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Wednesday, November 18, 2015

Financial System: Options for Reform

It has been quite some time since Lehman Brothers—one of the venerable investment banks from America’s Wall Street—collapsed, setting the global financial infrastructure aflame. Now, some are wondering, of course on hindsight, that if only the government had bailed out Lehman, markets would not have plunged into such a mess. Some, of course, comment that the US is right in letting Lehman fail, for capitalism squarely rests on the principle of “the lure of wealth and the fear of bankruptcy.”

A true analysis of the origin of the Financial Crisis – 2008 should trace a myriad of reasons: one, low interest rates maintained by the Fed under the leadership of Alan Greenspan for too long; two, repealing of Glass-Steagall Act of 1933 that prevented the deposit-taking commercial banks from tying up their capital in risky bets on securities; three, relaxation in limits on leverage that investment banks can undertake; and, four, unbridled expansion of trading in complex, opaque derivative transactions to even systemically important financial institutions. Finally, it is, of course, the bonus-driven compensation structure that made them exploit the opportunities thrown open by the free markets to the hilt.

Above all, there is another important reason that silently crept into the rational decision making of investors: vanishing of equity risk premium from the US markets. A study carried out by the Federal Reserve Bank of Minneapolis revealed that in the last four decades preceding the collapse of Lehman, lenders made as much return as the equity investors.

It is this missing equity-premium that had impacted the globe badly, forcing individual investors to look elsewhere for profits. Financial assets designed in the Wall Street had become the main attraction for investors. The net result was the credit bubble. And with the increased flow of dollars from the Chinese exporters and from the petroleum-exporting countries into the Wall Street, the credit bubble—converting even subprime mortgages into securities and selling them to gullible investors as though they were as good as treasuries, duly aided by dilution of standards in terms of rating, absence of prudence, and above all an environment of lax regulations—had only inflated further to gigantic proportions. Thanks to the Fed, as returns on these instruments got squeezed further, even the risk-averse investors boarded the bandwagon.

As is natural, following such unruly growth in profits for even corporates from the Wall Street rather than from labour-linked assets, the credit bubble finally burst, while the governments and central banks across the globe got busy in pumping trillions of dollars—fiat money—into markets to first unfreeze the credit markets and then to offer a safety net to the collapsing financial architecture.

Over and above these happenings it must also be remembered that “the array of financiall instruments deployed within the global financial system has become so complex that it defies understanding. For decades to come”, Dr Ken Henry said, “policy makers around the world are going to be asking why those with sufficient authority didn’t, at some point, stand above the buzz of the financial markets and declare, in simple language, that all of this doesn’t make sense.”

Now, against these happenings, what the financial markets are essentially expected to do is: allocate scarce capital to the most productive uses, taking into account both risk and return. In the process of allocation, markets are also expected to pool up the incongruent information about various market participants—of course, none of which depicts the full picture of the available investment opportunities. And these two functions are highly interdependent.

That said, market experiences indicate that markets do not perform these two functions perfectly—there are limitations to aggregation of individual motivations behind their transactions and also about the range of financial products being offered by the markets. What it obviously means is that trading on risks and rewards under such limitations will not give the same results that would have been achieved from a fully informed market—a hypothetical model of an economist. Indeed, it is this constraint on information that motivates the varied behaviour of market participants and the varied market features. All these imperfections would only mean: there is hardly any way to improve on market outcomes.

It is amidst these developments that Shann Turnbull, the author of the paper—Options for Reforming the Financial System—based on historical experiences, has offered four non-exclusive options for reforming the economy and the financial system: one, reintroduction of cost-carrying money, of course in electronic form; two, allowing private issues redeemable into official money; three, private issues convertible into specified commodities; and four, usage of existing fiat money to reduce the cost of seigniorage, interest on government debt, size of organizations considered too big to fail, tax incentives to favour equity rather than debt, the different types of risks accepted by financial institutions and the ability of banks to create credit to finance derivatives many times greater than the GDP of the global economy, etc. He presents a powerful argument in favour of each of these options with a belief that the kind of present crisis can be averted by adopting these options, although these arguments in turn pose many new questions/problems that need to be answered more carefully. 


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