Five years after the credit crisis began we have entered a bull market for regulation. It is stretching further, and faster, than most of us realise. The process is inevitable, following recent excesses. Some aspects of it are beneficial. But the line between market regulation and capital punishment is becoming increasingly thin.
The re-regulation of markets marks a reaction to the policies of benign neglect which were in operation during the credit boom, when regulators took their cue from Alan Greenspan, former chairman of the US Federal Reserve, who believed central bankers could rely on market participants to correct their own excesses.
Nothing could be further from the truth. During the boom, individual borrowers overlooked the cost of servicing debt because they were desperate to buy into a rising property market. Financial advisers did not bother to check out whether or not borrowers could afford to service their mortgages, because they collected commissions for every loan they arranged.
Banks competed with each to lend the money, often on soft terms, to pay bonuses to staff out of their fat profit margins. Investors operating in the wholesale market bought packages of loans from the banks because they were hungry for yield and never thought people would default.
The packages were mainly generated in the US, where credit rating agencies were particularly generous with their assessments, but they also featured in the UK and other parts of Europe. Normally staid German and French investors became desperate to invest in high-yielding Anglo-Saxon mortgage packages.
French philosopher Voltaire believed the division of property among the people was the solution of a society’s ills. He observed: “The spirit of property doubles a man’s strength.” He failed to mention that a sharp rise in its price doubles the greed.
The credit crisis has led to intense analysis of the flaws in human behaviour, not least by regulators. Margaret Heffernan, author of Willful Blindness pointed out: “We can’t notice and know everything. The cognitive limits of our brain simply won’t let us. That means we have to filter or edit what we take in."
She points out the parts we edit out tend to be those that makes us feel uncomfortable. Just as the English of the 1930s preferred to appease Hitler rather than come to terms with his character, investors in the noughties came to believe that house prices were incapable of falling.
Greed had taken the place of rational analysis. Herd behaviour took over. Daniel Kahneman, author of Thinking, Fast and Slow, points out that individuals are happier to use snap judgements to run their lives than go to the effort of working out whether or not different courses of action would make more sense.
On this argument, investors in the noughties piled into mortgages without much thought. Putting aside a few US hedge funds, no one could be bothered to work out where the trend was leading. Let’s call it wilful laziness, which needs to be countered by a deree of regulation.
After 2007, when interest rates rose and borrowers started walking away from their mortgages, the wholesale market collapsed. Banks stopped doing business with each other for fear their counterparties would go bust. Governments not only had to inject liquidity into the system, they were forced to guarantee loans and deposits to prevent a run on the banks.
A big shock was inevitable because wilful laziness had pumped so much debt into the system. Even now, central bankers are being forced to prop up the economy through a mixture of low interest rates and quantitative easing. Markets remain dependent on state funding for support, to an astonishing extent.
While walking softly, however, the state is carrying a big stick. Regulatory initiatives have also multiplied, to ensure that the greed is suppressed through fear. Banks are being forced to raise more equity – much more equity if they dare to package up structured products. Banks are being told to stop using their own money to trade and separate investment banking from the rest of their business, just as they were by the 1933 Glass-Steagall Act.
Bank remuneration is becoming long term and dependent on the results of their actions in succeeding years. Potential insider trading is being subjected to forensic analysis, and the willingness of regulators to take legal action against miscreants is noteworthy.
Regulators are reviewing practices across the financial sector, with a view to nipping problems in the bud: their recent reform of the flawed Libor debt benchmark will be the first of many. There is zero tolerance for a bank that fails to segregate client money from its own funds. The marketing of funds needs to meet a client suitability test. Managers are being stopped from paying kickbacks to distributors. Restrictions on the marketing of alternative investments are multiplying.
More recently regulators have spread their attention to parts of the legal, accounting and insurance world. Governments seeking to balance their books have commenced a crackdown on tax avoidance. In agreeing to rescue indebted peripheral economies in the eurozone, the European Union is insisting that their governments impose austerity on their populations.
According to its current government, Greece will have seen 25% lopped off its gross domestic product by the year 2014. And the banks, fearful of regulatory demands are making people jump through an extraordinary series of hoops every time they need to borrow money.
Heaven knows where all this ends up. But involvement of the state in western capitalism is starting to feel distinctly unhealthy.