Academic journal article The Reserve Bank of New Zealand Bulletin

How May the New Architecture of Financial Regulations Develop?

Academic journal article The Reserve Bank of New Zealand Bulletin

How May the New Architecture of Financial Regulations Develop?

Article excerpt

28 January 2010

Public lecture by Professor Charles Goodhart

The global financial crisis

What I want to talk about is the regulatory response to the crisis that we have had. And, in particular, one of the set of buzz words nowadays is the need to move on from micro-prudential supervision, which is really the way in which the authorities look after the individual institutions, to be much more concerned with macro-prudential supervision; that is, trying to see how robust and resilient the system as a whole might be. These are very different.

If you cast your mind back to mid-2007, at that stage, the capital ratios and the profitability of banks of virtually all countries was at an all-time high. It was thought that the condition of individual banks was so strong that a relatively minor shock to a small section of the mortgage market, admittedly in the biggest country in the world, shouldn't be capable of having the effects that it turned out to have. One of the reasons that it turned out to have such a large effect was that the system as a whole was subject to severe pressures. These pressures were interactive, as a result of the fact that everybody was over-extended in leverage, with the effect that when things started to go wrong, individual banks had to lighten their positions and sell assets, lowering prices and worsening the position of everybody else. Effectively ,you got a self-amplifying spiral.

One of the things that we have learnt in the course of this crisis is that the achievement of price stability doesn't guarantee financial stability. Until the crisis struck--and I want to give it a specific date, 9 August 2007--the central banks had been remarkably successful over the previous 15 or so years in maintaining price stability, in maintaining inflation at low and stable rates, without having much volatility in output. Indeed, in my own country, output growth had been positive in every quarter since the end of 1992 until early 2008.

Not only is it now clear that the maintenance of price stability does not carry through to financial stability, you can even argue that they run counter to each other. The reason why they run counter to each other was effectively explained by an under-appreciated American economist called Hyman Minsky, who in many ways produced some of the most insightful writing on financial cycles in recent years. He argued that stability generates instability. Effectively, what he meant was that if you have a very stable period, and particularly if you think that the authorities can maintain that stability indefinitely, it then becomes your view that risk is reduced. We have had a generalised view throughout almost the whole of the developed world that risk had been contained. In part, there was this expectation that central bankers had become so good that they were able to counter any significant crack or collapse in financial markets. What was known as the Greenspan put--which effectively meant that if the markets collapsed, the authorities could and would lower interest rates sufficiently quickly and sufficiently far to restore the situation and bring about recovery in the markets--had become credible because, after all, it had effectively worked. It had worked on Black Monday, on 19 October 1987. It worked again in the South East Asian crisis of 1997 and 1998. It worked in the LTCM crisis and it worked again at the time of the NASDAQ bubble and bust in 2000 to 2001. In each case, Greenspan and the Federal Reserve held interest rates sufficiently low in order to bring about recovery pretty quickly, and the developed world never really suffered a severe crisis during these times. So there was a belief that Alan Greenspan in particular, and central bankers as a generality, were almost walking on water. They had the ability now to make the system safe.

If the system is safe, particularly when interest rates are low, and particularly when you are promised that interest rates will remain low for any extended period of time, it is more or less an incentive, a signal, to commercial bankers and financiers around the world to go out and put on leverage. …

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