A Paradigm Change for the Global Financial System

Sami Al-Suwailem

05 Apr, 2023

We cannot afford to keep stumbling from one crisis to the next

— Angela Merkel (2009)

The title of this article is the title of a speech delivered in the wake of the Global Financial Crisis of 2008 by former European Central Bank President Jean-Claude Trichet. Although his call was made 14 years ago, it seems as relevant today as it was then. To see why, we need to look at the nature of markets and banking.

From a realistic point of view, markets are about matching, while banking is about mismatching. The inherent incompatibility between the two explains, to a large extent, why market economies are repeatedly plagued with financial crises and credit crunches.

Markets are places where supply is matched with demand. Money itself is an ingenious invention for matching buyers and sellers. Trade brings value to both parties, so matching is instrumental in creating wealth.

Banking, in contrast, is built on mismatching. Banks borrow from depositors with the undertaking that their money is available on demand. And it uses depositors’ money in relatively long-term investments that are not available on demand. This is maturity mismatching—borrowing short and lending long and earning profit from the difference between the two rates.

A closely related form of mismatching is currency mismatching: Borrowing in one currency and lending in another because of the difference between the rates of the two currencies. Yet another form of mismatching is commercial insurance: Creating huge but uncertain liabilities funded by small but certain streams of premiums. Derivatives create all kinds of mismatching to generate as much profit as possible.

Mismatching, by design, creates imbalances. These imbalances cannot persist for too long—a correction must take place to restore balance. Unfortunately, the longer it takes to correct the imbalance, the more costly it will be. Mismatching, therefore, makes the system vulnerable and fragile. Even a minor shock can be amplified to become a systemic crisis. The system becomes “inherently unstable,” as economist Hyman Minsky famously described it half a century ago. Almost all financial crises in the post-WWII era, including the Debt Crisis of the 1980s, the Asian Crisis in 1997, and the Global Financial Crisis in 2008, are due to serious mismatching of one form or the other. No wonder mismatching has been dubbed “The Original Sin.”

Mismatching is essentially a zero-sum game. Matching, in contrast, creates value for the two sides of the transaction, and this contributes to the resilience and stability of the system. While technological innovations improve the efficiency of the real economy, they make the financial sector more volatile and less stable, as can be observed in the postwar performance of the US economy.

Mismatching was a major factor behind the Global Financial Crisis in 2008. In response, Basel III proposed some measures to guard against excessive mismatching and other related risks.

Despite the importance of these measures, they are not sufficient to eliminate the fundamental source of instability in the system. First, while some measures have already been adopted in the US, the complete Basel III standards will probably not be adopted before 2025.

Moreover, according to the Federal Reserve, the measures apply to “large banks.” The idea that only large banks, or “systemically important financial institutions,” can cause a systemic crisis is inconsistent with the architectural evolution of the financial system. Financial institutions create a surreal web of interconnections that are mostly incomprehensible due to the very nature of mismatching. If the entire system is built on fragile foundations, the collapse of even a mid-sized bank can trigger a major catastrophe, as became evident in the recent turmoil following the collapse of the Silicon Valley Bank in March this year.

Furthermore, Basel III applies only to commercial banks. A sizable portion of financial intermediation takes place outside the commercial banking sector. According to the Financial Stability Board, non-bank financial institutions account for about half of the assets of the global financial system. The assets controlled by the “shadow banking sector” are estimated to be around $226.6 trillion. These institutions tend to replicate the commercial banking model of borrowing short and lending long without the regulatory controls of commercial banks. Since these shadow banks are interconnected to commercial banks in many opaque ways, the risks can spread beyond the power of regulators.

In the current crisis, as in every crisis, there are incidences of mismanagement, fraud, and misbehavior. Such incidents also exist in the real economy but do not result in devastating consequences like in the financial sector. Behavioral errors are supposed to be self-corrected through the market mechanism. The fact that the financial industry cannot internally neutralize these errors except with additional regulations is clear evidence that the system is inconsistent with the logic of free markets. Imposing stricter regulatory measures while keeping the fragile foundation in place is likely to help only temporarily but make things down the road even worse.

“We cannot afford to keep stumbling from one crisis to the next,” former German chancellor Angela Merkel remarked in March 2009. We, therefore, need a paradigm change to redesign the financial system, as Jean-Claude Trichet pointed out. His advice is as valid today as in 2009: “We should correct the substantial flaws in the financial system that have now become evident.”

See also: https://blogs.isdbinstitute.org/us-banking-crisis/

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