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: As finance appears to get back on its feet, the same question is back: Can we rely on markets? I contend that markets have been reasonably efficient, but only within poor regulatory constraints. Until we improve the regulatory perimeter within which markets operate, we will not be able to generate stable economic growth.
Most of the leverage built by financial firms between 2004 and 2007 was either done through regulatory arbitrage or was the result of lax regulation. Commercial banks added over $700 billion to their off-balance-sheet leverage by providing under-capitalised guarantees to structured purpose vehicles (conduits) that themselves had hardly any capital. Regulators allowed this, even though a similar leverage game brought down Enron. Once the Securities Exchange Commission (SEC) lifted its ‘net capitalisation rule’ in 2004, investment banks ramped up their exposure to sub-prime mortgages. In no time these banks drove up their debt-to-equity ratios from 22:1 to 33:1.
Markets could be deemed inefficient in all this if they had the relevant information, but made a mistake in not using it. But many activities through which the financial sector built up leverage, such as conduits and over-the-counter exposures, were not visible to investors. In contrast, these activities were—or should have been—visible to regulators.
The low price of credit risk of financials until 2007, coinciding with the rising path of their leverage, implied that the hidden trajectory of expected taxpayer losses was exploding. Put simply, profits were being privatised and risks socialised. It was regulation, not markets, that allowed this to happen.
Regulation is supposed to fix market failures. But regulation also reduces market discipline. Thus, when regulators deem a bank well-capitalised, the onus is on regulators that this be right. Markets may not have the incentive to gather this information, nor possess the details of regulatory supervision that led to such an assessment. Conversely, when regulation allows itself to be arbitraged, the financial sector becomes more opaque, exposing markets to unexpected outcomes.
When such adverse outcomes materialised in the first eight months of 2007, market learned fairly quickly. By then, Countrywide had fallen, Bear Stearns had to bail out hedge funds invested in the US subprime assets, and indices tracking such assets were declining day by day. When BNP Paribas declared on August 8 that there was no market for subprime assets in its hedge funds, it became clear to investors that the entire financial sector had made a one-way...
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