Financial practitioners and regulators largely agree that the Global Financial Crisis (GFC), and other recent crises, was compounded by the use of International Financial Reporting Standards. These standards emphasize marking the value of assets to their current market price. The accountant shorthand for this practice is “mark-to-market.”¹ The application of IFRS’s standard that governs the loan-loss provisions for financial institutions and extends mark-to-market² meant that when asset prices fell sharply in 2007 and 2008, financial institutions were forced to raise capital to set against the deterioration in their asset/liability ratio. To raise cash quickly they had to liquidate assets. This depressed asset prices, which in turn caused an increase in computed risk, a need for more capital and more selling. A vicious cycle ensued that was driven primarily by these valuation conventions rather than an actual need for readily available cash.

This unfortunate cycle might have been broken if cheaper asset prices had drawn in cash-rich buyers looking for bargains. However, most of these buyers were themselves constrained by similar valuation approaches. These valuations were embedded in modern risk management systems that fed off short-term price volatility and correlation or utilized credit ratings that are a lagged response to price developments. Valuation and risk systems forced potential buyers to either stand back or put up an onerous amount of capital to be set against the computation of risks.³ We have touched in the last few chapters on the unhelpful procyclicality of bank and insurance capital adequacy requirements.⁴ The requirement that participants adhere to both current asset valuations and risk assessments driven by the volatility and correlations of these prices was a critical component of this negative dynamic.

In a financial crisis, when readily available cash or other forms of liquidity are in short supply, the price of most financial assets falls substantially below the price they would fetch after the crisis is over or when a bond matures. The extra yield (above the yield of an otherwise identical asset)⁵ that an illiquid asset must offer to incentivize investors to buy or hold them is known as the liquidity premium. Usually for those securities that trade on an exchange the liquidity premium is a forgettable fraction of a percentage point. However, during a crisis it can rise to tens of percentage points or more. Assets that are most distant from ready cash will offer the greatest liquidity risk premium.

Several commentators have suggested that, during a crisis, mark-to-market accounting should be suspended. This would limit asset holders being forced to liquidate assets at the worst possible time because of accounting and valuation rules rather than because of a pressing need for cash. In crises, policy makers are cornered into limited choices and uncomfortable trade-offs and so I am generally sympathetic to such heterodox proposals and less attracted by opposing moral hazard arguments. However, I believe there are better solutions that would not weaken incentives for responsible lending before the crash. In previous chapters in this book I have suggested that to stop or soften financial crashes we must tackle the booms. Offering forbearance from mark-to-market accounting during a crisis, yet using them during the preceding boom, will not reduce the frequency or severity of subsequent crashes. It could actually worsen the crisis—particularly if this pattern of policy response became routine.

Moreover, financial crises are a febrile time. Rumors morph into self-fulfilling prophecies as panic and fear whip through the economy. It is not the time to indulge in greater opacity and uncertainty by fiddling with valuation standards. This is not to negate the view that a significant revision to accounting rules is desirable. But a rule revision based on having complete faith in the messenger’s every word during the good times but shooting him in the bad is unlikely to work in the long run.

The focus on the role of accounting standards in financial crises is a little unfair. In previous chapters we argue that financial cycles are amplified by a number of factors working in unison. There was the so-called risk-sensitive capital adequacy regime we have described and discussed previously in Chapters 5 and 6. Then there were regulatory-approved and promoted market-sensitive risk management systems.⁶ In these systems, risk limits and sell orders are triggered in response to a rise in short-term price volatility and correlation. Embedded in these first two approaches, and in the reporting standards banks used, was the mark-to-market valuation approach. Often, in blaming a process they were uninvolved with, one set of professionals try to disentangle the effects of each approach. In reality they are a single package. Mark-to-market accounting standards were simply one limb of a wider regulatory philosophy to publicly incorporate market prices into the valuation of assets, the assessment of their risks, and the response to both. It may now seem obvious that this is circular and conducive to systemic collapse. Yet it was part of the dominant market fundamentalism we have described before. Back then to disagree with this fundamentalism risked ridicule and being branded a heretic.⁷

From Bank Finance to Market Finance

The 20-year trend prior to the GFC was the “marketization” of finance: a shift from bank finance to market finance. Loans were originated and securitized by banks, rated by credit rating agencies, and then relocated to investors. Cynics argue this was really regulatory arbitrage. Risks were transferred, (at least on paper), from the regulated sector where capital had to be put aside for credit risks, to the unregulated sector, where it did not.⁸ But bear in mind that bank supervisors and regulators who were on the Basel Committee in the 1990s had welcomed the marketization of banking risk. They looked favorably on a process that appeared to distribute risks away from a small number of large and systemically important banks to a large number of investors. Attempts have been made to distract us from the regulators’ role as protagonists in the ancien regime by emphasizing iniquitous behavior among bank originators and credit rating agencies and the potential collusion between the two.⁹ Do not be too distracted.

Context is paramount. In fairness to regulators, the banks had proved inferior at managing risk on their balance sheet in the past. In the mid-1970s, there were economic crises that spilled over into banking crises in the United States, United Kingdom, and elsewhere. The Basel Committee on Banking Supervision was formed by the Group of Ten¹⁰ in response to these crises—in particular the messy international liquidation of Cologne-based Herstatt Bank in 1973.¹¹ But the Committee’s work did not reduce the frequency of bank failures. In the late 1980s and early 1990s, US-based bank regulators would have had the Latin American debt crisis and the Savings-and-loans disaster¹² preying on their minds plus the collapse of institutions such as Continental Illinois,¹³ MCorp and All First, among others. Each collapse threatened widespread dislocation if taxpayers’ money was not liberally spent in a bailout or put at risk through guarantees.

The 1990s witnessed widespread banking crises in Japan, Sweden and Finland. It is worth recalling that one of the other motivations for the establishment of the first Basel Accord on banking supervision was Western powers′ concern that the rapid emergence and increasing systemic importance of Japanese banks was linked to less stringent capital requirements in Japan.

Fresh out of the UK’s “secondary banking crisis” of 1973–75 and the resulting concentration of commercial banks into just the four majors, UK regulators did not suffer any generalized crises during the 1980s and 1990s. However, they still had to grapple with the collapse of a host of small to medium-sized institutions such as British and Commonwealth, Barings, and Johnson Matthey Bank, as well as the much larger, though less UK focused, Bank of Credit and Commerce International (BCCI).

Before the 1990s, banks, like other companies, primarily used historic cost valuations for their loan books. Re-valuations to reflect current prices were infrequent. The marketization of banking brought the greater use of market prices in the valuation, measurement, and control of bank risks. During quiet times, taking credit risks out of the dark corners of bank balance sheets and placing them into the open arena of continuously priced financial markets seemed reasonable. It appeared to offer greater liquidity, lower risk premium and a more sophisticated, nuanced risk management than the model of bank finance underpinned by the first Basel Accord (“Basel 1”) on bank supervision.¹⁴ By being more conducive to transparent, frequent, external valuations, market-price based finance was perceived as helping to decrease fraud and increase market discipline. Under the glare of mark-to-market, surely banks would behave better. At least the intentions were good.

Market flaws have been laid bare by the GFC to such an extent that it may be difficult to recall that until quite recently it was the flaws of credit officers and supervisors that preoccupied regulators. The market vigilantes were assumed to be less forgiving than credit officers and bank executives. Back when Basle II was developing, corporate and securities fraud was the pressing concern. During the 1980s and 1990s, fraud featured in a number of salacious stories. In America, the savings-and-loan debacle exposed improper behavior and accounting—often with a political dimension.¹⁵ Crony capitalism was rife. In Canada, there was the Bre-X mining stock scandal in the mid-1990s. Australia had the Pyramid Building Society bust of 1990. In the UK there was the 1987 Blue Arrow Affair. The riveting case of Morgan Grenfell’s rogue asset manager, Peter Young also had the British public enthralled.¹⁶

For bank supervisors, “marketization” was the future of banking and the future looked brighter than the murky past. The marketization of banking was not so much a conspiracy directly hatched by the “gnomes of Zurich” as by the gnomes of Basel.¹⁷ It was integral to their approach to banking and cemented in the European Capital Requirement Directive and the new International Convergence of Capital Measurement and Capital Standards (Basel II).

This vision of market-sensitive regulation was swathed in the political zeitgeist of the 1980s and 1990s. The consensus was that the state had overreached itself during in the prior two decades. Through deregulation and privatization, the correct balance would be restored. Prime Minister Thatcher’s election in 1979 and President Reagan in 1980 are often cited as the turning point in this political thinking. However, its genesis was much earlier and lasted long after they had demitted office. Cold economic logic alone cannot create seismic political shifts. For that kind of movement there must be the additional ­ingredient of passionate belief. The zeal for privatization went beyond the economics of defining certain government activities as really commercial and better suited to private ownership. It was driven by an increasingly held faith in the democratizing influence and financial discipline of markets and the ­market price.

The privatization of government and the marketization of banking were flip sides of the same coin. Without acknowledging this context, it would be hard to explain why banking regulators had fashioned a regulatory regime that placed market prices at its core, when tackling market failure should have been the main organizing principle. Earlier in Chapter 2, I argued that the principal reason we regulate the banking system over and above standard corporate regulation is because markets fail. There is, of course, a legitimate debate on where the boundary, or the lace, lies between laissez faire and intervention. Across a wide spectrum of activities, market discipline offers many benefits, but it would be a rare circumstance, when relying more on markets was the solution to a natural market failure.¹⁸

The preeminent role of market prices in the measurement, reporting and control of risk is reflected in the last couple booms. As the asset values rose, and the market price of risks fell, regulatory standards and mechanisms did not constrain bank lending or force a tightening of lending standards. Instead the opposite happened. Banks were incentivized to redouble what was later seen as imprudent lending. And later, when the value of assets fell and the price of risks rose, those same regulatory standards and mechanisms worked to keep banks from lending, reinforcing deflationary pressures. Mark-to-market accounting definitely played a role in this behavior, but as an ­integrated ­component of a wider set of mechanisms. However pleasing to bank ­regulators, the blame for the liquidity crisis cannot be laid entirely at the feet of accountants. Blame also rests at the shrine built to the market paradigm where regulators, bankers and accountants met to worship.

Cheerleaders for the regulatory regime operating prior to the GFC ­comfort themselves with the thought that at least no one else saw the crisis was ­coming. But inconveniently it was foreseen. There were warnings that the marketization of risks contained a Faustian bargain. Greater liquidity, lower-risk premiums and the appearance of sophisticated risk management in quiet times happened at the expense of systemic liquidity when markets are under stress.¹⁹ The broader intellectual and political context allowed the gnomes of Basel to sweep aside these warnings.

En passant, there is an interesting unintended consequence of making market prices central to the management and control of risks and capital. When markets fail, liquidity disappears and the authorities are compelled to intervene, they are now obligated to set a floor in the market price of the kind of assets they would not normally touch. The marketization of banking has been associated with a switch in the role of the central bank from lender of last resort for a handful of institutions to “buyer of last resort” for the markets.²⁰ As argued earlier, this is a far more arduous task.²¹ The levers of influence are diminished, unintended consequences widen and the space for important but delicate subtleties and nuances is lost.

The Perils of Homogeneity

Banking regulation has historically focused on identifying good practices at certain banks and then making these practices the standard to which all others must comply.²² Protagonists of Basel II oddly boasted that the framework better aligned regulatory capital with what the best banks were doing. It is a poignant reminder of the power of the prevailing zeitgeist we discussed in the last section that they were blinded to the senselessness of that statement. Surely the aspiration of regulation is to push banks to a different point than they might otherwise arrive at and towards a framework for operation that will better incorporate the social externalities of banking, which, left unattended, would lead to a state of calamitous failure. Because of the liquidity transformation and the quasi-money involved in bank deposits, banking is systemic. The banks’ focus on their private interests will lead them to underinvest in systemic stability. We discussed this basic requirement for regulation in Chapters 2 and 3, and the notion of banking having social externalities is a well-traversed idea.²³

I have discussed the dangerous procyclicality of giving the central role to market prices in a variety of processes from assessment of risk, to valuation of assets, to risk management. What I would like to explore further in this section is something related but separate—namely the deleterious effects on liquidity and stability of common behavior in financial markets. At the very heart of the approach of banking regulation was the faulty idea of creating more homogenous behavior by imposing common standards and rules.²⁴ This common behavior was artificially created by the widespread adoption of the market price, and hence a single, common price, in the valuation of assets and their risks. However, as I discuss later, other regulatory initiatives can produce homogenous behavior and so it is important to appreciate the perils of homogeneity in general.

A common mistake is to see measures of market size as synonymous with its liquidity. If a financial market has only two people but whenever one person wants to buy an instrument, the other wants to sell it, the market is liquid. Imagine next a market with 1,000 participants all using the same investment universe, the same market data, the same best-practice, valuation, risk-management, and accounting systems and the same prudential controls based on published credit ratings. When one member wants to sell an instrument in response to these systems, so does everyone else. This is an illiquid market. At any one time there will only be buyers or only sellers. An elementary prerequisite for liquidity is having buyers and sellers simultaneously. A market may be big in terms of the number of participants, but if at any one time it has primarily buyers or sellers, the thinner it is in terms of liquidity. Liquidity is about diversity.²⁵

This tends to be an issue in times of market stress. During quiet times when markets seem directionless, they appear to exhibit good liquidity. However, this proved to be false liquidity. It is there when you do not need it and disappears when you do. When an event takes places that creates market stress and liquidity is most needed, these common rules and systems send all participants in the same direction and liquidity is drained. I call this false liquidity during the quiet times in markets “trading liquidity.” It is a concept well illustrated by the ever-tighter spreads between the prices at which traders buy and sell the same security.²⁶ I term liquidity when the system is under stress “systemic liquidity” i.e. that liquidity available at times when short-term traders are all trying to swap assets for cash simultaneously.²⁷

Outside of finance, common standards that lead to common behaviour are generally a good thing. You want your railways, electricity and gas companies to abide by common standards. Drivers should obey traffic lights, drive in the same direction and on the same side of the road. Using common terminology agglomerates activity and increases safety in everything from architecture to everyday conversation. It is no surprise, then, that bank regulators, who do not all have professional experience in the workings of financial markets, would be attracted to the benefits of a common standard.²⁸ But finance is different. Homogeneity of behavior in financial markets will reduce systemic resilience. Heterogeneity strengthens it.²⁹

The notion that liquidity requires diversity may at first appear counterintuitive—especially to financial commentators who routinely confuse market capitalization or turnover with liquidity. How often have you heard the liquidity of the foreign exchange market extolled in the same breath as recent estimates of total daily turnover in the market? However, it is a familiar idea in the literature on networks, big systems as well as microstructures whose resilience rests on diversity, or what some fields term redundancy. Systems and networks in which participants have identical tastes and responses are prone to collapse.³⁰

First, the good news. Most societies contain enough routine diversity in terms of economic liabilities and assets for there to exist a substantial amount of systemic liquidity naturally and without trying. A pensioner, a young saver putting aside money for a distant future, an insurance company and a charitable endowment all have varying objectives and divergent capacities for dissimilar risks. This diversity should be reflected in different valuation and risk management systems. For example, an illiquid five-year bond backed by good collateral would be a risky asset for an investor funding her investment by borrowing and repaying the money every day—like a one-day cash deposit. However, as we have discussed at length in Chapters 5 and 6, it would be a safe asset for an institution like a young pension fund with no cash commitments over the coming ten years. It is not just capital adequacy requirements that must vary. The risk management, valuation, and accounting systems used by institutions with overnight funding must be different from those used by long-term investors.³¹

The bad news is that the trend for employing the same valuation, accounting, and risk management rules artificially reduces this natural diversity and increases systemic fragility. Some of the special-purpose investment vehicles (SPVs and SIVs) that were forced to sell assets in the credit crunch were made to do so because of this homogeneity of standards. Their funding had not dried up but they were subjected to the common rules that all banks used.

One of the key lessons of the GFC is that a critical factor in systemic resilience is funding liquidity. When the system freezes, those with short-term funding topple over. Stability lies with those who have secured long-term funding. They are the risk absorbers. However, by using mark-to-market valuation in accounting, capital adequacy requirements and risk rules, regulators failed to make any distinctions between those with a funding liquidity issue and those without. They did not and do not currently differentiate the risk absorbers from the risk traders. Risk traders, or simply financial traders, move between different risks—ostensibly trying to find relative value though often simply following short-term trends. As a result of short-term funding these traders have limited capacity for holding onto a risk and carrying heavy losses. It is those with long-term funding liquidity, or long-term liabilities, who have the capacity to absorb market and liquidity risks. The absence of any distinction between risk traders and risk absorbers at the regulatory and accounting level led to a disproportionate growth in the number of risk traders in the financial system. The explosion of high frequency trading is also a part of that because the lowering of capital requirements for short-term liquid assets held on the trading book of banks gives a regulatory advantage to risk traders. The rise of risk traders who shuffle assets between each other most of the time, but look to drop them all and get to the exit before others in the bad times, gives the appearance of greater liquidity and lower transaction costs through greater trading turnover and finer dealing spreads. This provides some political cover for the preponderance of these traders. However, all along, systemic liquidity is deteriorating and the financial system is becoming more fragile. Evidence of this is the increasing number of large price movements that are big enough for some investors to lose substantial sums, before they can reverse like the “Flash Crash” of May 2010.³²

The fundamental systemic problem with the originate, rate and relocate model was not the deceptiveness of the bankers or rating agencies and their conflicts of interest. That was a problem but was one that could have been addressed by microprudential regulation. The fundamental problem was that a disparate group of market participants, borrowers, creditors, and investors, by using common valuation, accounting, credit rating, market risk systems and prudential controls, ended up behaving homogenously in times of stress. They were either only buyers or only sellers of risk at the same time. There were numerous players involved in trading, which the authorities mistook for a greater spread of risk, but there was little functional diversity. Risk is about behavior. Appearing to spread risk from a few, well-known, disparate players, to a large number of players, behaving homogenously, concentrates risk.³³

Reintroducing and Developing Diversity in a Financial System

In this chapter, and more at length in Chapters 5 and 6, I have discussed the importance of maintaining a diversity of liabilities or funding in the development of financial market liquidity. There are several ways in which financial diversity has been artificially and erroneously reduced and in which it can also be preserved, protected or even reintroduced.

Regulators’ adoption of credit ratings as a measuring tool for credit risk on bank balance sheets reduced diversity and in the process undermined good banking. A good bank lends to some that others will not, based on its superior credit knowledge. It does not lend to some that others will lend to, again based on superior credit knowledge. The originate, rate and relocate model works against this. Modern lending and investing by banks or shadow banks is done using common, public data, and public ratings.³⁴ If banks and investors are not incentivized to be deeply knowledgeable about the credits that one of them quickly resells to the other, they will not invest in doing so. Under the business model that regulators pushed on the industry in the name of transparency and standardization, the profit opportunities for the insiders versus the investors are where the common rating system initially overvalues a credit. No surprise then that when the credit derivative instruments packaged and sold by banks to investors began to fail investors were shocked about the underlying risks of these instruments, triggering even greater risk aversion and a big stampede for the exit.

Greater diversity in how institutions lend would strengthen resilience. More diversity in how others invest in loans repackaged as securities would also strengthen resilience. But this diversity is being narrowed, ironically, in the name of effective regulation. During the GFC, there was much moaning about too many gaps in regulation across countries, institutions and instruments. Many believed it was these gaps that undermined regulation.³⁵ If only we could close these loopholes, they said, regulation would work. They see the crisis as resulting from unfettered finance. We need more regulation they argued and we must have a common regulatory system across all countries, states, institutions and instruments. I recognise the good intentions of those who hold this view, and there is no shortage of instances of inadequate regulation. However, I am cautious about some of the proposed solutions. We have to acknowledge that most of the behaviour during the GFC was incentivized to occur because of the existing regulation. It is misguided to argue about whether more or less regulation is required before we have better regulation. It is proven that commonality in finance holds systemic dangers. We need high standards but not ones that generate common behaviour. Diversity is not the enemy of the financial system. It is the savior. This includes diversity of institutions and instruments. In the next chapter we shall examine instruments. For the rest of this section, we will examine how to preserve the diversity of institutions.

The crisis has been the occasion for renewed calls to implement greater regulation of nonbank institutions that appear to be conducting banking business like hedge funds and money market funds. Europe has been particularly vocal regarding hedge funds. In the United States there is more concern about money market funds, high-frequency traders and even asset managers. In the case of hedge funds, the motivation behind regulation is a reflection of an unhelpful conflation of issues.

Big commercial banks, especially those that do not lend to, or trade with, hedge funds, caution that if they are subject to unduly onerous regulation, banking will simply flow to the nonbanks. This would create new and unforeseen risks. The issues here are regulatory but they also involve competition. Since hedge funds are private, focused on outperforming other investors, they are secretive and usually closed or by invitation only. This secrecy can harbor deceptions, unethical and even illegal behavior. In a case that typifies these concerns, the US Securities and Exchange Commission, on July 19th, 2013, charged leading hedge fund manager, Steven Cohen, with rewarding employees with a $9 million bonus for trades that should instead have raised internal suspicions of insider trading. It has been suggested that Mr. Cohen was able to reward the behavior and reap the profits for his firm because of the hedge fund’s lack of transparency. Further, in the GFC, the authorities felt that hedge funds were establishing “short positions” and spreading negative rumors about certain financial stocks. It was assumed they were doing this in order to drive these stocks down to the point where the covenants with their lenders would force an issue of further equity, which would in turn validate the lower share prices and generate profits from the shorts.³⁶

This perspective on hedge funds ought to be softened a little by the observation that not all should be tarred with the same brush. Secrecy can also harbor baseless rumors. We often assume the worst when we are ignorant of the truth—which is why more transparency is generally good. Governments have a long history of disproportionately blaming foreign speculators for local difficulties. And lest we forget, there is no shortage of poor behavior from public, collective, investment funds such as mutual funds and unit trusts.³⁷ Moreover, it is illegal to undermine market integrity with false rumors. Mandatory reporting of trades and disclosure of beneficial owners makes getting away with illegal behavior harder today than ever before.

We implore and assume that regulators effectively enforce existing laws on disclosures, insider trading, market abuse and all else and we ask if, with that condition, nonbanks should be regulated in the same manner as banks. An unleveraged hedge fund that invests the equity of its shareholders has limited spillover effects. It is like a nondeposit-taking bank with a 100 percent equity-to-loan ratio. As a result it is not a systemically dangerous activity. If the shareholders of such funds are restricted to the wealthy who can afford to lose their shirt on an investment without jeopardizing their livelihood, then hedge funds could play an important stabilizing role in markets. Financial market liquidity needs losers. We need people prepared to buy when everyone else is selling, taking a short-term loss in the belief that the market will soon turn and they will profit handsomely from going against the tide. Who should the potential losers be? Should it be Aunt Agatha’s pension fund, George Soros, Steven Cohen, or Lewis Bacon?³⁸ Private equity funds potentially provide a similar stabilizing role, purchasing companies undervalued by the public markets, perhaps as a result of their preferences, constraints, and restrictions, and selling overvalued ones.

The systemic risk of nonbanks like hedge funds, private equity, and money market funds should be addressed by limiting leverage. It must also be made clear to those putting money in these nonbank institutions that they are investors not creditors. They must be able and prepared to lose all and be aware that these institutions do not carry deposit insurance. We should regulate who can buy into a hedge fund to ensure this is the case. These non-bank institutions get their leverage from banks, and this supply can be limited through regulations on bank lending. While we must ensure that laws are followed by all, that consequences for not doing so are prohibitive, and that reporting is full and prompt, we must be very careful to ensure that regulation does not, in the name of levelling playing fields, restrict a diversity of views, trading strategies, and risk appetite. If we want a resilient financial system we need diversity.

A Different Approach to Value Accounting

The diversity that matters is not what institutions are called, not what sectors they may appear to be in, and not the different investment styles and objectives they may claim to follow. We need behavioural diversity. To have genuinely diverse behavior, in a world that generally shares the same information, we need a value accounting system that is better at linking the value of an asset to various holders and to their divergent risks of holding that asset. Below, I will describe a system of value accounting that dovetails with the system of capital adequacy regulation we described in Chapters 5 and 6.

If you are desperate for cash and must sell your house tomorrow, the price you will achieve will be different from the price you would get if you could wait to find the buyer who particularly wants your house. What if the house is not on the market but an assessment of your current assets and liabilities is required in order to decide how to better balance them? Which price should be used for valuation? This conundrum acknowledges that at any one time the same asset can have different but equally legitimate values. Critically, the determining feature of the most appropriate price depends as much on how the asset is funded as the asset itself. An equity portfolio purchased with short-term funds is quite a different beast from one purchased with long-term funds.

Accountants, regulators and politicians find the idea that the same asset can be priced differently by different people, disorienting and self-evidently wrong. Regulators have been known to complain when they see banks valuing the same assets and risks dissimilarly. But it is the regulators who are mistaken. Diversions in valuation of the same asset may be the result of the ­contrasting ways in which the asset is funded. Accountants and regulators commit a fundamental error believing that there is something called risk that looks the same no matter who is holding it. The riskiness of an instrument depends on who is holding it and why, how it was funded and their response to changes in its short-term price. Perhaps in 1954, when Harry Markovitz³⁹ was pioneering the mapping of volatility for different assets, when the savings markets were slim and instruments were infrequently traded, risk was inherent in the type of assets held. Today, deep markets for savers, real-time prices, high-frequency trading, common data, cheap computing power and self-feeding cycles make risk much more about behavior than ever before. The current application of finance and accounting theory has not kept pace with this change.

Valuing things has troubled economists since the discipline began. Economics has always recognized that the value-in-use of a good to one individual may not be the same for another person. Trading only happens when people value the same good differently from each other thus creating the opportunity for a mutually beneficial swap. For convenience, value was linked to price through the mechanism of exchange. For an accountant or a regulator, it is obviously easier to have a single price for an asset. In truth many goods are infrequently traded, if at all,⁴⁰ and many people will value the same product differently.

Mark-to-market is the price that an asset would achieve were it sold tomorrow. It is the price on exchange. But for the corporate pension-fund investing for the next 20 years, the price to be considered is related to the current value of an asset that, with some risk and uncertainty, will deliver a particular value in 20 years time. The influences on that long-run price today are often quite unlike those acting on today’s price. For instance, today’s market price will be strongly related to the general demand for cash and the ability to quickly realize the asset for cash. At times of financial stress, illiquid assets will see their price fall far. What we term the long-run price would ignore these issues. Price would instead reflect an assessment of the risks and uncertainties attached to the value of the asset in 20 years time when today’s volatility or the intervening series of booms and crashes are long forgotten.

If a corporate pension fund requires market prices to be used to assess its solvency, and it follows a regulatory regime demanding a higher level of cash should solvency based on market prices dip below a certain level, the fund’s investments would tend to be confined to assets that exhibited low, short-run price volatility. This would effectively force long-term investors to behave as if they are short-term market participants lacking the resources to endure volatile, temporary shifts in liquidity and market price. Consequently, they are unable to earn the liquidity premium available to long-term investors who can lock up cash in illiquid and volatile investments. This is a huge loss for pensioners who are ironically the very group regulators claim to be protecting. Existing and upcoming regulatory pressures to use mark-to-market pricing of assets and risks is forcing long-term institutions to earn a credit risk premium by taking credit risks they have limited capacity to hedge. Alternatively, they demand higher customer contributions than would be unnecessary were they earning the liquidity premium by safely taking on the risks they have capacity to hedge over the long term.

Furthermore, as already noted, when the financial system experiences a shock and the banks, with their short-term funding, are forced to sell assets, the system is safer if long-term investors are able to view these assets in terms of their long-term cash flows and not solely based on their short-term market conditions. Forcing long-term investors to behave like banks will oblige them to sell assets at the same time as the banks, resulting in systemic fragility. Systemic resilience requires the presence of investors who can value an asset differently, so that when one is selling, the other is buying. The different requirements of short and long-term funding provide a genuine capacity to price an asset differently.

How could we achieve that? There are broadly two methods to estimating the current price of an asset, beyond simply using the historic cost. First, there is the discounted cash flow approach closely related to the traditional value-in-use notion. By estimating the future cash flows of an investment, and taking into account future risks and uncertainty by discounting these cash flows (typically by using the weighted-average cost of capital), it is possible to establish a net present value of an asset. Any investment funded by long-term liabilities⁴¹ could be measured using this approach. The valuation of future cash flows could be carried out by a third party so that the absence of a traded price does not mean the pricing is biased. How long the funding or liabilities need to be to justify this approach is not clear. What is essential is that it is long enough to be able to weather temporary dips in liquidity and market prices. Most financial crises are sharp but short, over within 6 to 24 months. The effects of the GFC have lingered far longer. A conservative approach would be to limit this valuation of assets to those that are funded or backed by liabilities with a maturity greater than 36 months.

The alternative approach is the market price approach, that is, using the asset price if it were sold tomorrow. Any asset funded by liabilities maturing in less than 6 months should be priced this way. A weighted average of the two approaches could be used for assets with funding between 6 and 36 months. It would be cumbersome and inflexible to match each asset with its own funding. However, pools of assets can be matched to either pools of short-term funding or pools of long-term funding with a maturities greater than 36 months. Assets can be switched between pools. All that matters is that the assets you will have to sell if your short-term funding is not rolled over are valued on the basis that they may be sold tomorrow. Those assets that you do not need to sell overnight because they are matched with long-term funding, must be priced on the basis of their long-term cash flows. I call this approach, which I first introduced back in 2008, “mark-to-funding.”⁴²

Mark-to-funding is not an easy choice. In the GFC, banks that could not have survived another day without public injections of liquidity were allowed to claim that they were holding assets to maturity. This facilitated pricing of these assets based on historic costs, which, in many cases, was far higher than the current market price. The positive effect of this on the reporting of bank balance sheets was offset by the negative effect of investor uncertainty over when the assets would or could be sold and at what price. Under mark-to-funding, the banks would have to price these assets in relation to the maturity of their funding which in most cases is short-term. Mark-to-funding helps because it moderates a crisis through natural rather than artificial means. On a mark-to-funding basis, long-term savers would find that the assets being sold by the banks had become cheap and buying them cheaply would boost their solvency. This would arrest the vicious cycle of asset price decline triggering fresh selling. Mark-to-funding would incentivize and reward banks that have more long-term funding. During a crisis, it would allow banks to match those assets that had fallen the most and where the risks had risen mainly because of short-term factors with pools of long-term funding. This would limit the sale of the most troubled assets in an already-weakened market that would only aggravate collective losses. Banks would then need to raise less cash and would be able to do so by selling their most liquid and highly priced assets.

Accounting Treatment of Long-Term Savings Institutions

We have rehearsed the underlying point that institutions with different liabilities should value assets differently a few times in this and previous chapters. This is a radical idea and since many readers think more about bank regulation than insurance regulation, it is worth drilling down specifically to how this would work for long-term savings institutions. There is an understandable instinct to shield individual savers, particularly the elderly, dependent on pensions or insurance policies. At the same time, pension funds and insurance companies can only generate returns for their members by taking some risk. The regulatory approach should not be about stopping pension funds and insurance firms from taking risks, but about how to ensure they take appropriate risks. Too often, appropriate risk is wrongly equated as low or moderate risk. In Chapter 6 we showed how appropriate risk-taking is supervisory code for taking less of the kind of risks that are most appropriate for long-term investors to take. In our approach it means taking those risks that are best absorbed.

It is my contention that the valuation rules embedded in regulation, and not just the capital adequacy requirements but also the accounting standards are pushing pension and life insurance funds and sometimes sovereign wealth funds to take the wrong kind of investment risk. It is exposing these funds and their customers to inappropriate danger. In thinking about what the right kind of investment risk is for pension and insurance funds to take, we must review the nature of risk. Recall that there is not one kind of financial risk but several, and that “riskiness” has less to do with instruments and more to do with behavior. Risk is a chameleon. A “risky” instrument held by a bank may be a “safe” instrument if held by a pension fund. In Chapters 5 and 6, we discussed in depth the three types of risk that financial institutions are most exposed to: market risk, credit risk, and liquidity risk. The way to diversify market and liquidity risk is through time. The more time available, because the funding or liabilities are long term, the more the institution can ride out passing periods of illiquidity or price volatility. But having more time does not allow you to hedge credit risks, because the risk of a credit defaulting rises the more time there is for the default to take place. A young pension fund or life insurance company has the ability to earn the market and liquidity premium but not the credit risk premia. It should therefore invest in high-quality credits that offer higher yields because they have low liquidity and experience short-term market volatility.

What pension and life insurers should avoid is investing in highly liquid instruments and low-volatility instruments with large credit premia. In doing so, they are paying—through foregone returns—for a liquidity and short-term stability they do not require. They are also earning a premium for a risk they have little natural ability to hedge because of their long-term liabilities. Yet this is precisely the path they are being driven down by mark-to-market, valuation, risk, and other market-price-driven regulatory standards. A pension fund is required to match the duration and value of its assets to its liabilities, value its assets as if they will be sold tomorrow and earn a high yield. It can only do so by raising premiums or buying liquid instruments with poor credit. This is one of the reasons for the relatively strong demand for ultra-long-dated corporate and emerging-market sovereign debt. The loser in this unnatural asset allocation is the pensioner or the insured, not the consultants, actuaries, and managers.

Banks were also pushed toward the wrong kind of risks. A bank has short-term funding. It follows that it has little capacity for liquidity and market risks. However, it has ample capacity for credit risks as an expert in credit origination and, through origination activity, is able to actively source and hedge across a variety of credit risks. Yet, what did banks do prior to 2008? They sold their credit risk to pension funds and funded private equity and hedge funds that were effectively taking liquidity and market risk. Both of these examples of inappropriate risk taking—pension funds and life insurers eschewing illiquid instruments and banks pursuing these instruments—created a net reduction in systemic liquidity.

Mark-to-funding will help to change that. It allows long-term institutions to maintain customers’ contribution levels while reducing their actual risk by opting out of of those risks they are less able to value and absorb. This means not touching long-dated corporate credit risk and switching to, for example, diversified, quoted, and private equity portfolios. It prevents banks hiding shrunken assets behind the notion of holding to maturity and rewards them for embracing longer-term funding.

A measure of the misunderstanding of risk in the current regulation of long-term savings institutions is the heaping together of both life insurance and general or casualty insurance in insurance regulation and accounting. The risk-absorptive capacities of these two types of insurance are markedly different. A life insurer, that actuaries estimate will need a payout in the distant future, has a capacity to absorb liquidity and market risks. It cannot take credit risks that rise the more time there is for a credit default to take place. From both an economic and investment sense life insurance companies should keep a significant part of their investment portfolio in public and private equities and in illiquid but asset-backed, or partial government-guaranteed, securities.⁴³ Unfortunately, these are often the very type of securities that are discouraged through capital charges or unapproved for the purposes of “regulatory capital”.

A casualty insurer needs near-immediate access to liquidity. It has limited absorptive capacity for liquidity and market risks. Liquid instruments should dominate its investment portfolio, with diversification across short-maturity credits to boost their returns. Even minority exposures to illiquid or volatile assets, often a key part of the insurer′s strategies for earning above-average returns, should be avoided. The current one-size-fits-all approach of insurers, using price volatility as the principal measure of risk on the asset side does not take into account the maturity of liabilities and makes no economic or investment sense. If we think an insurer or pension fund’s risk as the likelihood of a short fall in the investment portfolio when it is needed, then the current regime makes insurance and pension funds riskier than they should be.

Conclusion

This chapter has emphasized the value of diversity and argued that the pursuit of liquidity and systemic resilience is furthered if institutions with different liabilities or funding are allowed to behave differently and in accordance with their individual risk-absorbing capacity. Chapters 5 and 6 showed that natural diversity in liabilities exists and must be allowed to lead to diversity in behavior. To artificially suppress this diversity at the altar of common accounting standards, risk management approaches, or equal treatment of institutions, will undermine systemic liquidity and financial resilience. An institution’s capacity to absorb risks is not its appetite or mood for risk, which is how risk is haphazardly allocated today. It is something embedded in the very structure of its liabilities.

Several market participants publicly claim to be looking for long-term value. Yet their value accounting, risk management and investment processes mean they act short-term. Under stress, these supervisor-approved systems cause diverse market players to act in the same way, killing liquidity and amplifying the crisis. This is entirely artificial. It makes little investment and economic sense. Risk management and value accounting systems, such as mark-to-funding, that take into account the fact that the risk of an instrument is linked to the liabilities of its holder, will allow the natural heterogeneity of the financial system to be present in a crisis, moderating its sharpness and speeding up its end.

___________________

¹This chapter is the development of my article, “Regulation, Valuation And Systemic Liquidity,” Banque de France, Financial Stability Review, no. 12, October 2008.

²The stated intent of IAS 39, or the International Accounting Standard 39, is to harmonize accounting standards internationally. These standards are set by the International Accounting Standards Board, which is an independent body of the IFRS Foundation that is monitored by, and accountable to, the European Commission, the Japanese Financial Services Agency, the US Securities and Exchange Commission, the Emerging Markets Committee of IOSCO, and the Technical Committee of IOSCO—the International Organization of Securities Commissions. IOSCO is comprised of 120 securities regulators and 80 securities market participants. These accounting and reporting standards are the standard used in the EU and many other countries except the United States, which uses its own set of rules known as GAAP, or Generally Accepted Accounting Principles.

³I recall a discussion about a survey of buyers of credit derivative instruments that happened just before a meeting of CESR, the Committee of European Securities Regulators, at which I gave a presentation. If memory serves, the meeting took place in Paris sometime in 2008. Almost every respondent reported that credit derivative instruments were now extremely cheap but they would not be buying any. Through their risk management systems formidably high capital requirements were imposed for holding instruments with high volatility whether they were near rock bottom or not.

⁴See in particular Chapters 3, 5 and 6.

⁵One with a similar risk of credit default or that is similarly exposed to the volatility of some market price. An example is the shares of two oil companies with similar exposures but where one has a larger free float of shares.

⁶Under Basel II, banks that could boast sophisticated price-sensitive risk models like Value-at-Risk (VaR) and Daily Eearnings At Risk (DEAR) could adopt the internal risk model approach to calculating capital adequacy, often resulting in lower capital adequacy requirements.

⁷I suspect I was called a heretic more often than some who now try to argue they called it right, but in godless Britain being called a heretic is often a compliment. I recall in 2005 one official from the UK’s FSA, who has gone on to very senior regulatory positions, responded to my suggestion that risk transfers should not be left entirely to the market but incentivised to go where they are best absorbed, by calling me a “Stalinist”. Now that hurt.

⁸This sometimes happened within the same institution. Early on in the crisis, Charles Goodhart observed that many of the banks that needed to be rescued or failed in the GFC were those that appeared to follow the “originate and relocate” model, where loans were issued and then packaged into groups of loans that were then securitized and sold off, but they did not relocate the risks far enough. Holding the opinion that these instruments were of good value, they clung on to too much of the risk in off-balance-sheet special-purpose vehicles to which they also foolishly extended a liquidity backstop. For a detailed study of this behavior, see Viral V. Acharya, Philipp Schnabl, and Gustav Suarez, “Securitization Without Risk Transfer,” Journal of Financial Economics 107, no. 3 (2013), pp. 515–36.

⁹Many inquisitors focus on the role of the suspicious business model of credit rating agencies—where they are paid by those they rate—as a reason why the originate-redistribute model failed. They ignore the fact that the agencies only adopted this model after investors stopped paying for ratings. Why pay for a good whose value increased the more common it became? They also overlooked the fact that this flawed business model worked reasonably well for single-issue ratings. Where the ratings failed spectacularly was in structured products and this is where the agencies were acting more as statisticians, not their strength, than as credit analysts. They used statistical models, which assumed sample independence. This assumption was undermined by regulatory encouragement of the disclosure of rating methodologies. Using this disclosure, banks built security packages to the likely rating, destroying sample independence. The rating agencies profited and actively participated in this process, though never as much as the banks. I recall sitting on a panel in 2000 with Barbara Ridpath, then a member of Standard & Poor’s rating agency and hearing her presciently state that making credit ratings part of bank regulation was going to be bad for everyone including the rating agencies.

¹⁰The Group of Ten (G-10) is actually 11 countries today, having originally been made up of the eight countries (Belgium, Canada, France, Italy, Japan, the Netherlands, the United Kingdom, and the United States) that agreed in 1962 to participate in the General Arrangements to Borrow from one another and from the central banks of two others, Germany and Sweden. In 1964, the group was joined by Switzerland. Before the G-20 Group of Finance Ministers and Central Banks was established post-Asian Financial Crisis of 1997–98, the G-10 was the financial complement to the G-7 political powers. It is a sign of the changed international political economy that the Bretton Woods system of pegged exchange rates, negotiated and signed by 44 countries in 1944 under the auspices of the UN, was dismantled by the Smithsonian Agreement signed in December 1971 by this unofficial grouping of 11 countries. For more history of the Basel Committee, see Charles Goodhart’s definitive work, The Basel Committee on Banking Supervision: A History of the Early Years, 1974–1997 (Cambridge, UK: Cambridge University Press, October 2011). For a reflection of the different international political economy of Bretton Woods, see Eric Helleiner’s fascinating Forgotten Foundations of Bretton Woods: International Development and the Making of Postwar Order (Ithaca, NY: Cornell University Press, 2014).

¹¹On June 26, 1974, German regulators closed the troubled Bank Herstatt. However, they did so before Herstatt’s New York branch delivered dollars in return for deutschmarks that Herstatt’s Frankfurt branch had received before the closure. This caused a dollar shortage in New York for several days. In an attempt to avoid what became known as the Herstatt risk, the G-10’s Basel Committee was established to improve regulatory cooperation. Amongst other things it supported the development of the real-time gross settlement system for banks, and some 32 years later, the continuous linked settlement platform for foreign exchange transactions.

¹²The savings-and-loan crisis was the failure of 747 savings-and-loan associations (S&Ls) in the United States in the late 1980s and early 1990s. The ultimate cost of the crisis, as estimated by a financial audit of the Resolution Trust Corporation set up to rescue the S&Ls, was approximately $160.1 billion.

¹³The Continental Illinois National Bank and Trust Company was at one time the seventh-largest bank in the United States as measured by deposits. In May 1984, the bank became insolvent, due partly to bad loans purchased from the failed Penn Square Bank N.A. of Oklahoma—loans for the Oklahoma and Texas oil boom of the late 1970s and early 1980s. It was then the largest-ever bank failure in US history, and it is said that the phrase “too big to fail” became popularized by Congressman Stewart McKinney in a 1984 congressional hearing on the FDIC’s intervention with Continental Illinois.

¹⁴One of the problems of Basel I was that it did not take a nuanced view of risk but allocated risk between crudely defined buckets. Over time it was felt that banks were “gaming” these distinctions to take more risk than first appeared.

¹⁵One of the most notorious cases was Charles Keating’s Lincoln Savings-and-loan Association, whose failure in April 1989 cost the US Government $3.4 billion. Large, concentrated, speculative real estate investments contributed to the fast growth and subsequent failure of the institution. In 1986, the Federal Home Loan Bank Board (FHLBB) found that his S&L had $135 million in unreported losses and had surpassed the regulated direct investments limit by $600 million. Mr. Keating tried to thwart the FHLBB in several ways. He commissioned the then private economist, Alan Greenspan, to write a study which concluded that direct investments were benign. He tried to hire FHLBB members or their wives. He finagled the appointment by President Reagan of his friend and debtor, Lee H. Henkel Jr., to the FHLBB. He recruited help from a group of US senators who later became known as the Keating Five: Alan Cranston, Dennis DeConcini, John Glenn, Donald Riegle, and the only Republican of the group, Senator John McCain. It is alleged that Mr. Keating made political contributions of about $1.3 million to this group and that Senator McCain and his family were treated to several trips using the firm’s private jet and to Mr. Keating’s private retreat in the Bahamas.

¹⁶Peter Young, an Oxford math graduate, joined Morgan Grenfell in 1992 and rose rapidly through the ranks. Two years later, he took over the European Growth Trust Funds. The funds reported strong performance from investments in a number of small-technology stocks, attracting more inflows. Mr. Young rapidly acquired rock-star status, which he greatly enjoyed. When one of the companies he had invested in came under investigation by the American SEC, internal suspicions were raised. Investigations revealed that Mr. Young had orchestrated a complex system of mirrored investments to conceal his large investments in obscure high-tech businesses, including his personal company, many of which had gone sour. He was able to falsify the fund’s performance because the stocks were unquoted so valuations were not based on a market price. The fraud case took a further turn to the sensational when Mr. Young turned up at his trial at the City of London Magistrates’ Court wearing a scarlet blouse and matching tight skirt and insisted on being addressed as “Beth.” He later attempted to castrate himself and in 2002 was deemed unfit to stand trial. Deutsche Bank reportedly lost about £400 million as a result of the affair and subsequently dropped the Morgan Grenfell name that it had bought as part of a $1.48 billion acquisition in 1989.

¹⁷Of course banks and bankers played an important role in lobbying for the underlying approach embedded in Basle II. The irony of regulatory capture by bankers, helping to create a regulatory system that ultimately failed the banks and their shareholders was not lost on the Financial Times headline writer for my op-ed, “Banks Put Themselves At Risk In Basle,” Financial Times, October 16, 2002, reprinted at the end of this book.

¹⁸Though it would not be theoretically impossible in a certain world with complete markets.

¹⁹One general warning was contained in “An Academic Response to Basel II,” written by a raft of eminent thinkers in financial economics: Jon Danielsson, Paul Embrechts, Charles Goodhart, Con Keating, Felix Meunnich, Oliver Renault, and Hyun Song Shin. See Special Paper Series 130 (London: LSE Financial Markets Group, May 2001). There were others. A couple years prior to the paper above, I included a specific warning of the Faustian bargain between everyday trading liquidity at the expense of systemic liquidity in my paper “Sending the Herd off the Cliff Edge: How Modern Risk Management Systems and Investor Herds Create Risk,” (Jacques de Larosiere Awards in Global Finance, IIF, Washington, 2000).

²⁰See Wilem H. Buiter, “Central Banks as Market Makers of Last Resort 2,” Financial Times: Willem Buiter’s Maverecon, August 17, 2007, http://blogs.ft.com/maverecon/2007/08/central-banks-ahtml/#axzz3bC7yFKnV.

²¹See Chapter 4.

²²See Charles Goodhart, Basel Committee on Banking Supervision, 2011.

²³For a good survey of the issues, see Shelagh Heffernan’s Modern Banking in Theory and Practice (Chichester, UK: Wiley, 2004).

²⁴There was a period after the Asian Financial Crisis in which financial policy makers thought that their main job was to self-evidently encode and enforce standards. For a while, the IMF thought it had found a new role as a vanguard of international codes and standards. See Benu Schneider, ed., The Road to International Financial Stability: Are Key Financial Standards the Answer? (Basingstoke, UK: Palgrave Macmillan, 2003).

²⁵See Avinash Persaud, ed., Liquidity Black Holes: Understanding, Quantifying and Managing Financial Liquidity Risk (London: Risk, 2003). See also Avinash Persaud, “Liquidity Black Holes” (Working Paper, State Street Bank, 2001).

²⁶This is sometimes reflected in lower transaction costs, but the presence of a large number of high frequency traders looking to catch a trend can increase the market-impact of trading which is often the largest component of transactions costs, often equal to bid-ask spreads, broking commissions, settlement and clearing fees and transaction taxes put together.

²⁷I first drew this distinction in my explanation of different types of liquidity in a paper I cowrote with Marco Lagana, Martin Perina, and Isabel von Koppen-Mertes: “Implications for Liquidity from Innovation and Transparency” (Occasional Paper Series 50, Frankfurt am Main, Germany, European Central Bank, August 2006). This notion has been taken up by a number of others. See Anastasia Nesvetailova, Financial Alchemy in Crisis: The Great Liquidity Illusion (London: Pluto Press, 2010) and Jakob Vestergaard, “Crisis? What Crisis? Anatomy of the Regulatory Failure in Finance,” (DIIS Working Papers 2008/25, Copenhagen: Danish Institute for International Studies, 2008).

²⁸Traders, whose status prior to the GFC was as “masters of the universe” and whose words were taken more seriously than they are today, also vigorously expounded the view that anything that caused “fragmentation” of markets was self-evidently evil.

²⁹This was one of the messages of my paper “Sending the Herd off the Cliff Edge: How Modern Risk Management Systems and Investor Herds Create Risk,” (Jacques de Larosiere Awards in Global Finance, IIF, Washington, 2000) reprinted at the end of this volume.

³⁰This is one of the essential, and perhaps innovative, ideas in “Sending the Herd off the Cliff Edge,” (2000) and “Liquidity Black Holes,” (2001). Examples outside of finance include: (1) Lenore Newman and Ann Dale, “Network Structure, Diversity, and Proactive Resilience Building: A Response to Tompkins and Adger,” Ecology and Society 10, no. 1 (2005), www.ecologyandsociety.org/vol10/iss1/resp2/; and (2) Abhijit V. Banerjee, “A Simple Model of Herd Behaviour,” Quarterly Journal of Economics CVII, no. 3 (August 1992), pp. 797–817.

³¹To illustrate this point “…Imagine a long-term investor called Felicity Foresight. Every year Felicity knows which are the ten best currency trades for the year and she puts them on at the beginning of the year and uses a state-of-the-art, daily mark-to-market, value-at-risk, risk-management system. Over the past ten years she would have lost money in almost every year, stopped-out by her risk-system when the trades had gone against her. Whatever you think your investment style is, it really is largely determined by your risk-management system. Investors proudly proclaim a raft of different styles, models, approaches, but the vast majority adopt the same risk management approach and so they behave like everybody else, leading to little diversity and many black holes.” in Avinash Persaud, Liquidity Black Holes, UNU/WIDER, Discussion Paper No. 2002/31, March 2002, Heleinski, pp. 10.

³²On May 6, 2010, at 2:30 p.m., the S&P 500 Index fell almost 600 points before recovering a few hours later. 21,000 trades were eventually cancelled because it was felt this movement was not legitimate and a new rule imposed that stopped trading whenever a stock fell by more than 10% in any five minute window. In Liquidity Black Holes: What They Are and How They Are Generated, published in the Singapore Foreign Exchange Market Committee’s Biennial Report, 2001–2002, Singapore, I develop a statistical test for liquidity black holes that reveal how much the equity markets have become more prone to this behavior over time.

³³For an early critique of how risks were being spread and yet concentrated, see Avinash Persaud, “Credit Derivatives, Insurance Companies and Liquidity Black Holes,” Geneva Papers on Risk and Insurance 29, no. 2, April 2004, pp. 300–12.

³⁴Given the oligopolistic industry of credit ratings, there is also little diversity in individual ratings or the general direction of ratings.

³⁵For an excellent balanced articulation of this view, see Richard B. Freeman, “Reforming the United States’ Economic Model After the Failure of Unfettered Financial Capitalism,” Chicago-Kent College Law Review, 85, no. 685 (2010).

³⁶On September 18, 2008, acting in concert with the UK’s FSA, the US SEC responded to these concerns by prohibiting short selling the stock of financial companies.

³⁷See Footnote 11 in this chapter. For further stories of the misselling of pension plans, deceitful hyping of stock recommendations by conflicted analysts, and market timing abuses by public fund providers, see Avinash Persaud and John Plender, Ethics and Finance (London: Longtail, 2007).

³⁸Lewis Bacon is the legendary owner of Moore Capital, one of the largest hedge funds.

³⁹At the RAND Corporation in California, Harry Markovitz and his associate George Dantzig were the developers of what became known as the “efficient,” or the Markovitz frontier between risk and return, where risk was defined as price volatility. Markovitz had the algorithm and Dantzig had the computing power. Markovitz won the 1990 Nobel Prize in Economics for his contributions to finance and portfolio theory. The frontier was presented as static, and generations of finance practitioners have been taught to think of it as if it were so. In “Sending the Herd off the Cliff Edge” (2000), I argued that in the age of costless information, computing power, real-time prices and trading, and public pressure on investors for relative outperformance, the observation of the risk-return frontier in the past, changes investment behavior today. This in turn changes the risk-return frontier tomorrow and makes the past risk return frontier possible to observe but not to achieve.

⁴⁰What is the value of the White House, St. Peters in the Vatican, the Taj Mahal, or the Imperial Palace? We know the value today of a square meter of surrounding land, but the circumstances of a sale are probably not reflected in the current market price of surrounding land.

⁴¹An example of an asset funded by long-term liabilities is the purchase of a house (the asset) with a mortgage (the liability) that does not need to be repaid for 30 years. The maturity of this funding/liability is 30 years.

⁴²See: (1) “New Twist on ‘Mark-to-market’ Stirs Debate,” Financial Times, November 30, 2008, www.ft.com/intl/cms/s/0/d03c782a-bd86-11dd-bba1-0000779fd18c.html#axzz3FYuoy63Y; (2) Markus Brunnermeier, Andrew Crocket, Charles Goodhart, Avinash D. Persaud and Hyun Shin, “The Fundamental Principles of Financial Regulation,” Geneva Reports on the World Economy 11 (Geneva, Switzerland: ICMB International Center for Monetary and Banking Studies, 2009), pp. 1–66.

^{43See Chapter} 6^.