Lessons from the financial crisis

It shouldn't have happened, but it did. I don't know of anyone who can honestly claim to have seen the financial crisis coming, although there were a few people who were sounding a mild alarm about a bubble in the U.S. housing market.

There must have been people who knew that there were some very bad loans being made in that market, and that those loans were being resold to unsuspecting investors, but those people probably neither understood nor cared about what that could do to the world economy.

I think we'll get over this. Most people in a position to do something are behaving rationally. But we should start thinking about how to prevent the next such occurrence.

One thing should be very clear. Financial markets need government regulation. The folks who used to preach that the private sector would produce boundless wealth for all if governments would just get out of the way had a very free hand in the U.S. for the past 8 years and the results are obvious.

That does not mean that every regulation is a good regulation. A law that bankers must henceforth always wear pinstripe suits and bowler hats will not help much. So what kind of regulation do we need?

The financial system has a simple job to do. It needs to act as an intermediary between those who have more money than they need at the moment, and those who need to borrow for some productive purpose. A system to do that does not need to be so complex that no expert has a good grasp of how it works.

Regulators in many countries, but especially the U.S., let the system get far to complex. That complexity allowed people to pass off risky or worthless assets as good investments and served no other purpose. “Innovative financial instruments”, many of them little more than Ponzi schemes, flourished.

So one goal of regulation should be simplicity. In hindsight, many of those schemes should have just been killed off with legislation.

The main goal of regulation in the past has been soundness, and that is still important. After the string of bank failures at the start of the great depression, regulations were put in place to ensure that banks didn't lend out too much of the money they received from depositors, but kept a certain minimum reserve. Also, they were required to buy deposit insurance so that, if they did fail, depositors would get paid.

Those regulations worked well for many years, but in the lax environment south of the border, people began figuring ways to get around them. They set up investment banks which were not burdened by the same rules. They could play fast and loose and make great profits for a while, but they were also accidents waiting to happen.

Another regulatory goal should be responsibility. At first, when U.S. officials started bailing out financial institutions, I accepted it as a lesser evil than letting them fail. But Paul Krugman, the recent winner of the Nobel Prize for economics, points out that there is another alternative.

If an institution is failing, the government could take it over, kick out the old management, spend whatever is needed to return it to soundness, and sell it off to new management. That way, multi-million dollar CEO's wouldn't get to play this game of “heads I win, tails the taxpayer loses and I still win” that they seem to be getting into.

We also need to ensure that if a financial institution makes a loan, it keeps the risk associated with that loan, and can't pass it off to someone else.

Our Canadian financial system seems, so far, to have been very well regulated compared to most others. But we still need to watch and learn so we don't make the same mistakes some time.

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