Systemic credit risk vs systemic liquidity risk

Felix Salmon critiques a column by Lloyd Blankfein.  But he misses the real problem with the column:  Blankfein wants to perpetuate a system that failed.  “But the most critical question is what the systemic regulator should do, and what responsibilities will make it effective – not who, so much as how? …  the systemic regulator must be able to see all the risks to which an institution is exposed and require that all exposures be clearly recognised.”

Notice how anti-market this position is.  Blankfein places the responsibility for systemic risk squarely on the shoulders of regulators.  Most people who work in the financial sector, however, don’t seem to have much faith that regulators will ever manage to gain a sufficiently detailed understanding of what is actually going on in financial markets to regulate them effectively.  (This is also one of Felix Salmon’s criticisms.)  Thus Blankfein’s “solution” gives responsibility for systemic risk to people who are sure to fail.  In order for the Blankfein solution to work it must be the case that regulators are better able to manage systemic risk than markets — but Blankfein never gives us any explanation for why this would be the case.

One problem with debate over responsibility for systemic risk is that two very different forms of systemic risk are being confused.  Central banks have always taken responsibility for systemic liquidity risk because they have the ability (with the support of the government) to print money.  Thus if there is a liquidity problem central bankers are perfectly situated to solve it.

Systemic credit risk is a completely different issue.  Systemic crises of bad debts due to poor underwriting were unknown in the early years of central banking, because credit risk was the responsibility of the private sector.  This meant that underwriting standards were conservative, as bankers knew that bad debt would bankrupt them.  While individual firms collapsed due to poor underwriting, in the 19th century the standards of the financial sector as a whole did not.  Systemic credit risk is a problem that central bankers are poorly placed to supervise and control — it belongs in the hands of the managers of credit risk, and thus in the hands of the financial industry itself.

If responsibility for systemic credit risk is transferred to regulators, despite Blankfein’s optimism they are unlikely to ever have sufficient information to control that risk, and thus are sure to fail.  Of course, when they fail, they will create profitable situations for well-informed financiers — the profits that accrue from faulty regulation will come at the expense of either simple investors or taxpayers.  As I have said many, many times before the only solution to the current crisis is to keep the responsibility for systemic credit risk where it belongs — in the hands of the financiers, who are professional risk managers.

The only job of regulators and central banks, when a bank that has failed to manage risk collapses, is to provide enough liquidity to the financial system  to ensure that those banks that are  still solvent after the losses on the liabilities of the failed firm have been taken into account are not bankrupted by the illiquid markets resulting from the collapse.   When the regulators and the central bankers allow credit risk to be transferred on a long-term or permanent basis into the hands of the government, they undermine the foundations of the financial system, by underwriting the losses of the financiers.  Any attempt to address the “most critical question” generated by the crisis must take the fact that central banks are not responsible for systemic credit risk into account.

Note, however, that in my view given the system that was in place before the crisis, the transfers of taxpayer money to the financiers may have been a good move.  If — and only if — subsequent regulation puts the responsibility for systemic credit risk squarely in the hands of the private sector, then it will prove to have been the correct short-term policy.  If, however, the Blankfein’s of the world win the regulation debate and responsibility for systemic credit risk is transferred into the hands of the regulators, the bailout will just serve to make the next crisis worse.

The role of toxic assets in global imbalances 2

For a follow up piece discussing this question:  Did synthetic assets slow the current account adjustment process by vastly expanding the supply of investment grade assets and thus maintaining interest rates at a level well above the market rate?

see here:

The role of toxic assets in global imbalances

In June Martin Wolf wrote approvingly of a report on the role of global imbalances in the financial crisis:

The authors conclude that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. With better regulation, the mess would have been smaller, as the International Monetary Fund rightly argues in its recent World Economic Outlook. But someone had to borrow this money. If it had not been households, who would have done so – governments, so running larger fiscal deficits, or corporations already flush with profits? This is as much a macroeconomic story as one of folly, greed and mis-regulation.

Since then this view has become common.  For example Wolfgang Munchau in Monday’s Financial Times states:  “Without excessive imbalances, the demand for products we now refer to as toxic assets would have been smaller.”

It is not clear, however, that this causal story really makes sense when analyzed in a demand and supply framework.  Afterall, the “crazy lending” that Martin Wolf references represents an increase in the supply of financial assets over and above what would exist in a world with normal lending.  It is far from clear why it is correct for anyone to claim that a shift in the demand for financial assets “causes” a shift in the supply of financial assets.  Standard economic analysis would usually claim that a shift in the demand for financial assets results in a movement along an existing supply curve raising the price of the assets and lowering their yield.

While it is true that we observe in the data a decline in the yields of fixed income assets, this phenomenon is consistent with the observed increase in supply of these assets – as long as the shift in demand was sufficient to outweigh the effect of an increase in supply.  In other words, while “crazy lending” caused an increase in supply and tended to raise the yields on these assets, this effect was overwhelmed by the increase in demand.

Now in a world with alternate assets, like ownership interests, increasing the supply of fixed income assets and therefore their yields will tend to attract investors to bonds and discourage them from entering more pricey stock markets.   Thus, as long as we acknowledge that there was “crazy lending” going on and thus that the supply of fixed income assets was greater than it would have been a world without “crazy lending,” surely we must also acknowledge that this raised fixed income yields above their natural level and reduced the tendency of investors to put their money into equity and alternative assets instead of fixed income assets.

In fact, it is entirely possible that extremely low yields in fixed income markets and a shift by emerging market money into equities would have prompted reconsideration on the part of both developing and developed economies of the wisdom of maintaining massive current account imbalances.  That is, it is entirely possible that “crazy lending” actually slowed the current account adjustment process – precisely because “crazy lending” prevented the returns on fixed income assets from falling to derisory levels.

In short, elementary economic analysis allows us to reach a conclusion opposite to Wolfgang Munchau’s:  Without toxic assets, the quantity demanded of fixed income assets would have been smaller.  We can also conclude that in the absence of toxic assets, foreign capital flows into US equity investments would have been greater.  Left with a choice between derisory fixed income returns and riskier investments, foreign investors would have had a strong incentive to reduce their allocation of funds to the US market.  In other words, in the absence of toxic assets the “savings glut” might have started to unwind on its own.

Thus, while emerging market demand for fixed income assets made it possible for financiers to produce and sell toxic assets, the fact remains that the supply of toxic assets increased the supply of bonds, raised the yields on bonds relative to an environment without toxic assets and by doing so interfered with the price mechanism that would tend to reduce emerging market demand for fixed income assets.   Whether allowing market forces to operate would have been enough to start the unwind of global imbalances is unknowable, but we can be sure of one thing:  the production and sale of toxic assets worked to keep the demand for fixed income assets high and by doing so worked against the resolution of global imbalances.