Lax Governance and Poor Supervision

April 1, 2009

In the current atmosphere, one could be forgiven for thinking that the current financial meltdown was due to a technical engineering problem, or at least that the U.S. Treasury thinks so. The complex proposals Treasury recently put forward—for stress tests, bad asset pricing, and bank recapitalization without government control—seem consistent with this belief. They treat the financial crisis as a failure of specific mechanisms subject to a technical fix by the more clever engineers now in charge. If only the risk models used by investors and supervisors were less short-sighted, less blindly reliant on so-called Gaussian copulas; if only banks’ private managers and public supervisors had the intellectual or computational firepower to see how various risks interacted; and thus, if only we can carefully realign incentives and information flows, we can fix the financial system.

Yet it was not technical failures, mistaken models, misaligned incentives, computational errors, or gaps in risk monitoring that led us to the financial wreckage we see today. These all happened, but they were symptoms, not causes. What led us to today’s financial wreckage was a decade of lax governance and supervision of financial companies. And that permissive environment was itself the result of a politically powerful view in favor of self- regulation and expansion by banks and near-banks, driven by a combination of ideology and self-interest. In fact, the design of Basel II was an expression of the same impetus toward self-regulation: its implementation depended upon trusting the banks’ own models and trusting supervisors to decide whether or not risky activities like SIVs could be treated as offbalance-sheet. We should not be surprised, then, at how little Basel II did to prevent the crisis.

Indeed, more than almost anything, political environments determine the nature and effectiveness of financial regulation. This should be obvious. Economic institutions and policy frameworks are the result of political processes, not of tabula rasa designs or of independent market evolution. Accordingly, they reflect the dominance of particular interest groups and ideas at a given moment. Societies grant central banks independence when a politically dominant coalition decides that inflation fighting is a priority and creditor interests are paramount. They may do so for well-intended reasons, but the institutions reflect the political environment. The same holds for fiscal policy: balanced budget amendments and other fiscal rules are adopted when societies decide budgetary discipline is important. Those fiscal rules get ignored or dropped when politically dominant coalitions decide they do not care about balancing budgets, as we saw during the Bush years.