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Reshaping the financial system after the storm

The question of the social utility of the financial services and of the appropriate modes of remuneration of its actors has occupied a central place at the G20 meeting held in Pittsburgh. Indeed, the G20 leaders expressed a shared willingness to back new global regulatory standards for the banking industry. Yet, their reasons for doing so need some unpacking.

The recent interview by Prospect magazine of the FSA Chairman Adair offers a case in point, as does his recent speech at Mansion House. Turner suggests that the financial services sector should slim down to a more ‘socially useful’ size and reduce bankers’ pay accordingly. He also estimates that market deregulation has led to an oversized financial sector. Finally, he proposes that regulators should step in to reconnect the size, profit and pay level of the sector to what is ‘socially optimal’.

Though it may sound intuitive, the idea of a ‘social optimum’ that could be used as a guideline for regulating finance is ambiguous and deserves a close look.

The market as optimum. There seems to be some agreement on what the ‘social optimum’ is not anymore. Indeed, Turner’s stance is an outspoken move away from the intellectual framework that dominated economic regulation over the past decades. This framework relies on the so-called ‘efficient market hypothesis’ according to which prices on capital markets incorporate all relevant information. It implies that equities are traded at their fair value and that differential returns depend only on the products’ various levels of risk. Deregulation and increased liquidity are viewed as features that foster exchanges and improve the reliability of the overall system.

A social optimum is presumed to be reached once the markets are free to function unimpeded. It is precisely this belief that the crisis has disrupted. The credit crunch has pointed out that more liquid and deregulated markets mean neither better efficiency nor a more stable system. Furthermore, a view has developed that some products, such as derivatives, might generate systemic risks. Taken together, these changes of assumptions are described by Turner as a ‘very fundamental shock to the efficient market hypothesis’.

So, what may be a ‘social optimum’ that would be different from the ‘market optimum’?

A prudential approach. Even if the efficient market hypothesis is discredited, the need for financial markets is not put into question. Most actors are willing to preserve the financial sector as it performs the vital economic role of matching saving and borrowing needs. Avoiding a similar collapse in the future or, as Turner has it, stopping ‘the credit bubble of 2015-2020’ might comparatively appear as a socially more valuable aim. Let us call this attitude the ‘prudential’ approach.

This stance consists in reducing the probability of a collapse by increasing the banking system’s systemic resilience to downturns. In the run up to the crisis, some innovations such as credit securitisation had local and global actors lose track of the actual risk level of these assets, which led to a global shortage of liquidity as creditors defaulted and asset value dropped. Various regulatory responses could be considered, from a strict ban to higher capital requirements against risky activities.

The implicit idea is that the sector should not grow so big or the activities become so risky as to bring a shortage of liquidity, leading to a collapse and to high costs for the overall community. In this perspective, winding down the financial sector serves (instrumentally) a prudential purpose. Banks incur a major part of the cost as they lose income on those products they would not be able to sell under restrictive conditions.

Fairness. The prudential approach includes a dimension of fairness, understood as proportionality between people’s contributions and retributions. Contributions can be defined as effort or actual work and so on, while the retribution can be money, a decent job, housing security, etc.

On this view, it sounds reasonable that those who do not benefit from a determinate economic arrangement should not bear the costs generated by its functioning (externalities). So, by preventing a future crisis and its associated economic harm, the prudential approach benefits everyone and not least the weakest members who are most at risk of facing job losses and house repossessions despite bearing no direct responsibility in the crisis. The prudential stance thus reflects a better sense of proportionality than a laisser-faire policy that would end up with the most vulnerable bearing the externalities of a market collapse.

In the same spirit, it also seems fair that those who derive the greatest benefits be the greatest contributors to insuring the system does not blow up. It also sounds reasonable that those who do not derive any benefit may not be requested to pay premiums for ensuring its safety. Thus, the prudential approach sounds fairer as it intends to make those who derive the greatest benefits from the riskier activities (arguably the banks, their shareholders and some employees) and not the community at large secure sufficiently high reserves to resist future downturns. Yet, this leaves the question open as of whether fairness might require more stringent measures than prudential ones.

Meeting society’s needs. Alternatively, one may consider that a socially optimal financial system should meet to some extent its clients’ needs. For some including Turner, deregulated markets may have failed to offer some possibly useful (though low margin) products, such as GDP bonds; and have possibly sold products beyond buyers’ needs and expertise. Turner points at the financial industry ‘ability to generate unnecessary demand for its own services’.

This may be partly explained by the power and information imbalances between the buy and sell sides, bankers being more aggregated and better informed agents than their clients. Some funds may thus have stricken not as good deals as they could have, had they been better informed. Similarly, the less aware individual fund suppliers such as pensioners may be hit even harder.

Pointing to the limits of agreements reached on markets does not provide a clear line for a regulatory response. For risky products may be partly useful, and drawing the line between the functional and the dysfunctional may be a tricky business.

And yet, now is probably the moment to ask these difficult questions. If fairness consideration may be taken into consideration at times of handling crises (as discussed in this blog by Tom Douglas in Bailing out banks) they should even more pressingly be taken into account at times of designing the institutions which will shape the future balance of contributions and retributions.

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