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Mythbusting four excuses for failed financial regulations

August 14, 2017
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It takes a kind of “willful blindness” to liken financial crises to natural disasters.

Credits: Reuters/Brendan McDermid

In the nearly nine years since the great financial crisis of 2008, Anat Admati has watched in mounting dismay as politicians and regulators settled for what she saw as unfocused, poorly designed steps to create a better financial system. Her distress deepened in June, when the Republican-controlled House of Representatives passed a bill — with support from the Trump administration — that would significantly weaken key financial regulations put in place in reaction to the crisis.

In an essay that was published as a book chapter, Admati, a SIEPR senior fellow and the George G.C. Parker Professor of Finance and Economics at Stanford Graduate School of Business, says “policymakers who repeatedly fail to protect the public are not accountable, partly because false claims obscure reality, create confusion, and muddle the debate.”

Creating savvier consumers of the financial system and better educated citizens has become Admati’s passion — not just as a researcher and advocate, but also in her teaching. She has developed an interdisciplinary course, titled Finance and Society, that is offered to graduate and undergraduate students throughout the university.

In a recent interview, Admati discussed four myths that contribute to what she calls “willful blindness” on the part of politicians, regulators, and others and explained why it is essential to educate the public on the issues.

Myth 1: Financial crises are like natural disasters — they will inevitably occur at some point, and they are impossible to predict or prevent.

If a financial crisis is both unpredictable and unpreventable, goes the thinking here, there isn’t much point in passing regulations to improve safety in advance. The best we can do is rescue victims if necessary and minimize the harm when a crisis occurs.

But even for natural disasters, says Admati, we do act in advance to reduce harm. We impose tougher building codes, for example, in cities near earthquake fault lines and hurricane zones. The recent London high-rise fire showed how disastrous a weak safety code can be. Similarly, the nuclear disaster in Fukushima, Japan, in 2011 was entirely preventable, even though it was triggered by an unpreventable tsunami, she says.

Safety standards in other contexts might cost real resources, says Admati, but properly designed measures to make the financial system safer can actually improve the way it functions without sacrificing any of its benefits. “Much of the extreme fragility of the financial system is entirely unproductive and unnecessary,” says Admati. “It benefits primarily those within the system, while endangering and harming many others.”

It is also false, she says, that financial crises cannot be predicted. It may be impossible to predict their exact timing, but it’s clear that reckless practices and dangerous conditions make a disaster much more likely.

“There were in fact numerous danger signs in advance of the last crisis, including a plunge in lending standards and shocking levels of indebtedness and risk taking,” Admati says. “Regulators appeared blind to those signs, relying on rating agencies and the banks themselves to rationalize and obscure the extent of the danger.”

Admati is concerned that the analogy of “unpredictable” natural disasters ignores the fragility and distortions in the financial system and gives those who are responsible for the problems an excuse for doing little to change a bad status quo. If the public believes that crises are unpreventable and that the persistent scandals associated with companies in the financial sector are just the result of “a few bad apples,” she contends, then those who are in a position to improve governance can avoid accountability and continue to fail the public.

Myth 2: Problems in banking are just about flaws in the plumbing of the system.

The “plumbing” metaphor turns on the idea that the recent crisis was due to a sudden and unpredictable drying up of “liquidity” — the ability to turn financial claims into cash, in layman’s terms. Admati says that this myth is flawed for some of the same reasons as the one about natural disasters.

“Liquidity problems, panics, and runs do not happen in a vacuum,” Admati says. “They are more likely when the system is opaque, when investors fear what they do not know about the value of financial securities, and when too much risk is taken with debt funding and losses start to mount.” Suggesting that the problem is only or mostly in the “plumbing” or “liquidity” — which implies a relatively easy technical fix such as “liquidity support” from central banks like the Federal Reserve — diverts attention from the root causes of those problems, she says.

Some of the most harmful distortions in the financial system, according to Admati, come from deception and fraud. When large corporations break rules, they typically settle with the government and pay fines, sometimes without admitting guilt and without the details becoming public. Individuals, including business executives — as well as policymakers — who could have but failed to prevent the harm, rarely suffer meaningful personal consequences. “Fundamental governance failures allow few to harm many with impunity,” she says.

Focusing on plumbing and liquidity — or implying that every loan is good for the economy even though excessive credit booms are often precursors to crises — diverts attention from the underlying and pervasive distortions in the financial system, Admati says.

Myth 3: Stricter banking regulations have “unintended consequences” as financial services move from regulated banks to an unregulated “shadow banking system.”

It is highly misleading, even perverse, to present this concern as a threat or as an argument against regulation, says Admati. “It scares policymakers into maintaining a bad system,” she says. “If regulations fail because financial institutions are able to get around them in clever ways, then the regulations are poorly designed and poorly enforced. The lesson is not that we should avoid regulation, but that we must do a better job of it, just as we try to close tax loopholes rather than giving up on tax collection. It was the failure to enforce effective regulations 10 years ago that had the ‘unintended consequence’ of ushering in an awful financial crisis.”

Myth 4: Regulations always come at a cost because they constrain what corporations can do and interfere with the efficiency of free markets.

“In fact, so-called ‘free markets’ can create their own distortions and inefficient outcomes,” says Admati. “Laws or regulations are sometimes essential for enabling markets to work better. For example, my colleagues and I have shown in our research that companies, particularly banks, become inefficiently ‘addicted’ to borrowing. That can have terrible consequences for the financial system unless regulations counter the incentives.”

One obvious distortion is that banks want to use extremely low levels of equity to finance their investments — levels that other companies could never get away with in actual markets, she says. If the government enables and subsidizes banks’ excessive borrowing, through explicit and implicit guarantees and tax subsidies, it effectively feeds the debt addiction.

The solution for this problem, says Admati, is to require that banks use much more equity funding. She has written extensively on why the relevant regulations are inadequate and flawed and remains dismayed that bankers and policymakers continue to make misleading statements about the true cost and benefits of different regulatory approaches.

Admati cautions that unfocused anger with big banks or the “rigged system,” while understandable, is not sufficient unless we get to the root of the problems. She also contends, and follows up in her teaching of Finance and Society, that the issues are not as complex as those within the system would like the public to believe. “The confusing narratives allow those involved to maintain their willful blindness and get away with failing to protect the public properly,” she says.