Have banks become big by selling snake oil? If so, do we stop them selling snake oil or should we stop them becoming too big?
Robert Shiller wrote a column in Monday's Financial Times arguing that standard economic assumptions about the corrective behaviour of markets do not hold when set against recent findings by behavioural economists. In short: so-called rational agents demand things they want and their collective wants determine an equilibrium price; but there are also times when individuals demand things that they 'think' they want, based on what others are demanding. In such situations, individuals could even end up paying for snake oil if they were convinced enough that others also found snake oil valuable.
Shiller, a Yale professor, argues that, despite buyers not being able to fully evaluate the quality of financial assets, the market has managed to sell the financial equivalent of snake oil because of how the psychology of 'animal spirits' affects economic behaviour. Stories of people making money on, say, securitised mortgages led others to buy and sell these products without proper due diligence. The influence of 'animal spirits' on economic behaviour results in crises on a regular basis. (Shiller is the co-author of 'Animal Spirits' (Princeton University Press, 2009) along with George Akerlof, who won the Nobel Prize in 2001 for his seminal work on asymmetric information in the famous 1970 article, "The Market for 'Lemons'".)
If the above is correct, then the question for a policymaker or a regulator would be either to ensure that snake oil (a.k.a. dodgy assets) is not sold or that no financial institution becomes so big that it has to be bailed out when its own balance sheet is full of snake oil.
Last Friday, I had the opportunity to be a fly-on-the-wall in a closed-door meeting of central bankers, senior investment bankers and policymakers from around the world. They were discussing what had brought the world economy to its current state, what rules would be needed to prevent this in future, and what institutional reforms were needed to govern the new rules. I cannot mention what was discussed, but later I had a chance to pose three questions that I think are also relevant in light of Shiller's column:
1. As a central banker/regulator, is there a rule/principle/trigger that tells you that a bank or non-banking financial institution has become 'too big to fail'?
2. If not, what kind of boundaries would you put around different activities of financial institutions so that insurance companies, say, do not become hedge funds or put their fingers in so many pies that it is hard to distinguish between legitimate and dodgy transactions?
3. And how is the situation further complicated when institutions that previously operated as investment banks have now become deposit-taking institutions?
What do you think? Since many central bankers have previously been investment bankers, I'd especially like to hear from my banker friends. Information asymmetries are always going to hamper oversight by external agencies. So, if you had the responsibility of overseeing a healthy financial system, what would your answers be? Would you look out for animal spirits (individual behaviour), would you look out for snake oil (dodgy assets/transactions) or would you look out for financial institutions that had become 'too big' too soon?