The reform of financial regulation: a Post Keynesian perspective

1. The reform of financial regulation: a Post Keynesian perspective Sheila C Dow summary argument Reform of financial regulation is required to address: the endemic potential for financial instability in capitalist economies the functionality of finance but needs to consist of more than incentives and constraints. SCEMEUniversity of Stirling s.c.dow@stir.ac.uk for presentation to the PKSG, Cambridge, 9 November 2010

2. Structure of the Argument • Purpose is to focus more on the principles of regulation than on the detail, and to focus on banking • The role of financial regulation: promoting the efficiency or functionality of the financial sector? • Regulation in its narrow and broad senses • Theory of banking: focus more on calculative rationality or social convention? • Case study: addressing moral hazard • Policy implications: focus more on constraints/incentives or on restoration of social conventions?

3. 1 Mainstream Approach to Reform of the Financial Sector1a Theory of Banking • Banks are simply financial intermediaries, maximising profit subject to constraints • Market forces generally ensure the efficiency of financial institutions • Different financial institutions are distinguished by regulation, transactions costs and information asymmetries • Banks in the past dominated credit supply because they enjoyed information advantages from managing deposit accounts • Banks benefited from regulation to protect depositors, which created moral hazard re lending • Confidence/trust in banks is the outcome of a rational calculation of risks

4. 1b Mainstream Approach to Financial Regulation • Market forces produce the best outcome, cet par • Free Bankers/New Monetary Economists: extreme free market position - no role for regulation • Washington consensus I: financial liberalisation • Washington consensus II: improve governance • New Keynesians: regulation to address market imperfections

5. 1c Moral Hazard in Mainstream Theory The unintended effect of insurance as increasing the willingness to take on risk (with limits on monitoring) Origins in insurance literature: implied moral judgement Developed in decision theory as the outcome of the rational pursuit of selfish ends, ie opportunism Credit rationing literature: moral hazard arises from rational response to asymmetric information No ethical connotation to term ‘moral’ hazard: ‘moral sentiment’ meaningless Moral hazard was only identified once the crisis emerged

6. 1d Mainstream Approach to Policy to address Moral Hazard The problem: moral hazard - rational opportunism in response to incentives has unintended consequences for the financial system and confidence in it The solution: Don’t discourage rational behaviour Free Bankers: remove all other state interference New Keynesians: if accept that market imperfections are inevitable: improve governance by the state, and by banks, and Regulate against risky opportunities Change the incentives (eg terms for bonuses) Reduce LOLR protection: banks small enough to fail But none of these will successfully restore confidence if the potential for financial instability is endemic

7. 2 Post Keynesian Approach to Reform of Financial Regulation2a Post Keynesian Theory of Banking(drawing particularly on Victoria Chick’s work) Banks are agents of the state (as principal), providing society’s payments system The emergence of bank liabilities as money was the product of confidence as a social convention This allows credit creation, so banks are not just financial intermediaries Emergence of role of central bank in promoting confidence in banks Lender-of-last-resort facility (LOLR) intended to reduce systemic risk in both senses (interconnected portfolios and confidence in banking) Normally this takes the form of supplying liquidity to support bank rate rather than active support of individual banks Functionality of banking declined from stage 5

8. Evolving Tensions in Banking • LOLR increases confidence but reduces central bank leverage on credit creation • Both cooperation and competition between banks: importance of interbank market • Confidence in banks is lower the more free is competition and thus exposure to risk: the natural tendency of banking is to concentrate, increasing market power • Increasing confidence in banks allows reduced reserve ratio, increasing their vulnerability • Fractional reserve banking is inevitably potentially fragile • Banks vulnerable in crisis situations to collapse of confidence in Keynesian sense: CARs inadequate protection

9. Role of social conventions re confidence • Institutional structure and social convention provide foundation for economic activity • Includes social conventions with respect to asset valuation • Trust provides basis for (non-calculative) confidence • Moral values are a necessary element of successful activity • Immoral/opportunistic behaviour undermines socio-economic structures • Immoral/opportunistic behaviour undermines the functionality of banking

10. 2b Post Keynesian Approach to Financial Regulation • The financial system works best as a decomposable system • Aim of promoting functionality of finance against backdrop of inevitable potential for financial instability • Functionality refers to provision of credit and liquidity according to society’s needs • Need to build on social conventions, which build on history, to strengthen social structures in finance (cf régulation approach) • Segmentation + sand-in-the-wheels to moderate tendencies for swings in market sentiment and thus leverage (reducing efficiency in mainstream sense) • Need for non-calculative confidence in money to underpin the financial sector and commercial society

11. 2c Moral Hazard in Post Keynesian Theory • Morals are relational: concern here is with the structure of finance in relation to society and thus with ethics, rather than personal morality in an atomistic sense • Moral hazard at a micro level is uncertainty about the honesty or prudence of the other party (person or institution) • It is broader than active concealment of information: full information is not available anyway • So decision-making under fundamental uncertainty requires confidence in others’ behaviour and in institutions • Moral hazard at the societal level is the risk that social conventions will weaken, eroding trust

12. Moral Sentiment and the Financial Sector • The central role in the crisis of market sentiment is an epistemic issue, but euphoric market sentiment can encourage opportunism • Financial companies are social entities • Sense of fairness and social responsibility are important drivers (not just profit); opportunistic behaviour not to be assumed as the norm • Ethics and profitability not mutually exclusive • But conventions can evolve which are immoral eg Enron (misrepresentation of information, not just concealment) and banks encouraging customers to be imprudent • Regulation (by government or professional bodies) can put some bounds on immoral practices

13. Evolution of the principal-agent relationship • Traditionally, banks’ portfolio behaviour was constrained and monitored as a quid pro quo for LOLR • Change in social character of this relationship: substitution of regulation for gentlemen’s agreement due to globalisation in banking • Relaxation of regulation from the 1980s legally freed up banks as agents to accept more risk: moral hazard on the part of banks • Reduced monitoring and supervision, and then the possibility of the central bank not guaranteeing LOLR led to loss of confidence and focus on agency/trust issues: moral hazard on the part of the central bank

14. 2d Post Keynesian Policy to address Moral Hazard • The problem: need to rebuild trust, to create a climate of confidence, in banks and central banks • Prevent narrow moral hazard by simple regulatory restrictions in line with traditional banking culture: • prohibit some activities (eg proprietary trading) and • apply simple regulations (eg liquidity ratios, rules on mortgage lending and eligibility for credit cards) • But take care: restrictive regulation can create new types of risk in a dialectical process (eg CARs) • Reassert LOLR for traditional banking, to prevent moral hazard of central banks • Establish global insurance fund and/or Tobin tax to support LOLR in case of systemic risk

15. Some Issues • Fragility of fractional reserve banking • Should confidence in money be guaranteed by 100% reserves (narrow banking) or in a state-run gyro system? • But this removes the special capacity of banks to create credit and encourages alternative assets to be used as money • Non-bank money • The liabilities of shadow banks may seem perfectly liquid as market sentiment picks up, but will lose liquidity in downturn again and not be covered by LOLR • Can this be handled by more clarity over deposit insurance and LOLR? • Could the central bank ensure enough liquidity through the repo market to avoid recourse to alternatives? But then should the central bank restrict liquidity to discourage excessive asset price rises?

16. Addressing Broad Moral Hazard with ‘Broad Regulation’ • The aim is to change behaviour and attitudes, ie financial culture, through changing the structure of the financial sector • Design this structure on the basis that socially-aware behaviour is inevitable and other-regarding behaviour is not irrational • Increased emphasis on governance • Checks on management of banks: active monitoring and supervision • Checks on management of bank regulation, supervision and monitoring • Active support for social/cooperative/ethical banking • Active socialisation of banking: • improve government knowledge of the financial sector for early identification of culture problems • provide a vehicle for promoting a more ethical culture.