Knowing and Making

Robert Peston has an interesting insight into the financial regulation debate today: In other words, what's known as micro-prudential issues dovetail with macro-prudential issues. And if that's the case, it would make sense to put the central bank, the Bank of England, in charge of both. Or so the shadow chancellor believes. Intriguing. Indeed, it's true that there is a direct causal link between micro and macro behaviour in the financial markets. There are two reasons for this. First, the trivial one that all macro outcomes are ultimately caused by individual decisions. Second and more interestingly, one of the key influences on credit and asset markets is the appetite of individuals for risk. And a key factor in the stability of markets is whether these risk appetites are governed by rational preference theory and therefore have the ability to self-correct. In the long run everything (more or less) does correct itself, but an asset bubble and a financial crisis can easil...

Martin Wolf's article on Lord Turner's review is a good one (by which I mean, of course, that he agrees with me). He identifies irrationality as "the main analytical conclusion" of the report, but he doesn't take the next step of suggesting that it can be directly regulated. There are a range of interpretations of Turner's report. Some think his diagnosis was that banks are too thinly capitalised. Some that he condemns financial innovation. I think Martin Wolf has found the most important part: his conclusions about irrationality, both collective and individual. But while Turner has diagnosed the right disease, he doesn't propose a workable cure. To combat irrationality, he suggests a set of tools that work through rational means. Counter-cyclical capital requirements, leverage ratios, remuneration and centralised CDS clearance are perfectly sensible measures, but - like interest rates, the main tool of existing counter-cyclical policy - they work by mark...

Lord Turner's report " A regulatory response to the banking crisis " was released yesterday. One of the key findings is that markets, and market participants, can be irrational. This can lead to problematic outcomes such as bubbles in asset prices and massive mispricing of derivatives such as CDOs and CDSs. However, Turner's recommendations barely address this problem. There are several valid recommendations about procyclical reserves and a hint at a power to intervene in momentum trading (such as short-selling which feeds on itself). But this only dances around the edges of the problem. He also recommends technical training or qualifications for bank executives. But that's not where the irrationality is. Indeed, many bankers have been all too rational throughout this crisis - extracting rents for themselves at the expense of shareholders and creditors. Turner does recognise this principal-agent problem and some of his recommendations deal with it. However it is n...