Government and Institutions

Can we regulate our way towards financial stability?

Governments like financial stability. Central banks and other regulators impose rules that they say will ensure we get it. But they do not tell us – except by implication – what they think it is, are hopeless at seeing shocks coming to it, and the rules they impose are not just misguided but actually harmful. 

The Financial Times of 13 December 2022 reported that not only did the Bank of England want to retain most of the regulations introduced after the Global Financial Crisis, but that it may well want to extend regulation well beyond banks, looking at the non-banking financial sector, and that it is planning a “’deep dive into specific risks’ in markets dominated by institutions such as hedge funds, mutual funds, and pension funds, so that policymakers can ‘propose solutions’”.

What is this stability the Bank wants to protect? It likes firms to be able to survive shocks. We know that because it wants banks to hold lots of capital. But what matters is not the individual firm, but the banking system. This was known in the 19th century, when the concept of Lender of Last Resort was explained and then taken up.  

It involved central bank lending in a period of panic to any financial institution that had set up decent security. The central bank was not concerned at all with the firm, but only with the security. This meant that firms which had not been prudent might well fail, but that prudent firms were lent cash and survived. The failure was contained, the banking system as a whole survived, and there was no widespread financial collapse.  

Modern attempts to stabilise individual banks, ones that are ‘too big to fail’ are misguided because, while they may help good banking, they will also prop up incompetence. The ‘gale of creative destruction’, to use Joseph Schumpeter’s magnificent phrase, will not sweep through finance and create room for innovators. 

So they are aiming at the wrong target. Furthermore, are the regulators and central bankers good at seeing problems coming? Can they at the least issue warnings? 

Here a new book by Alex Pollock and Howard Adler gives the answer. The book is called Surprised Again, and for good reason. Central bankers frequently tell us that they have fixed the problems of stability this time, and then, often quite soon afterwards, they are surprised and another shock comes. 

Why is this? However clever they are, the world fools them, and always will. The explanation turns on the difference between risk and uncertainty. Risk is when we know the range of possible outcomes, and the chance of each. There are many such situations about. But there is also uncertainty – when we may not even know the full range of possible outcomes, and we certainly cannot know how likely each is. This important distinction was the subject of a book by Frank Knight in 1921, and was emphasised recently by John Kay and Mervyn King in their Radical Uncertainty. 

The distinction is at the heart of another new book by Jon Danielsson, who shows that to stabilise finance we need to think about the system as a whole. In The Illusion of Control he writes that 

“The more different the financial institutions that make up the system are and the more the authorities embrace that diversity the more stable the system becomes and the better it performs” (p. 9).  

This is an important part of the explanation for the stability of the British banking system in the nineteenth and a good part of the twentieth centuries. The names of banks – Midland Bank, Bank of Scotland, British Linen Bank for example –make one aspect of this diversity clear. 

Diversity rather than one-size-fits-all regulatory overkill: Danielsson’s insight, and further thoughts on financial stability, are explored in more detail in my article “The Search for Stability” in the new issue of Economic Affairs.

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