Gordon Brown admits a mistake, but politicians now might be making an even bigger one

Gordon Brown has admitted that a mistake was made in the regulatory structure for financial services ahead of the crisis, principally in a failure to appreciate systemic risk.  He blamed pressures for less regulation from those concerned at the competitiveness of the City - despite the fact the problem was clearly the wrong regulation rather than just too little - and said that the same mistake was made by "just about everybody".  Is that true?  And, if we want to avoid future crises, where could the next mistake fall?

Here are a few of the mistakes that I would say were key to the recent crisis:

• Excessive optimism about the path of asset prices and particularly the sustainability of the boom in house prices and therefore mortgage backed securities.  Everything from bank strategies to the path of public spending were much too vulnerable to the property market getting in trouble.


• Insufficient appreciation of systemic risk.  Regulations were too focussed on individual firms ticking boxes to show that they were treating customers fairly rather than on factors that could lead to a broader collapse.  This is the mistake that Brown acknowledges.


• The euro.  Many of the smaller eurozone economies are completely in the tank but getting higher interest rates because they are needed by Germany.  They got in trouble because a then sluggish Germany needed lower interest rates that encouraged an asset boom when they were growing rapidly.


• The tripartite structure of financial regulation left the Bank of England poorly prepared for its lender of last resort role in a crisis.

Only the first was really a mistake that all of the main institutional players made and was reinforced by other mistakes like the procyclical Basel regulations.  The British Bankers Association were warning that regulation was insufficiently focussed on systemic risk well before the crisis.  Lots of sceptics, then derided by the likes of the Financial Times, argued the euro would be a disaster.  David B. Smith, now Chief Economist of the 2020 Tax Commission, pointed out the weaknesses of the tripartite structure.  There is more about how we got into the financial crisis in a report we released a couple of years ago.

More important than the old mistakes, are the new ones.

Over the weekend Ed Balls set out international agreement on changes to financial regulation as one of his "tests" for the chancellor.  He argues that is necessary to protect jobs and the competitiveness of the City.  A feeling that the City is resented and a target for ever higher taxes is driving investment and employment abroad.  I don't think reasonable regulation that is genuinely conducive to financial stability is nearly as problematic.  The real danger is in following the crowd and making common mistakes, not in standing out and trying to set a more reasonable course.

In a paper published with the Legatum Institute we looked at the dangers of the trend towards financial regulation being increasingly globalised.  There is a huge risk that everyone makes the same mistakes at the same time leading to global crises that are far more dangerous to the entire financial system, and create the risk of a collapse that drives future bailouts and recessions.  As we wrote in that paper:

"Common capital adequacy rules, while increasing transparency, also encourage homogeneity in investment strategy and undertaking of risk, leading to a high concentration of risk. That means that global regulations can be dangerous because they increase the amplitude of global credit cycles. If every country is in phase, systemic risk is higher than in situations where there are offsetting, out of phase, credit booms and busts in individual countries. The situation is akin to a monoculture, a lack of diversity makes the whole crop more vulnerable."

Gordon Brown has admitted that a mistake was made in the regulatory structure for financial services ahead of the crisis, principally in a failure to appreciate systemic risk.  He blamed pressures for less regulation from those concerned at the competitiveness of the City - despite the fact the problem was clearly the wrong regulation rather than just too little - and said that the same mistake was made by "just about everybody".  Is that true?  And, if we want to avoid future crises, where could the next mistake fall?

Here are a few of the mistakes that I would say were key to the recent crisis:

• Excessive optimism about the path of asset prices and particularly the sustainability of the boom in house prices and therefore mortgage backed securities.  Everything from bank strategies to the path of public spending were much too vulnerable to the property market getting in trouble.


• Insufficient appreciation of systemic risk.  Regulations were too focussed on individual firms ticking boxes to show that they were treating customers fairly rather than on factors that could lead to a broader collapse.  This is the mistake that Brown acknowledges.


• The euro.  Many of the smaller eurozone economies are completely in the tank but getting higher interest rates because they are needed by Germany.  They got in trouble because a then sluggish Germany needed lower interest rates that encouraged an asset boom when they were growing rapidly.


• The tripartite structure of financial regulation left the Bank of England poorly prepared for its lender of last resort role in a crisis.

Only the first was really a mistake that all of the main institutional players made and was reinforced by other mistakes like the procyclical Basel regulations.  The British Bankers Association were warning that regulation was insufficiently focussed on systemic risk well before the crisis.  Lots of sceptics, then derided by the likes of the Financial Times, argued the euro would be a disaster.  David B. Smith, now Chief Economist of the 2020 Tax Commission, pointed out the weaknesses of the tripartite structure.  There is more about how we got into the financial crisis in a report we released a couple of years ago.

More important than the old mistakes, are the new ones.

Over the weekend Ed Balls set out international agreement on changes to financial regulation as one of his "tests" for the chancellor.  He argues that is necessary to protect jobs and the competitiveness of the City.  A feeling that the City is resented and a target for ever higher taxes is driving investment and employment abroad.  I don't think reasonable regulation that is genuinely conducive to financial stability is nearly as problematic.  The real danger is in following the crowd and making common mistakes, not in standing out and trying to set a more reasonable course.

In a paper published with the Legatum Institute we looked at the dangers of the trend towards financial regulation being increasingly globalised.  There is a huge risk that everyone makes the same mistakes at the same time leading to global crises that are far more dangerous to the entire financial system, and create the risk of a collapse that drives future bailouts and recessions.  As we wrote in that paper:

"Common capital adequacy rules, while increasing transparency, also encourage homogeneity in investment strategy and undertaking of risk, leading to a high concentration of risk. That means that global regulations can be dangerous because they increase the amplitude of global credit cycles. If every country is in phase, systemic risk is higher than in situations where there are offsetting, out of phase, credit booms and busts in individual countries. The situation is akin to a monoculture, a lack of diversity makes the whole crop more vulnerable."