Called upon at the start of the credit crunch to explain the collapse in value of a Goldman Sachs investment fund, the bank’s chief financial officer did some high-net-worth headscratching: “We were seeing things that were 25-standard deviation moves, several days in a row.” Which all sounds plausibly lofty and technical until you are reminded of the observation from the economist Tim Harford that one wouldn’t expect to see three 25-standard deviation days in a row for far longer than the 13bn years the universe has been in existence. Goldman’s David Viniar was effectively saying that his models weren’t at fault; it was reality that was wrong.
Laughable though that sounds, fi nancial regulators – the people paid to protect the rest of us from overconfident financiers – have trusted the bankers and their highly sophisticated models of risk. Indeed, the watchdogs have themselves adopted ever more complex models of risk – thus taking the bankers at their own word. As the Bank of England’s Andy Haldane points out in an important new paper, The Dog and the Frisbee, the first international Basel rules on fi nance reached in 1988 ran to only 30 pages. The latest incarnation, Basel III, weighs in at 616 pages. In America, the DoddFrank act on financial regulation is more than 20 times as long as Glass-Steagall, the 1933 law that split investment banks away from savings
Euro crisis
Plenty of pain in Spain
Whether the European single currency survives its existential crisis (and the betting on that must be yes, more or less), the larger project of bringing the continent closer together has been fatally damaged.
That much was admitted by the European Central Bank last month in a bulletin titled Indicators of Market Segmentation, which found that lending across borders within the eurozone has fallen from 60% of money-market flows last summer to 40% this February. Foreigners held about 45% of all Spanish government debt in 2009; now the figure is closer to 30%. What was one continent – at least in financial terms and for over a decade at that – is swiftly coming apart.
But the Great Break-Up goes further and deeper than that: not only are European nations coming unstuck from each other, they are also breaking into regions. Clear evidence was visible in Spain last week, with Andalucía becoming the fourth province in the country to ask Madrid for a cash rescue, after Valencia, Murcia and Catalonia. In part, this is about regions unable to bear the fiscal discipline that northern Europe has imposed on Madrid and banks. All this complexity costs: the number of people employed in the UK’s fi nancial sector has barely increased over the past 20 years (despite the lobbyists’ promises, finance does not create jobs); the number of regulators has leapt almost six fold.
Yet all this detail and sophistication is a less effective guide to regulation than the old trusty rules of thumb. As Mr Haldane effectively demonstrates, looking at how much banks had borrowed by the end of 2006 – their leverage ratio – would have been a better predictor of which would go bust than all the rest of the armoury. As the Bank’s head of fi nancial stability sums up: “Modern finance is .… too complex … As you do not fi ght fi re with fi re, you do not fi ght complexity with complexity.”
Two obvious conclusions fl ow from this. The fi rst is that financial economics is heading back towards the world as Keynes and Hayek knew it: where economic uncertainty was recognised as such, rather than mathematised and mis-sold as controllable risks. Second, that regulators really ought to deal with bankers using a regime of brutal simplicity that errs o n the side of caution. If a bank looks like it’s borrowed too much, it probably has – and should be stopped. Mr Haldane’s view makes far more sense than that described in the Basel agreements or Vickers commission: and in its simplicity, it is pleasingly radical.
Laughable though that sounds, fi nancial regulators – the people paid to protect the rest of us from overconfident financiers – have trusted the bankers and their highly sophisticated models of risk. Indeed, the watchdogs have themselves adopted ever more complex models of risk – thus taking the bankers at their own word. As the Bank of England’s Andy Haldane points out in an important new paper, The Dog and the Frisbee, the first international Basel rules on fi nance reached in 1988 ran to only 30 pages. The latest incarnation, Basel III, weighs in at 616 pages. In America, the DoddFrank act on financial regulation is more than 20 times as long as Glass-Steagall, the 1933 law that split investment banks away from savings
Euro crisis
Plenty of pain in Spain
Whether the European single currency survives its existential crisis (and the betting on that must be yes, more or less), the larger project of bringing the continent closer together has been fatally damaged.
That much was admitted by the European Central Bank last month in a bulletin titled Indicators of Market Segmentation, which found that lending across borders within the eurozone has fallen from 60% of money-market flows last summer to 40% this February. Foreigners held about 45% of all Spanish government debt in 2009; now the figure is closer to 30%. What was one continent – at least in financial terms and for over a decade at that – is swiftly coming apart.
But the Great Break-Up goes further and deeper than that: not only are European nations coming unstuck from each other, they are also breaking into regions. Clear evidence was visible in Spain last week, with Andalucía becoming the fourth province in the country to ask Madrid for a cash rescue, after Valencia, Murcia and Catalonia. In part, this is about regions unable to bear the fiscal discipline that northern Europe has imposed on Madrid and banks. All this complexity costs: the number of people employed in the UK’s fi nancial sector has barely increased over the past 20 years (despite the lobbyists’ promises, finance does not create jobs); the number of regulators has leapt almost six fold.
Yet all this detail and sophistication is a less effective guide to regulation than the old trusty rules of thumb. As Mr Haldane effectively demonstrates, looking at how much banks had borrowed by the end of 2006 – their leverage ratio – would have been a better predictor of which would go bust than all the rest of the armoury. As the Bank’s head of fi nancial stability sums up: “Modern finance is .… too complex … As you do not fi ght fi re with fi re, you do not fi ght complexity with complexity.”
Two obvious conclusions fl ow from this. The fi rst is that financial economics is heading back towards the world as Keynes and Hayek knew it: where economic uncertainty was recognised as such, rather than mathematised and mis-sold as controllable risks. Second, that regulators really ought to deal with bankers using a regime of brutal simplicity that errs o n the side of caution. If a bank looks like it’s borrowed too much, it probably has – and should be stopped. Mr Haldane’s view makes far more sense than that described in the Basel agreements or Vickers commission: and in its simplicity, it is pleasingly radical.
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