Can the Governments and regulators prevent the next crisis?

Recently I came across an article from Knowledge@Wharton. The article quotes two  professors: Wharton’s Peter Conti-Brown and Carnegie Mellon’s Allan Meltzer. I would like to highlight one point in particular that Prof. Meltzer talked about..

Meltzer noted that regulators failed to anticipate the 1929-1932 financial crisis and others that followed over the decades. “The whole idea that the government, the Federal Reserve or any other agency — clever, intelligent [and] smart people that they are — will anticipate the next crisis is very small,” he said. “It will come from a direction in which they are not looking. That is why crises blow up, because they aren’t looking in the direction where the crisis is coming from.”

Meltzer argued that regulation alone will not solve financial crises, and called for banks to have higher equity as a proportion of their total capital. “We can regulate the mistakes of the past; we can’t foresee the mistakes of the future …”

At the same time, they discussed that the only way is to increase the bank’s own capital. The skin was not in the game for the banks. Many banks were hugely leveraged. Though the banks are required to maintain a capital adequacy ratio, many banks took off-shore routes to register their SPVs (Special Purpose Vehicles) and heavily used derivatives. Lehman Brothers, the famous failure of the 2008-09 crisis had more than 50 times leverage.

There are so many instances referred in the book:

  • Benjamin Graham later said that the mistake was that he owed money.
  • The leverage at LTCM was way too high. At some point, it was more than 50 times the capital. Leverage can enhance returns when the cost of borrowing is lower than the return on investment. However, when the returns are poor, the cost and the liability of repayment can be detrimental.
  • Easy availability of cash (foreign capital, easy credit, leverage – in whatever form) is one of the common factors among all the market frenzies.
  • Leverage used to invest in illiquid assets also poses a risk. Once again, if you do not have an alternative cash flow and the asset is illiquid, repayment of borrowed capital becomes difficult.

I have just highlighted a few from the book.

Two important points here: Every crisis looks very different in the beginning. This happens since we keep looking at the events that happened without understanding the lessons. We keep looking for the old crisis to happen again from the same place. Government and the regulators are no different.

The crisis is not new. It just crops up from somewhere else.

#RidingTheRollerCoaster – 171

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