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21 April 2009
Regulatory reforms that call for increased transparency in the global financial system may have the effect of increasing, rather than decreasing, the probability of financial crises in the future, Professor David Andolfatto, argued at a Macroeconomics Workshop at Deakin University.
“Changes to the regulatory structure governing the release of bank information will have to be thought out carefully. Economists have long known that legislation designed to elicit more information may be counterproductive. The key question, from the perspective of policymakers, should be which type of information to make public. Yelling “Fire!” in a crowded movie theatre is an example of the type of information that should likely not be made public.”
Professor Andolfatto, an expert on bank runs and banking stability from Simon Fraser University in Canada, told the workshop that the suppression of some information was an important stabilising factor in economic crises in the past.
“During the banking panics that occurred in the US National Banking Era (1863-1913), private clearinghouses would react to a panic by suspending withdrawals and issuing clearinghouse certificates that represented claims against an aggregated portfolio of bank assets. At the same time, they would suspend publication of information relating to the balance sheet position of individual banks that were members of the clearinghouse. This manufactured vagueness was clearly designed to prevent runs on individual banks and to stabilise the banking sector as a whole. A forced transparency policy would have prevented this from happening.”
Professor Andolfatto also remarked that US Federal Reserve Chairman Bernanke’s recent controversial policy of suppressing the identity of agencies making use of the Fed’s discount window constitutes another example of where less public information may serve the public good. In contrast, the recently introduced mark-to-market accounting rule may have had the opposite effect.
“The mark-to-market accounting rule is another example of where more information is not necessarily desirable. This is because when markets are not efficient, the valuation of illiquid assets according to market prices leads to large accounting losses giving the impression of insolvency. The ensuing fear this creates may actually help make insolvency a self-fulfilling prophecy.”
Professor Andolfatto also spoke at length concerning his views of the current financial market crisis.
“The proximate cause of this financial crisis lies in the rapid expansion of the so-called “shadow banking” sector over the last 25 years. This sector emerged largely as a private sector response to the rapidly increasing world demand for collateral assets. Since these collateral assets are not insured by the government, they resemble in many ways the private liabilities issued by banks during the U.S. National Banking Era. It is possible, therefore, that the emergence of this relatively unregulated sector recreated the conditions necessary for panic.”
As for policy advice, Professor Andolfatto maintains a cautious view.
“Central banks have reacted in a reasonable manner under difficult circumstances. I am less confident that the proposed fiscal stimulus policies will have their desired effect. Proposals to regulate the shadow banking sector need to be thought out carefully. After all, the response of our predecessors to banking panics was not to outlaw demand deposit liabilities. It was to facilitate the creation of riskless debt through insured demand deposits, combined with valuable bank charters and oversight. Some analogue to this is needed today.”
Professor David Andolfatto
Simon Fraser University, Department of Economics