不要忽视金融改革的需要

The philosophy that has helped me both in making money as a hedge fund manager and in spending it as a policy oriented philanthropist is not about money but about the complicated relationship between thinking and reality. The crash of 2008 has convinced me that it provides a valuable insight into the workings of the financial markets.

The efficient market hypothesis holds that financial markets tend towards equilibrium and accurately reflect all available information about the future. Deviations from equilibrium are caused by exogenous shocks and occur in a random manner. The crash of 2008 falsified this hypothesis.

I contend that financial markets always present a distorted picture of reality. Moreover, the mispricing of financial assets can affect the so-called fundamentals that the price of those assets is supposed to reflect. That is the principle of reflexivity.

Instead of a tendency towards equilibrium, financial markets have a tendency to develop bubbles. Bubbles are not irrational: it pays to join the crowd, at least for a while. So regulators cannot count on the market to correct its excesses.

The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further.

I believe that my analysis of the super-bubble offers clues to the reform that is needed. First, since markets are bubble-prone, financial authorities must accept responsibility for preventing bubbles from growing too big. Alan Greenspan and others refused to accept that. If markets cannot recognise bubbles, the former chairman of the US Federal Reserve asserted, neither can regulators – and he was right. Nevertheless authorities have to accept the assignment.

Second, to control asset bubbles it is not enough to control the money supply; you must also control credit. The best known means to do so are margin requirements and minimum capital requirements. Currently they are fixed irrespective of the market’s mood because markets are not supposed to have moods. They do, and authorities need to counteract them to prevent asset bubbles growing too large. So they must vary margin and capital requirements. They must also vary the loan-to-value ratio on commercial and residential mortgages to forestall real estate bubbles.

Regulators may also have to invent new tools or revive ones that have fallen into disuse. Central banks used to instruct commercial banks to limit lending to a particular sector if they felt that it was overheating.

Another example of needing new tools involves the internet boom. Mr Greenspan recognised it when he spoke about “irrational exuberance” in 1996. He did nothing to avert it, feeling that reducing the money supply was too blunt a tool. But he could have devised more specific measures, such as asking the Securities and Exchange Commission to freeze new share issues, as the internet boom was fuelled by equity leveraging.

Third, since markets are unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks, believing they can always sell their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. That means the positions of all major participants, including hedge funds and sovereign wealth funds, must be monitored to detect imbalances. Certain derivatives, like credit default swaps, are prone to creating hidden imbalances so they must be regulated, restricted or forbidden.

Fourth, financial markets evolve in a one-directional, non-reversible manner. Financial authorities have extended an implicit guarantee to all institutions that are too big to fail. Withdrawing that guarantee is not credible, therefore they must impose regulations to ensure this guarantee will not be invoked. Such institutions must use less leverage and accept restrictions on how they invest depositors’ money. Proprietary trading ought to be financed out of banks’ own capital not deposits. But regulators must go further to protect capital and regulate the compensation of proprietary traders to ensure that risks and rewards at too-big-to-fail banks are aligned. This may push proprietary traders out of banks and into hedge funds, where they properly belong.

Since markets are interconnected and some banks occupy quasi-monopolistic positions, we must consider breaking them up. It is probably impractical to separate investment banking from commercial banking as the Glass-Steagall act of 1933 did. But there have to be internal compartments that separate proprietary trading from commercial banking and seal off trading in various markets to reduce contagion.

Finally, the Basel Accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans: they ignored the systemic risks attached to concentrated positions in securities. This was an important factor aggravating the crisis. It has to be corrected by raising the risk ratings of securities held by banks. That will probably discourage the securitisation of loans.

All these will cut the profitability and leverage of banks. This raises an issue about timing. It is not the right time to enact permanent reforms. The financial system is far from equilibrium. The short-term needs are the opposite of what is needed in the long term. First you must replace the credit that has evaporated by using the only source that remains credible – the state. That means increasing national debt and extending the monetary base. As the economy stabilises you must shrink this base as fast as credit revives – otherwise, deflation will be replaced by inflation.

We are still in the first phase of this delicate manoeuvre. Banks are earning their way out of a hole. To cut their profitability now would be counterproductive. Regulatory reform has to await the second phase, when the money supply needs to be brought under control and carefully phased in so as not to disrupt recovery. But we cannot afford to forget about it.

The writer is chair of Soros Fund Management and author of ‘The Crash of 2008’.