By Dave Altig
The subject of this post's title was, in essence, the centerpiece of the most recent edition of the Atlanta Fed's annual Financial Markets Conference, convened this year in Stone Mountain, Ga. (just outside Atlanta). In terms of formal papers, the conference was bookended by work that came to very similar conclusions but from very different angles. From the vantage point of recent developments in micro banking structure, Arnoud Boot offered this diagnosis:
"A fundamental feature of more recent financial innovations is their focus on augmenting marketability. Marketability has led to a strong growth of transaction-oriented banking (trading and financial market activities). This is at least in part facilitated by the scalability of this activity (contrary to relationship banking activities). It is argued that the more intertwined nature of banks and financial markets induces opportunistic decision making and herding behavior. In doing so, it has exposed banks to the boom and bust nature of financial markets and has augmented instability."
Taking the very long view, Moritz Schularick presented (from a paper co-authored with Alan Taylor) pretty compelling evidence that the ongoing shift from relationship banking to transactions-based banking has fundamentally altered the nature of financial developments on real activity in modern economies:
"We first document and discuss our newly assembled dataset on money and credit, aligned with various macroeconomic indicators, covering 14 developed countries and the years from 1870 to 2008. This new dataset allows us to establish a number of important stylized facts about what we shall refer to as the 'two eras of finance capitalism.' The first financial era runs from 1870 to 1939. In this era, money and credit were volatile but over the long run they maintained a roughly stable relationship to each other, and to the size of the economy measured by GDP. The only exception to this rule was the Great Depression period: in the 1930s money and credit aggregates collapsed. In this first era, the one studied by Friedman and Schwartz, the 'money view' of the world looks entirely plausible. However, the second financial era, starting in 1945, looks very different. With the banking sector progressively more leveraged in the second financial era, particularly towards the end, the divergence between credit supply and money supply offers prima facie support for the credit view as against a pure money view; we have entered an age of unprecedented financial risk and leverage, a new global stylized fact that is not fully appreciated."
If there was agreement on increasing threats to financial stability, what to do about it (unsurprisingly) was somewhat more controversial. On the microprudential front, several conference participants — Viral Acharya, for example — looked to greater capital buffers as a key to greater financial stability. Others — George Kaufman commenting on Boot's paper, for instance — were more inclined to rely on market solutions. Boot, for his part, was highly skeptical of the self-correcting market forces and, while sympathetic to greater reliance on bank capital, believes much more is required:
"What we have also argued is that market discipline might be rather ineffective. We described this as a paradox. When particular strategies have momentum in financial markets, the market as a whole may underestimate the risks that these entail. How then can we expect market discipline to work? It appears to us that market discipline might not be present when banks follow financial market inspired strategies. Things are even worse because these strategies will lead to a high correlation in actual exposures between financial institutions because all see the same opportunities and hence herding occurs. Systemic risk would then be considerable and not checked by market discipline."
Earlier in the paper, Boot puts forward:
"We believe that heavy handed intervention in the structure of the banking industry — building on the Volcker Rule — might ultimately be an inevitable part of the restructuring of the industry. It could address complexity but also help in containing market forces that might run orthogonal to what prudential concerns would dictate (as the insights on market discipline in section 6 suggest). For now, the structural interventions in the banking industry are rather tentative. Other measures such as higher capital and liquidity requirements are clearly needed. But these primarily focus on individual institutions while a more system-orientation is crucial to identify externalities and interlinkages (Goodhart, 2009; and Calomiris, 2009). Anti-cyclical capital surcharges and other measures and surcharges depending on the degree of interconnectedness are needed as well to add some further comfort. We tend to subscribe to John Kay's (2009) notion of redundancy: having comfort in the stability of the financial sector dictates building redundancy into the regulatory and supervisory structures of banking."
With respect to "system-oriented" signals, Schularick was clear where he and his co-author think their research leads:
"These new results from long-run data, if they pass scrutiny, inform the current controversy over macroeconomic policy practices in developed countries. Specifically, the pre-2008 consensus argued that monetary policy should follow a 'rule' based only on output gaps and inflation, but a few dissenters thought that credit aggregates deserved to be watched carefully and incorporated into monetary policy. The influence of the credit view has certainly advanced after the 2008–09 crash, just as respect has waned for the glib assertion that central banks could ignore potential financial bubbles and easily clean up after they burst."
Credit and bank capital — along with sound fiscal policy and a little good luck — do appear to have been key to how well different economies fared during the recent financial crisis. At least that is the conclusion reached in a study by Stephen Cecchetti and his co-authors from the Bank of International Settlements:
"The macroeconomic performance of individual countries varied markedly during the 2007–09 global financial crisis … Better-performing economies featured a better-capitalised banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part."
As we seek to shore up our financial timber to avoid a repeat of recent history, it is appropriate to remember that, while it is good to be lucky, fortune is probably not arbitrary in choosing where it will shine.