To Regulate or Not to Regulate: No Easy Fixes for the Financial System

Petram demonstrates how the Court of Holland eff ectively built the world’s fi rst securities law. Th is legal framework also included regulatory aspects, for instance through the prohibition of short-selling in 1610. What is interesting to see is that the gradual clarifi cation of this legal framework also infl uenced private enforcement mechanisms on the secondary and sub-markets. Such mechanisms typically included some form of self-regulation, for instance through peer pressure or through trading clubs submitting voluntarily to adjudication in case of disputes. In short, the successful emergence of a secondary market for VOC shares and the legal framework that was created around it resulted in a relatively stable system of shares trading that enabled the VOC to meet its high capital requirements and thrive. As such it became a model to be copied.

Joke Mooij (Chapter 3) off ers another story of successful fi nancial innovation in the Netherlands, but in a very diff erent time period and context. Th e creation of a network of co-operative agricultural banks in the Netherlands during the early twentieth century not only facilitated access to credit and fi nancial services for small-scale farmers, but also made the individual, small-scale banking institutions themselves more resilient in the face of adverse conditions. Th is was, Mooij argues, largely because of an idiosyncratic business model, characterized by an intimate knowledge of the customer base and a built-in, high degree of mutual solidarity, whereby the network took responsibility for the individual members whenever they got into trouble. In exchange for this solidarity, a relatively high degree of centralization, strong internal safeguards and an embryonic form of prudential supervision were accepted by the participating banks from early on. Th ese factors allowed the co-operative agricultural banking sector in the Netherlands to get through the Great Depression without any signifi cant bankruptcies and with its market share largely intact. However, such an outcome was not a given: in Belgium, where the co-operative banking sector operated on a similar model, its evolution during the 1920s and 1930s was, by contrast, disastrous, before making a remarkable come-back aft er the Second World War.15 In other words, institutional robustness is no absolute guarantee, and particular circumstances, short-term business decisions and investment practices matter a lot. Nevertheless, the Dutch case, as analysed by Mooij, provides a good example of an institutional innovation that has been successful in reducing risk.

Institutional innovation may have been helpful in mitigating risks in times of crisis in the case of the Dutch co-operative banks, but Tobias Straumann highlights other, less orthodox, strategies of risk management (Chapter 4). Straumann is puzzled by the fact that Swiss Re, one of the world’s leading reinsurance companies, got through the Great Depression of the 1930s seemingly unscathed. Did Swiss Re owe this outcome to a far-sighted management taking timely action to counteract the fall-out from the crisis? Or was it thanks to the implementation of a timely strategic re-orientation of the company’s business model? Based on a thorough analysis of the unpublished records of Swiss Re,

Straumann comes to a very diff erent conclusion. Th e truth of the matter is that Swiss Re managed to weather the storm only thanks to the high amount of hidden reserves accumulated over the preceding decades. In that way, the company was able to report a positive result and to maintain a solid market reputation in spite of the underlying fi nancial results being catastrophic. In other words, during the 1930s, hidden reserves allowed Swiss Re to absorb a major macroeconomic shock. Th is was not possible during the 2008–9 fi nancial crisis: the primacy of shareholder value and the necessity to create full transparency over the accounts had long since done away with hidden reserves. As a result, Swiss Re took the full brunt of the crisis and suff ered accordingly. In that sense, Straumann off ers a cautionary tale on how the markets react to the revealed positions of fi nancial fi rms – even, or particularly, when these prove to be incomplete or unreliable – and, more generally, on how the fi nancial sector interacts with the real economy.

A severe fi nancial crisis, such as the Great Depression or the current crisis, always produces a political and regulatory backlash, particularly when the crisis can be and is widely blamed on fi nancial innovations – be it at the product or institutional level – having gone wrong. However, the regulatory responses are far from unambiguous. In Chapter 5, Federico Barbiellini Amidei and Claire Giordano illustrate this point vividly by comparing the re-design of the banking industry in the US and in Italy in the wake of the 1930s crisis. Th ey convincingly refute the received wisdom that the US Banking Acts of 1933–5 and the Italian Banking Act of 1936 responded in a broadly similar fashion by splitting commercial from investment banking. In fact, both sets of legislation diff ered substantially in that they sought to address very diff erent problems (‘evils’). While the US legislator was mainly concerned with the risks posed by commercial banks’ direct and active role in the stock exchange market, the Italian legislator primarily sought to address the problems caused by the long-term debt and equity stakes in industrial fi rms held by Italian commercial banks. Th is is a classic story of political economy and (attempted) regulatory capture. At the same time, it demonstrates that while regulatory responses to crises tend to cut off a particular path of future development, they can, at the same time, lay the foundation for a diff erent development path (which, with time, may create new problems). Indeed, in both the US and Italy, the banking legislation resulting from the 1930s crisis profoundly changed the fi nancial sector landscape, and for a surprisingly long period of time – until the 1990s.

An alternative vision of the potential link between fi nancial innovation and crisis and the subsequent ‘need’ for regulation is off ered in Niall Ferguson’s contribution (Chapter 6). Ferguson strongly cautions against the idea that the supposed dangers of fi nancial innovation can be or should be reined in by stricter regulation. Th is idea, he argues, stems from an overly nostalgic interpretation of the post-war Bretton Woods era, in which tight regulation and controls made for very conservative – even ‘boring’ – but also very safe banking. However, Fer-

guson argues, the UK’s experience in the 1970s belies the notion that regulation is the best guarantee to prevent fi nancial innovation from going wild, and thus to preclude a fi nancial crisis. Th e 1970s were still a highly regulated decade in British banking, but nevertheless spawned a major banking crisis, a stock-market crash, a real estate bubble and double-digit infl ation. Recounting the history of the City’s most innovative bank during the post-war decades, S. G. Warburg & Co., Ferguson concludes that it is not deregulation or fi nancial innovation that bears the blame for the fi nancial instability and crisis witnessed in the 1970s, but rather the misguided monetary and fi scal policies of the central banks and governments of the time. Th e same conclusion, he contends, applies to the current fi nancial and economic crisis, which has been the result not of fi nancial innovations gone awry, but rather of a toxic combination of ‘imprudently low interest rates and unjustifi ably large public borrowing’.

However, regulatory changes are not only the direct result of crisis. Th ey may also be triggered by the need to meet new institutional challenges. Th is is the underlying argument in Welf Werner’s contribution (Chapter 7). Werner investigates how the move towards free trade and open borders since the Second World War has aff ected the fi nancial services industry. Financial market liberalization and the cross-border integration of fi nancial markets pose particular challenges which seem to set them apart from trade liberalization in the goods markets. Th e key reason for this, Werner argues, is that fi nancial services liberalization and integration need not only to secure open markets, but also to guarantee the overall stability of the system. In other words, liberalization of the fi nancial sector, and the innovations which this entails, should be managed or steered in such a way that they do not lead to a crisis. To avoid this from happening, Werner contends, regulation and supervision ought logically to be exercised at an international level too. But in reality, national authorities, foremost central banks and regulatory bodies, have jealously defended domestic authority over regulation and supervision. Harmonization of prudential regulation, while desirable, has proven a hard nut to crack.

Th e diff erent case studies brought together in this volume allow one to step back from the fray of today’s news headlines and to look for parallels and diff erences between earlier episodes of fi nancial crisis and instability. Still, it remains to be seen how and to what extent history can inform the current debates. In the fi nal section of this volume, two experts – practitioners from the world of central banking and fi nancial supervision – shine their light on the current fi nancial crisis.

From his unique position as chair of the UK Financial Services Authority (FSA), Lord Adair Turner provides a sweeping review of the current fi nancial crisis, with ample references to history (Chapter 8). Financial innovations play a key role in his account. On the back of fi nancial innovations, the fi nancial intensity and complexity of developed economies have grown ever more rapidly. While the real economic benefi ts of this evolution remain disputed, Turner is

convinced that it has led to increased volatility in fi nancial markets and, hence, to a heightened risk of fi nancial crisis. Th e challenge, then, is to strike the right balance in regulating the fi nancial sector so that it can continue to play its crucial role and provide economic value added, while at the same time safeguarding the longer-term stability of the system. Such a stance points to the need for a policy response, which in Turner’s view should focus on three broad areas: bank capital and liquidity standards, the very structure of the banking system, and the development of a truly macroprudential approach that factors in the overall stability of the fi nancial system. Moreover, he stresses that ‘the history of fi nancial systems and fi nancial markets has a crucial role to play’ in framing such reforms. Indeed, it may have been more than a lucky coincidence that Ben Bernanke, Chairman of the Federal Reserve Board and one of the key monetary policy decision makers when the crisis broke in 2007–8, had in a previous life written extensively about the Great Depression of the 1930s.

Finally, Bill White, currently at the OECD and the former Economic Adviser of the Bank for International Settlements, was one of the few Cassandras who, starting in the early 2000s, consistently warned of the oncoming crisis. In Chapter 9, he discusses a number of hotly debated topics that all have to do with improving regulation to avoid or mitigate future crises, without, however, choking off fi nancial innovation in the process. He focuses his attention in particular on the too-big-to-fail problem, which played such a major role in the 2008–9 banking crisis. He also discusses whether lax fi nancial regulation was to blame for the crisis, and whether or not policymakers are now overreacting, with the risk that this will lead to regulatory overkill.

From the perspective of the current crisis, it may seem self-evident that there is, or at least can be, a strong relationship between fi nancial innovations, (failed) regulation and fi nancial crisis. Th is is certainly a relevant observation given the potential consequences of a severe systemic crisis. Th e Great Depression has taught us that a fi nancial crisis like the one we are living through today might lead to a ‘renationalisation of economics and politics’ and a reversal of the globalization that we have come to accept as the normal state of aff airs.16 Th e mere fact that it took a crisis of this amplitude to remind us of these seemingly self-evident facts is testimony to our capacity to forget or ignore key lessons from history.17 Th at is in itself a good reason to continue to study historical episodes of fi nancial innovation, risk management, regulation and crisis. Th e study of fi nancial history, as Barry Eichengreen puts it, should enable ‘fi nancial market participants and policymakers … to look beyond recent events; history will remind them that what goes up can come down’.18 Th is volume aims to contribute to such a refl ection.

Th e views expressed are those of the authors and do not necessarily refl ect those of the Bank for International Settlements.