A previous post, here, discussed the tensions in the internal governance of international banks, specifically the balance between growing the balance sheet and risk management. There is, however, another tension between efficiency and stability that also requires a judicious balance. Since the global financial crisis, regulatory reforms have grappled with this tension.
Before the crisis, banking in mature economies at the core of the global economy was highly efficient. A dollar of capital was leveraged to such an extent that it generated a many-fold increase of assets. Unfortunately, the system was also highly unstable. If that remarkable increase in leverage financed productive assets, which generated income streams to service the debt, all would have been well. Unfortunately, the surfeit of liquidity weakened credit assessments and fuelled asset price bubbles. As it was, a shock to the sub-prime mortgage market (a relative small segment of the U.S. financial system — recall the initial reassuring words of chairman Bernanke) triggered a cascading collapse of balance sheets that threatened the entire global financial system and almost resulted in a catastrophic economic collapse.
The regulatory response was predictable. In the wake of the crisis, demands were made for more stringent regulations so that the global financial system would never again be threatened with systemic collapse. Leverage should be reduced, it was argued, and more capital held to buffer the system against potential shocks. In addition, reformers from Paul Volker in the U.S. to Sir John Vickers in the U.K. and Erkki Liikanen in the European Union called for the introduction of restrictions on business lines to inoculate traditional banking (liquidity and maturity transformation) from speculative finance.
These reforms are important means of limiting the system's exposure to possible fatal risks. But however useful they are in fostering stability, they reduce efficiency (as defined by the metric above). In this respect, the international community must strike a judicious balance between stability and efficiency, to ensure the financing of investments needed to rebalance the global economy and meet the demands that climate change will impose. The problem is that this balance is a moving target: competitive forces are such that any given regulatory change that imposes a constraint will, inevitably, elicit innovation designed to relieve the constraint. As a result, progress made to move towards greater stability will, over time, be met with innovations that increase efficiency.
These pressures are magnified, arguably, by global financial integration and regulatory arbitrage. The years preceding the financial crisis witnessed the growth of a shadow banking system, fuelled in part by the fact that some jurisdictions practiced a "light touch" regulation in comparison to home-country regulation. Efforts by the Financial Stability Board (FSB) to introduce prudential guidelines on shadow banking represent an attempt to contain these risks.
The crisis revealed the dangers of tipping the balance too far towards “efficiency.” The danger now may be that moribund financial systems, burdened with bad assets and a “never again” attitude, slow economic recovery. This risk is probably greatest in Europe, where efforts are underway to screen banks’ balance sheets to identify and deal with problem assets so that banks there once again do what banks are meant to do: lend. There is a lot riding on this process.