The pathologies that led to the global financial crisis of 2008-09 — the fact that we didn’t understand the interconnections that flawed the financial services sector — are still in evidence today. People still do not pay enough attention to the business models of the different institutions and the fragmentation, in terms of both understanding the problem and devising the response. There is great emphasis on individual parts of the problem that collectively do not constitute a solution.
It is interesting to observe the evolution of the financial services sector, the nature of financial architecture, as well as the inadvertent ways by which changes made after the crisis have benefited some groups and not benefited others. I have explored the evolution of the alternative investments world, which is the complement to the formal banking sector. All of that is really looking at the business models which led to the financial crisis, our responses to the crisis and asking what the next steps are.
The financial crisis was not the fault of a handful of greedy bankers sitting on Wall Street, nor was it a “black swan” event. It happened because a system was set up to implode. The subprime crisis, collapse of the collateralised debt obligation (CDO) market, meltdown of inter-bank lending and the need for massive government intervention were all predictable results of changes in business models and industry architecture – the “rules of the game” through which businesses interact.
With regulations favouring securitisation, we granted a massive subsidy to all things securitised. Basel (the global voluntary banking standard) and solvency (plus national legislation) put faith in credit ratings as a guide to how much capital to hold, or how much money to put in any type of asset, making ratings agencies the linchpin to pricing and setting demand for a host of financial products.
We had, and still have, no qualms about allowing these guarantors of quality to be paid by issuers, to be profit-maximising companies, and to suffer no penalty for getting it wrong. Throw in the desire to let financial innovations run unsupervised (legitimised by the moral imperative of neo-classical economics), however much they changed the balance between recognition of income and realisation of risk, and we had a recipe for evolutionary disaster.
Unfortunately, since then, rather than a systemic rethink of the financial services world, the past few years have produced a clutter of regulations, primarily intended to limit banks’ size and scope and increase buffers for capital and liquidity. This ignores the fact that a systemic crisis of confidence will test the limits of any buffer, no matter how big.
An important question to consider is – what should be the objectives of a renewed financial system?
First, it should provide an aggregate level of credit, effectively allocating credit to those who need and can repay it, and be resilient to crisis. This must be clearly laid out and the trade-offs between these objectives considered. In such a model, mainstream finance theory must be complemented with a better institutional model of the sector, as well as an appreciation of the behavioural predispositions of its actors. Regulators should familiarise themselves with the changing business models of regulated entities, and focus on governance. They should employ scenario planning to evaluate policy responses in context.
Regulators and institutions need to be much bolder in coming up with solutions and safety measures to prevent another crisis. The reality is that the current approach of piecemeal regulation is more likely to shift rather than reduce risk and recklessness.
Regulators and politicians find solace in the easy rhetoric of “good” versus “bad” banking. Yet they still allow ratings agencies to play the same role, with the same corrupting incentives, and let Basel III and Solvency II place their faith in them. This appears wrong-headed. Regulatory frameworks could use a blend of ratings and market and crowd-based mechanisms to establish credit risk and related capital requirements.
Speculators, especially short-sellers, could become useful signal-setters who help to spot fault lines. Rather than wishing them away, policymakers and regulators should consider how to use them to make the system safer. Regulation may seek to revamp governance, moving beyond banks alone. For instance, ratings agencies could be strengthened if their payment model was re-thought, and if they were partnerships with some liability, as opposed to publically traded companies.
What we need is a bolder approach: one that looks at the financial system as a whole and considers the right rules, roles and incentives to maintain stability. Changing regulators’ skillset is essential. More crucial yet is a frank debate about what type of financial service sector we want, domestically and internationally, and how to make it robust.
It is also important to up-skill and update regulatory bodies. At the local level, regulators tend to be underpaid, understaffed, and have limited understanding of business models. Traditional (“orthodox”) macroeconomists and finance theorists still dominate the debate, and regulators’ porousness to the sector has reduced.
Internationally, the Financial Stability Board should play a key role, yet is currently staffed by a part-time head and has limited clout over national regulators. Even if it had adequate resources (which is not currently the case), it would need a stronger direct mandate to match a situation where actors play globally and regulators answer locally.
Finally, banks and other participants in the sector react defensively, rather than pushing forward a discussion on the sector’s future. This needs to stop.
The current game of cat and mouse between regulators and regulatees is only weakening the system we are building, and making us oblivious to systemic side- effects. It is time for a serious, systemic rethink of the sector, focusing on how its business models operate, and an intelligible public debate on how to improve them for the good of society as a whole. Both are long overdue.
Michael Jacobides is a Sir Donald Gordon associate professor of entrepreneurship and innovation at London Business School
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