Ignazio Visco: What does society expect from the financial sector?
Panel discussion remarks by Mr Ignazio Visco, Governor of the Bank of Italy following the
Per Jacobsson Lecture by Dr YV Reddy, 24 June 2012, Basel, Switzerland.
* * *
The global crisis has spotlighted a number of problems. Some are well known (eg the fact
that in some countries in the past the regulatory and supervisory approach was inadequate
to address them). Others are relatively new. A comprehensive overview of the many issues
facing public authorities has just been provided by Dr Reddy, with a thorough checklist of
what has gone wrong, what is being done, and what direction we should probably be moving
in.
I would like to focus on a more limited set of issues, which in my view are among the most
telling about the weaknesses of the financial system today.
First, however, let me recall that although the title of our roundtable is "What does society
expect from the financial sector?" we are likely to only be able to discuss what we think
society "should" expect. With this in mind, I would like to make three points:
● Finance has long been viewed as a morally dubious activity. My appeal to authority
on this matter is a reference to a lecture delivered by Amartya Sen about twenty
years ago as the first Paolo Baffi Lecture
(Money and value: on the ethics and
Bank of Italy, Rome, 1991). Sen wondered: "How is it
economics of finance,
possible that an activity that is so useful has been viewed as being morally so
dubious?" He recalled a series of historical episodes: Jesus driving the money
lenders out of the temple, Solon cancelling debts and prohibiting many types of
lending in ancient Greece, Aristotle describing interest as an unnatural and
unjustified breeding of money from money. Recent protests against the financial
industry - the Occupy Wall Street movement, the "Indignados" in Spain and their
counterparts in other European countries - can certainly lay claim to an eminent
series of historical precursors.
● Superimposed on this "structural" mistrust, one can detect cyclical patterns in the
public's attitude towards finance, affected by the conditions of financial systems and
shifts in the political mood about state intervention in the economy. Until the 1970s it
was taken for granted that market failures required the presence and response of a
regulator to avoid suboptimal results. Then came the great inflation of the 1970s,
combined with high unemployment, and the accent began to be placed on
government failures. Governments, central banks and other regulators were blamed
for failing to prevent those developments. This eventually led to an ideological
swing: a push to reduce the magnitude of state intervention. The failures of the
"regulated economy," the pace of technological advance and the rapid expansion of
international trade after the end of the Cold War fuelled a protracted process of
financial deregulation that was halted only by the financial crisis that broke out in
2007. The latter triggered a move toward re-regulation - or better regulation - that is
still under way. The pendulum keeps swinging and will certainly continue to do so.
● But despite the negative perception of banking and finance, blind backlash is a
danger to be avoided. As Amartya Sen argued, finance is essential to the
functioning of the real economy. And I share Dr Reddy's view that finance is a force
for good. It is crucial for sharing and allocating risk, especially for poorer societies
and people, insofar as risk aversion decreases with wealth. It is crucial for
transferring resources over time and removing the liquidity constraints that hamper
the economy and the exploitation of ideas. It is very important in promoting
economic growth, especially by fostering innovation. We have countless historical
examples of good financial innovations. Think, for example, of the "letters of
exchange" introduced by Italian merchants in the Middle Ages: they were probably
the first fiduciary money, and trade benefited enormously from this financial
instrument. More recently, consider the development of "micro-finance" in the 1970s:
an innovation that has enhanced financial inclusion, helping poor borrowers to
smooth their income and cope with illness or other temporary shocks. And, in the
last two decades, recall the role of the "venture capital" industry in the promotion of
successful innovative corporations such as Apple, Intel and Google.
I would now like to offer a few thoughts on issues related to what has gone wrong in the
financial system in the last few decades. I will consider four points:
● Financial market participants tend not to be aware of the fundamental
nonstationarity of economic developments. The wave of financial innovation in the
2000s was fuelled by the idea, in principle correct and fruitful, that the proliferation of
new (and complex) financial instruments, allowing agents to insure against many
dimensions of risk, was a way to "complete the markets", to get closer to the
theoretical Arrow-Debreu world, enabling investors to transfer resources efficiently
across time, space and states of the world. But this idea relied on the presumption
that the world is basically stationary (and substantially linear), that the future is pretty
much like the past, that we can extrapolate from relatively small samples, and that
there is a single "data generating process" that we can identify and understand. (We
must admit that all this is not limited to finance but also applies more broadly to
macroeconomics, econometric modelling and forecasting.) The real world is
different, though; for many years the big investment banks were able to sustain
returns much higher than what was justified by economic growth, but the day of
reckoning was bound to come. In a way, innovation, based on the presumption of
stationarity, sows the seeds of the non-stationarity that eventually undermines that
very presumption.
● Complexity was also used, somewhat perversely, as part of the case for a sort of
benign neglect on the part of regulators. The big financial players argued
successfully that financial innovation was too complex and too opaque for the
regulators to get their heads around it. Indeed, they said, to safeguard the
international financial system from systemic risk, the main priority was promoting an
"industry-led" effort to improve internal risk management and related systems. This,
in a nutshell, was the view espoused by the Group of Thirty report following the
outbreak of the Asian crisis ("Global institutions, national supervision and systemic
risk", Group of Thirty, 1997. See also the article by John Heimann, and comments
therein, in the special issue of the on
Banca Nazionale del Lavoro Quarterly Review
"Globalization and stable markets", March 1998). But this thesis was often
accompanied by the argument to the effect that "you, regulators and supervisors,
will always be behind financial innovation; it would be better to allow us, the big
financial international players, to self-regulate; we are grownups, we can take care
of ourselves". And, after all, "if someone makes mistakes, some will gain what
others lose; why can't we be left alone to play this zero-sum game of ours?"
Accepting this argument was a critical mistake. The regulators did not, in fact, have
either the right incentives or the ability to acquire the necessary information, for two
reasons. First, the big financial players are global, and national regulators had
powers too narrow to be able to confront them. The difficulties in coordinating the
regulators' actions, in the face of a natural tendency to preserve each one's
particular sphere of influence, was a powerful drag on the ability to rise to the
challenge posed by a finance gone global. Second, the phenomenon of regulatory
capture that Dr Reddy mentioned in his talk was a definite reality. Powerful political
and economic influences were at play, and in some cases prevailed.
● Other factors that have now become well known were the financial industry's
remuneration policies and incentive structure, which ultimately induced excessive
risk-taking and short-termism. (On these attitudes, I would like to recall the pertinent
insights of Tommaso Padoa-Schioppa and Andrew Crockett at the last two Per
Jacobsson lectures.) Significantly, compensation structures that favour risk-taking
are correlated with banks' default risk. Of course this may be useful to attract
managers with low risk aversion, which may be a desirable trait for financial
intermediaries. But from the systemic perspective, default by a bank generates costs
that do not fall entirely on its shareholders, so that the "optimal policy" from the bank
shareholders' standpoint may be very suboptimal for the economy overall. While this
state of affairs benefited the "whole" financial industry, it may also have led to a
possibly serious misallocation of resources. We may now be observing a reversal,
with an outflow of highly skilled people from the financial industry. Whether this is
desirable or not depends on one's view of externalities, and on the costs that a less
efficient financial sector may have for society. After all, social returns might be
higher in other occupations. Anyway, a reduction in salaries in the financial industry
may reduce the potential skill gap between the industry and its regulators. The
regulatory agencies may become better able to attract highly skilled financial
workers, improving the effectiveness of their regulatory and supervisory activity.
● Finally, there has been a change in the relative importance of the various banking
activities. In particular, proprietary trading has expanded very significantly.
Interestingly, the cost of financial intermediation has been trending upward in the
past 40 years. This is counterintuitive, given the technological advances in
information and communication technologies, which should have disproportionately
increased efficiency in the financial industry. It is likely that the technological
advances have mostly been internalised by the industry itself and deployed to
increase secondary market activities, in particular proprietary trading.
Over the last few years the crisis has heightened appreciation of the benefits of a more
stringent regulatory regime. And much has been done to remedy the shortcomings of
financial systems. At the international level, under the political impulse of the G-20, the
Financial Stability Board and the Basel Committee on Banking Supervision introduced
substantial regulatory changes to reduce the frequency of financial crises and increase the
resilience of economic systems. Improvements have been introduced in many areas such as
bank capital and liquidity, OTC market infrastructure, and compensation policies in finance;
importantly, new macro-prudential authorities have been established in many countries. But
the regulatory overhaul has not yet been completed. Several issues are still being actively
discussed, such as the role of rating agencies and accounting standards. Although new
regulations on systemically important financial institutions have recently been approved, the
"too-big-to-fail" issue is still a major concern. It would be foolish to pretend that defaults can
be avoided, so we need to be prepared for their occurrence. The ongoing work on resolution
regimes is a promising approach in this regard.
Rules alone are not enough, however. Allow me to mention a few scattered areas from which
progress should be expected:
● One element that is essential for guaranteeing systemic stability is the method of
measuring risk-weighted assets (RWA), the denominator of capital adequacy ratios.
RWA measures have recently attracted increasing attention from market analysts,
banks and supervisory authorities. It has been argued that the methodologies for
computing RWA may not be comparable across institutions and, especially, across
jurisdictions, and that they should more properly reflect risk in order to avoid
ultimately jeopardising financial stability. These problems highlight the relevance of
supervisory practices in determining banks' capital requirements (for example, in
validating internal banks' models for calculating risk weights). Here, rigorous
microprudential supervision is essential. We really need to work out a single rulebook, to
move with determination towards taking joint responsibility and using peer reviews
as much as possible in our supervisory activity. The watchword can only be: "more
and better supervision".
● Furthermore, in today's globalised world, it is crucial to make sure that countries
cooperate and agree on the appropriate stringency of financial regulation. Countries
should not compete by relaxing rules in order to attract financial intermediaries, as
this may generate negative externalities for other countries. This is a most delicate
issue, and while a perfectly level playing field may not be achievable, we have to be
conscious of the consequences of a "beggar-thy-neighbour" approach to regulation.
The transition to a uniform system of rules and oversight of the financial sector must
be hastened. In the euro area, and in the European Union at large, the project for
banking union is ambitious, but it goes in the right direction.
● Let me close on a different but related topic. Some countries are now investing
increasingly in efforts to improve the financial literacy of the public. This too is
important. On the one hand, it helps to build the demand side of the "inclusive
finance" that Dr Reddy mentioned, while on the other, financially literate citizens are
better able to understand the efforts of regulators and policy makers to improve
supervision and regulation, and less likely to subscribe to the simplistic view that
"finance is evil". But we should realise that - as the case of Bernard Madoff and
others in the US and elsewhere clearly show - this is no panacea. (Madoff's
customers were surely much better educated than the average.) Therefore, for
purposes of consumer protection in the financial services industry, financial
regulation and good supervision are the necessary complements to financial
education and inclusion.
To conclude, following Dr Reddy's final remarks, I would like to quote from a book by the
brilliant Bank of Italy economist Curzio Giannini, who passed away prematurely nine years
ago Edward Elgar, 2011, translated from the Italian
(The age of central banks, L'età delle
Il Mulino, 2004). In that "beautifully written and illuminating" work, as Charles
banche centrali,
Goodhart describes it in his foreword, Curzio applied "a theory of history" to describe how
from pre-industrial payment technologies through the rise and fall of convertibility we ended
up with the revolution in the payment system that has accompanied the globalisation of
money and the challenge of building trust in an under-institutionalised environment. Already
at the turn of the century, Curzio clearly saw the likely consequences of financial
developments, and concluded, "In the years to come, the most interesting developments will
probably be precisely in the sphere of supervision and regulation" and that "[w]hatever its
detractors may say, the central bank has no need to move into new lines of business.
Capitalism generated the central bank and capitalism will come to it again, even if the current
infatuation with the financial markets' self-regulating capacity were to endure. [...] The central
bank produces an intangible but essential good - trust - of which capitalism has an immense
need. We must not forget that trust, or its synonym "confidence", derives from the Latin fide,
meaning faith, which cannot be produced simply by contract. In fact the legitimacy of central
banks does not lie in their policy activism, or the ability to generate income, or even, save in
a highly indirect sense, their efficiency. Rather, [...] it derives from competence, moderation,
the long-term approach, and the refusal to take any tasks beyond their primary role." In the
end this, perhaps, is what society should expect, if not from the financial sector, from those
who are called to look after financial stability.