26/08/2010 - 00:00

Tone down the thrill factor to reduce risk

26/08/2010 - 00:00

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The finance sector needs to be less ambitious for growth and more conscious of risk.

DURING the past 20 years there has been a major increase in the size and breadth of activity of the financial sector in most economies, as well as acceleration in the globalisation of finance.

Statistics abound to demonstrate this. In Australia, total assets of financial institutions have increased from the equivalent of around 100 per cent of GDP in the early 1980s to almost 350 per cent in recent years. It is widely assumed that financial deregulation played a major role in this increase, and the timing seems to fit.

Now, in the aftermath of the crisis, there is a more questioning tone about whether all this growth was actually a good idea – maybe finance had become too big (and too risky).

There are at least two potential problems in a world where the finance sector becomes ‘too big’. If it is accepted that finance has its own cycle – of risk appetite, leverage, crisis and then de-leveraging – then a bigger financial system risks de-stabilisation of the whole economy. In the current episode, the direct costs to the public purse of restoring financial stability in some of the North Atlantic countries are non-trivial. But the cost of lost revenue in the lengthy periods of economic weakness that seem invariably to follow financial crises is an order of magnitude larger.

Secondly, an overly large financial sector, if characterised by perverse incentives that can drive extraordinary remuneration for individuals, may draw in too many resources that could otherwise be employed at a higher social return. To put it in practical language, too many PhD physicists, mathematicians and engineers working on options pricing and designing structured products could lower, rather than increase, the productive capacity of the economy.

For finance is not, for the community, an end in itself. It is a means to an end. Ultimately it is about mobilising and allocating resources and managing risk, and so on. Yet people have become suspicious of the way much of the activity in the financial system amounts to the production of ‘intermediate’ financial services, delivered to others within the same sector – the ‘slicing and dicing’ of risk, re-allocating it around the system to those who are most willing and best able to bear it (or, sometimes perhaps, and much more troublingly, to those who least understand it).

Some commentators – among them the chair of the UK Financial Services Authority – have openly questioned the social usefulness of much of this activity. They are also questioning implicitly whether the thrust of financial liberalisation in the 1980s and 1990s was correct, or at least may have gone too far.

These questions are likely to be debated intensely over the next several years. It is premature to draw strong conclusions, but a few observations may be useful.

First, a small point of measurement. In most modern economies, the share of GDP accounted for by services generally has long been growing, as agriculture and manufacturing get (relatively) smaller. It would not be surprising for the finance sector to be part of that.

Second, a fair bit of the growth in financial sector activity was surely bound to happen in view of changes in technology. These dramatically lowered costs, so that the provision of news and information became instantaneous and ubiquitous, as did the ability to respond to news. The increasing development of financial management techniques and new instruments also led to a lot more gross activity. So surely some of the growth in the finance sector has been genuinely useful.

Third, the increasing integration of the global economy – itself assisted by financial development – brought the savings of literally hundreds of millions of Asians into the global capital market. This meant that differences between countries’ policies and saving and investment appetites became more likely to affect financial trends and market prices. Surely this had a major bearing on the pace of growth of intermediation and, ultimately, the appetite for risk in the global system.

Fourth, we need to be careful how much blame we ascribe to changes in regulation for everything that went wrong. It cannot be denied that the regulations had shortcomings. But while all significant countries were operating on more or less the same minimum standards for bank supervision, some countries had serious financial crises, but many – in fact most – did not.

Where then does this leave us?

The regulatory cycle has come fully around. After two or three decades of liberalisation, the international debate has of late been consumed with issues of financial regulation – how to re-design it, and generally increase it.

The objective shouldn’t be to suppress finance again to the extent it was for so long in the past. There would be a cost to the economy in attempting this, and in any event the financiers will be quicker to figure out the avoidance techniques than they used to be. The objective should, rather, be to foster arrangements that preserve the genuine benefits of an efficient and dynamic financial system, but restrain, or punish, the really reckless behaviour that sows the seeds of serious instability. Such arrangements surely have to include allowing badly run institutions to fail, which must in turn have implications for how large and complex they are allowed to become.

There is a large reform effort under way at the international level. I would only say that while no doubt regulations can always be improved it is unlikely that regulation per se, becoming more and more complex and widespread as it is, will be the full answer. A big part of the answer must come from practice, not just black-letter law.

The finance industry, certainly at the level of the very large internationally active institutions, needs to seek to be less exciting, less ambitious for growth, less complex, more conscious of risk and more responsible about where those risks end up, than we saw for the past decade or two. And, of course, it does have to be better capitalised.

Equally, regulators and supervisors in some jurisdictions need to be more intrusive and assertive, to be prepared to go beyond minimum standards and to be a little less concerned about the competitive position of their own banks, than they have been in the past.

But to be effective, supervisors need support from their legislatures and executive government – in having strong legislation, adequate funding, and a high degree of operational independence from the political process in the conduct of their duties.

• Glenn Stevens is governor of the Reserve Bank of Australia. This is an extract from the Shann Memorial Lecture delivered last week at the University of WA.

 

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