Capitalism and Its Troubles: A Survey of International Finance

The capitalist system has proved surprisingly robust in the face of recent crises, but if it is to keep delivering the goods it needs an overhaul.
Matthew BishopMay 24, 2002

Capitalism and Its Troubles: A Survey of International Finance Capitalism and Its Troubles

The capitalist system has proved surprisingly robust in the face of recent crises, but if it is to keep delivering the goods it needs an overhaul.

The capitalist system has proved surprisingly robust in the face of recent crises, but if it is to keep delivering the goods it needs an overhaul.

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Capitalism has had a rotten time lately. Not as rotten as in 1917, when those revolutionary shots in St Petersburg launched a form of anti-capitalism that ended (except in Cuba and North Korea) only just over a decade ago. Nor, with luck, as rotten as in 1929, when a stockmarket crash on Wall Street set off the global Great Depression. But rotten, nonetheless. Nobody knows for sure yet, but 2001 might come to be seen as the year when two decades of mostly unbroken progress for capitalism gave way to something more ambiguous and uncertain.

That year was the first in ages, perhaps since the start of America’s great equity bull market in 1982, when the world became significantly less wealthy. Total global marketable wealth — that is, all assets traded in the financial markets, such as shares and bonds — fell by 4% last year, according to a study by the Boston Consulting Group. The number of households with at least $250,000 of marketable wealth dropped from 39m to 37m. Those who believed that in today’s economy wealth always increases and the rich keep getting richer have been proved wrong.

The sudden collapse of Enron, a Texan energy-to-finance-to-fraud conglomerate, has shaken faith of another sort: in the integrity of corporate America, and in the Wall Street-centred model of capitalism that has been hawking its wares to investors the world over. The dotcom bubble was one thing; the realisation that apparently profitable companies are not making any money quite another. Much of the appeal of American securities to investors rested on the belief that companies have become much more productive and profitable. After Enron, investors are now questioning the accounts of many American firms, including such admired stalwarts as General Electric and American International Group (AIG), as well as some foreign ones. Given that the American economy has become the engine of the world economy and its companies are being held up as models, this is troubling.

If the doubts about the supposed revolution in productivity and profitability prove justified, the consequences could be dire. Huge amounts of debt have been accumulated by firms and individuals alike, in the belief that the general optimism about corporate America — reflected in continuing high share prices — is justified. Huge amounts of foreign capital have flooded into America for similar reasons, allowing the country to run an enormous current-account deficit and keeping the dollar strong. If these trends were reversed, America’s economy could suffer serious damage, and America’s model of capitalism might lose much of its appeal to other countries.

In many countries, experience calls that model into question in any case. Argentina’s problems have already dealt a serious blow to the idea that the global triumph of capitalism is inevitable. Even such rich countries as Japan flinch from American efficiencies such as securitising bad debt and getting it off bank balance sheets. To a lesser degree Europe is also a reluctant capitalist. Progress of the model can no longer be taken for granted in large parts of Asia, Latin America and the former Soviet Union, and has never been a serious prospect in much of Africa and the Arab world.

The most awful shock of the past year was the terrorist attack on September 11th. The financial system stood up to it remarkably well. Moreover, both the American economy and, more broadly, the world economy have rebounded much more strongly than anybody dared hope. Yet the attacks proved that even where capitalism is well established, it is increasingly vulnerable to those who hate it. No amount of success in the current war on terrorism will eliminate this hideous new risk, which is impossible to quantify — as the insurance industry is indicating by making cover against it prohibitively expensive.

Assuming terror can be kept away from the developed world, there are two broad schools of thought about the future of capitalism. The bulls argue that the system’s performance over the past year, particularly in America, bodes well for the future. Clearly, bursting stockmarket bubbles and scandal-ridden collapses of leading companies are cause for concern. But America has a long record of learning from its excesses to improve the working of its particular brand of capitalism, dating back to the imposition of antitrust controls on the robber barons in the late 1800s and the enhancement of investor protection after the 1929 crash. There is no reason why it should not turn the latest calamities to its advantage too. Senator Jon Corzine, a former boss of Goldman Sachs, puts the case for the optimists: “At the conclusion of any bull market there are always elements of excess that get washed out or cause the system to evolve. But the fact is, we are coming out of the most shallow recession in post-war history, and the outlook is good.”

Star Performer

The resilience of the financial system has surprised even the regulators responsible for its health on both sides of the Atlantic. As one of them put it, “If you had told me on September 10th that we were going to get the terrorism, Enron and Argentina, I’d have predicted at least one major international financial institution going bust, and serious consequences for the economy.” As it is, the only financial firms to go under were on the fringes of the system: some banks in Argentina, and a handful of mostly long-troubled or small insurers.

The bears too have been surprised by the system’s resilience, but they still see a large remaining financial bubble which they fear may burst, possibly plunging America and the world into a depression similar to that of the 1930s, or at least of the past decade in Japan. The threat of further terrorism, fighting in the Middle East (with its repercussions for the oil price) and maybe a transatlantic trade war, conjuring up ghastly parallels with the 1930s, have all clouded their crystal balls further. With Argentina’s default, they feel, perhaps globalisation has peaked.

The dotcom bubble has burst, but not the bubble in the broader stockmarket. Pessimists predict economic collapse when it does. As Robert Shiller noted in his best-seller “Irrational Exuberance”, it can take a while for bubbles to burst, and longer for their full economic consequences to become clear. The Wall Street crash of 1929 was followed by numerous rallies and dips, and only a couple of years later by the Depression. For now, Alan Greenspan, the chairman of the Federal Reserve (and the man who coined the phrase “irrational exuberance”), continues to blow air into the bubble that his loose monetary policy has created. But he cannot pull off this trick forever. Interest rates can go only so low.

Neither the optimists’ nor the pessimists’ scenario is inevitable. In America and elsewhere, there are important choices to be made that will influence the outcome. Should there be new rules to curb abuses by investment banks? Can accounting information be made more meaningful? Can the incentives of company bosses be aligned more closely with the interests of shareholders? Can capitalism take root in the developing world? The answer to each of these questions is yes, up to a point, but what needs to be done to achieve that result is not easy.

One big hurdle is that the will to reform may be lacking, especially if the world economy continues to recover. Already, there are signs that Congress is backing away from some of its more radical proposals (several of which will be no loss). As Harvard’s Andrei Shleifer and others point out in a recent article, Wall Street’s heart may not be in it either: “Compared to the profits directly related to high stock prices, those from unwinding bubbles must be minuscule.” Although market forces are likely to solve some of these problems, and are already punishing any firm that might conceivably become the next Enron, they may not be sufficient. Bill Gross of PIMCO, a huge bond fund, is unimpressed by the market’s response: “My fear is that this newborn faux hostility in the investment attitudes of lenders and stockholders will go the way of many other short-term jiggles in the inevitable march of capitalistic excess.”

Is Mr Gross right? The answer lies in the financial system, which is where this survey begins.


Crisis? What Crisis?

The financial system has coped remarkably well with a horrendous couple of years.

A huge, unexpected decline in profits. A sharp and equally unexpected rise in corporate bankruptcies. A sudden nationwide plunge in personal wealth. These are the classic early signs of a banking crisis, of the sort that has happened roughly every decade in America and has also become increasingly common in the rest of the world over the past quarter-century. Among the victims have been Britain, Scandinavia, France, Turkey, Thailand, South Korea, Mexico, Japan and Argentina.

Even without the tough economic environment, it would not have been surprising if the terrorist attacks of September 11th had caused system-wide banking failure, by disrupting the transmission of payments between banks and creating an atmosphere of fear. Yet in the event, banking and the broader financial system proved remarkably resilient. This is worth celebrating. Research into the banking crises of the past 25 years suggests that they typically cost around 25% of GDP to put right. How did things, so far, turn out so much better this time?

Clearly, after the horrors of September 11th, fortune smiled in adversity. The war on terror proceeded as planned, and there were no immediate follow-up attacks on American soil. Consumers remained confident and carried on spending, keeping both the economy and the financial system stronger than had seemed possible straight after the attacks.

It also turned out that the system was better prepared to survive the attack than might have been supposed. The elaborate precautions taken to deal with the supposedly devastating millennium computer bug, which until recently had been ridiculed as a waste of money, proved to have been an invaluable “stress test” for the financial system. They ensured that back-up systems and emergency procedures were in place when the disaster happened.

But luck was not the only reason why things turned out better than expected. Both the authorities and the market participants also showed remarkable skill in restoring the financial system after the attacks. Inevitably, there were unexpected heroes, including the usually despised local telephone company, Verizon, whose employees laboured impressively to reconnect downtown Manhattan. The interbank payments system slowed for a while after the attacks that Tuesday morning, but did not break. The bond market reopened on the Thursday. The New York Stock Exchange trading floor was back in action on the following Monday.

Textbook Response

The Fed and other central banks played their parts to perfection. In effect, they allowed unlimited lending, and suspended normal prudential requirements for banks to set aside capital against loans. Banks increased their lending to provide short-term finance for companies suddenly deprived of access to the commercial-paper market. If ever there was a time to flood the system with liquidity and deal with the consequences later, this was it, especially given the technical difficulties faced by some banks (notably the Bank of New York) in clearing payments.

Had the market started to fear that some payments would not be cleared, the resulting panic could easily have taken down one or more big global banks and many of their clients as well. The Fed, and some foreign regulators, took on enormous credit risk. But so long as the liquidity was withdrawn (which it was as soon as the need had passed), for once there was no concern about creating a moral hazard. Banks would hardly leave themselves recklessly exposed to the after-effects of a terrorist attack simply because they expected the Fed to come to the rescue.

For a crucial moment, regulators everywhere turned a blind eye to rules — for example, on solvency for insurers — that would have caused chaos if rigidly enforced. New York and London proved more interchangeable than expected. Many firms were able to shift their operations to London immediately, flying lots of staff over from America. Britain’s Financial Services Authority helped by giving instant authorisation to the workers when they arrived. Most of the banks, brokers, stock exchanges and other firms that operate the financial system also suspended their usual practice of competing at every opportunity, pulling together in the interest of the system as a whole. This has not always happened in past financial crises.

Not quite everything went smoothly. The Bank of New York discovered it had been unwise to keep its main back-up facility only two blocks from its head office. Other firms have taken note. In New York, back-up facilities are now being placed in New Jersey or even farther afield. In London, banks based in the City are opening back-ups in Canary Wharf a few miles away, and vice versa.

Is that far enough apart? “If something takes out both the City and Canary Wharf at once, there will probably be more to worry about than the health of the financial system,” says one regulator. Another explains that thanks to the steps taken after September 11th, the financial system is now “inoculated against every terrorist act, short of nuclear or other weapons of mass destruction”. That will have to do.

Bigger, Broader, Stronger

In America and the richer European countries, in particular, the financial system has undergone huge changes over the past decade. Some of them help to explain why the recent calamities did not do more damage. But not all of them are for the better, and some raise new dangers.

For the most part, the industry leaders today are no longer banks, but financial-services companies. Their activities extend far beyond traditional commercial-banking tasks such as taking in savings and making loans. Many now engage in investment-banking activities such as underwriting bond and equity issues, advising on mergers and acquisitions and, crucially, selling on loans to other investors (by organising syndicates, buying credit derivatives that pay out in the event of a default or issuing securities bundling loans together).

Enron’s use of such techniques may have given them a bad name, but many banks seem to have used them to reduce their exposure to credit risk — the traditional way they lost money — so they could remain active in the more profitable business of arranging credit for clients. Asset management, for both institutions and individuals, also accounts for a growing share of revenues, and is expected to become much more significant over the next five years. So, too, is the sale of insurance products.

A decade ago, continental European banks were typically engaged in a broader range of activities than their American counterparts, which under the Glass-Steagall act, now scrapped, had to make a choice between commercial banking, investment banking or insurance. But the big multinational financial-services firms today have gone much further than the European firms of ten years ago. They are certainly much bigger than any previous financial businesses, as measured by the latest market capitalisation of the top 15 firms compared with the 1990 figure.

A bigger balance sheet makes it easier to absorb the sorts of losses that J.P. Morgan Chase suffered when Enron went bust. There are hardly any triple-A rated banks left, but with the exception of Japanese banks — many of which might face bankruptcy without the implicit support of the government — the world’s big financial firms are mostly well-capitalised. This is thanks in part to regulatory pressure, notably through the Basel capital-adequacy standards, and in part to growing market sensitivity to the financial soundness of lenders. Today, the big financial firms mostly have more capital relative to liabilities than regulators require, though recent losses may have reduced the cushion.

Growth has been achieved both organically and through a wave of mergers and acquisitions. M&A has been particularly important in helping the big financial firms to become genuinely international in their operations. In America, where until the 1980s many banks faced severe prohibitions on expanding across state lines, M&A has also helped reduce the exposure of individual firms to any one local economy. In the 1980s, a failure like Enron’s would probably have taken down the Texas banking system. But Texas Commerce Bank, one of the company’s long-standing bankers, was long ago absorbed into J.P. Morgan, which is able to cope with bigger-than-expected losses from Enron without any serious threat to its viability. Argentina’s main banks are part of institutions based in Madrid, Boston and New York, which probably gave the country more time to deal with its problems than it would otherwise have had. Unfortunately, it did not use the breathing space to best advantage.

Overall, today’s bigger financial institutions are finding it easier to heed the old advice about not putting all their eggs into one basket. Their exposure to credit risk is now geographically diversified and balanced by exposure to risks in other lines of business which, they hope, are not closely correlated with the credit cycle. More of the credit risk has been shifted to other investors who, at least in theory, are able to suffer losses without the troublesome consequences for credit creation, and thus economic growth, that big losses in the banking system have often caused in the past. The emergence of thriving public-debt markets has anyway reduced the economy’s dependence on bank credit.

The recent bout of bubble-bursting and the huge sovereign and corporate failures of Argentina and Enron seem to have more in common with financial crises in the half-century before the first world war, when the damage from bank failures to other sectors was limited, than with the failures in the 1930s and recently in Japan, when the damage done to banks affected every aspect of the economy. Even so, there remains plenty to worry about.


New Dangers

Relying less on banks and more on the markets creates fresh problems.

Banks are putting their eggs into more than one basket, and even selling some eggs to investors with baskets of their own. But are they as skilled at diversifying and transferring risk as they like to think? Are those to whom they are transferring the risk capable of managing it? Do these new holders even understand what risks they now bear? In short, could the shift from a bank-based system to a market-oriented one bring new dangers of its own?

Diversification does not absolve lenders from being prudent in their credit decisions. Banks have made some pretty dreadful loans in recent years. Obvious examples include the hundreds of billions of dollars lent to telecoms firms during the tech bubble, and generous credit extended to Enron and Argentina. From the mid-1990s, huge sums of money were promised to companies through guaranteed back-up credit lines to support issues of commercial paper, often without charge if no money changed hands at the time the credit lines were set up. When the economy turned down and credit became harder to find, many companies suddenly called on their back-up facility. By this time, lending billions of dollars to firms such as Xerox and Lucent had become an act of high-risk speculation that the banks had never contemplated, let alone priced, when the facility was first agreed.

One reason for this excessive generosity is that commercial banks were trying to win investment-banking mandates from companies, a business traditionally dominated by investment banks such as Morgan Stanley and Goldman Sachs. Underwriting an initial public offering or advising on mergers and acquisitions is much more profitable than lending money, so banks have been offering free loans to entice companies to give them investment-banking business. Judging by the chorus of complaints from the investment banks, this seemed to be working. However, the economics of the strategy are now looking less attractive in the light of the commercial-paper problems and a number of big losses on loans to large investment-banking clients.

The same forces that have pushed financial firms to grow bigger and more diversified are also raising the level of competition in the industry. In many product areas, a combination of fiercer competition, more transparency and the introduction of electronic systems is driving down margins. For example, margins on institutional brokerage are declining by around 5% a year. The collapse of IPO underwriting and the shrinkage of M&A in the past two years has taken out two of the few remaining lucrative areas of business, and helps to explain recent job cuts in investment banking.

Bob Gach, of Accenture, a consultancy, reckons that within a few years the industry could be dominated by only four to six global financial-services firms. Five years ago there were perhaps 20-25 banks with a chance of making it into this new “bulge bracket”. Now the number is less than a dozen. Each of the winners will probably need access to at least $100 billion of capital on its balance sheet. A few niche players will also survive. Dedicated investment banks such as Goldman Sachs will find it hard to decide whether to remain independent, says Mr Gach.

All this gives rise to various dangers. An ever-tighter squeeze on the profits of financial firms may tempt them to take bigger risks in their proprietary trading operations, in the hope of staying independent long enough to make it into the bulge bracket. A surprising number of them invested heavily in venture capital during the tech boom, and after initially trumpeting stellar returns have now had to write off most of the money.

Derivatives allow their users both to shed risks and to take bigger risks. This dual role makes it hard to tell whether their impact is benign or malign, and there are plenty of people who argue for each side. What is certain is that financial firms, especially on Wall Street and in the City of London, love derivatives, and have hired an army of mathematicians and physicists to work as “financial engineers”, creating complex new derivatives to shift risk around the financial system. The market for these products is growing rapidly, both on futures and options exchanges and in private sales, which tend to be more complex and more lucrative. Credit derivatives already have a nominal value of almost $1 trillion, up from around $100 billion five years ago. They are forecast to top $3 trillion by 2005. The nominal value of over-the-counter derivatives now exceeds $100 trillion, 60% of which is handled by a mere five dealers, including J.P. Morgan and Citigroup. Derivatives and other tools of financial engineering can be used to manage risk better by hedging positions and transferring unwanted risk to a counterparty, which is what banks say they mostly use them for. However, those tools can also be used to increase risk, perhaps by a big margin, and there is a growing danger that this will be done accidentally.

Emanuel Derman of Goldman Sachs describes much of what a financial engineer does as “a high-tech version of estimating the unknown cost of fruit salad from the known price of fruit, or often, in reverse, estimating the unknown cost of fruit from the known price of fruit salad”. A financial engineer can take the risk in, say, a bond and break it down into a series of smaller risks, such as that inflation will reduce its real value or that the borrower will default. These smaller risks can then be priced and sold, using derivatives, so that the bondholder keeps only those risks he wishes to bear. But this is not a simple task, particularly when it involves assets with risk exposures far into the future and which are traded so rarely that there is no good market benchmark for setting the price. Enron, for instance, sold a lot of those sorts of derivatives, booking profits on them straight away even though there was a huge question-mark over their long-term profitability.

Black Holes

The consolidation in the banking sector may be increasing the riskiness of the financial system in other ways. In a recent paper, Avinash Persaud of State Street, a bank, describes the growing frequency of what he calls “liquidity black holes”. Investors wishing to sell, particularly in large volumes, suddenly find that they can do so only at a much lower price than that set by brokers for small amounts, if at all. This is happening increasingly in some of the markets typically regarded as highly liquid, such as those for American Treasuries and foreign exchange, as well as in smaller markets such as for emerging-country debt. Volumes in the foreign-exchange market have fallen sharply.

The reason these black holes can develop, explains Mr Persaud, is that liquidity is a function not just of the size of a market but also of the diversity of opinion of those trading in it. The less they disagree, the less liquidity there will be. Several factors have reduced diversity, he argues. Technology has allowed information to spread faster, reducing the scope for disagreement arising from disparity of information. Consolidation has cut down the number of big market participants. In 1995, 20 banks in the United States accounted for 75% of forex transactions; by 2001, the number was down to 13.

Moreover, the big firms are increasingly using similar internal risk-management systems. These are sensitive to movements in the markets, and cause their users to respond in similar ways, so the few big firms that dominate the markets increasingly move as a herd, reducing diversity of opinion and thus liquidity, argues Mr Persaud. Some bank regulators say this danger is not all that significant because the underlying risks taken by financial institutions are quite different even if their risk-management systems are similar. But everybody agrees that less liquid markets may be more prone to financial crisis.

Is there a way of increasing the diversity of opinions? One possibility would be for institutional investors with different time horizons to become providers of liquidity. Big private investment-banking partnerships, such as Salomon and Goldman Sachs, used to be willing to take big contrarian bets in markets that they thought were out of line. But now that they are public companies, they are too concerned about short-term earnings volatility to take many such risks. Obvious candidates to take their place include hedge funds, which are free to invest against the grain of the market if they wish, and insurers and pension funds, which have very long-term liabilities and no need for market-sensitive risk-management systems.

Warren Buffett, a famously contrarian investor, often hints at this opportunity in the annual report of his firm, Berkshire Hathaway, which is, at root, an insurance company. The firm has plenty of liabilities that will not be called in for a long time, as well as diverse earnings, vast liquid resources and shareholders willing to accept the earnings volatility that can result from taking relatively risky positions. This “enables us to assume risks that far exceed the appetite even of our largest competitors”, as Mr Buffett puts it.

Where the Buck Stops

Some insurance companies are now starting to take on some of the risk that the banking system and traditional market intermediaries no longer want. Swiss Re and Munich Re each account for about 10% of the credit-derivatives markets. Insurers have also become huge buyers of asset-backed securities.

This may have its downside. Diversity of opinion is certainly welcome, but few contrarians, particularly within the insurance industry, are as sophisticated and well-informed as Mr Buffett. Indeed, many insurers have a reputation as the hicks of the financial world. Tim Freestone of Seabury Insurance Capital, a consulting firm, reckons that the investment and risk management of the typical insurer is roughly as sophisticated as the typical bank’s was 10-15 years ago. Few insurers have a good record of underwriting, supposedly their bread and butter.

During the 1990s many insurance companies simply parked premiums in the stockmarket, where they grew so much that there was no need to worry about underwriting losses. Now that the investment climate is harsher, the insurers are looking for new high-yielding (ie, riskier) investments, which banks are providing through financial engineering.

Fixed-income products, such as asset-backed securities, are particularly attractive to insurers with fixed nominal liabilities who failed to predict low inflation and low interest rates. Much of the Japanese life-insurance industry has gone bust because of its inability to deliver promised nominal yields. In Britain, Equitable Life got into trouble for similar reasons.

But some observers worry that problems lie ahead when the true risks of these investments become clear. In its December 2001 Financial Stability Review, the Bank of England devoted a whole chapter to risk transfer between the banking and insurance industry, mentioning “challenges for market participants and the authorities: in tracking the distribution of risks in the economy, managing associated counterparty exposures, and ensuring that regulatory, accounting and tax differences do not distort behaviour in undesirable ways”. Privately, one regulator admits that some insurers are “doing very racy investments to get yield”.

There is a danger that this risk will eventually find its way back into the banking system. Much of the risk-transfer apparently being undertaken may be an accounting ruse, designed to escape regulatory capital requirements without truly shedding the risk. And if insurers are unable to meet their liabilities and go bust, the banks may be caught short. There are potential legal risks too. J.P. Morgan, for example, faces a court battle to get the $1 billion it expected from a surety bond it had bought from a group of insurers to reduce its exposure to Enron.

Much of the risk may end up in the hands of less sophisticated investors, including some of the individuals now being targeted by the financial-services firms. They may be taking on this risk unwittingly. Nobody knows how those individuals might react if they found out, or how this would affect the economy as a whole. They might feel poorer and less inclined to spend, which could inflict the sort of damage on the economy and the banking system that the bears had predicted when the dotcom bubble burst.

If there is still a bubble in share prices, as many economists believe, the entire financial system — traditional and new bearers of risk alike — remains exposed to its bursting. But it has become harder than ever to say how great this exposure is.

Still, as long as risk remained concentrated within a country and largely its banks, its financial regulators should have been able to keep tabs on it. The trouble with today’s global pool of capital is that regulators may be out of their depth.


Unexploded Bombs

Beware of Fannie and Freddie.

Banks may be busy trying to get rid of risk, but two huge American institutions cannot get enough of it. The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, known affectionately as Fannie Mae and Freddie Mac, have become arguably the two most worrying concentrations of risk in the global financial system. This is because of their portfolio of mortgages and securitisations, their use of derivatives and the habit of many other borrowers, including hedge funds, of using their debt as collateral.

At the end of 2001, Fannie had a total credit risk of $1.56 trillion (a $705 billion mortgage portfolio and guarantees on securitised mortgages of $859 billion). Freddie’s was $1.14 trillion ($492 billion plus $646 billion), adding up to a combined exposure of $2.7 trillion, nearly double the 1996 figure of $1.45 trillion. Bert Ely, an economist, calculates that the current level amounts to a hefty 13.9% of the total credit risk in the non-financial sector of the American economy, and 49.8% of home-mortgage credit risk.

Worries about Fannie and Freddie owe more to concerns about corporate governance and sheer size than to any evidence of poor risk-management. The two were set up to ensure that the poor had access to affordable mortgages. They are “government-sponsored”, a vague status that allows them to maximise profits for their private-sector shareholders. It also earns them a subsidy from the markets worth an estimated $10 billion a year, because despite official insistence that there is no federal guarantee, Fannie and Freddie are so big, and so plugged into the Washington establishment (their boards are rest-homes for former government officials), that it is hard to imagine them being allowed to fail.

What might go wrong? They do not appear to be making the common error of using short-term finance to back long-term liabilities — though, as with any big derivatives user, it is hard to be sure. They stress-test their portfolios, for instance to see what would happen if the Texas real-estate crisis 15 years ago were repeated nationwide: say, a 25% fall in house prices, no home equity left, people defaulting on mortgages. They think they could survive that. The biggest danger may be counterparty risk: Fannie and Freddie are heavily dependent for their risk-management programmes on a handful of big banks. If there were an unexpected sharp rise in interest rates, those banks might be unwilling or unable to provide the derivatives Fannie and Freddie need to hedge their risks. The chance of this is small, but if it ever came to pass, the consequences would be huge.

The Regulator Who Isn’t There

Does a global financial system need a global regulator?

Who regulates Citigroup, the world’s largest and most diverse financial institution? With its operations in over 100 countries, selling just about every financial product that has ever been invented, probably every financial regulator in the world feels that Citi is, to some degree, his problem. America alone has the Federal Reserve, the Securities and Exchange Commission, the Commodities and Futures Trading Commission, the New York Stock Exchange, 50 state insurance commissioners and many others. Yet in a sense nobody truly regulates Citi: it is a global firm in a world of national and sometimes sectoral watchdogs. The same is true of AIG, General Electric Capital, UBS, Deutsche Bank and many more.

Might that be a good thing? Howard Davies, boss of Britain’s Financial Services Authority, notes that it has become fashionable to think of regulators as Shakespeare’s “caterpillars of the commonwealth, creatures who, far from adding value, get in the way of the market”. Naturally Sir Howard does not share this opinion. All the same, it seems clear that much of the dynamism in global finance during the past three decades has been due to fewer regulations on the movement of capital, particularly across borders, and on what can be done with it. For the most part, money is now free to flow wherever an opportunity presents itself, and has generally done so, leaving everybody better off than with heavy regulation.

Leaving capital free to move where it could earn the highest return also showed up over-costly or misplaced regulation: the money simply went elsewhere. For instance, because Japan prohibited the use of derivatives, options in Japanese securities were traded in more accommodating Singapore. As Japan gradually eased these restrictions, some of the offshore business shifted back to Tokyo. In general, competition for capital has encouraged countries to improve their regulation to appeal to mobile capital — although some, such as Malaysia, have resisted this pressure, and continue to impose controls on cross-border capital flows.

Strikingly, there has been no race to the bottom in regulation. Behind every great market is good regulation — whether by a government agency or organised by the market participants. Internationally mobile capital has tended to reward regulation that protects investors and minimises privileges for market insiders.

Broadly speaking, this has led to a convergence of regulation around common international standards, but this process is by no means complete, particularly for investment products sold to personal investors. The day when a global firm can sell the same simple stockmarket-index fund anywhere in the world remains a long way off. America remains reluctant to allow European securities exchanges to ply their trade via screens in America, even though technically this is now easy to do. “Outrageously protectionist,” comments one European regulator.

Given the political difficulties, the idea of a single global regulator is not on any serious agenda. That may be just as well: competition among regulators has some benefits. What is on the agenda, at least of the regulators in countries open to international capital, is to ensure that good information is available about the state of global markets and about financial firms’ global operations. The FSA, for example, is able to regulate only Citigroup’s British activities, but it will have a much better chance of doing it well if it knows enough about the health of the firm worldwide.

Information is already flowing more freely between different national regulators. Multinational institutions such as the International Monetary Fund, the Bank for International Settlements and the Financial Stability Forum all play a useful part in this, but it is bilateral communication between national regulators that matters most — and the global financial system is nowhere near as transparent to national regulators as it should be.

One reason is that no global consensus exists on what exactly should be regulated. For instance, in Britain reinsurers are regulated by the FSA, but in their home markets Munich Re and Swiss Re, the world’s largest reinsurance companies, are mostly unregulated.

Non-financial firms with big financial operations do not fit comfortably into the current regulatory framework anywhere. Enron, which has been plausibly described as an investment bank or hedge fund with an energy business on the side, was not regulated in America. In Britain, the firm itself was not regulated, but its financial subsidiaries were monitored by the FSA. There are big question marks over who regulates the growing number of firms now transforming themselves into financial behemoths, modelled on GE with its huge GE Capital operation. Hedge funds and other highly leveraged institutions are regulated lightly in most countries, and not at all in America. A proposal by a presidential working party for tougher regulation of hedge funds, prompted by the collapse of Long-Term Capital Management, was unexpectedly blocked in Congress.

Too Much of a Good Thing

A second problem, at least in foreign eyes, is that America has too many different regulators. Whereas Britain has merged its numerous financial regulators into a single authority, and several other countries around the world are moving the same way, America continues with its plethora of different regulators for different parts of the financial-services industry. It seems doubtful that any of them has a good overview of what is happening in America’s financial system as a whole — though the Fed claims it gets all the information it needs, one way or another. During the Clinton administration, regulation often took place on the golf course between Mr Greenspan, Arthur Levitt, the chairman of the SEC, and Robert Rubin, the Treasury secretary. All the same, single foreign regulators would find it easier to resolve cross-border issues with a single American counterpart.

Some American regulators defend their multiple system, despite the considerable duplication it entails, mainly on the ground that regulatory competition keeps them keen and lean. Certainly, the superiority of the single, consolidated regulator has yet to be proved. According to a report published last year by the Centre for the Study of Financial Innovation, “There is a pervasive mood of discontent in the City with the FSA: people find it bureaucratic, intrusive and insensitive.”

Still, the current division of labour among the different American regulators is hard to justify. Why, for instance, should the SEC oversee trading on stock exchanges and the CFTC trading on futures exchanges when the regulatory needs of all exchanges are essentially the same? And why is insurance regulated not federally but at the state level, mostly by elected insurance commissioners? Nobody really thinks this makes sense, but the system survives because each regulatory body has its own supporters in Congress. In some respects, an inefficient regulatory system suits powerful financial firms. The Glass-Steagall laws, which kept banks, investment banks and insurers separate, survived a dozen attempts in Congress to scrap them — until 1998, when Travelers, an insurer, merged with Citibank, which immediately ended its expensive lobbying against abolition. They went soon after.

One senator who thinks that a single regulator along FSA lines would be good for America’s capital markets is Jon Corzine, a former boss of Goldman Sachs. “I hope to get consolidation of American regulation on to the agenda,” he says, “but it will need a bigger crisis than Enron to make it happen.”

So far America’s cumbersome regulatory system does not seem to have retarded the development of its markets, but in the long run it may prove costly, particularly if — and it is a big if — the European Union succeeds in fully integrating its capital markets and introducing appropriate regulation. America has long boasted of having the most efficient capital markets in the world, and to date that has broadly been true. But its unwieldy system of multiple regulators could become a competitive disadvantage should Europe develop a better, less costly regulatory mousetrap.

Regulatory Competition

Indeed, it is possible that pressure from the EU will help to consolidate American regulation. Under a forthcoming EU directive, any financial conglomerate operating within the Union will have to choose a main EU regulator who will be responsible for global supervision of the firm. In practice, the European regulator for the big American firms, such as Goldman and Citi, will probably delegate by requiring the firm to nominate one of the American regulators as its “co-ordinating regulator”, which would become a de facto single national regulator for the firm.

Even if the infrastructure for effective global regulation were in place, huge challenges would remain. Some are of an intellectual sort. “How much failure should a regulatory system allow?”, asked Sir Howard Davies in a recent speech. He did not supply an answer, beyond saying it should be more than zero, and less than would cause system-wide collapse. Another regulator reckons that the ideal would be “a trickle of little problems, to keep people aware of the risks”. It may be a tribute to American regulation that Enron was actually allowed to go bust, and luckily this does not appear to have had system-wide consequences. Some countries might have tried to organise a rescue; indeed, even the Fed has a reputation for keeping alive firms that should have been allowed to die.

Understanding whether the level of risk is getting too high has become harder now that so much risk is being transferred out of the banking system. Andrew Crockett, general manager of the Bank for International Settlements, worries that regulators and financial firms alike are better at judging the relative riskiness of different instruments, institutions and counterparties than the total risk in the system.

The problem has been brought to the fore by the technology bubble, and the fear of a wider American equity bubble. Do regulators know when a bubble has formed and the financial system is becoming dangerously imbalanced? Probably not with enough certainty to base policy on. What is clearer is that aggregate risk ebbs and flows with the economic cycle, says Mr Crockett. Credit officers tend to lend too much in good times, heating up the economy, and then cut back too much in a downturn, making things worse. One way to get round this, Mr Crockett suggests, would be to require banks to set aside higher amounts of capital during economic booms than during recessions, to make risk-taking less pro-cyclical.

How much capital financial firms should set aside against risks going wrong is the trickiest decision international regulators have to make. Since 1988, big banks have been abiding by the Basel capital regime, which links the amount of capital they have to hold in reserve to the riskiness of the loans they make. However, the categories of risk are too undifferentiated: banks have to set aside as much capital against a loan to Microsoft as to a Hungarian dotcom, as much against a loan to America as one to South Korea. Banks have also discovered ways to use derivatives and other securities to allow relatively risky loans to qualify for a low-risk, low-capital treatment. Regulators fear that a large part of the growth in the use of derivatives and securitisation by banks may stem from evasion of regulatory controls.

Basel 2, a more sophisticated version of risk-based capital rules, is now in the pipeline. It is meant to apply not only to big banks but to all banks worldwide, and to all investment firms in the EU. There is also talk of an insurance Basel before long. But Basel 2 has met with considerable opposition, partly because it is too complicated, partly because some countries disagree over how much capital should be set aside against some sorts of loans. Germany wants a lower capital requirement for loans to small businesses, for example, because bank loans are their traditional source of funding. The launch of the new regime, originally scheduled for 2004, has already been delayed until 2006, and even that may prove to be optimistic. Meanwhile, the banks are operating with a capital regime that does not work as intended, but may be lulling regulators into a false sense of security.

In determining regulatory capital, Basel 2 would give an important role to credit-rating agencies such as Moody’s and Standard & Poor’s. How good their ratings are is the subject of much debate. As an alternative, banks will be encouraged to use their own in-house credit ratings. But regulators still mistrust the use of quantitative credit-risk models to set regulatory capital. They need better techniques and better data, especially in Europe. Many big banks already use quantitative models to assess how much capital they need to set aside against portfolios of marketable securities. These “value at risk” (VAR) models typically measure the most the firm could lose in a day, judging by past performance, but they tend to underestimate the frequency with which really bad days occur.

There have been half a dozen “perfect storms” in the market in the past decade, during which VAR calculations proved useless in predicting losses. Stress-testing portfolios against imaginary perfect storms remedies some of the weaknesses. But modelling credit risk in this way is much harder, not least because data about past credit performance are scarce.

Another market-based system of regulation has also received some attention. If banks issue short-term subordinated debt that is traded every day and has to be refinanced regularly, and can stay in business only as long as the debt is refinanced, then the market will in effect regulate the bank. Lenders will not finance a bank they think is in risk of default. Alas, the only country to have tried it so far has been Argentina, where the government’s fleecing of the banking system after its debt default rather spoilt the plot.

Regulators are only too aware that the sheer complexity of the financial system imposes practical limitations on what they can do. Increasingly, they are having to rely on the private sector to assist them in their regulatory task. They simply do not have the capacity to find out what risks are being taken inside a large international bank unless it tells them.

Caveat Emptor

All this suggests that, just as market failures are an inescapable feature of free-market capitalism, so too may be regulatory failures by its watchdogs. The first line of regulation should be those whose money is at risk. In an important sense, Enron was regulated by its bankers. Alas, they made a lousy job of it. The best piece of advice to market entrants is “buyer beware”.

As it is, buyers often seem to be positively reckless, not least in the stockmarket. Recent years have seen the return of the sort of financial bubbles that many economists and regulators thought had gone forever. Why are bubbles back, and can anything be done to prevent them?


Bubble Trouble

And what policymakers should do about it.

Mr Greenspan has allowed the creation of a potentially disastrous financial bubble, say Andrew Smithers and Stephen Wright, two British economists. In a recent article, they argue that the Fed’s chairman, having chided the markets for their irrational exuberance in December 1996, should have raised interest rates by enough to bring the exuberance down to more rational levels, and share prices with it. Instead, he did nothing. Share prices continued to rise. People felt wealthier than they should have done, and spent more and saved less than was prudent. Companies with rising share prices borrowed more against their equity, which they invested in all sorts of risky activities, many of which proved unwise.

Messrs Smithers and Wright blame Mr Greenspan’s do-nothing stance on two ideas. One is the “efficient-markets hypothesis”, one of the cornerstones of modern financial theory which is credited with revolutionising the workings of financial markets in the past quarter-century. In efficient markets, prices are assumed to reflect fundamental values and to incorporate all relevant information. When ill-informed investors move prices away from their true value, informed investors will arbitrage them back to the right level, so there is no chance of a financial bubble, defined by Peter Garber in his book “Famous First Bubbles” as a high price “at odds with any reasonable economic explanation”. Efficient markets have become an article of faith in some corners of the financial markets. If a price goes to a level for which there is no obvious economic explanation, the believer will simply conclude that there is a non-obvious economic explanation — such as the coming of a more productive “new economy”. What he will not conclude is that there is a bubble.

One illustration of how believers in efficient markets think is the debate about accounting for managers’ share options, which has been revived by Enron’s collapse. Share options are clearly a cost of employment, an alternative to paying cash. So it would seem to make sense to allow for the cost of the options before calculating a company’s profits; but American accounting rules require merely that the options be disclosed in a footnote, not passed through the profit-and-loss account. Efficient-market adherents believe that a footnote is all that is needed, because the market is perfectly capable of subtracting the cost of the options from stated profits when calculating true value. As Holman Jenkins, writing recently in the Wall Street Journal, put it, “In the real world, any information, as long as it is deemed relevant, will be processed into the mill for pricing securities. It doesn’t matter whether the data is computed into the income statement, or appears in a footnote, or is shouted up and down Wall Street by a man in a tutu.” On the other hand, the fact that senior managers are fighting so hard to stop the cost of their options being set against profits suggests that they, at least, do not think the market is as efficient as all that.

A growing number of economists have turned against efficient-market theory, at least in its extreme “no bubbles” version. One weakness in the theory is its assumption that arbitrage by the informed against the uninformed is riskless and costless. Shorting shares involves borrowing a share and selling it now in the hope of buying it back later at a lower price to return to the lender. But borrowing a share can be costly, especially if the price continues to rise for a while before it falls. The further it goes above the price at which it was sold, the more nervous the lender will get, and the more collateral he will want the borrower to post as security.

Perhaps the most famous example of the cost of arbitrage becoming unbearable was the collapse of Long-Term Capital Management in September 1998. LTCM was betting on the prices of various securities moving closer together, because it believed the true value of different pairs of securities was the same. In the event, many of these prices headed further apart, often much more so than at any point in the past. Later, the prices did move in the direction predicted by LTCM, and would have produced a handsome profit for the company had it been able to hold its positions for long enough. However, when the prices first diverged, the net market value of those positions dropped so much that some of the counterparties of LTCM trades feared it would go bust. They therefore required ever more collateral or became reluctant to do business with LTCM at all. In the end the Federal Reserve had to organise a rescue by several big banks.

At this point, it should have become clear that markets were not as efficient as the theorists claimed. After all, two of LTCM’s founders had won the Nobel prize for their work on another cornerstone of modern finance, options-pricing theory. In fact, their fate did not stop millions of people getting caught out soon afterwards when they bought hugely overpriced Internet shares. A fascinating study of the dotcom bubble by Eli Ofek and Matthew Richardson of the Stern School of Business further illustrates the limits to arbitrage. With many of the dotcom companies, the authors point out, the number of shares in circulation was very small. There were not enough available to borrow to meet the demand from would-be shorters. Given that in practice the scope for arbitrage is limited, it is quite possible for people with inaccurate valuations to set prices, and for these prices to get way out of line.

Strikingly, once post-IPO lock-up restrictions on selling by corporate insiders ended, prices often fell sharply — perhaps partly because well-informed investors were able to communicate their knowledge to the market by shorting.

A growing number of economists have become adherents of “behavioural finance”, which attempts to explain real-world deviations from the asset prices predicted by modern finance using the insights of human psychology. One example is that people often use a “representative heuristic” — that is, they use data from the recent past as a basis for predicting the future. Thus, when share prices have risen strongly in the recent past, perhaps for a good reason such as a fall in interest rates, investors may assume that they will continue to rise. They will therefore buy the shares, making their rise a self-fulfilling prophecy, at least for a while.

If current share prices reflect a belief that the returns on shares earned in recent years will be repeated in future, they are probably mistaken. The average share-price-to-profits ratio of American equities — as well as British and some continental European ones — remains high by past standards. Jay Ritter, an economist at the University of Florida, estimates that shares might reasonably be expected to earn around one percentage point more per year than the risk-free rate of interest. That would be far less than the average return on shares during the past 20 years.

In “Triumph of the Optimists: 101 years of Global Investment Returns”, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School also question whether future returns will match those of the recent past. The global post-war bull market in shares, they say, owed much to two trends that cannot be relied on to continue. First, the world enjoyed a long period of relative peace and prosperity far exceeding expectations at the end of the war. Second, equity holders increasingly diversified their portfolios, which led them to regard their shares as less risky and therefore more valuable.

Physics Envy

Why do so many people cling so hard to the notion of efficient markets? Andrew Lo, an economist at MIT, suggests that they may be suffering from a “peculiar psychological disorder known as ‘physics envy’…We would love to have three laws that explain 99% of economic behaviour; instead, we have about 99 laws that explain maybe 3% of economic behaviour. Nevertheless, we like to talk as if we are dealing with physical phenomena.”

There may be some truth in this. In 1947 Paul Samuelson, later awarded the Nobel prize for economics, set out to apply the principles of thermodynamics to economics. More recently, Bill Sharpe, another Nobel-prize winner for his contribution to modern finance, wrote an interesting paper on “Nuclear Financial Economics”, drawing parallels with nuclear science. This work yielded some useful insights, but left a lot of question marks.

Emanuel Derman of Goldman Sachs, one of the growing number of former physicists working in investment banking, puts the financial world’s physics envy into perspective. “There is no fundamental theory in finance. There are no laws.” In finance, he says, you are playing against people, who value assets on the basis of their feelings about the future. “These feelings are ephemeral, or at best unstable.”

The art (not science) of valuing shares may be getting harder because of changes in the nature of the economy, creating even greater scope for bubbles to form. When the bulk of a company’s assets were physical and its markets were relatively stable, valuation was more straightforward. Now a growing proportion of a firm’s assets — brands, ideas, human capital — are intangible and often hard to identify, let alone value. They are also less robust than a physical asset such as a factory. As Enron showed, a reputation for trustworthiness, and the market value resulting from it, can vanish in a moment. The dotcoms pushed this valuation challenge to extremes, often expecting investors to put a price on profits that would not be forthcoming for many years, and would be derived from business models and intangible assets such as brands that had not yet been created.

To Pop or Not to Pop

But back to Mr Greenspan. Messrs Smithers and Wright, having dispensed with market efficiency and established that asset bubbles are possible, next take issue with the Fed chairman’s belief that central bankers are supposed to control only inflation, not asset prices. They argue that the downside of a bubble bursting — possibly some combination of depression and deflation — far outweighs the cost of raising interest rates to stop the bubble forming in the first place.

The Fed does take asset prices into account in its policymaking, but only in so far as changes in them are transmitted to demand in the economy and thus potentially affect the rate of inflation. The likely transmission mechanism is the “wealth effect”. As share prices rise, people feel better off and spend more; as they fall, people feel poorer and spend less, reducing inflationary pressure.

In practice, Mr Greenspan has seemed to act on the wealth effect only after share prices have fallen. For instance, when prices tumbled after the collapse of LTCM, the Fed cut interest rates sharply, and shares started to recover at once. This has given rise to the notion of a “Greenspan put”: just as an investor can set a floor for the price of a security by buying a put option, so Mr Greenspan will provide a floor for the stockmarket by cutting interest rates when it gets too low for his liking.

Whether or not there is really a Greenspan put, there is certainly no “Greenspan call”, or ceiling on share prices that would trigger a rise in interest rates. Should there be? It would be a risky strategy. Typically, bubbles begin when something has happened to make people feel more optimistic about the economy — say the building of the railways, or hopes of a new economic paradigm. This optimism might prove quite persistent. Small rises in interest rates might not be enough to burst such bubbles. Indeed, they might reinforce them by creating small falls in prices that provide “buying the dip” opportunities. To be sure of bursting a bubble permanently, a central bank might have to impose huge rate increases, with unpredictable and potentially severe economic consequences. That would make sense only if it could be quite sure that it really had a bubble on its hands that needed to be pricked.

There are various guides for judging whether shares are overvalued, including the ratio of share price to earnings and Tobin’s Q, which shows the ratio of a firm’s market value to its book value. But the only time anyone can be reasonably certain that there has been a bubble is after it has burst, and e