There has been huge debate over the last 15 months surrounding the speculation on the probable outcome of the credit crunch. The question is now is whether we are entering the worst stage of the cycle, namely when a financial crisis becomes a real economy crisis. At the moment the Bank of England is being very, very clear that a recession is coming, the only question being as to the scale of an economic crisis we are facing.The final problem of what is to come next is de-leveraging, which is something which few people really understand. We have had a steep build up of leveraging over the past few years. That has to be taken out of the system and one of the main consequences of that is that there will be less money available in the market. We don't know how much less and how difficult that drop will be to manage. One of the main questions facing policy makers going forward is how do you de-leverage the system without causing too much damage to the economy? The most important aspect of the financial crisis, however, is how do we learn from it? There are various lessons to be learned which can be subdivided into three categories: lessons learned by the authorities; lessons to be learned from firms and lessons to be learned by society.
First of all, it is clear that there is a question as to what extent should central banks and regulators be seeking to influence the macro credentials of economic cycles through macro preventive policy. This is essentially the argument of should the central banks reduce interest rates in the lead up into an economic boom. You are essentially asking the question "do you know what a bubble looks like when you see it?". Secondly, the question would be "when you see a bubble can you prick it?" Historically the answer to the second question has been "no you can't". Bernanke and the Fed have denied that this is possible; the UK Central Bank has always felt that they have an inflation target, and don't have a job to try and deflate booms. Society, on the other hand, is probably saying that we should take this line of action. I think there will be quite a debate around whether there should be more macro protective policy in the system designed to lean against booms. The issue is that we enjoy booms when they are going on, politicians like booms, particularly around the time of elections so that will be one of the key problems in adopting this particular approach. One of the reforms we have already seen, however, is that the BoE has issued a financial stability objective (which is in the banking bill currently going through Parliament) as an initial response to the crisis so that will encourage the Bank to take a greater interest in macro protective policy.
We also need a new liquidity framework. One of the interesting features of the current framework is that none of the banks that failed actually broke the liquidity rules so the current set of laws are obviously not very good. I think generally if we have these changes in the regulatory framework you need a mechanism with which to make them in a timely and thoughtful way. We also need to draw a distinction between policy, i.e. the rules themselves, and the application of these rules. I think that the discussion as whether to adopt a principal based approach as opposed to a rule based approach is one of the key issues facing regulators at the FSA. I think the events of the last 15 months actually support principal based regulation because the essence of this approach is to get people to look at the consequences of their actions rather than just taking issue with the actions people can or cannot take. One of the examples I commonly give is Northern Rock who should have better understood the limitations of its business model as well as the risk it was running with its securitisation and the circumstances under which its firm would fail. Then there is the question whether these firms should be more intensively supervised with inspectors going in and looking more closely at what they were doing. Historically the FSA has been a relatively lightly resourcesd organisation so we haven't been able to go in and pull the books apart. I think you will increasingly see a more inspective approach and presumably they will be increasing the amount of resources available to the FSA.
The next important point is the lessons to be considered by the firms themselves. The quality of management has been lacking within many institutions. Interestingly, one of the things we have seen throughout the crisis is that the institutions which have fared better are those whose management come from a trading background rather than a client background. Firms that have a collective approach to risk management rather than one which is subdivided into different committees across the organisation have also fared better. In general, the problem became too complex. There were different individuals understanding only certain components of what was going on . The complexity meant that only firms that were ready to work together to tackle to the problem as a unit were able to solve it effectively.
Another issue is the need for added transparency with regards to companies' balance sheets. There is a whole series of issues going forward with respect to what is the right business model for investment banks and other financial institutions. Many firms will have to adapt to a new environment going into a post financial crisis world. Certain areas of fund management, for example, will have to look at new ways of investing. Hedge funds and absolute return funds remain an attractive proposition but the opportunity to be highly leveraged is not going to be there in the future. A whole series of shakeups will be forthcoming, not least the ability for investment banks to operate without a direct source with which to intake deposits.
Last of all there is naturally going to be debate as to what lessons, if any, society itself is going to take from the events which have take place. One of the more interesting areas of debate is to what degree do consumers have a responsibility rather than a right when it comes to how much they spend. To what degree was the growth of household debt and the consumer culture to blame and how can we go about educating people better? In this respect the FSA have a consumer education objective which will need to be brought to the fore as was not the case at the early stages of the process. The lack of awareness amongst the public was partly behind the runs on banks that you saw taking place. In the Northern Rock case, for example, it wasn't the bank itself that failed but the fact that customers began taking their money out en masse so the question is whether we could we have persuaded people not to start withdrawing.
Generally, there is an issue here about the role of regulation. It is interesting how historically the FSA has said very clearly that we are not a 'no-fail' regulator, we will not guarantee there will never be failures in the system. Even if we did, we would be doing society a disfavour - without innovation and risk you do not have economic growth but of course on the other hand with innovation and risk you do have failures. For a long period of time we had failures, but they were not ones that society themselves were particularly worried about. The moment a large deposit-based institution fails everybody becomes terribly anxious so there are obviously different objectives for the public than there are to the industry itself. If we are only looking to protect deposit-taking institutions that would mean a different form of regulation than one which protects the financial services industry as a whole. The big issue here is what do people want from their regulators or their financial community; what obligation, if any, will people place on consumers going forward and to what degree will politicians realise that they are involved in setting the economic climate.
One thing that will change in respect to our financial crises, which have come our way quite frequently in recent history, is that the current one is so severe that I predict on this occasion it will take a bit longer than usual to come out of the current crisis and into the next one. The next crisis that comes our way will look wconsiderably different. I'm not entirely sure what form it will take but hopefully it wont take place in my life time, at least not while I'm in my current job!
Hector Sants was speaking to students at the Oxford University Said Business School.