Financial regulation has lost its compass and been led astray. The perspective of this book is neither that of the neoliberal who is instinctively against meddling regulators nor that of the unreconstructed Stalinist who is suspicious of private enterprise. If we are to finance better health and education for all of our citizens, we need economic growth. Growth requires risk takers. Too little risktaking starves the economy, feeding economic, social, and political malaise. Excessive risktaking allows a few players to flash brightly before plunging us all into darkness. To achieve a Goldilocks¹ amount of risktaking—not too hot, not too cold, not too large, not too little—requires a fresh take on financial regulation. This is not to be confused with the decision to have more or less regulation—the binary choice presented by competing political ideologies. What we need is a substantial reinvention.

Chapter 2 sets the stage, showing why we regulate the financial sector considerably more than we do other industries. This stems from the singular consumer protection problems that finance poses as well as the fact that banking is highly systemic. If a green grocer consistently sells bad apples, you can shop elsewhere with minor repercussions. By contrast, most people will only buy a few financial products in their lifetime—a mortgage, a life insurance policy, a pension, and perhaps a car loan. Unfortunately they rarely find out if these are bad products until it is too late to rectify the problem. More importantly, the consequences of having swallowed the wrong product could be life changing. Perhaps it was an unlucky decision. But they might also have been persuaded to purchase something wholly inappropriate by a commission-grabbing salesperson. Much work is required to protect all consumers from conflicts of interest and the other causes of the mis-selling of financial products. Further measures are needed for protecting particularly vulnerable consumers. My thoughts on this are set out in Chapter 7.

By and large, the problem of consumer protection is understood. Systemic risk, on the other hand, is much cited but little understood. It is fast becoming a phrase that means so many things that it no longer means anything in particular. In fairness, while consumer protection and systemic risk are distinct challenges with separate foundations and remedies, they are not always easy to differentiate, especially when in the throes of a financial crisis. Taxpayer bailouts of the financial sector during the highly systemic, Global Financial Crisis (GFC)² of 2008–09 caused dramatic increases in public debt for those countries engulfed by the financial crunch. Amid slumping growth and rising unemployment, the crisis countries responded with varying degrees of public-sector belt tightening as well as central-bank largesse. This is not new. Past financial disasters have been similarly punishing for ordinary members of the public. The losers can be loosely classified as those most dependent on public-sector safety nets or with their savings in bank deposits and this time around the victors have been those with homes and other assets that rose in value as interest rates sank to zero.

Financial crashes and their responses are as political as they are technical—a subject I address in Chapter 3. Disgusted by the immorality of the situation, many justifiably angry people gravitate toward the bad apple theory of financial crises. They propose cleansing the system by locking up evil bankers and reclaiming their bonuses. No one doubts there is room to enforce existing laws more rigorously. But legal solutions offer little redemption. Crashes follow booms. Blame is widely shared and several of today’s villains were yesterday’s heroes. Courts are ill-equipped to sort that out in any coherent way.

Dissatisfied in neither seeing a lot of bankers led off in chains nor much change in bank behavior, voters and populist politicians began chanting “Never again!” and “Let the banks fail!” When the point is made that letting individual banks fail can have systemic repercussions, the common response is that bank rescues must be self-funded and specifically targeted to ordinary banking and there should be no opportunity for regulatory arbitrage between nations. Bailouts, it is shouted, must never again be taxpayer funded. Yet it is unclear that this is possible or desirable and in Chapter 4, I explain that the financial system is actually incapable of insuring itself against a systemic disaster.

All is not lost. Regulation can be reinvented to be less prone to the extremes of the boom-bust cycle and the iniquities this pattern brings. However, even reinvented regulation of the financial sector cannot be done through a single instrument.

We look at the issues of banning certain financial products in Chapter 9; restricting bankers’ pay in Chapter 10; the efficacy of pressing criminal law to change behavior in Chapter 11; using tax policy in Chapter 12; rearranging regulatory institutions in Chapter 13; and the role of international regulation in Chapter 14. The greatest inadequacy of financial regulation remains its inability to deal with systemic risk. That is where this book offers the greatest reimagination of financial regulation. I build the case in Chapters 3 and 4 and offer my proposals for dealing with it in Chapters 5 and 6.

The systemic character of banking flows from the nature of the credit economy. When a house owner borrows money from one bank to pay his builder for refurbishment, the builder may deposit the cash in another bank. That second bank could then use the builder’s deposit to lend to someone else, who in turn uses that loan to pay another, who makes a cash deposit in a third bank. One bank’s borrower is thus another’s depositor, and that depositor serves to fund yet another bank’s borrower, and so on. The failure of one bank, causing the receiver to pull its loans, will bring down several others. This is the nub of the systemic risk problem. Connectivity in the banking system runs deep. No other industry is like this. It is also why regulators should be more wary than they have been in demanding systemic regulation of other sectors and activities in finance that are not as fundamentally systemic as deposit-taking lenders.

Shareholders of a bank usually worry only about the loss of their investment in that particular bank. They do not feel a responsibility to consider the combined losses of the shareholders, depositors, and borrowers in all the other banks that would be brought down by the failure of their bank. They believe that responsibility rests with others, namely the government. From the perspective of the financial system as a whole, therefore, shareholders underinvest in the safety of individual banks. One of the guiding lights of financial regulation—its North Star—is to make all banks take greater precautions than they would if left to their own devices. These safety measures should rise where a bank’s size or connectivity increases the probability that its failure willgenerate systemic repercussions. Regulation should seek to internalize this social externality so that bigger, highly connected banks face tougher requirements than their smaller or less connected competitors.

During the two decades or so prior to the GFC, the zeitgeist proclaimed that markets were the source of much that was right and good in the world. Governments bore the blame for what was wicked and wrong. Regulators lost their mojo—their ambition shrunk to encouraging the worst banks to look like the best. Banking regulation was crafted in the image of what the biggest banks said they were doing. Worse still, regulators achieved this by effectively mandating all banks to have the same expensive credit and risk models as the largest banks. Rather than having the big banks face tougher requirements, they were handed a competitive advantage. Some of the regulators scurrying around today wagging their fingers and declaring that no bank is too big to fail or jail were the very ones who contributed to them bloating in the first place. Regulators are also guilty of dismissing the concerns of those of us who argued that the new “risk-sensitive” approach to bank regulation emerging in the late 1990s would inflame systemic risks.³

Risk sensitivity sounds so correct that many blindly assumed it must be so. It is utterly wrong. Under the mantra of greater risk sensitivity, prudence, and transparency, banks were forced to set aside more capital for loans they thought were risky and less for those they thought were safe. They made this determination using regulatory-approved common risk models, driven off publicly available data. However, banks don’t generally get into trouble by issuing loans they already estimate will be risky. Industry practice dictates they put aside more capital for these risky loans or secure greater collateral—like a lien on a business owner’s home—and agree on additional covenants. A typical demand is that the loan is instantly repayable in full unless the borrower keeps 12 months’ interest on deposit at the bank. Where banks frequently come undone is by issuing loans to those they believed were safe-but later became risky. Following the risk-sensitive approach, since the loans were classified as safe, they set aside the least amount of capital to guard against their failure. This is why the banks that looked wholly undercapitalized in 2008 were often those that boasted levels of capital substantially above their minimum, risk-sensitive, requirements just 12 to 18 months previously. Its not the things you know are dangerous that kill you.

Banks were all utilizing similar risk models fed by the same data. Inevitably their holdings were concentrated in the same assets that the models indicated provided the optimum mix of return and risk. In Chapter 8, I explain that the concentrated purchases of these assets, bidding up prices and bidding down quality, turned these previously safe assets into risky ones. When they turned sour, the risk models instructed every bank to sell simultaneously. This turned them from uncorrelated, stable assets into correlated, volatile ones. Bank risk models were pushed into an apoplexy of selling orders that opened up liquidity black holes in the financial system.⁴ Signs of this behavior were already visible during the Asian crisis of 1997–98, the Long-Term Capital Management debacle in 1998, and the dot-com bust in 1999–2000. Risk-sensitive regulation added to systemic risk. Regulators sought to make individual banks safe and ended up making the entire system perilously unsound.⁵

To work, the risk models required a fictitious view of risk, one in which there was just one thing called risk that could be dialed up and down. Whenever regulation failed the regulators would effectively try to dial risk down. Not only was this shutting the stable door after the horses had bolted but it unintentionally created another risk. Attempts to reduce risk often simply pushes it elsewhere. When it caused a problem in that new site, regulators there simply shoved it along someplace else. The systemic implication of this is that risk kept on being thrust from site to site until it could no longer be seen. That is a dangerous space for risk to occupy.⁶

The reinvention of financial regulation must confront the paradox that the process of anointing something safe actually makes it risky for the reasons I previously cite.⁷ Safety is not statistical; it is behavioral. I argue in Chapter 5 that managing risk in the system should not rest on contemporary estimates of what is safe or risky. Efforts to do so will inevitably fail. Risk sensitivity should be thrown out of the window. I suggest it is replaced with a new concept of risk capacity. The first half of this book shows how that idea naturally emerges from a long, hard look at the actual challenges we face rather than the imaginary dragons we think need slaying.

When an institution has risk capacity it can absorb a risk. Take liquidity risk, the risk that an asset will fetch a far lower price if one is forced to sell it this minute rather than sell at a time within the next year or so. In Chapters 5 and 6, I show that a young pension fund that does not need to raise cash to pay out a pension for five years or more has a capacity for liquidity risk. It can own assets for an extended time thereby avoiding the worst moments to sell. However, the same pension fund may have limited capacity to hold concentrated credit risk. Liquidity risks fall with time, but credit risks rise over time. The probability that a credit will blow up in the next hour is much lower and more certain than the likelihood that it will explode anytime within the next five years. A bank with a diversified set of borrowers and overnight depositors has the capability of absorbing credit risks but little capacity to swallow liquidity risks.

The other key tenet of a reinvented financial regulation must acknowledge that different parts of the financial sector possess varying capacities for absorbing distinct risks. Moreover, it recognizes that this is a crucial source of systemic strength. Crude ring fencing of different sectors of the financial system will not make it safer. All this does is restrict natural fits between risk and risk capacity. Such restrictions increase the system’s vulnerability. We need to promote an incentive structure that drives risks to the right places. Capital-adequacy requirements should be based on the mismatch between an institution’s risk capacity and the risks it is taking across the financial sector. By so doing, we would incentivize institutions with one type of risk capacity to safely earn the risk premium from buying assets with that type of risk and to sell other assets they own to those better suited to holding them. Risks would no longer be banished from the visible world and left to lurk menacingly in dark corners. They would instead be drawn to that part of the system where they are best absorbed. The system would then be safer than its individual parts.

The ideas presented are partly about a fallacy of composition. Trying to make individual financial firms safe does not necessarily make the financial system safe. This book is about how you risk manage the financial system from the start rather than dancing around the individual consequences of not doing so. After consumer protection, that must be the principal object of regulation and this book expands on these and related issues. It is a blueprint of how regulation can be reinvented so that the risktaking necessary for growth and development is done more safely. Finance is a fascinating subject. All of human emotions, failings and some virtues can be found there. In addition to argument, I have shared a number of anecdotes and stories in the hope that you will enjoy reading this book and will be enticed to join the debate.

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¹Goldilocks and the Three Bears by Robert Southey (1837).

²Throughout this book the Global Financial Crisis is abbreviated to GFC.

³As the Financial Crisis was emerging, Martin Wolf, Economics Editor at the Financial Times, speaking at the paper’s Annual Economists’ Dinner in November 2008, in London, said, “I am not seeking to deny that a few people saw important pieces of the emerging puzzle and some saw more than a few pieces. In my gallery of heroes is Avinash Persaud, who told us early and often that the risk-management models on which regulators foolishly relied were absurd individually and lethal collectively.”

⁴See Avinash Persaud, ed., Liquidity Black Holes: Understanding, Quantifying and Managing Financial Risk (London: Risk Books, 2003).

⁵See Avinash Persaud, “Sending the Herd Off the Cliff Edge: The Dangerous Interaction of Herding Investors and Market-Sensitive Risk Management Practices” (BIS Papers 2, Basel: Bank for International Settlements, 2000); reprinted with kind permission at the end of this book.

⁶See John Nugee and Avinash Persaud, “Redesigning the Regulation of Pensions and Other Financial Products,” Oxford Review of Economic Policy 22, no. 1 (2006), pp. 66–77.

⁷In “Avoiding The Risks Created By Avoiding Risk” (Financial Times, August 27, 2005), Andrew Hill describes this as the “Persaud paradox”—wherein “the observation of safety creates risk and the observation of risk creates safety.”