The Financial Sector after the Crisis

When Italian Prime Minister Silvio Berlusconi announced Ignazio Visco as his pick for Governor of the Bank of Italy in October 2011, it came as something of a surprise. Berlusconi was under pressure from various ministers to pick their candidates for Governor, but he ended up picking none of their choices and going with Visco. Visco was the third-ranked official at the Bank of Italy before he replaced Mario Draghi when Draghi became President of the European Central Bank. Visco did his PhD at Penn and was chief economist at the Organization for Economic Cooperation and Development from 1997 to 2002.

Based on a lecture he gave in London earlier this month, Visco seems to be a wise choice. Visco's lecture, titled "The Financial Sector after the Crisis," is epically ambitious. The first section of the lecture is called "'Good' finance as a force for good." He is heavily influenced by Amartya Sen, whom he quotes multiple times. The first Sen quote, referring to finance, asks "How is it possible that an activity that is so useful has been viewed as being morally so dubious?" It is apparent that Visco has reflected on this question quite a lot:

One can detect cyclical patterns in the public’s attitude towards finance, affected by the conditions of financial systems and shifts in the political mood about state intervention in the economy. Until the 1970s it was taken for granted that market failures required the presence and response of a regulator to avoid suboptimal results. Then came the great inflation of the 1970s, combined with high unemployment, and the emphasis shifted to government failures. Governments, central banks and other regulators were blamed for failing to prevent these developments. This eventually led to an ideological swing: a push to reduce the extent of state intervention. The failures of the “regulated economy,” the pace of technological advance and the rapid expansion of international trade after the end of the Cold War fuelled a protracted process of financial deregulation that was halted only by the financial crisis that broke out in 2007. The latter triggered a move toward re-regulation – or better regulation – that is still under way. The pendulum keeps swinging and will certainly continue to do so. 

The global financial crisis, with its huge costs for the whole society, has caused a further deep erosion of the trust in financial institutions. Witness to this are the widespread protests against the financial industry, from the Occupy Wall Street movement to the “Indignados” in Spain and their counterparts in other European countries. Anger has been fuelled not only by the discovery of wrongdoings and perverse incentives, but also by a perceived lack of action against those responsible, in a context of exceptionally high remunerations. The integrity of financial intermediaries’ codes of conduct has been called into question under many dimensions: honesty, the ability to manage financial risks and the commitment to take care of the interests of their clients.

He also quotes Sen as saying that “finance plays an important part in the prosperity and well-being of nations.” He takes a long historical perspective on financial innovation, from the “letters of exchange” introduced by Italian merchants in the Middle Ages to today's structured finance products and originate-to-distribute intermediation model.

He recognizes that both the distrust of finance and its role in prosperity come from its complexity. He praises financial literacy efforts as a way to alleviate some of the public distrust of finance, but cautions that "as the case of Bernard Madoff and others in the US and elsewhere clearly show – this is no panacea (Madoff’s customers were surely much better educated than average). Therefore, for purposes of consumer protection in the financial services industry, financial regulation and good supervision are the necessary complements to financial education and inclusion." When it comes to regulation, however, he believes that "Complexity was also used, somewhat perversely, as an argument in favour of a sort of benign neglect on the part of regulators."

The big financial players argued successfully that financial innovation was too complex and too opaque for the regulators to get their heads around. Indeed, they said, to safeguard the international financial system from systemic risk, the main priority was promoting an “industry-led” effort to improve internal risk management and related systems. This, in a nutshell, was the view espoused by the Group of Thirty report following the outbreak of the Asian crisis. But this thesis was often accompanied by the argument to the effect that “you, regulators and supervisors, will always be behind financial innovation; it would be better to allow us, the big financial international players, to self regulate; we are grown-ups, we can take care of ourselves...” 

The difficulties in coordinating the regulators’ actions, in the face of a natural tendency to preserve each one’s particular sphere of influence, was a powerful drag on the ability to rise to the challenge posed by a finance gone global... The phenomenon of regulatory capture was a definite reality...Financial regulation and supervision have to keep pace with developments in the financial industry... The coordination of financial supervision across borders and across sectors is a key condition for the stability of the global financial system. More importantly, regulators and supervisors have to pay attention to keeping financial industry lobbies at due distance.

The next section of the lecture, "In search of a better regulatory and supervisory regime," is worth reading for a summary of recent reforms by the Basel Committee on Banking Supervision. But more interesting and surprising is the subsequent section of the lecture, "Observations on the analytical implications of economic and financial instability."  He describes, with more lucidity and in fewer words than I have heard before, the challenges of "non-ergodicity."

Changes in institutional arrangements, technological innovation and revisions in economic policy paradigms continuously reshape the framework in which economic agents (consumers and businesses) make their decisions...When there is marked discontinuity with the past, such changes may be far-reaching and the past fails to provide enough guidance for the present (never mind the future). We should always remember that the financial system is part of a richer social, economic and political environment... 

However, a stationarity assumption of sorts underpins our theoretical and statistical models, in the case of economic forecasting and (macro) policy making as well as in the case of financial analysis and risk management. In general, the basic tenet is that future outcomes will be drawn from the same population that generated past outcomes, so that the time average of future outcomes cannot be persistently different from averages calculated from past observations and future events can be predicted with a certain degree of statistical accuracy. In non-ergodic environments, on the contrary, at least some economic processes are such that expectations based on past probability distribution functions can differ persistently from the time averages that will be generated as the future unfolds.

In case of acute uncertainty, no analysis of past data can provide reliable signals regarding future prospects. The challenges posed by the non-ergodic nature of economic systems may be met by recognizing that our models are by necessity “local” approximations of very complex economic and financial developments.

In the above paragraphs he cites a 1991 paper by Paul Davidson, “Is probability theory relevant for uncertainty? A Post Keynesian perspective." He also cites Charles Kindleberger: “For historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways.” In conclusion, he adds:

This is not to say that all the analytical efforts of the past and the progress achieved should be disregarded. It means rather that in order to make the best out of them one needs to remember that models are by necessity “local” approximations to very complex phenomena and they should be used with good sense as a framework, not a straightjacket, for our decision-making. Quantitative analysis and modelling can also help to establish institutional and behavioural norms to rein in patterns of instability and developing proper learning devices to deal with major shocks and regime changes. In turn, models should take into account the impact of such norms on economic developments.