The Financial Turmoil

In the fifth year of a financial crisis, Europe is still trying to right itself, joblessness stays high in the U. S. , and China’s ability to escape the depression in the West remains an open question. The recent Libor scandal and the trading losses at JPMorgan have brought further unwarranted criticism for the banking industry. The increasing size and complexity of financial linkages between countries have increased the risk of rapid and simultaneous shocks between countries, with dramatic consequences for economic conditions. There will always be a next crisis

Crises continue to come, even with intense oversight exercised by the authorities. One reason is the natural tendency of government officials to fight the last battle, i. e. , looking for systemic weaknesses unfolded by the most recent crisis. Reforms are necessary; however, we cannot stop tomorrow’s crises by looking backward. Flaws in the regulatory and supervisory apparatus will be exploited in the name of innovation. Managers of financial institutions are always on the lookout for the boundaries defined by the regulatory apparatus, and the more detailed are the rules, the more ingenious is the avoidance.

These strategies will continue since this brand of ingenuity is handsomely rewarded. Our current economic regulations are not just neutral but they are outright perverse. If a bet with a positive payoff is available in exchange for a chance of crashing the bank and along with it the economy, it is the fiduciary duty of the executives to take this bet because it maximizes shareholder wealth. JP Morgan Chase, for instance, had predicted, to the tune of $100 billion that we are hurtling towards a financial crisis this year.

Its “London Whale” trade – a complicated $100 billion bet was designed “to make money for JP Morgan in a global credit crisis”. The bank was so positive that this systemic event would occur that it was planning to make money on it! More to RBI than just inflation targeting The RBI, as a supervisor, has expertise in evaluating the banking sector conditions, the payments systems, and capital markets as well. Such evaluations must be done very quickly when financial stability is threatened or when there is fear of the spread of problems in one institution.

In other words, appropriate actions require that bank supervisors and monetary policymakers internalize each other’s objectives and separation of duties makes this difficult. In their daily interactions with banks and other financial institutions, RBI needs to manage credit risk both in their lending operations and in the payments system. Central banks worldwide take on credit risk as the lender of last resort. To do so in a responsible manner, information about the borrower is needed, which is almost impossible without having complete and fast access to supervisory information.

The only insurer against liquidity risks is the RBI. If it does not control those who create credit and liquidity, it will continue to induce agents to create massive amounts of liquidity, thereby endangering the financial system. Operations in the middle of a financial crisis are quite similar to maneuvers during a war. Separation of supervision from the central bank is akin to having two generals with potentially different objectives and giving orders to the same army! What determines how we behave? It is not so much our attitudes, education or personal values, but the underlying environment in which we find ourselves in.

This influences our moves and behavior and so changing the underlying environment seems a plausible solution. And what constitutes our underlying environment? A major part is comprised of the prevailing culture and values in which we operate and our organizations’ purposes, goals and objectives, as well as the monetary and non-monetary incentives. The pressures to conform to what our peers or rivals are doing – and the time pressures we are subjected to – are all important constituents of the environment.