Davos: Are markets now reasonably safe?
A distinct 'post-crisis' feel is in the Davos air at this year's World Economic Forum (WEF), with many of the topics under discussion representing longer-term, structural themes - sustainable growth, the environment, technology, science and demography are such examples. There seems to be genuine relief that the financial and European debt crises are behind us.
But one panel discussion today did look back on the financial crisis, asking "Are markets safer now?" than before the Lehman crisis. Comparing today's financial system to that which delivered the worst financial shock for 80 years (arguably ever) was a laughably low hurdle to set, as host Martin Wolf acknowledged, so the debate was framed in terms of, "Is the system reasonably safe?" with 'markets' referring to banks and financial institutions.
Unsurprisingly, HSBC Chairman Douglas Flint and Barclays CEO Anthony Jenkins argued markets are much safer now, citing improvements in market infrastructure and oversight, increased resilience to shocks and better incentive structures. Taking the other side was Stanford finance professor Anat Admati and hedge fund investor Paul Singer. For them, leverage remains too high, the financial system undercapitalised and subject to a multitude of risks, from huge derivative positions, concentration risk, opacity, government subsidies and bad incentives to the distortions created by quantitative easing (QE).
Overall, the audience agreed that the system is now safer, with 62% voting in favour versus 38% against.
What should we make of this?
There clearly has been some progress to solidify financial institutions since the Lehman crisis - capital levels and liquidity buffers have improved markedly and progress is being made on the supervisory and regulatory front, although it remains a work in progress with a variety of proposals and ideas on the table.
But we set ourselves too low a hurdle if we choose the 2007 financial system as the benchmark. So, as Martin Wolf asked, "The system is safer, but is it safe enough?"
The world economy remains more highly leveraged than ever before. What progress has been made in reducing private sector debt in certain areas has largely been offset by sharply rising public sector debt. Accordingly, the global economy remains driven by asset prices. Any severe shock to asset prices would risk another economic crisis, even if the system is more robust than in 2007/08.
Professor Admati makes a convincing argument that banking is exceptional as an industry in respect of the massive leverage that is permitted. She is right that requiring banks to hold substantially more capital (20% common equity ratios anyone?) would make them safer. It also makes sense to ring-fence certain activities (retail banking from investment banking) and reducing proprietary risk-taking (a la the Volcker rule), although the issues are complicated.
The trouble is that, generally speaking, regulations to make banks safer have been working in the opposite direction of an economic recovery, which is so badly needed too. Imposing yet further tougher capital requirements and other regulations would further dampen the global recovery.
Other problems such as TBTF (too big to fail) or massive and sometimes opaque derivative positions (just look at the London Whale debacle at JP Morgan) remain a concern and regulators need to continue working to mitigate the risks they pose. The break-up of the larger universal or investment banks may ultimately be desirable. Other ownership structures such as the old City partnerships model could also be investigated, but may no longer be viable unless there is radical change to the system that would level the playing the field for smaller institutions.
As a longer-term goal, it is hard to argue with the aim of making banking safer still, having witnessed the destruction caused by the financial crisis. But this needs to be done with care if we are to avoid persistently weak growth. A further cost is likely to be a higher cost of borrowing for the rest of the economy, but this is arguably a price worth paying if sensible measures can reduce the risk of the kind of crisis we experienced in 2007/08.
As a final point, in our view, the world economy is less vulnerable now than probably any time in the past decade. Growth is accelerating, imbalances have lessened somewhat and the financial system is safer than it was. But this doesn't mean more cannot and should not be done to make it safer still. If nothing else, though, we need to recognise that in today's sophisticated financial world, the issues are highly complex and decisions to improve the long-term health of the financial system (and therefore the world economy) must not be rushed and must be made for the right reasons. Tristan Hanson is Head of Asset Allocation (International) at Ashburton Investments.
Tristan Hanson is Head of Asset Allocation (International) at Ashburton Investments.