The ECB’s Draghi gave a speech in which he extolled the achievements of regulatory reform since the beginning of the Great Financial Crisis. What makes the speech noteworthy is it nicely highlights how regulators believe they can prevent a financial crisis.
From the regulators’ perspective, here is what it takes to prevent another crisis:
When moving from identifying to addressing risks in the financial system, a number of elements need to work in tandem: good regulation and supervision make individual firms safer; recovery and resolution regimes provide legal certainty when a firm gets into trouble and they ensure that failure is orderly; and macroprudential policy looks beyond individual institutions and deploys tools to target systemic risks.
There is only one small problem with this and Draghi even identifies it.
Take, for example, the issue of interconnectedness between different parts of the financial system. Interconnectedness – be that through direct exposures or indirectly via common or correlated asset holdings – is a natural feature of an integrated financial system. But during times of financial stress, interconnectedness transmits and potentially amplifies shocks, and can lead to contagion. Full visibility is of the essence here.
Full visibility may be of the essence, but in the decade since the Great Financial Crisis began have regulators taken any steps to ensure all market participants have full visibility?
Regular readers know financial crises occur in the Blind Betting quadrant of the Information Matrix (shown below).
|Does Seller Know What They Are Selling?|
|Does Buyer Know What They are Buying?||Yes||No|
|Yes||Perfect Information||Antique Dealer Problem|
|No||Lemon Problem||Blind Betting|
It is in this quadrant that investments are sold based solely on the story Wall Street tells. When the story is called into doubt, there is no logical stopping point in the downward revaluation of these investments other than zero. Investors know this and “run” to get their money back as soon as the story is called into doubt. This “run” is the panic regulators see.
Since these investments are opaque, regulators have no way of understanding how risky they are while investors still believe Wall Street’s story. How can regulators expect to prevent a financial crisis when, like the investors, they cannot assess the risk or value of these investments? They cannot.
The myth regulators can prevent a financial crisis is actually harmful. It increases the likelihood of the next crisis.
It makes the financial system stability dependent on the regulators. As everyone knows, a system with a single point of failure will fail at that point at some time.