Strength in global equity markets last week will prove temporary. I am still waiting for a more lasting turnaround to visit us in September/October as discussed in my last article. In the mean-time, only buy extreme value and meditate on the wider lessons of recent financial developments. One of the most important recent developments was the rescue of Fannie Mae and Freddie Mac announced by Treasury Secretary Paulson on July 15. This was the inevitable consequence of the ?marketisation? of banking that has now transformed developed country central banks from lenders of last resort to buyers of last resort.
Established by government charter in 1933 and 1968 respectively, in more recent years, Fannie Mae and Freddie Mac became the poster children of the switch from bank finance to market finance. They did not originate loans, they owned or guaranteed securitised loans originated by others. When a report into accounting improprieties in July 2003, led Freddie Mac to scale back its activities, banks, then looking around for a new source of income in the wake of the dotcom ?bezzle?, tried to replicate the model and push the envelope. They weren?t secretive in doing so. If you can picture the image, some of the main cheerleaders of the marketisation of banking were the gnomes of Basel?the centre of international bank regulation.
Many regulators thought the ?marketisation? of banking represented a brave new world, where grizzly, idiosyncratic lending officers were replaced with best of the breed credit models, policed by third-party rating agencies and where risk was digitised, spread across a large number of investors and traded. But it was a Faustian bargain. The appearance of liquidity and sophisticated risk management during normal times was the trade off for an increasingly brittle financial system when stressed. Many regulators, especially those separated from the central bank, were lulled into this bargain by thinking that bank regulation was the same as regulating the railways or the gas industry: if players accepted common and transparent standards of gauges and signals, the system would be safe. But finance is not like the railways. Systemic stability in finance requires diversity.
A market with just two players, where whenever one wants to sell an asset the other always wants to buy it, is liquid. A market with ten thousand players, where each uses best of breed valuations systems based on publicly available data and best-practice mark-to-market accounting and risk systems, is one where when one player wants to sell an asset; so will everyone else. This market is bigger, yet thinner.
Financial systems, especially India?s, have naturally diverse players. There are young savers and old pensioners, wealthy people with money to punt and poor people with little to risk. Adopting common fair value accounting and risk systems, collapses this heterogeneity into a mono-dimensional world of ?current price?. Today, when prices drop in a volatile manner, it does not draw out bargain hunters; it brings out forced sellers as accounting write-downs and risk systems dictate asset disposals. Price declines feed price declines. The only thing that can reverse this cycle, as Professors Buiter and Siebert have argued, is for the authorities to buy assets. The announcement that Fannie Mae and Freddie Mac, non-banks not even involved in sub-prime mortgages, will have access to emergency liquidity at the Fed may seem shocking, but it is the inevitable consequence of the marketisation of banking.
What are the lessons? A critical objective of systemic regulation should be to preserve structural diversity, not create artificial homogeneity in the blind pursuit of common practice. I believe Governor Reddy and his team appreciate this more than most. In preserving diversity, regulators must pay less heed to old-fashioned distinctions between institutions and instruments, and instead focus on risk capacity. An important aspect of the capacity for risk is funding. Institutions funded by overnight depositors or money markets have limited capacity for holding instruments with volatile prices and shifting liquidity. They should set aside capital against these risks and as these risks are pro-cyclical, the capital regime should be contra-cyclical, as proposed by Professors Goodhart and Persaud.
Institutions that have long-term funding or liabilities have a capacity to diversify risks across time. They can act as risk absorbers, strengthening systemic stability. They could be a young pension fund, or an unleveraged hedge fund with long-term lock-ups. But they have been robbed of their risk absorption powers by a wrong-headed notion, sponsored by the big banks and better suited to the railways, that all financial institutions must be treated the same, measured the same and behave the same. A regulatory backlash to the crisis may extend this approach further. In which case we will be presiding over more financial fragility and ever increasing schemes of emergency asset purchases around the world, but hopefully, not in India.
The author is chairman of London-based Intelligence Capital, governor of the London School of Economics and Emeritus Professor of Gresham College in the UK