By Janese Silvey
I once hosted a party and no one showed up.
Well, that’s not entirely accurate. Four people came. Still, it was a lot fewer than I’d planned.
I haven’t hosted a party since.
But I did help promote my first event at Stephens this week and the fear is similar. Despite the press releases and posters, what if * gasp * no one shows up?
My worry was not justified. Some 50 people attended Charles Littrell’s talk last night and the man gave a rock star performance. It was so interesting President Lynch had to cut off questions when it ran 30 minutes longer than expected. After that people still gathered around him with more questions.
Littrell is the executive general manager of Policy, Research and Statistics at the Australian Prudential Regulation Authority, which regulates Australian banks and other deposit-taking institutions, along with insurance companies and pension funds.
I’m no financial whiz (unlike my husband, who thoroughly enjoyed Littrell’s presentation), but he explained things in a way even I could understand.
If you missed it, here are some take-aways.
Economies go through painful variations. We recover, then enjoy a boom, then begin dropping into recession and sometimes depression before recovering and starting the wave all over again.
Regulation can help mitigate some of that fluctuation but basically, America doesn’t like the type of banking regulations that other, financially stable countries (such as Australia) have.
Littrell described regulations like this: America’s is more like a highway patrol that responds to disaster after it happens. Australia, by comparison, has shepherd regulators who referee banks and make sure everyone is playing by rules and going in the right direction to avoid disaster in the first place.
Trying to change regulations here now is a little difficult, kind of like telling a man to go jogging after he already had a heart attack.
If you weren’t fortunate enough to hear the talk for yourself, you can read Littrell’s entire speech below.
DOES DISTANCE BRING PERSPECTIVE?
A VIEW OF THE AMERICAN FINANCIAL SYSTEM FROM DOWN UNDER
Thank you for your kind invitation to speak this evening. I have always had a warm spot in my heart for Stephens College. My mother is a proud and active alumna, and one of my daughters also attended Stephens.
Before proceeding with my speech, let me emphasize that I am speaking in my personal capacity tonight, not as a representative of my employer, and still less as any sort of representative for the Australian government.
I grew up in Columbia, and emigrated to Australia in 1990. I have spent the last thirty years working in financial services and financial regulation, mainly focusing upon troubled institutions. For the past decade I have been responsible for policy, research and statistics at the Australian Prudential Regulation Authority, or APRA.
From 2007 and particularly 2008, an unexpected disaster struck the U.S. and global economies. Tonight I intend to briefly discuss the results and causes of that disaster, including its ongoing effects. Then we can consider what might be done to protect ourselves from the next crisis.
What does a successful economy look like?
This picture shows the received wisdom about the economic cycle: global and national income are broadly predictable, but with sometimes very painful variations away from the trend.
The world’s politicians, central bankers, and financial regulators generally strive to minimize an economy’s booms and busts, because even temporary recessions do great harm to the financial system, to businesses, and to the financial prospects of citizens, particularly younger workers relatively new to the employment markets.
Until about 2006, there was a general sense that the world had figured out how to run the global economy. Here for example is a 2006 projection of global income growth, showing the expectation for more or less constant 4 per cent growth.
What went wrong?
Now have a look at this chart: until 2008 we see that global income was growing in the conventionally expected way, steadily but slowly up with some cyclical variation. Then we hit 2008, and it’s “whoops!” in a major way.
Absent some catastrophe, it is difficult for the global economy to actually shrink, because the world’s developing countries are growing so rapidly as they catch up to western economic best practice. But that shrink was incurred in 2009. Here you see a perhaps boring kink in a graph; the human effect was that hundreds of millions of people had their lives blighted by financial hardship.
Even more surprisingly, this disaster occurred without any catastrophe outside the financial system. In effect, the financial system blew itself up, and took the global economy down with it.
There is a massive and steadily growing literature on “what went wrong in the global financial crisis?” I won’t repeat this literature tonight; a Google search and a few month’s reading can bring anyone up to speed.
The symptoms of what went wrong in the American banking system include:
- For the decade prior to 2008, credit growth was (with hindsight) much greater than was sustainable. Far too many people received loans that they couldn’t pay back. In good times bankers become too confident, and start making too many risky loans, and this increases the financial system’s risk;
- This unsustainable bubble was made worse by massive speculation in complex credit-linked products, mainly credit derivatives and securitization structures;
- The bubble in America was still further exacerbated by the fact that prudentially regulated commercial banks are a relatively small part of the financial system, and unregulated or lightly regulated entities such as investment banks and money market funds also fed the credit boom and bust; and
- Regulation was ineffective both at the prudential level, in preventing institutions from failing, and at the behavior level, preventing some lending institutions from deliberately harming their borrowers.
There is general agreement as to the consequences of what went wrong, in what has clearly been the worst American financial crisis since the 1930s:
- From 2007 and particularly 2008, many large financial institutions failed, or would have failed without extraordinary government support, otherwise known as bail-outs;
- These failures contributed to a crisis of confidence in the global and U.S. financial markets, leading them to seize up in a manner unprecedented in over sixty years, and in a manner which was no longer thought possible until it happened;
- The financial sector crisis created an economic crisis, with skyrocketing unemployment, business failures and a severe recession; and
- The extreme interventions taken by the Fed and other central banks mean that many savers are suffering from zero interest rates, and we are at some risk of an inflation break-out in the future. Deficit spending by many governments also increases future economic risks, though the absence of this spending would arguably create even greater risks.
Although there is general agreement that America has suffered a financial crisis, and still suffers from the aftermath of this crisis, it is striking that little consensus has formed on what lessons to take from the crisis, and what policy reforms are necessary to create a sounder and more satisfactory banking system.
Let’s take a side trip to consider the Titanic disaster, when an allegedly unsinkable ship in fact sank, killing a great many people in the process. There were three classes of problem in the Titanic disaster:
- First, there were insufficient controls in place to prevent a collision. The ship was travelling faster than it could be steered to miss an iceberg, in iceberg infested waters.
- Second, there was an engineering fault in that the Titanic’s anti-sinking measures were insufficiently robust, in the event of a collision.
- Third, measures to rescue the crew and passengers, given a sinking, were insufficient. Arrangements to send out effective radio distress calls were ineffective; there were insufficient seats in the lifeboats for all the people on the ship; and in the event, the available lifeboats were not filled with the maximum number of people who could have been saved.
There are strong parallels between the Titanic disaster and the global financial crisis of 2007 to 2009. As with the Titanic, the financial system’s over-confidence led to too-rapid growth, and insufficient protections against failure when the crash arrived. Then the measure in place to protect the companies and individuals affected by the crash proved insufficient to the task.
The Titanic disaster, however, resulted in rapid improvements to the global arrangements for safe sea travel. The global financial crisis, I regret to say, has as yet failed to generate a similarly satisfactory global response.
Why haven’t we learned (enough) from the global financial crisis?
Broadly speaking, the market freedom narrative, often associated with Republicans, is that government intervention over decades forced banks and other lenders to extend poor quality loans, eventually these chickens came home to roost, and rather than letting the market work by letting major institutions fail, the Bush and Obama interventions made a bad situation worse through their bail-out programs.
A competing narrative, often associated with Democrats, is that vastly overpaid bankers and their minions blew up their own firms and ultimately the economy through unrestrained greed and speculation.
Now clearly, if there is no agreement as to the causes of the financial crisis, then there can be little agreement on the solutions. Hence we have Republicans saying, more or less, that if only government intervention can be removed from the financial markets, all will be well. And we have Democrats saying that clearly more government intervention is necessary to prevent future financial crises.
Here we have a quote from Republican Congressman Spencer Bachus, until recently the chair of the House Financial Services Committee. In 2010, after the financial crisis was well and truly apparent, he still felt it necessary to opine that “regulators are there to serve the banks”. The congressman later protested that his comments had been misunderstood, but I can tell you that no regulator misunderstood. Their main committee in the House of Representatives was chaired by a friend of the banks and a foe of the regulators, even after the need for better regulation was so abundantly obvious.
This is not just a Republican issue: here is a quote from Democratic Representative Barney Frank, suggesting in 2003 that he thought it good to “roll the dice” on the safety and soundness of Fannie Mae and Freddie Mac. Those have proven the most expensive dice in history, costing the U.S. taxpayer perhaps $100 billion each.
I hasten to add that neither of these congressmen was acting from bad motives; with their colleagues, they truly believed that they were taking the right approach for America.
Australian supervisory culture
Let’s contrast this with the Australian approach, where our politicians are interested in ensuring credit availability, but equally interested in ensuring a safe financial system. Accordingly, APRA’s typical supervisory stance for the largest entities has this character: we are the cat and they are the goldfish.
Furthermore, if these entities are appreciably less safe than APRA would like, the supervisory approach begins to look like this: not actually rending flesh from bones, but thinking about the menu.
This approach is fairly typical in Asia and Canada, but not the typical approach in the U.S. and much of Europe, where supervisors too often to question their own powers of intervention.
I freely acknowledge that the above analysis greatly and perhaps unjustly abbreviates what is a complex and ongoing argument. But it’s my speech.
The global perspective
The so-called global financial crisis was broader than just America. The United Kingdom and Swiss crises were similar to the American crisis, featuring complex speculation in credit derivatives and (in the UK) a home lending bubble. The Irish, Icelandic, and Spanish crises were old-fashioned foolish lending by banks. There is also an unfolding sovereign debt crisis in Europe, which may have some way to run.
On the other hand, much of the world has not recently experienced either a banking crisis or a sovereign debt crisis. This includes Australia, Canada, some Nordic countries in Europe, Asia, Latin America, and Africa.
What separates the non-crisis countries from the crisis countries? For one thing, most of the unaffected countries suffered from one or more financial crises since 1990. This means that both bank executives and regulators, as well as the politicians in those countries, remembered that banks could be dangerous as well as valuable. This in turn led to more cautious bankers, and more assertive regulators, which turned out to be the correct strategy.
But the U.S. and the UK had both experienced material bank failures in recent decades. Why didn’t they learn an equivalent lesson?
Causes of the financial crisis—the Littrell version
As noted above, it’s my speech, so here is my explanation for what went wrong in the United States, and with some variations in Europe.
First, at least since the 1930s and arguably much longer, there has been bipartisan support in the United States for cheap and easily available credit. American politicians love easy credit much more than they love a strong banking system. This love was exacerbated, among many other factors, by decades of lobbying from the almost-government entities of Fannie Mae and Freddie Mac, among many other lobby groups.
Second, and this was a North Atlantic as well as an American issue, the Reagan/Thatcher thesis that government is the problem, not the solution, took firm hold. The idea of free markets then metastisised into the fallacy of unregulated financial markets as a self-evident good.
Third, and particularly in America, money politics came to rule too much of what happens in Washington. Wall Street and the banking industry got what it wanted, and what it paid for, from Congresses and Presidential administrations, with this trend accelerating as elections have become more expensive. What they wanted was the appearance of sound regulation and the absence of effective financial supervision, and that is what they got.
A people that fails to exercise financial self-restraint will find itself badly exposed to economic adversity. An electorate that allows its political institutions to be sold to the highest bidders will find their interests subordinated to moneyed interest groups. A banking system that is allowed to pursue short term profits, with too little focus on long term stewardship, will eventually fail. All this has come to pass in America, and with differing local circumstances has afflicted parts of Europe.
Regulation, supervision, and inspection
We all use the word “regulation” as shorthand for a complicated process. Let’s define our terms a bit more carefully, with:
- “Regulation” is the rules;
- “Supervision” the regulator’s acts of engagement with and intervention into banks and the financial system; and
- “Inspection” a sub-class of supervision, under which the goal is to ensure that banks or other regulated entities comply with the regulations.
In my experience, the world’s financial regulators are more or less equal in their intelligence, training, experience, and commitment to the public good. But among financial regulators there is a striking difference in relative national reliance upon regulation, supervision, and inspection.
Some metaphors might prove useful here.
Many regulators operate something like the Highway Patrol: they try to prevent problems, but often they are doing so by issuing tickets against demonstrable offences such as speeding. This is an appropriate approach for many regulators, but less so for risk based regulators, who must intervene well before they can prove that any rules have been broken.
Next we have the referee metaphor: this works pretty well in prudential supervision. In the game, the players are doing most of the work, and the referee is seeking to ensure that the game is played within the rules. Even this model, however, is probably too inflexible for good prudential supervision.
Finally we have the shepherd metaphor for supervision. Shepherds protect the flock from danger not by consulting a rulebook, but by proactively leading the flock away from danger. Among other things, shepherds must ensure that the lead animals in the flock go in the right direction, and that any strays are brought back to the flock… and persistent strays are culled. There are clear parallels in effective prudential supervision.
In my experience, every regulator needs to be able to enforce its rules in the face of the hopefully rare criminal or terminally incompetent operator. Despite any uninformed opinions to the contrary, however, bankers are seldom crooks or incompetents, but people trying to do a hard job in the face of many challenges and temptations.
For honest and competent operators, some combination of the referee and the shepherd model seems to work best. It is a broadly accepted outcome from the global financial crisis that countries emphasizing supervision have performed better in regulatory terms than countries emphasizing regulation and inspection.
It is a matter of some regret, unfortunately, that most of the global response to the financial crisis has emphasized new regulations, rather than more effective supervision.
Now what? At the national level
America’s financial system would be stronger if it could achieve two changes. First, the long mania for easy credit should be replaced with a desire for sensible credit. “Sensible” credit includes two features that have too often been missing: the credit is highly likely to improve the borrower’s long term financial position; and the credit is highly likely to prove profitable to the lender. Getting this balance right has been hard in America and in many other countries.
Second, America’s banks and other financial institutions have excellent access to the American political system, and as a result probably too much influence upon how they are regulated and supervised.
Unless and until America can form a political consensus that sensible credit and sound institutions are more important than easy credit and unfettered bankers, then it is inevitable that we will eventually suffer another financial crisis.
Now what? At the family/citizen level
At the family finance level, I suggest that a “back to basics” approach makes sense. If you owe money you can’t conveniently repay, then in a commercial sense you aren’t the lender’s customer: you are the lender’s slave. If you are living paycheck to paycheck, then you have no margin for error in your finances. I sympathize and agree with those who note that achieving financial independence is hard, particularly for those on low incomes. “Hard” is not the same thing as “impossible”. There is a great deal of sensible financial advice available online or for the price of a book, most of which boils down to: have a savings plan, don’t spend more than you earn, and don’t borrow unless you really need to do so. To the extent that more American families become more disciplined in their financial habits, then not only those families but the American financial system will become sounder.
All of us are financial consumers, and by definition, most of us do business with the largest financial institutions. That is why they are the largest, after all. In this room, I expect that a remarkably large proportion of us do at least some business with one of the four biggest American banking groups.
There are two problems with doing business with the largest banks: very large banks are probably not the right answer to improved American financial stability, and each customer is a very small and distant part of a large empire.
There is something to be said as a financial consumer for seeking to do business with well established but smaller or medium sized institutions. I could walk down the main street outside this building, for example, and find several community or regional banks that have served this town well for a long time, and are likely to continue doing so.
Let’s now consider what you might do as a citizen, as well as a financial consumer. Those of you who have $100,000 to contribute to a congressional or senatorial campaign, congratulations and you don’t need my advice. For the rest of us, you can’t outbid the lobby groups in congress, but you can outvote them.
The basic civics lesson applies here: the choice for citizens isn’t to engage in politics or not to engage: it’s to engage in politics, or surrender your rights to those who are engaging. I guarantee you that the banking and other financial industries are enthusiastic engagers, and the imbalance of power that arose as a result is one reason America suffered a financial crisis. The core element in engagement is of course to vote, ideally for candidates who are pragmatically committed to sound banking.
In closing, allow me to repeat four points:
1) America and much of Europe has suffered a terrible financial crisis, and continues to suffer from the aftermath of that crisis;
2) The root causes of the crisis were an addiction to easy credit, with a politically driven consensus that unfettered banking was more important than sound banking, from which ineffective regulation was one result;
3) Although many worthwhile incremental changes in regulation are proceeding, there is no guarantee that America, Australia, or the world won’t suffer another financial crisis;
4) Therefore, it remains the responsibility of each American family to protect itself through disciplined financial decisions, and by engaging as citizens to balance the efforts of the moneyed lobby groups.
Thank you for your attention, and I wish you well in your individual and collective financial endeavors.