On Greenspan’s pandering and the example of Canada’s banking system

I was on Business News Network with Rob Cox of Reuters Breakingviews yesterday. We were talking to Howard Green about all things economic. The video clip is linked below. But let me say a few words about the discussion.

One of the two major topics of discussion was financial regulation and Alan Greenspan. As a jumping off point for the discussion, Howard noted some comments by Scotia Bank CEO Richard Waugh about the need for macroprudential regulation in banking in place of the formulaic Basel approach on capital requirements now taking form. Waugh said "the approach currently being taken is in danger of placing too much emphasis on overly prescriptive rules and requirements, which have never proven effective in preventing crises." He says, "the next crisis isn’t likely to look like the last one, and it’s impossible to design rules for every scenario. That’s why the focus needs to be on strong principles of sound supervision and risk management, not rules."

I agree with this statement. First and foremost, banking regulation is about sound macroprudential risk management.

Think of the regulator like a sports referee. If games are marred by heavy-handed refereeing, no one will want to watch. No one will want to play the game. Analogously, if you hamstring the financial system with overregulation, it increases the cost of capital and reduces the economy’s investment capital in a way that negatively impacts long-term economic growth. However, rules exist for a reason. The referee needs to enforce the rules or games would get well out of hand, with players committing fouls and engaging in reckless play. In a banking system with systemic risk that affects the entire economy, that reckless play leads to financial crises and economic depressions.

Sound macroprudential risk management then is first and foremost about creating rules for a safe business environment and then about enforcing those rules judiciously. You need good rules first and then you need good regulators to enforce them.

Alan Greenspan believes that we don’t need to enforce the rules. A lot of people seem to believe he had recanted his anti-regulatory  religious beliefs based on some more common sense comments he made in 2009. But, alas, he has not recanted. If you read his comments from 2009 closely, you will see that he is saying the same thing today that he said then.

• Oct 2009: Greenspan: "If they’re too big to fail, they’re too big” – “If they’re too big to fail, they’re too big,” Greenspan said today. “In 1911 we broke up Standard Oil — so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”
• Sep 2009: BBC News – In order to prevent the situation arising again, financiers and governments should look to clamp down on fraud and increase capital requirements for banks, the former central banker said.."The most recent endeavour to re-regulate is a reaction to the crisis. The extraordinary impact of these global markets is making a lot of financial people feeling they have lost control. "The problem is you cannot have free global trade with highly restrictive, regulated domestic markets."

Greenspan only seems to admit that self-regulation of fraud is preposterous. He was and still is saying that regulations are bad. This is how the BBC reported Greenspan’s view on his own personal responsibility for the crisis:

Mr Greenspan denied any responsibility for the problems gripping the global economy.

"It’s human nature, unless somebody can find a way to change human nature, we will have more crises and none of them will look like this because no two crises have anything in common, except human nature."

Essentially, Greenspan is denying that breaking the rules by exempting investment banks like Lehman Brothers from strict leverage ratios was a direct cause of the crisis. As we have seen during the credit crisis, this view should be entirely discredited as it leads to catastrophic outcomes. Everywhere, you have derivatives, these so-called financial weapons of mass destructions. Common sense would tell you that one needs to regulate closely how derivatives are used and which derivatives are permissible. It’s like children playing with fire. Without supervision, someone is going to start lighting dynamite and blow up the entire schoolyard.

At least Greenspan says breaking up the banks is a worthy solution to the problem. That puts him at odds with Scotia Bank which is saying that too big to fail is fine as long as regulators are on the job.

So what about Canada? They have big banks like BMO, TD, Scotia Bank, CIBC and RBC dominating the marketplace. Seemingly, they have avoided the worst of the crisis by focusing on good macroprudential regulation. You didn’t see the Canadian banks feeding at the Fed discount window like the European banks. And the Canadian banks are universal banks, meaning they take investment banking-style risk too.

f the U.S. did adopt a Canadian style banking model, the big American banks would be very large since the U.S. economy is ten times the size of the Canadian economy. What would that mean in terms of their ability to take on overseas assets? I see this as a philosophical divide between the emphasis on macroprudential regulation to control systemic risk and the emphasis on limiting bank size to do so. The U.S. is in the unenviable position now of having neither approach.

It’s too early to tell if the Canadian model works. Some people (like me) see a housing bubble in Canada driven by household sector leverage. Right now, there are predictions of a crash in Canadian house prices and the attendant household sector deleveraging. If that comes to pass, we will then see how the Canadian banks do. I should mention that the Canadian banks did not fail during the Great Depression as they did in the U.S.

Click on picture below for video.