I have been discussing what can be learned from the Covid-19 financial market turmoil, already covering the official view, the socialist take, the libertarian conclusion and the crypto-technical utopia. I disagree with all. So what do I suggest?

We bail the financial system out every decade. The reason is simple: we want the banks and other financial institutions to take risk since the economy won’t grow without risk, and we don’t like that. We want the banks to make risky loans to small and medium-sized enterprises and take on the very maturity mismatches that allow us to make demand deposits that allow the banks to make 30-year loans. Meanwhile, safety is expensive, and we don’t want banking services to be even more expensive than they are now — the spread between deposit rates and lending rates should be as low as possible.

The end result is a financial system composed of levered intermediaries with a lot of liquidity and credit risk. And we like it that way.

With all of that risk comes a chance of things going pear-shaped, as they did with gusto in 2008. And, then the government has no choice but to step in and bail the system out.

It is not easy to do something about all these crises and bailouts because of the tradeoff between crises and growth. We can certainly make the system supersafe and prevent all financial crises, but that will make financial services prohibitively expensive and curtail growth. Risk will either be driven into the shadow sector or pushed out of the official sector altogether.

We can debate where the safety-growth tradeoff is, not that there is one.

I show the tradeoff in the following figure, what I call the regulation intensity pendulum:

In the years before the crisis in 2008, we generally opted for growth, not stability. The pendulum swung back after the crisis, but now with Covid-19 is yet again moving back.

Bailouts and regulations are inevitable. The taxpayer will be called on to assist, no matter how good the system is. We just have to find the best way to manage the cost.

To do that, the best place to start is asking the question of what are we trying to accomplish.

In a good system, the accumulated economic benefit should outweigh the cost of crisis intervention. In other words, a good policy goal is to maximise:

$\frac{\text{cumulative long run economic growth}}{\text{cumulative cost of crises}}$

And that means thinking both about the numerator and the denominator. The political leadership usually cares about the numerator, but the financial authorities seem to focus on the denominator. The FSB holistic document certainly does. All about reducing risk and reducing the need for intervention, more regulations and nothing about what we need the financial system for — growth.

Despite what one often reads in research papers and punditry on financial stability, the political power is very firmly on the side of growth, not stability.

The purpose of financial policy is to maximise that ratio, and if that entails accepting crisis, so be it.

And that takes me to what to do about crises. There are several competing narratives, as I discussed in my earlier pieces. To start with the three most political. I don’t think the laissez-faire view of no bailouts is credible, the politicians will be forced to bail out the middle class when things go wrong. Similarly, the socialist vision of a government run financial system will hold back growth, but crises will still happen. And the crypto-technical vision of either a cryptocurrency monetary system or a central bank digital currency is both inherently authoritarian and unstable, and hence undesirable.

And that leaves the current set up, and what to do with it.

There is a need for a central bank ready with liquidity injections and a regulator preventing the worst abuses in today’s financial system with its levered intermediaries and high liquidity risk.

And straying firmly into controversy, unlike so many other commentators, I think a key purpose of central banks is to help the financial system operate at higher risk levels than it otherwise could do. That is the best way to maximise the policy objective function.

How should we do that? One vision is expressed by the financial authorities in their FSB holistic document, and as I already covered that in an earlier piece, I don’t want to rehash it here, but to summarise the authorities’ view, at least as expressed in the holistic document, is:

1. Bring everybody under the same regulatory umbrella;

2. Every time a crisis happens, ratchet up regulations to close the loopholes;

The reason I don’t find this the best way forward is that:

1. Risk is progressively reduced — hampering growth;

2. Diversity is squeezed out of the financial system — increasing systemic risk;

3. The state is increasingly responsible for the financial system — asymptotically taking us to either a nationalised or lobotomised state-controlled private system.

So what to do?

I do have a whole book coming out on the subject, but to summarise.

#### 1. Aim for diversity

The most important way to achieve the financial system that helps driving growth without too many costly crises is diversity.

The more similar financial institutions become, the higher systemic risk is since then the financial institutions behave in the same way, amplifying the same shocks and inflating the same bubbles.

The antidote is diversity. To paraphrase Minsky,

Diversity is stabilising.

Unfortunately, diversity is steadily being eroded. Competitive forces drive mergers, and the financial authorities use mergers to contain financial crises. Regulations have an ever-increasing fixed cost and level playing fields, favouring the largest market participants, driving mergers and concentration.

So what can the authorities do? To begin with, don’t let the number of banks drop. A system with a handful of very large banks is not only much less diverse in a system with many small banks, these huge banks have a lot of lobbying power they can use to prevent competition.

It would be much better if the authorities actively encouraged different types of financial institutions. Do everything in their power to get new entrants in the markets. Create multiple categories of financial institutions, all with different types of regulations. Encourage alternative ways of financial intermediation that are not banks.

About a third of financial intermediation in the United States is made by banks, over 80% in the United Kingdom, 92% in Germany and 96% in Spain. The rest of the world is very much like Europe in this regard. The result is much less financing for innovative and risky companies. The cost of finance is very high, and it is very hard to regulate the banks without imposing significant economic costs. The stillborn European Capital Markets Union was meant to help, but the power of the incumbent interests was just too high.

OK, I suspect almost every policy authority would agree with the principle of institutional diversity, but most, if not all, don’t back that up in action. It is so incredibly hard to get the authorisation to create a new bank, and even harder to be allowed to set up a different type of financial institution, one that does financial intermediation but differently than banks.

The reason is an unholy alliance between incumbent banks and policymakers. The banks don’t want competition, and the financial authorities don’t want the extra work.

#### 2. Avoid regulating by riskometer

A few years ago, I came up with the concept of the riskometer, a device that when plunged into the bowels of the financial system pops out an accurate measurement of risk.

The riskometer is then a device akin to the thermometer that keeps the risk manager’s office at steady 22°C. I don’t want to go over the issues here, I did that in earlier pieces, for example, how easy it is to manipulate risk forecasts, and I did make recommendations on how riskometers should be used.

As I argued, the riskometer is a myth. There is simply no way of accurately measuring risk, and it is too easy to game the outcomes.

And, riskometers only measure the most visible risk. The risk we know about is the least dangerous type. If the stock market goes down by $200 billion today, nobody will care very much because it’s a known-unknown. Subprime losses were less than$200 billion in 2008, and it was almost like the world had come to an end — Unknown-unknown. We prepare for known-unknowns because that is the risk directly in front of us, while nobody knows about unknown-unknowns until it’s too late, so we can’t build resilience for what matters. By 2007, we become experts in managing the known-unknowns, which gave us the false sense of resilience that allowed the excesses that culminated in the crisis in 2008.

Modern financial regulations are founded on the riskometer. Measure all the risk that is possible to measure and sets rules to keep that in check. The problem is, along the way the policymakers may have fallen for the the McNamara fallacy.

#### 3. Don’t focus on de-risking

I have seen a lot of financial research where the author makes claims like: “The financial system is dangerous, I have identified the most important risks, and this is how you measure and control them. If you follow my suggestion, we meet our objective, which is to reduce risk.” In other words, they see the objective of financial regulations as — de-risking.

No. That misses the point The objective of financial regulations is not to de-risk, it is to help us meet our economic objectives: growth, savings, the environment, and the like. Risk, or the absence thereof, should only be judged in the context of whether those two objectives are met. We may even want instead to increase risk, just like after Covid-19, where economic recovery depends on the banks being willing to increase their levels of risk.

#### 4. Break up the silos

We should consider the entirety of government policies towards the financial system together. We don’t do that today. Policymakers live in silos. They care deeply about their corner of the world but are instructed to ignore the rest of the universe. They optimise locally, not globally, solving the problem inside their silos, not society’s overall objective.

To overcome the silo mentality, financial policy should be done globally, and the only authority who can make that happen is the government. It can mandate the necessary interagency and intersilo cooperation. The task is difficult. How do we allocate responsibility without setting boundaries, and then how to prevent these from creating silos?

And, perhaps most importantly, how do we avoid ending up with a single regulator with one rulebook that is anti-diversity in practice?

There are examples to follow, most importantly, Singapore, and there is no inherent reason why such global optimisation can’t be done elsewhere.

And, diversity makes the silos less damaging.

#### 5. Worry about the fundamentals, not the triggers

The number of fundamental factors causing financial crises is very small. Excessive leverage. The belief that liquidity infinite. Good control of visible risk while the hidden risk is ignored. Deep understanding and control of silos and ignorance of anything else.

There is an almost infinite number of triggers that push on these fundamentals. The same trigger one day could result in a crisis, and the next whimper out into nothing. Focusing on the triggers is counterproductive, leading to resources being wasted on irrelevance while we miss out on the more dangerous ones.

#### So…

There are no silver bullets when it comes to the financial system, as the Covid-19 financial turmoil illustrates so well. The very thing that brings all the benefits, all the risk and maturity mismatches and leverage is also what creates all the danger.

No matter what some think, it is not only impossible to prevent crises, trying too hard causes real damage. Crises will happen, and the only way to prevent them is not to have a financial system, but that means not having economic growth. It is much better to acknowledge that crises will happen, not try too hard to prevent them, but instead have the appropriate contingency measures. Hence, when the inevitable happens, we are prepared.

The strongest force of financial stability is diversity. When financial institutions are all different, seeing the world in their own way and reacting individually, then the aggregate behaviour is like random noise.

#### Thanks

Several friends and colleagues have commented on this series. Robert Macrae and Nikola Tchouparov gave me excellent comments that significantly improved the pieces. We don’t always, or even usually, agree, and all opinions are mine alone.