLUMNjanuary 10, 2009 EPW Economic & Political Weekly8Do Not Be Distracted by Mr Madoff Avinash PersaudFinancial crashes do not occur randomly, but generally follow booms. Through a number of avenues, sometimes regulatory, sometimes not, though often in the name of risk-sensitivity, sophistication and modernity, the impact of current market prices on behaviour has increased. This increased use of market prices has increased the endogeneity of financial market risks. In the economic up-cycle, price-based measures of asset values rise, price-based measures of risk fall and competition to grow bank profits increases. A critical component of the policy response to crisis should be for bank regulation to act as a countervailing force to the natural decline in measured risks in a boom and the subsequent rise in measured risks in the subsequent collapse. The unveiling of the Bernard Madoff scam on 11 December 2008, a po-tentially $50bn investment fraud, the largest carried out by an individual, is leading people to the false and dangerous idea that the global meltdown in financial markets was caused by variations on this kind of unscrupulous behaviour. We have already heard of greedy mortgage bro-kers in the United States thrusting mort-gages in the arms of the jobless and of in-sider trading scams in London. Unethical banking is an easy answer to a complex issue and one that panders to the preju-dices of those who never thought banking was anything but. The reality is that it is the meltdown in financial markets that tends to blow the cover off scams like “Madoff” and others. Scams prosper in rising markets. When everyone is making money there is little scrutiny. When markets fall, scrutiny returns and scams come unstuck. Warren Buffet, the sage of Omaha and legendary investor, famously remarked “you only find out who was swimming naked when the tide goes out”. But while scams ebb and flow with the boom and bust of finan-cial markets, they rarely cause them. They are symptoms of the environment; wall flowers at the party. The global meltdown would have occurred even if there was not a single illegal and unethical activity. Not one.To think that it was all caused by bad bankers will lead to a few being fined, some being led away in handcuffs, but for the whole thing to occur again, and again. Remember this is the 85th banking crisis, not the first or second. We can draw a few important implica-tions from this observation. If an event with widespread and severe economic and social consequences keeps on repeating itself, the onus is surely on the authorities to change something. Locking up some bankers and chiding others is satisfying, but insufficient. When the existing regu-latory mechanism has failed to mitigate boom/bust cycles, simply reinforcing its basic structure is not likely to change much. Moreover, a type of crisis that re-peats itself cannot easily be put down to new and fiendishly complex instruments. Banking policy needs to moderate the recurring cycle of financial crises, cycles that are not wedded to particular instru-ments, institutions, or individuals. This crisis occurred because of the time- honoured optimism, bred by rising finan-cial markets, that leads to excessive lend-ing and borrowing. This excess is not based on a fraud, though there are always frauds around, it is more pervasive than that. It is based on a triumph of optimism, on a view that risks have indeed, truly, genuinely, this time, fallen compared with last time because of – take your pick – somenewtechnology (railroads, motor cars, electricity, internet) or some new business practice (leverage buy outs, securitisation, quantitative diversification models, global supply chains, etc) or some new exotic markets (South Seas, India, North America, Latin America, Asia). Crises repeat them-selves because regulatory policy – perhaps too distracted by individual rogues – has failed to address the credit cycle.In considering the right policy re-sponse it is important to remember that the banking industry is different from others. When a high street shoe shop fails, its competitors get a bigger share of the business. When a bank fails, its competitors may collapse, partly because banks lend to banks. The externalities from an individual bank failure both to other banks and thence to the wider economy are just so much greater. The regulation of banks must do far more than instil good practice amongst bankers. One of the key purposes of bank regulation should be to internalise the social costs of potential bank failures via capital adequacy requirements. The current approach to systemic regu-lation focuses on the behaviour of individ-ual firms and traders. It implicitly assumes that we can make the system as a whole safe by simply trying to make sure that Avinash Persaud (avinash@intelligence-capital.com) is with Intelligence Capital, London. He is also associated with Gresham College in London. 
HT PAREKH FINANCE COLUMNEconomic & Political Weekly EPW january 10, 20099individual banks are safe. This sounds like a truism, but in practice it represents a fallacy of composition. In trying to make themselves safer, banks often behave in away that collectively undermines the system. Selling an asset when the price of risk increases is a prudential response from the perspective of an individual bank. But if many banks act in this way, the asset price will collapse, forcing insti-tutions to take yet further steps to rectify the situation. It is, in part, the responses of the banks themselves to such pressures that leads to generalised declinesinasset prices, and enhanced correlations and volatility in asset markets.Booms and Crises Financial crashes do not occur randomly, but generally follow booms. Through a number of avenues, sometimes regulatory, sometimes not, though often in the name of risk-sensitivity, sophistication and moder-nity, the impact of current market prices on behaviour has increased. These avenues include mark-to-market valuation of assets; regulatory approved market-based meas-ures of risk, such as credit default swap spreads in internal credit models or price volatility in market risk models; and the increasing use of credit ratings, which tend to be correlated, directionally at least, with market prices. This increased use of market prices has increased the endogeneity of financial market risks. In the economic up-cycle, price-based measures of asset values rise, price-based measures of risk fall and com-petition to grow bank profits increases. Market discipline encourages financial institutions to respond to these three re-lated developments by some combination of (i) expanding their balance sheets to take advantage of the fixed costs of bank-ing franchises and regulation, (ii) trying to lower the cost of funding by using short-term funding from the money markets, and (iii) increasing leverage. Those that do not do so are seen as underutilising their equity and are punished by the stock markets. When the boom ends, and asset prices fall and short-term funding to insti-tutions with impaired and uncertain assets or high leverage dries up, leading to forced sales of assets which drives up their meas-ured risk, the boom quickly turns to bust. Instead of reducing the tendency of markets to boom and crash, international bank regulators have increased this tendency through their support for the greater use of market prices in the assessment of risk and value of bank balance sheets. A critical component of the policy response to crisis should be for bank regu-lation to act as a countervailing force to the natural decline in measured risks in a boom and the rise in measured risks in the subsequent collapse. This countervailing force has to be as much rule-based as pos-sible. Supervisors have plenty of discre-tion, but their ability to utilise it is limited by the general short-sighted desire to prolong a boom and by bankerspleading forequalityoftreatment. In a boom, lend-ing, leverage and reliance on short-term liquidity become mutually reinforcing and excessive. To counter this Charles Goodhart of the London School of Economics and myself have proposed, counter-cyclical capital charges on financial institutions (Financial Times, 4 June 2008). Regulators should increase the existing capital adequacy requirements (based on an assessment of inherent risks) by two multiples. The first is related to above average growth of credit expansion and leverage. Regulators should agree on the degree of bank asset growth and lever-age that is consistent with the long-run target for nominalGDP, so that the multi-ple on capital charges rises the more credit expansion exceeds this target. The pur-pose of this capital charge is not to elimi-nate the economic cycle – something which would be unrealistically ambiguous – but to ensure that in a boom, when risk measures are suggesting banks can safely leverage or lend more, banks are putting aside an increasing amount of capital which can then be released when the boom ends and asset prices fall back.The second multiple on capital charges should be related to the mismatch in the maturity of assets and liabilities. One of the significant lessons of the Crash of 2007/08 is that the risk of an asset is large-ly determined by the maturity of its fund-ing. Northern Rock and other casualties of the crash might well have survived with the same assets, if their average funding had been longer. When regulators make little distinction of how assets are funded, there is a tendency for financial institu-tions to rely on cheaper, short-term fund-ing, which increases systemic fragility. If short-term funding of long-term assets carries a capital cost – because it weighs on systemic stability – it will moderate banks’ reliance on systemically adverse short-term funding and encourage them to seek longer-term funding. A combination of these charges should help push banks to develop incentive pack-ages that are more encouraging of longer-term behaviour. A little more is required on this front than just that, though I do not share the zeal of some for governments tobe involved in the micro-decisions of private firms. The structure of regulation should reflect the purposes and powers of the regulatory authorities. Macro-prudential, and micro-prudential, instruments are both needed, but differ in focus and in their needed professionalism. Hence, they should be carried out separately, respec-tively by central banks and by financial services authorities. Again, financial and asset-price cycles differ from country to country. So contra-cyclical policy needs to be assumed more by the host country, thereby shifting some of the emphasis in regulation from the home to the host country. The idea of contra-cyclical policy is not new. Socrates, the Greek philosopher wrote in 450BC “Remember that there is nothing stable in human affairs; therefore avoid undue elation in prosperity or unduedepression in adversity.” It is the failure of policymakers to remember this or to act upon it that has led to the reoccurrence of financial crisis into the modern age. The authorities should lock up the rogues, but should not be distracted bythem from the task of leaning against the cycle. Style Sheet for AuthorsWhile preparing their articles for submission, contributors are requested to follow EPW’s style sheet.The style sheet is posted onEPW’s web site at http://epw.in/epw/user/styletocontributors.jspIt will help immensely for faster processing and error-free editing if writers follow the guidelines in style sheet, especially with regard to citation and preparation of references.
