The prevailing view amongst the commentariat (reflected in the recent deliberations of the G20) that the financial crash of 2008 was caused by market failure is both wrong and dangerous. Government failure had a leading role in creating the conditions that led to the crash.
● Central banks created a monetary bubble that fed an asset price boom and distorted the pricing of risk.
● US government policy encouraged high-risk lending through support for Fannie Mae and Freddie Mac (which had explicit government targets of providing over 50pc of mortgage finance to poor households) and through the Community Reinvestment Act and related regulations.
● Regulators and central bankers failed to use their considerable powers to stop risks building up in the financial system and an extension of regulation will not make a future crash less likely.
● Much existing banking regulation exacerbated the crisis and reduced the effectiveness of market monitoring of banks. The FSA, in the UK, has failed in its statutory duty to “maintain market confidence”.
● The tax and regulatory systems encourage complex and opaque methods of increasing gearing in the financial system.
● Financial institutions that have made mistakes have lost the majority of their value. On the other hand, regulators are being rewarded for failure by an extension of their size and powers.
● Evidence suggests that serious systemic problems have not arisen amongst unregulated institutions.
As such, no significant changes are needed to the regulatory environment surrounding hedge funds, short-selling, offshore banks, private equity or tax havens.
A revolution in financial regulation is needed. The proposals of the G20 governments and the EU are wholly misconceived. Specific and targeted laws and regulations could restore market discipline.
These should include:
● Making bank depositors prior creditors. This will provide better incentives for prudent behaviour and make a call on deposit insurance funds less likely.
● Provisions to ensure an orderly winding up, recapitalisation or sale of systemic financial institutions in difficulty. Banks must be allowed to fail.
● Enhancing market disclosure by ensuring that banks report relevant information to shareholders.
This should be reinforced with central bank action to ensure that:
● Proper use is made of lender-of-last-resort facilities to deal with illiquid banks.
● The growth of broad money is monitored together with the build-up of wider inflationary risks.
Dr James Alexander, Head of Equity Research, M&G; Prof Michael Beenstock, Professor of Economics, Hebrew University of Jerusalem; Prof Philip Booth, Professor of Insurance and Risk Management, Cass Business School; Dr Eamonn Butler, Director, Adam Smith Institute; Prof Tim Congdon, Founder, Lombard Street Research; Prof Laurence Copeland, Professor of Finance, Cardiff Business School; Prof Kevin Dowd, Professor of Financial Risk Management, Nottingham University Business School; Dr John Greenwood, Chief Economist, Invesco; Dr Samuel Gregg, Research Director, Acton Institute; Prof John Kay, St John’s College, Oxford; Prof David Llewellyn, Professor of Money and Banking, Loughborough University; Prof Alan Morrison, Professor of Finance, University of Oxford; Prof D R Myddelton, Emeritus Professor of Finance and Accounting, Cranfield University; Prof Geoffrey Wood, Professor of Economics, Cass Business School.
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