Regulating our way to disaster
24 Mar 09
Leading economist Professor Avinash Persaud believes that the banking crisis has happened because of a fundamental misunderstanding of risk
Last night’s Aileen Beattie memorial lecture honoured the memory of ICAS’s much loved and highly respected former technical director with an interesting and provocative talk by Professor Avinash Persaud.
A leading economist and an adviser to the United Nations on regulation, Persaud’s main theme was “value”, a topic that has become controversial with calls from some institutions and politicians to suspend fair value accounting for financial instruments while the banking system is still in crisis.
Persaud argues that to suspend mark-to-market valuation (a key element of fair value) in a slump would be the wrong measure at the wrong time, but he also says that mark-to-market can be misleading too. The problem, he says, is a misunderstanding of risk itself, which had in turn led to a massive failure if banking regulation
I won’t be able to do justice to Professor Persaud’s analysis here, but essentially his argument is that risk is not integral to a given instrument. It has far more to do with the way the instrument is funded, or to put it another way, the capacity of the holder. For example, a pension fund able to hold an asset for the next five or 10 years does not have to worry so much about liquidity risk (the risk that the asset cannot be realised in the short term). For a bank funded day to day through the money markets, on the other hand, liquidity risk is a serious threat.
Persaud believes that mark-to-market should apply to assets funded with short term finance, while assets funded long-term should be valued using discounted cash flows. If the entity that owns the assets has a mix of funding, that should be represented proportionately.
Regulators didn’t understand this, Persaud says, and that – together with other misconceptions such as “larger markets are safer” and “transparent financial reporting will impose market discipline on the banks” – led to the mess we are in now.
Persaud’s analysis is fascinating and persuasive, although applying it in practice would be an accountant’s nightmare. You would have to analyse the holding entity's balance sheet and apply the percentage of long and short-term finance to all of its financial assets.
His commentary is also a timely reminder that, whatever politicians may like to focus on, financial regulation right now is not all about the size of bankers’ bonuses – or their pensions. It’s about imposing order on a potentially chaotic system and finding ways to stop the herd instinct of the market become a stampede of lemmings towards the cliff edge.