The global financial crisis (GFC) had brought the global financial system (GFS) close to collapse. Extraordinary measures exhausting much of the available resources were brought to bear to prevent the collapse of the GFS. But the GFS is a menace to world peace and prosperity and it should be structurally reformed rather than simply saved. With the GFS apparently returning to a “new normal”, efforts to learn the real lessons of the GFC have faded.
Both Canada and Australia have undertaken a review or an inquiry into their own financial systems. Because these countries were least affected by the GFC for similar idiosyncratic reasons, they saw little need for serious reforms of their financial systems. Their situations may be illustrated by a parable:
Once upon a time, a man was unaware that he lived in a flood-prone area. He did not have insurance. A flood came but he was left unscathed. He congratulated himself on his fine judgement. Then another flood came. He lost his house and was swept away.
An important lesson of the GFC which was overlooked, perhaps due to a denial of potential culpability, is that the GFC was not exogenous, but was caused endogenously within the GFS by flawed academic theories and an ineffective system of regulation.
New reforms such as Dodd-Frank Act in the US or Basel III of the Bank for International Settlement (BIS) do not address fundamental fallacies of GFS regulation and have, therefore, left the regulatory architecture essentially unchanged. Only the parameters were altered: regulatory standards were tightened, capital ratios were increased, stress-testing was more frequent and supervision was increased, etc.
Regulation of the GFS depends substantially on complex mathematical models for managing credit risk. The GFC proved that the mathematical models used by banks and rating agencies were grossly inadequate for the purpose of risk management. A detailed investigation into credit risk modelling revealed that existing approaches suffer from many economic fallacies, making their use untenable for the GFS. Incremental improvements and refinements will not make those models adequate for the purpose, as much more fundamental changes are needed.
The GFC has refuted the fundamental assumptions of GFS regulation under the Basel Accord of the Bank for International Settlement (BIS), because there is no scientific basis for accepting that the mathematical models are adequate for managing credit risk.
Similarly the pricing of derivatives is based on mathematical models using unsound economic assumptions which have never been scientifically validated. In the case of exchange traded derivatives, there is at least the possibility of price discovery from market arbitrage activities. But for over-the-counter (OTC) derivatives - which are typically innovations of financial engineering - there is no way for anyone, including the regulator, to validate prices due to complexity and the lack of transparency of the models.
The key assumption for not regulating the OTC derivatives market is that the free-market should work for well-informed traders. The OTC transactions are between sophisticated big-bank traders who are assumed to have ample resources and knowledge to look after their own self-interests – they would not be knowingly or easily deceived. In other words, it is assumed that due to the self-interest of well-informed sophisticated participants, regulations are not needed for those markets to function properly.
The fatal flaw to this assumption is that the traders are not transacting with their own money – they are agents on commission trading with other people’s money – the money of depositors, investors, investment managers, pension funds, etc. Doing deals and earning commission are the primary motives of the trading agents even if it means higher costs, more risk and greater losses for their clients (who are usually also managing other people’s money).
The free-market assumption of voluntary exchange for one’s own benefit does not generally apply to financial markets where layers of intermediaries operate creating a wedge between risk and reward in markets leading ultimately to systemic dysfunction.
Pricing by “mark-to-model” may well be pricing by “mark-to-myth”, providing opportunities for fraud in OTC derivatives markets which have a notional value of over $700 trillion (and growing rapidly), as reported voluntarily by banks to BIS. It has not been recognized that, since the OTC derivatives market is where most of the unregulated banking transactions are taking place, it is by far the largest part of the shadow banking system which, usually and misleadingly, refers only to the much smaller non-bank lending between unregulated parties.
Without an accurate knowledge of OTC derivative holdings, the true leverage of a financial institution or that of the whole financial system cannot be properly quantified. Therefore, regulators cannot possibly know precisely about the risk from leverage of institutions or of the whole system. Essentially, GFS regulation is impossible when the values and risks of OTC derivatives cannot be verified with objective mathematics.
Mathematics has been confused with science in economics and finance. There is a general ignorance or ineptitude in mathematics which has created an information asymmetry between those who can and those who cannot do mathematics. Sophisticated mathematics then provides potential instruments for fraud, which was at the base of many past scandals.
Mathematical models for credit risk and derivatives are assumed to be accurate (or accurate enough) and that regulators have the ability to verify them. This assumption is so defective and dangerous for the GFS that it must be challenged to avoid a financial system collapse. The way the flawed mathematical models (MMs) may lead to financial system collapse comes from several contributing factors:
- Because of complexity, the MMs cannot be effectively challenged by regulators (who are not MM innovators);
- Through “mark-to-myth” accounting, the MMs can be used as instruments of fraud and to hide losses;
- Risks of asset portfolios can be under-estimated through the choice of MMs;
- Capital requirements can be reduced and leverage increased using MMs without regulators being aware;
- Systemic leverage and risk can increased without any effective means to measure, monitor or control them by regulators.
- Important physical markets can be so grossly manipulated through derivatives that distortions lead to serious misallocation of resources resulting in economic dysfunction.
Unless the underlying assumptions of the GFS, its structure and regulation are changed, we are likely to see the financial system collapse - which has so far been avoided. Instead of more regulations to save the inherently flawed GFS, reforms should be directed to simplifying the GFS structure and to reducing its risk and contagion. More details on this and other related issues are contained in a recent submission to the Australian Financial System Inquiry. In future posts, economic fallacies responsible for the false premises of the GFS will be discussed.