Since 2008, policy-makers in the OECD have consciously decided that they prefer to have bank stability even if this means instability in capital markets. They have concentrated regulation on stabilising financial institutions by curtailing their participation in capital markets whether as long-term owner or trader. They have not explicitly said that they are willing to accept greater instability in capital markets. Instead, their message is that they want capital market participants really to bear the risks implicit in the returns they hope to make and not to lay those off, via the banks, to the public purse the moment the risk looks like serious downside, rather than upside, risk. But the result is that capital markets will be less stable at moments of stress.
You might argue that 2008 showed that you could have both unstable banks and unstable capital markets, which is true enough. The damage endured by capital markets would, however, have been worse had the banks not absorbed significant losses, which were, through state guarantees, transferred to taxpayers. Defenders of the bank bailouts will point out that, overall, realised losses on the rescue were modest and even negative. Regulators retort that this was true ex post but was not evident ex ante and makes no allowance for the reputational damage of bailing out capitalists. And, anyway, if it ended so well and was such a good trade, why don’t you, the capital markets, next time carry the temporary losses.
They want banks to avoid risk of loss in the first place – less involvement in capital markets. And, in the event of loss, they want shareholders and creditors of financial institutions – capitals markets – to take as much loss as they can. They have tried to make sure that taxpayers only have to intervene at the very last resort when the reserves of the capitalists have been seriously depleted or exhausted. It is just harder for institutions to trade or and hold some types of securities, particularly those with greater risk of loss.
Capital markets participants are warning regulators that the diminished liquidity seen in markets is a result of the re-regulation of financial institutions, which implies that regulators are unaware of the consequences of their actions. They are aware. Prior to 2008, regulators and policy makers did not think there was a trade-off between the stability of capital markets and the stability of institutions. Now that they know there is, they have opted to ensure bank and insurance company stability by curbing their activity in capital markets. The other option available to policy-makers was to withdraw or water down the state guarantee. They did not do this. Indeed, they have rather reinforced it by their evident pre-occupation with the consequences of it.
Policy-makers are telling us they care about retail financial services. They do not want the payment system, retail and corporate credit or private and business insurance damaged by capital market losses. They also care about their own sovereign credit markets although, given the central banks have had such practice with QE, they should find it easy to maintain liquidity in those markets. Spot fx and commodity trading may also fall into activities that can be defended as necessary for the “real” economy. But, thereafter, I wonder. Futures, corporate bonds and structured credit, equities, derivatives: would policy-makers be able to make a case to save such speculators?
This is probably right from a first principles public policy point of view. Capital markets are there to underwrite risk. Why should state guaranteed financial intermediaries reinsure the risks of the risk underwriters? There are those who disagree and feel that the price of stable financial markets – periodic losses to the taxpayer and unequal income distributions – are worth paying for the broader economic benefit. But, regardless, to me, it is clearly politically necessary. One of the many causes of the apparently global current of anti-establishment sentiment (along with social media, less hierarchical culture and and) is the sense that the establishment is an accomplished player of heads I win, tails you lose.
So what? There is a trade-off between the stability of financial institutions and the stability of financial markets. Regulators know this and have made their choice. In the event of crisis, investors should be prepared to expect little intervention except in areas that relate directly to the real economy.
The Oblique View 