In the panel discussions at BIS, Basel, Switzerland Mr. José de Gregorio, Universidad de Chile and former Governor of the Central Bank of Chile remarked on the subject on 24 June 2012. I have based this post on his remarks.
The financial system must operate in order to fulfill its goals without threatening financial stability or imposing costs at the aggregate level. What society really demands from financial systems is quite difficult to define. Society is a collection of actors, with different interests and different needs. People want access to the financial system at fair conditions. Therefore it is useful to think of society as everyone who is not related directly to the financial industry or policy making.
The society expects safer and fairer financial systems. Unfortunately, the view that financial markets were big casinos, where the betting was done with other people’s money and gamblers walked away unpunished, is quite common around the world. Undoubtedly, financial intermediation is good, and a well functioning financial system is key to prosperity. It promotes economic growth by channeling investment funds from savers to borrowers. It is central to promoting entrepreneurship and to facilitating investment, including human capital accumulation. It provides financing to households in order to smooth consumption, and provides insurance. It provides safe and cheap means of payment.
What went wrong?
First and foremost, the crisis was caused by the irresponsible behavior of the financial industry. The structure of incentives was unsuitable. It led to excessive risk-taking without proper risk management. Compensation was heavily biased towards deal-making, regardless of the quality of the deals. Commissions and fees were a very important component of the compensation scheme. In the end, all that mattered was granting credit indiscriminately, maximizing packaging and selling securities, etc. This was at the foundation of the originate-and-distribute model of financial services, and served to increase leverage to unsustainable levels. Well, linking compensation to productivity is efficient, but the devil is in the details.
There was indifference in policy circles. None of the policy makers saw it coming, at least not with the intensity with which it arrived, which still persists. Markets should provide enough discipline to balance risk and return, but that was not exactly the case. The market functioned poorly.
What else may go wrong?
Financial systems in emerging markets escaped from the crisis due to some extent to prudent regulation, built on a history of recurrent crises. But perhaps it was also due to the fact that they are somewhat slow to adapt to financial innovation. Indeed, many issues, such as the use of derivatives by the banking industry, were being discussed in emerging markets on the eve of the crisis.
Not everything is bright in emerging markets. There are many challenges. One issue that has not been a problem so far, but presents potential risks, is the role of public banks. If public banks are prudent and avoid jumping on the bandwagon of optimism during the upturn this is good – they may even soften credit constraints during the downturn. However, public banks may also be an instrument to pay back supporters of politicians, and certainly this is unfair and inefficient. Public banks may also be subject to capture by the electoral cycle, or used as an instrument to implement industrial policy.
An issue that has been on the agenda in most countries is financial consumer protection. It is important, however, for consumer protection to form an integral part of the regulatory infrastructure in order to avoid inconsistencies among agencies and risks to depositors and overall financial stability in the name of protecting consumers. Consumer protection also has a high risk of being captured by the political cycle. This could be specially damaging in the financial system – and therefore every effort should be made to make the institutions safeguarding financial consumers autonomous and technical.
Today we have the opportunity to tackle the task of building a safer and fairer financial system, but we also have to avoid shortcuts that may end up rebuilding a weaker financial system.